DALLAS – The wave of refundings for public power utilities is likely to slow over the next two years with an anticipated rise in U.S. interest rates, according to Fitch Ratings.
"Fitch Ratings forecasts that long-term US interest rates will rise over 100 basis points by the end of 2018," said Fitch managing director Dennis Pidherny in a sector report released Thursday. "In our view, a rise of that magnitude could reduce refunding volume and limit the budget headroom from which utilities have benefitted."
In the first half of 2016, more than half of bond issues from the water and power sector were refunding deals, Fitch reported, citing data from Thomson Reuters.
Of the $33 billion of issuance by municipal power and water utilities during the first half of the year, more than $16.8 billion of the proceeds or 51% were used exclusively for refunding. An additional $7.5 billion of proceeds or 23% were categorized as "combined" use, indicating that some portion was also used for refunding. By comparison, in 2010, only 21% of issuance proceeds were used exclusively for refunding.
The continuing low-interest-rate environment has proven opportune for utilities as they struggle to deal with new emission standards amid falling fuel prices, analysts wrote.
"The replacement and refunding of debt at lower rates has allowed public power and water utility issuers to reduce interest expense, thereby creating headroom to recover increasing costs related to environmental compliance, demand side management initiatives, resource acquisitions and the replacement of aging infrastructure, while limiting increases in rates for service," Pidherny said.
Lower debt service outlays have also helped water issuers manage budget shortfalls and recover fixed costs, as consumption patterns stagnated from ongoing appliance efficiencies as well as drought curtailments, Fitch added.
"Difficulties in recovering all costs stem from rate structures that traditionally have generated the bulk of revenues from customer usage, while the vast majority of utility costs are fixed in their nature," Pidherny said. "Together, the trends of declining debt service and greater revenue flexibility have broadly resulted in sustained improvement in financial medians in recent years."
Fitch expects the Federal Reserve to raise rates once this year and twice in 2017.
"Our forecast is for a US 10-year yields to reach 2.2% by the end of 2017 and 2.8% by the end of 2018," analysts said. "While these increases are manageable and would result in rates that are still near the low end of their long- term range, we believe the gains from refunding are finite and that even a small rise in rates could retard recent improvements and result in additional upward pressure on rates."
In a separate report on the sector, Moody's Investors Service forecast a stable operating environment amid sluggish growth.
"U.S. public power electric utilities continue to demonstrate a steady financial performance, according to fiscal 2015 medians data," Moody's analyst A.J. Sabatelle said.
"These financial results are likely to continue, given a relatively stable business environment that includes low natural gas prices and interest rates, flat demand growth and continued low borrowing," Sabatelle said. "These financial results are likely to continue, given a relatively stable business environment that includes low natural gas prices and interest rates, flat demand growth and continued low borrowing."
The main driver of the steady metrics is utilities' willingness and ability to increase rates when necessary, Moody's analyst said, citing a recent increase for the Los Angeles Department of Water and Power as an example.
"Even in the face of broad public discussion, utilities continue to implement increases in retail electricity rates to support operations," Sabatelle noted.
Renewable energy trends and the development of distributed power generation bring some uncertainty to the sector.
"The evolving potential of distributed generation, particularly solar energy generation and storage, presents a potential risk," Sabatelle wrote. "We believe this risk, however, is several years away partly because of the need to better develop the ability to store solar energy."
Looking to manage the risk, utilities with significant fixed costs with amortization of existing debt stretching 30 years are now evaluating the legal and financial aspects of their fixed cost recovery, analysts said.
"A significant loss of retail revenue, should more customers take advantage of distributed generation would have significant consequences for the financially stable public power electric utility sector," Sabatelle wrote.
