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What's Behind Our Sector View

Our negative sector outlook reflects inflationary pressures that constrain rate-making flexibility and erode the financial performance of public power, electric cooperative, and municipal gas utilities.  NFP utilities' ability to adjust retail rates to recover rising costs--almost universally without regulatory oversight--is a cornerstone of our ratings analysis. However, retail electricity price inflation continues to outpace the broader CPI inflation rate, which constrains the ability to adjust rates to facilitate timely and adequate cost recovery, and erodes financial metrics. We view some rate-setting bodies' reluctance to adopt timely retail rate adjustments in line with rising costs as weakening the otherwise credit-supportive attributes we associate with autonomous rate-making authority. The trailing 12 months' electric retail rate inflation averaged 7.7% during the 35 months ended Nov. 30, 2024, compared with the CPI's 5.1% average increase. This contributes to creating barriers to rate adjustments and indicates that increasing costs of materials integral to system hardening, the energy transition, and load growth, such as iron and steel and labor, as well as debt, are outpacing recent years' fuel-price moderation (charts 2-4).

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Retail rates and financial metrics generally provide headroom to address elevated costs and maintain sound metrics; however, some NFP utilities' rates and service territory demographics limit or preclude rate increases.   Negative rating actions reflect a trend of delayed or diminished cost recovery. This is more pronounced among smaller utilities whose financial performance is more vulnerable to weakening as costs increase. Larger utilities that defer portions of cost recovery or place customers on payment plans tend to have greater financial capacity to absorb delayed or diminished cost recovery.

Financial performance and ratings on smaller utilities tend to be more sensitive to rising costs than those of larger utilities because smaller entities are frequently unable to socialize increasing costs as efficiently as larger systems. The median size of the 14 utilities on which we lowered ratings in 2024 was 13,888 customers. The median size of the retail electric NFP utilities we rate is 17,366 customers. Therefore, the prevalence of small utilities indicates the potential for credit quality erosion within the sector.

Our fixed-charge coverage (FCC) ratio remains more reflective of NFP utility credit quality than debt service coverage (DSC) or leverage ratios as utilities make environmental and load growth investments.   Two decades of stagnant electricity demand obviated the need for significant generation additions beyond the replacement of assets that had reached the end of their useful lives. The trend of limited generation investment needs has ended abruptly. To maintain resource adequacy, utilities are building and procuring new generation resources to respond to load growth associated with electrification mandates for transportation, homes, and businesses; prepare for the proliferation of energy-intensive data centers; and reduce emissions. The mismatch between the pace of the retirement of older, more emission-intensive generation assets and the installation of cleaner replacements compounds resource-adequacy exposure.

The American Public Power Assn. reports that only 28% of public power utilities own any generating capacity. Therefore, the lifeblood of many NFP utilities is found in power purchases through bilateral contracts, participation in joint action agency or generation and transmission (G&T) cooperative providers, and open market purchases. As utilities increasingly procure generation resources through arrangements with other suppliers, we view our FCC ratio, which treats portions of these power purchase costs as debt-like, as more reflective of credit strength than DSC or leverage ratios.

Although DSC and leverage ratios best capture the financial burdens of direct generation investments, we believe they do not adequately reflect indirect generation investment arrangements or provide comparability among utilities that invest directly in assets versus those that outsource all or portions of their supply function. Through the application of our FCC calculation, our analyses incorporate our view that portions of contractual payments to external generation suppliers are debt-like because they fund the suppliers' recovery of investments in power production resources dedicated to their purchasers. Therefore, we treat as debt service rather than operating expenses those portions of payments to power suppliers that represent suppliers' recovery of capital investments. Our FCC-centric focus also captures power procurement arrangements that reside beyond utilities' balance sheets and that are outside the scope of the leverage metrics we derive from the balance sheet.

We expect NFP utilities will continue to rely significantly on outsourced power supply resources, which accentuates the importance of our FCC calculation as a credit metric.

We foresee barriers to the president-elect's drive to improve near-term power sector economics.   During President Trump's first term, the Environmental Protection Agency (EPA) supplanted the Obama-era EPA's Clean Power Plan with the less stringent Affordable Clean Energy rule. Anticipating president-elect Trump's second-term agenda through the lens of his first term's regulatory actions and this past year's campaign rhetoric, we expect the incoming administration will dial back the EPA's most recent stringencies covering power plant emissions and generation byproducts, including the regulations embodied in the rules EPA finalized in April 2024. Yet, despite campaign promises, we do not expect revisions to the regulatory landscape will translate into material near-term improvements in electricity prices or enhanced rate-making flexibility.

