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Credit FAQ: Japan's Electric Utilities Need A Recharge

Japanese electric utilities' performance is deteriorating significantly.

Nine of 10 domestic major electric power companies (EPCOs) forecast weaker financial results for fiscal 2022 (ending March 31, 2023), due to rapidly increasing costs triggered by soaring fuel prices and a slide in the yen. S&P Global Ratings has a slightly negative outlook for Japan's major EPCOs. Seven of the companies have applied to Japan's Ministry of Economy, Trade and Industry (METI) to lift regulated electricity rates on households. If METI approves their applications in coming months, the EPCOs' performance is likely to improve considerably. However, public opposition to higher prices may lead METI to pare back or delay hikes.

Additionally, it is likely to take major EPCOs' much-deteriorated key financial ratios two to three years to recover to near their pre-pandemic levels in fiscal 2019 because their debt is likely to remain high.

In this report, we respond to questions many market participants have asked regarding Japan's major EPCOs, on topics such as prospects for their operating performance and credit quality; environmental, social, and governance (ESG) issues; and the cases of overseas peers.

Frequently Asked Questions

What is your view on the future performance and creditworthiness of major Japanese EPCOs?

Hikes are somewhat likely. We have a slightly negative view of prospects for the credit quality of major Japanese EPCOs. Their operating results and financial conditions have slid amid soaring fuel prices and a weak yen since 2022. The 10 major EPCOs' forecast net losses for fiscal 2022 total about ¥1 trillion. Japan's fuel cost adjustment system allows power companies to pass on the impact of fluctuations in fuel costs and foreign exchange rates to ultimate customers with a lag of three to five months. However, major EPCOs can't pass on all cost increases, having reached the maximum limit of the system. Another factor hurting their profitability is the changing composition of power sources. A widening gap is emerging between the current and past fuel source mix, the latter of which is the basis for EPCOs' price calculations. This makes it difficult to fully reflect cost increases to electricity bills. Low-cost nuclear energy remains unavailable because nuclear plants remain mothballed. Therefore, major EPCOs are procuring more energy from fossil fuel-based and renewable sources. However, fossil fuel prices are high and renewable energy prices are linked to prices in the wholesale electricity market, where prices have remained high and volatile.

How likely are electricity prices to be hiked?

Major EPCOs are likely to improve their performance considerably if METI approves applications to increase regulated electricity rates for households in the next two to three months. The seven EPCOs applying to METI want to raise electricity rates between 28% and 46%. Such price hikes would likely lift major EPCOs' aggregate net profits for fiscal 2023 to close to the pre-pandemic level of ¥430 billion achieved in fiscal 2019. We anticipate revision of electricity rates would also stabilize the EPCOs' profitability by eliminating differences between actual power source composition and those used for electricity rate calculations.

However, very negative public sentiment toward electricity rate hikes may lead METI to reduce price rises or delay timing of their implementation. Also, the Russia-Ukraine military conflict casts growing uncertainty over the industry's stable procurement of energy, creating geopolitical risk with both direct and indirect effects.

How do EPCOs' key financial indicators look?

Major EPCOs' key financial ratios, such as the ratio of funds from operations (FFO) to debt, have deteriorated significantly. We expect these ratios will take two to three years to recover to close to pre-pandemic levels. This is because major EPCOs' debts are highly likely to remain inflated. Their debts increased dramatically in the past one to two years due to much weaker operating performance and higher working capital amid soaring fuel costs. Meanwhile, they sourced fuels such as oil, coal, and liquified natural gas entirely from outside Japan. Additionally, working capital levels may not decrease much, because fuel prices are likely to remain elevated at least until 2024. We believe it will take time for EPCOs' debts to start declining, as the companies continue to face heavy capital expenditure burdens, such as for facility maintenance and updates, safety measures for nuclear power plants, and decarbonization.

What is the likelihood of extraordinary government support for major EPCOs?

We consider it highly likely that major EPCOs' business operations will continue to benefit from the regulatory framework, given the importance of stable electricity supply. We also think the Japanese government is highly likely to provide the major EPCOs with extraordinary support in times of financial stress. This is because they provide essential infrastructure for daily life, including exclusive electricity transmission and distribution operations. In 2021, we incorporated a greater likelihood of government support in our rating analysis of Shikoku Electric Power Co. Inc. (A-/Stable/A-2).

How do you analyze government support for them?

