Credit metrics for the North American utilities sector are weakening, in part because of regulatory lag, major capital needs and macroeconomic pressures, according to analysts with Morningstar DBRS.
The cash flow to debt ratio on average for Morningstar’s rated issuers in the utilities sector fell to 14.6% last year from 16.6% in 2019, the credit rating agency said in a report released Wednesday.
Generally, utilities’ authorized return on equity has lagged recent increases in interest rates and inflation, the Morningstar analysts said.
“Furthermore, as regulators seek to balance utility investment needs and consumer affordability because of the current economic condition, this often exerts downward pressure on the ROE,” the analysts said. “Having a relatively low ROE compared with the actual cost of capital can directly impact credit metrics.”
At the same time, utility capital expenditure programs have reached “unprecedented levels” — up 10% to 20% from previous cycles — driven by initiatives related to climate adaptation, modernization and the energy transition, according to the report.
The analysts said in many cases the spending plans have led to net free cash flow deficits and the need for funding.
“We anticipate the trend of elevated capex and reliance on debt financing will likely persist over the longer term, further adding stress on the sector's financial leverage ratios,” they said.
U.S. electric investor-owned utilities spent $150.8 billion on capital investments in 2022, and the spending is expected to grow to $166.9 billion this year and $168.2 billion in 2025, according to a Feb. 20 presentation by the Edison Electric Institute, a trade group for electric IOUs.
On the macroeconomic front, the slower-than-expected easing in inflation has resulted in revenue shortfalls for some utilities because of a lag in incorporating up-to-date inflation factors in rate case submissions, the analysts said.
“Without mechanisms in place for interim rate adjustments or timely regulatory approvals, some utilities may struggle to cover increasing costs over an extended period,” they said. “Liquidity constraints could leave utilities more exposed to unexpected costs such as project cost overruns, extreme weather damage, and commodity price shocks if they cannot be passed through in a timely manner.”
There are several avenues for financial relief for utilities, including a potential stabilization or drop in interest rates, according to the report.
Also, many utilities are adjusting their rates to include their actual costs while government initiatives and subsidies to support electrification and grid upgrades will likely offset some of the capital expenditure burdens, the analysts said.