In many respects, the near-term utility cost structure has been cast. Perhaps relaxing environmental rules will enable utilities to postpone retiring some coal plants to accommodate load growth. However, coal's contributions to U.S. electricity generation over the past two decades has significantly diminished to 16% in 2023 from 50% in 2004 (chart 5). Coal plant retirements and reduced dispatch reflect utility responses to environmental considerations and the weak economics of coal-fired generation relative to other resources. Therefore, except for highly coal-dependent utilities, it is unlikely that extending coal plant operations will profoundly influence electricity prices or forestall investments in alternative, cleaner generation.

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Factors that will more likely influence and add to utilities' near-term cost structures are the recent irreversible commitments many have made to build generation or purchase from other suppliers the output of gas-fired, wind, and solar fuel resources to prepare for compliance with the EPA's April 2024 generation emissions and byproducts rules and to position themselves to support load growth projections. Moreover, even if the incoming administration successfully relaxes environmental policies, utility management might nevertheless adhere to continued investment in decarbonization strategies that insulate operations from a potential pendulum of vacillating stringencies with each successive federal administration. We expect these strategies will perpetuate recent years' inflationary trends that are pressuring utilities' cost structures and retail rates.

On the other hand, because natural gas has displaced coal as the leading U.S. electricity generation fuel, a Trump-era regulatory environment that encourages fracking could benefit utilities and consumers by extending moderate natural gas prices based on ample supply (chart 6). However, retail electricity's inflation rate in recent years indicates that other utility capital and operating cost increases have more than offset declines in natural gas prices.

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If the incoming administration sets aside the EPA's carbon capture and storage (CCS) mandates, it could spare utilities and their consumers from the mandates' high costs. Utility-scale CCS has not been demonstrated as technologically or economically feasible on a commercial scale.

The anticipated relaxing of "beneficial electrification" mandates during a Trump administration could temper the cost pressures of upgrading generation and distribution networks to handle substantial additional electric loads, which could benefit utilities and their customers.

There is a caveat to the capacity of the incoming administration to shield utilities and their customers from increasing costs. Irrespective of whether the federal government institutes regulatory rollbacks, utilities and consumers could nevertheless continue to face increasingly costly electric service due to state-level and self-imposed environmental mandates. States, including California and New York, have adopted decarbonization goals that are more ambitious than federal mandates. Similarly, NFP utilities that have embraced self-imposed decarbonization targets that exceed state or federal mandates we believe will face added costs that their consumers will bear.

Therefore, it is our view that a litany of increasing operating and capital costs will perpetuate challenges in recovering those costs from customers at a time that consumers are saddled with rising non-utility costs. We view the amalgam of these utility and non-utility inflationary stresses as diminishing purchasing power, constraining rate-making flexibility, and negatively pressuring utility ratings.

The specter of tariffs and their effect on the capital-intensive utility sector remains uncertain.   President-elect Trump has reaffirmed a commitment to imposing tariffs on goods and materials the U.S. imports from several nations. Whether this stance represents posturing for negotiations with the leadership of target countries or is a harbinger of a definitive plan to impose tariffs is unknown.

Because the utility sector is in a build posture, the effects of tariffs might be substantial if construction materials are sourced from affected markets as utilities add generation and transmission infrastructure and upgrade distribution networks. Although China accounts for less than 1% of U.S. steel imports, almost one-third of U.S. steel imports comes from Canada and Mexico, two countries that feature prominently in the president-elect's sights. Therefore, tariffs might add to the costs of the foundational steel that underlies utility infrastructure projects. In addition, utilities could also face exposure to tariffs on myriad imported grid components, such as solar panels and transformers. Transformers have been in short supply for several years and their prices have increased substantially.

In December, President Biden issued an executive order that increased the tariff rate on Chinese solar wafers and polysilicon to 50% from 25%. These components are integral to solar energy development and energy transition objectives. President Biden's order appears consistent with the agenda that president-elect Trump plans to pursue. Although this action might spur domestic manufacturing by reducing demand for Chinese imports, many believe the order will make solar panels more expensive for utilities and their consumers.

Sector Top Trends

We continue to assess the divergence among autonomous rate-making authority and a willingness to raise electric rates.   When considering rate adjustments, rate-setting bodies governing wholesale and retail NFP utilities are increasingly attuned to affordability considerations and the financial strains facing consumers. Because consumers are simultaneously experiencing broad inflationary pressures, including retail electric rate increases, we believe the role of a utility's relative competitiveness compared with regional utilities is diminishing. Affordability is increasingly a paramount consideration. Therefore, relative competitiveness is no longer the strong pathway for garnering support for or diminishing opposition to rate increases that it had been.