We consider the likelihood of government support in two broad categories. First, we incorporate benefits from the regulatory framework for the EPCOs' business operations in our stand-alone credit profile (SACP) of each entity. Then we add one to three notches to the SACP to reflect a likelihood of extraordinary financial support from the government in times of financial stress. Major EPCOs still have a monopoly in transmission and distribution in their home markets. They also provide infrastructure essential to people's lives and economic activities, with each controlling over 70% of its respective retail electricity market. We believe the government views EPCOs' roles as very important.

Since the March 2011 disaster at Tokyo Electric Power Co. Holdings Inc.'s (Tepco Holdings) Fukushima No. 1 nuclear power plant, the Japanese government, and other government-related entities such as the Development Bank of Japan have given special support to major EPCOs. Recipients of support have included Tepco Holdings (BB +/Negative/B), Kyushu Electric Power Co. Inc. (not rated), and Hokkaido Electric Power Co. Inc. (not rated) through the purchase of preferred shares. We believe this record demonstrates strong ties between major EPCOs and Japan's government.

How else do nuclear power plant operations affect ratings and ESG assessments, domestically and overseas?

Some nuclear power plants that have been idle for more than 10 years may resume operations earlier than we expected. This is because Prime Minister Fumio Kishida's administration is supportive of restarting nuclear reactors or extending their maximum lifespan. Among EPCOs we rate, we anticipate that Chugoku Electric Power Co. Inc. (BBB+/Stable/--) will restart its Shimane nuclear power station's No. 2 reactor in the next one to two years, following a resumption of operations at Shikoku Electric's Itaka No. 3 reactor. However, nuclear plant restarts in the next one to two years are unlikely in areas with an absence of local communities' consent. Thus, we do not assume power generation will resume at other nuclear plants in the next one to two years.

In our credit rating analysis, operating nuclear power plants hurt long-term creditworthiness of major EPCOs from environmental and social perspectives. Environmentally, nuclear power generation helps reduce carbon dioxide emissions, but it also generates other issues related to nuclear waste. From a social point of view, EPCOs' debts have increased substantially to meet stricter nuclear safety standards introduced following the Fukushima No. 1 nuclear accident in 2011. Additionally, their profits have become more volatile depending on the operating status of nuclear power plants. Nevertheless, we believe the support of Japan's government and regulatory benefits somewhat mitigate such negative factors.

We have downgraded overseas electric utilities that operate nuclear power plants when their business operations have become unstable and have weakened operating results and finances significantly. For example, in June 2020 and February 2022 we downgraded France-based energy company Electricite de France S.A. (EDF; BBB/Stable/A-2), which generates about 80% of its electricity using nuclear power. In December 2022, we affirmed EDF. At the same time, we revised downward our SACP for EDF to reflect weaker cash flows from continued hefty losses. At the same time, we raised our assessment of government support for EDF to reflect a stronger likelihood of the company receiving extraordinary support from France's government.

How do governance issues such as violations of antimonopoly laws affect ratings?

Japan's Fair Trade Commission (JFTC) is increasingly likely to slap Chugoku Electric with a record antitrust fine of some ¥70 billion. In this event, we may revise downward our assessment of the company's management and governance upon examining the details. However, this may not lead us to downgrade our issuer credit rating on the company if we consider the penalty's impact on its operating performance is temporary, considering factors such as company countermeasures to prevent recurrences.

We consider it necessary to review other major EPCOs for similar governance issues. Reform of Japan's power system began in 2016. It has promoted free competition through full liberalization of retail electricity and legal separation of transmission and distribution business to ensure neutrality of such business. Major EPCOs have had a virtual monopoly in their home markets for more than 60 years. Thus, they may lack awareness of regulatory compliance or adequate systems to ensure such compliance. In December 2022, JFTC notified Chugoku Electric, Chubu Electric Power Co. Inc. (not rated), and Kyushu Electric that it planned to fine them over ¥100 billion for forming a cartel in the sale of electricity to corporate customers. Kansai Electric Power Co. Inc. (not rated) was part of the cartel but was exempt from the penalties. Since the end of December 2022, EPCOs' retail sales units have on many occasions illegally accessed new power suppliers' customer information managed by their transmission and distribution units. Further violations of regulations, taxation, and legislation are serious risks that would materially affect the business performance and finances of companies, in our view.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Hiroyuki Nishikawa, Tokyo (81) 3-4550-8751;
Secondary Contact:Ryohei Yoshida, Tokyo + 81 3 4550 8660;

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