Australia's gas distributors are on the cusp of a managed decline. The recent announcement by the Victorian government to ban gas connections to new (yet to be approved) residential premises and public buildings from January 2024 does not immediately affect our view on the rated gas distribution networks in Australia. However, S&P Global Ratings believes the step reflects a new urgency to curtail residential gas use, which should gradually lower entities' regulated asset base (RAB).

This will likely require entities to gradually cut absolute debt levels, in our view, and build their credit metric buffers.

Victoria-based gas distributors have visibility on their cashflows for the next five years. New connections have been generally around 1%-2% of total connections each year and their contribution to additional revenues has been modest.

It is difficult to assume or predict the regulatory outcomes considering the transition risk.

Factors That Will Shape The Credit Effect For The Sector

Government policies and regulatory changes by the Australian Energy Regulator (AER) will signal the direction for the gas distribution sector. In our view, the following factors will influence the long-term industry risk and credit impact for the gas distribution sector:

• The pace of legislative changes and government policies to support the transition from gas;
• The regulatory response to the current and prospective legislative changes, and funding costs.
• Potential alternate use of the existing gas distribution assets;
• Pace of growth in renewable power to substitute gas for residential use;
• The financial strategy of the asset owners based on the above factors; and
• The investor pool for the sector.

While we do not expect these factors to affect ratings for the next five to 10 years, afterwards the effects could be meaningful. As gas volumes decline, business risks will rise, particularly if regulators do not implement offsetting measures or alternate use of pipelines does not emerge. It invites many questions about how the regulatory climate in Australia will adapt to the emerging changes, and we review these questions below.

The regulatory framework is a big factor in our assessment, and we currently assess the framework as highly supportive because it ensures full cost recovery including an adequate return on assets.

Policy Landscape Is Complex And Evolving

With Australia now marching inexorably toward energy transition, the legislative framework governing the gas sector will evolve. It is already leading to several legislative, policy, and regulatory reviews. Gas use differs considerably across the Australian states, and this will also shape the state policies, notwithstanding their current climate related targets.

The Australian Capital Territory (ACT) was the first to ban use of gas in new homes or connections from Jan. 1, 2023.

The Australian energy market operator (AEMO) estimates the role of gas across various eastern seaboard Australian states will diminish from 2035 (see chart 1). Given the heavy use of gas across a few states, we believe the transition from gas will be complex and unfold over many years.

The varied rate of gas use by purpose means state policies to move away from gas will also likely differ. For example, in 2022 Victoria's residential gas usage was about 60% of total gas consumed, compared with 40% in New South Wales and 5%-15% in Queensland and South Australia (see charts 1 and 2).

Industrial use in Victoria was about one-quarter of total use, compared with about half in New South Wales, and 70% of use in Queensland. With the exception of South Australia, gas used in generation is relatively modest at 10%-25% of the total across the eastern seaboard given the still large coal fleet in Australia and the rising role of renewables in the market.

Chart 1

Chart 2

The current focus is to reduce gas consumption at new residential premises and public buildings over the coming years. Some notable announcements on gas use include:

• Victoria's Gas Substitution Road Map, released in July 2022;
• National Construction Code for Residential Energy Efficiency, released in October 2022;
• Federal Government Electrification Program, issued in December 2022;
• The New South Wales Electrification Pilot Scheme, released in February 2023; and
• The Victorian government ban on gas to new residential premises and public buildings starting in January 2024, announced July 2023.

The states of New South Wales and South Australia, the other two heavy users of gas, have not announced any changes to gas use in their states yet.

The transition is coming, but slowly and with care. Victoria has nearly 5 million households on the gas network, and a high proportion of use is weather driven. Residential users can account for 60%-65% of gas used, compared with 25%-35% use by the industrial segment, and 10%-15% for generation. Space heating dominates in Victoria (and South Australia), where it is driven by cold weather.

Moving existing residential users away from gas will be complex due to the high number of users, the cost of changing gas equipment and appliances, consumer willingness to change, and large abolishment charges to permanently disconnect households from gas networks. While several subsidies and programs are being offered to move from gas, we have no concrete visibility on the take-up of these initiatives, nor their likely effectiveness.

Lastly, growth in renewable power across the national electricity market also depends on several large projects going to plan. The success (or not) of these projects will affect the affordability and reliability of electrification to support the transition from gas.

The Regulatory Reset Recognizes The Transition Risk

Regulatory support will be a major variable. How and when the AER responds to the emerging legislative changes, timeliness of cost recovery, tariff setting changes, and compensation for potential decline in gas usage will have a bearing on our assessment of risk to the rated entities. Importantly, if the various state policies are different, we will ask how will the AER incorporate the differences into its decision-making for assets in different states?