Consequently, despite a need to respond to rising utility costs, some rate-setting bodies are delaying rate increases, adopting rate adjustments that are insufficient to support metrics at historical levels, or placing more customers on payment plans. Each of these actions could have negative cash flow implications and pressure FCC, liquidity metrics, and credit ratings. Small utilities have shown a greater susceptibility to these pressures.

The costs of reducing utility infrastructure's potential for triggering severe wildfires and the associated exposure to liability claims can materially erode financial performance and negatively affect ratings.   The EPA reports that climate change is prolonging the annual wildfire season in addition to increasing the frequency and severity of wildfires. Although wildfires occur most frequently in western states, the potential for significant wildfires spans the North American continent.

California's January wildfires highlight the substantial physical climate risks facing NFP utilities. To date, authorities have not identified utility infrastructure as a cause of the extremely destructive fires. However, if authorities determine that utility infrastructure triggered or amplified the fires, the already extensive harm to people and substantial property damage suggest that implicated utilities can likely face liability claims that meaningfully eclipse available liquidity and insurance coverage, which could catalyze steep negative rating actions. Even in the absence of assignment of fault, the revenue stream disruptions associated with customer sites that can no longer receive electric service and the capital costs of rebuilding damaged utility infrastructure, might materially weaken financial performance and credit ratings.

The costs of grid hardening to reduce utility infrastructure's potential for triggering wildfires compound the cost pressures of decarbonization initiatives and load growth investments. Electric utilities' possible exposure to substantial liability claims and the costs of mitigating exposure to them can aggravate negative credit pressures, especially in states with strict liability standards, like California. Sharply higher liability insurance costs and an inability to secure insurance in some markets add to the problem.

Data centers' surging demand will test NFP electric utilities' operational reliability and cost structure.   Power-hungry data centers are proliferating and adding to utility loads their accelerated servers that host energy-intensive artificial intelligence queries, data mining, and internet searches. In its December 2024 data center energy electricity consumption report, the U.S. Department of Energy (DOE) projects 2028 data center electricity consumption of 325 terawatt-hours (TWH) to 580 TWH, compared with 176 TWH in 2023. Consistent with the DOE's findings, the North American Electric Reliability Corp. has identified several U.S. regions where the grid is vulnerable to resource-adequacy deficiencies because of the interplay among load growth from data centers, electric vehicle adoption, the implementation of other electrification mandates, and thermal power plant retirements. Supply and demand imbalances lead to electricity price spikes and resulting unbudgeted utility operating costs can weaken financial performance and ratings.

Although data center demand for electricity will boost utility revenues, the generation investments needed to support the centers' increasing energy usage will create challenges that could overshadow the benefits of additional revenues. As utilities partner with data centers to develop the infrastructure that will support their substantial power needs, utility management will need to adopt cost-recovery frameworks that shield non-data center customers from cost shifting that exacerbates inflation's erosion of the rate-making flexibility that is integral to sustaining the financial metrics of NFP utilities.

The growth of data centers will also present utilities and the data centers with the challenge of adding and financing power resources that are consistent with these two sectors' pursuit of clean energy.

Increasing cyberattack threats can compromise operational and financial performance.   Geopolitical tensions enhance the attractiveness of the power sector to malevolent state attackers. Separately, hackers who act for economic gain might be attracted to the trove of consumer information that utilities possess. Power sector cyberattacks would not only disrupt utility operations but also economic activity and public safety that are inextricably linked to a reliable electric grid.

We believe utilities will need to spend more on cyber preparedness, including personnel, insurance, equipment, and software, which can weaken financial metrics and ratings. Some utilities, including smaller ones or those with less sophisticated management, might not be able to keep up with the latest cyber security measures and vulnerability to cyberattacks could create a meaningful credit risk. High-profile attacks such as those carried out by Volt Typhoon to infiltrate critical infrastructure in the U.S., including the power sector, highlight the continued need for vigilance in the sector.

In January 2021, President Biden issued an executive order rescinding the first Trump administration's order barring utilities from sourcing bulk power electric system equipment from countries viewed as potentially hostile to the reliability of the grid and national security. Implicitly, the Trump administration's order was intended to prohibit the importation of grid infrastructure from China, among other countries. Along with tariffs, if the incoming Trump administration resurrects his first administration's order covering foreign grid components, it could add to supply-chain bottlenecks and saddle utilities and their consumers with higher costs. Despite President Biden's 2021 order that opened the door to imports of grid components from China and other countries, some utilities are sourcing large power transformers and other components from countries other than China to avoid exposure to equipment that they fear might contain spyware or malware.

Ratings Performance

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