Operating a utility, whether it be electric, gas, or water, is one of the most capital-intensive businesses in the world. One of the primary mechanisms used by utilities to raise capital is the issuance of debt. But issuing debt does not come without risk, and in the United States, there are three primary credit-rating agencies (Standard and Poor’s (S&P), Fitch Ratings, and Moody’s) that are responsible for assessing a utility’s ability to service its debts. These agencies issue credit ratings, and in general, the better the utility’s credit rating, the lower the cost the utility must pay for issuing debt, reducing its cost of capital.

Given the highly regulated nature of utilities, particularly those that operate in markets that have not been subject to deregulation, the nation’s three credit-rating agencies have identified the regulatory framework in which a utility operates as a key risk factor when establishing its credit rating. Though each of the agencies defines regulatory framework a little differently, it typically includes the following factors:

• Timely Cost Recovery – processes are in place to ensure cost-recovery issues are resolved in a timely manner to reduce regulatory lag, and regulatory lag is minimized
• Transparency, Stability, and Predictability – regulatory process is well understood and consistently applied to all participants, and the outcomes (e.g., ROE) are relatively predictable
• Favorable Tariff-Setting Procedures – policies and procedures are in place to minimize the administrative burden and financial costs associated with setting rates (e.g., multi-year rate cases, use of riders to adjust rates outside of the formal rate-making process, automatic fuel clause adjustments, etc.)
• Independence and Autonomy – the level at which regulators are insulated from political and legislative interference

Key Details

• According to Todd Shipman, a primary credit analyst at S&P Global Ratings, “regulatory advantage is the most heavily weighted factor when S&P Global Ratings analyzes a regulated utility’s business risk profile,” and regulatory changes can “boost or lessen risk” based on the perceived impact of the change on the regulatory process
• In the past, Moody’s has indicated that for electric utilities, 25% of the total rating of the utility is based on the regulatory framework in which it operates
• When compared to electric and gas utilities, water utilities typically experience a lower level of regulatory risk

Implications

• Over the past several months, S&P had downgraded several utilities based on a perceived increase in regulatory risks:
  • Earlier this month (August 2016), S&P downgraded Southern Company and its utility subsidiaries, siting a “deteriorated regulatory environment” in the state of Mississippi driven by delays and cost overruns on Mississippi Power’s construction of an integrated gasification combined-cycle plant at Plant Radcliff
  • In June 2016, S&P downgraded Central Hudson Gas & Electric Corp. corporate credit and senior unsecured ratings due to “…average management of regulatory risk compared to peers.” The decision came days after the NY PSC commission approved three-year rate increases for two other electric and gas utilities
• Regulated utilities must recognize the impact the regulatory framework in which they operate has on their credit ratings and engage in activities to improve the regulatory climate. Specific activities may include:
  • Working with credit-rating agencies to better understand the specific regulatory factors that are impacting its credit rating
  • Establishing a collaborative relationship with regulators and other stakeholders (e.g., politicians, third-party interest groups, etc.) to ensure they are educated on the impact their rulings have on the fiscal stability of the utility and its access to capital
  • Establishing a comprehensive strategy focused on improving or maintaining the existing regulatory framework

More Information

SNL: How utilities manage regulatory risk major factor in S&P’s ratings, S&P downgrades CHG&E on average management of regulatory risk and S&P downgrades Southern, utilities

Fitch Ratings: Rating U.S. Utilities, Power and Gas Companies (March 11, 2014)

Moody’s: Moody’s Investors Service, Rating Methodology: Regulated Electric and Gas Utilities (Dec. 23, 2013)