The AER recognizes the emerging risk for the sector and has incorporated few factors in the regulatory reset issued for Victorian gas distribution entities from July 2023. The AER has been guided by the various scenarios that the AEMO outlines in its Gas Statement of Opportunities (GSOO). The regulator also notes that, from around 2035, the rate of decline will likely increase but remains uncertain. The likely decline in gas use in Victoria is one of the factors considered. Other notable changes incorporated include:

• Declining unit consumption per customer and new connections to the network.
• Accelerated depreciation of assets to recover the investment over a reduced time frame.
• Lower capital investment relative to the prior five-year period due to fewer new connections.
• Allowances for abolishment costs where consumers seek to cease gas services.
• Entities will have some flexibility to spread the operating cost among the remaining customer base (read: socialization concept); this will offer some protection to firms' margins; and
• Tariff adjustment to recover cost to comply with the Commonwealth Government's Safeguard Mechanism, or the cost of complying with carbon emission permit costs.

In our view, the regulator could usefully address a number of issues in the rate-setting process, as this will drive the return on capital for the gas distribution sector. We expect visibility on these matters will emerge over next phase of reset, from 2026-2028. Key questions include:

• Will the regulator have to differentiate entities based on jurisdiction if the state policies differ in terms of gas transition?
• How fast should the assets be depreciated to account for increasing risks amid uncertain timelines for transition?
• If gas usage declines faster than expected, how would return on investments be protected and will there be reopeners in the regulatory process to adapt to changing circumstances?
• Technological changes can spur alternate use of the distribution network, and how will the regulator look at it?
• How will the risk of potential stranded assets be incorporated into the building block?
• If residential use declines, will the operating and capital cost of the network be socialized across industrial and commercial customers?
• Will the regulator look to compensate the sector for possible higher cost of funds due to perceived risk of transition? And if so, how?

Alternate Use Of Gas Distribution Networks Is A Possibility

Over the long term, hydrogen and biomethane are the most talked about alternate use of existing gas networks. We think this is too nascent to factor into our assessment, and for the regulator to consider.

Proponents of the fuel types have yet to definitively prove their economic viability, although we understand most of the gas distribution networks are ready to take biomethane and some percentage blend that contains hydrogen. Biomethane is a distributed source and getting it to the grid access points may be harder in less densely populated areas, while hydrogen will need more compression.

Neither hydrogen nor biomethane are produced in large quantities in Australia. Both are more expensive than gas or electricity, although technological advances will likely alter this calculation in the coming years. If commercial production of hydrogen were to increase, economic and carbon costs may dictate where it is used--in residences or in commercial/industrial sector.

Owners Prepare To Adapt To Evolving Regulations

Entities' relationship and collaboration with all stakeholders, including the state and regulators, will influence balance-sheet management. Management will have to deal with a likely rise in the appetite of debt investors toward green instruments, and a narrowing of the investor base interested in investing in the gas sector. Average debt tenors and risk premiums may change for entities.

Issuers will want regulators to compensate for such changing circumstances. Provided regulatory support keeps pace with the transition from gas, we do not expect a sudden or rapid decline in the cashflow profile of the rated entities over the next seven to 10 years.

Rated entities have decent headroom in their financial metrics to manage the transition (see chart 3). Importantly, the Victorian gas distribution assets of the rated entities form a portion of their portfolio (see chart 4). The diversity of assets offers protection to the rated entities and buys them time to manage their balance sheets.

Chart 3

Chart 4

Even so, the current high leverage and the fast pace of regulatory measuring in the sector mean that entities will likely begin debt cutting sooner than they had previously planned. This may be required to also manage covenants such as debt to regulated asset base should this asset base decline faster due to accelerated depreciation and reduced investment.

For now, even after providing for accelerated depreciation, the recently provided regulatory determinations for the Victorian gas distribution assets allow for a reasonable growth in the regulated asset base (see chart 5). This incorporates some allowances for new connections in Victoria and could restrain growth in the regulated asset base if some of the allowances are not spent.

Chart 5

Operators Aim For A Gradual, Comfortable Decline

Gas distributors have the rest of the decade to prepare for the potential transition. We see only a marginal impact over the coming five to seven years for the rated Victoria-based gas distribution entities. Gas distribution or transmission entities in other states will not be affected by the Victoria decision.

For the Victoria-based networks, the main effect will be limited to new (yet to be approved) connections, perhaps a cap on gas use, or a modest decline due to lower connections. Most gas distributors had anticipated a gradual decline in gas consumption over the coming years. This expectation comes amid a drop in building approvals, a soft economy, and fewer new gas connections following the release of Victoria's gas substitution map in July 2022. As such, some negative trends are factored into the recent AER's decision for the period 2023 to 2028.

The larger factor will be a gradual hit on the asset base. Reduced new residential/public building connections in the next five years will reduce the level of capital investment. While this might increase rated entities' free operating cash flows (after capex), this will result in lower growth, or a slow decline, in the RAB.

We will have to assess the business risk impact of this trend as it emerges more clearly, taking into account the regulatory revenues for future years and the balance-sheet management of each rated entity. We may gradually lift the metrics threshold for a given rating as the business risk changes. This perhaps will also make the financial decisions undertaken by the companies for the use of these excess cash flows over the next three-to-five years important for maintaining their longer-term credit quality.

Editor: Jasper Moiseiwitsch

Digital design: Evy Cheung

Related Research

• Energy Transition: Gas' Role Varies By Sector And Region Amid Security Of Supply Concerns, July 20, 2022