As part of our investment process, SNWAM analysts make weighting recommendations for each sector in the municipal bond market, in addition to reviewing each credit held in SNWAM managed portfolios. The public power sector was the focus of SNWAM analysts’ July municipal sector review. Based on our analysis of its credit quality, supply and pricing, we recommend a neutral weighting to the sector and have a stable credit outlook.
However, change is here! First, overall electricity consumption has been flat for some time due to greater efficiency from more combined heat and power utility plants coming online, higher federal appliance standards and adoption of metered rooftop photovoltaic power systems. These trends have resulted in the sector as a whole having flat to negative sales growth.
Second, natural gas has replaced coal as the major source of U.S. electricity generation (see graphic). Proven natural gas reserves in the U.S. set a record in 2014, which has pressured prices and made natural gas the preferred source of electricity generation. In addition, natural gas has a reduced carbon dioxide emission footprint relative to coal.
Third, distributed energy resources and generation present opportunities, challenges and risks. Distributed energy resources (DERs) are rooftop solar panels, windmills and on-site electricity storage. DERs are undermining the traditional centralized electricity model, while providing strength to credits backed by revenues from “the grid.” In addition, DERs are accelerating in states that have adopted aggregate net metering policies. California is a great example of where aggregate net metering policies allow new customer types such as multi-property owners or municipalities to install DERs. California has seen solar photovoltaic and wind growth displace all other forms of electric generation capacity (see graphic).
Finally, the Clean Power Plan (CPP) authorized under the Clean Air Act has set the stage for a long-term reduction in carbon dioxide emission and will drive future capital spending for new plants and emission reduction technology. The U.S. Supreme Court has granted a stay to the CPP, and oral arguments will be heard this September—but states like California are already moving forward with policies to meet or exceed the CPP goals.
Changes are here for the public power sector, and these changes are material. Fortunately, credits in the sector are well positioned. The most significant hedge to the sector trends is that publicly owned utilities have rate-setting power. This means that the power utility must set customers’ rates at a level sufficient to recover costs, to earn additional returns that maintain bond ratings and accrue reserves for upgrades and to build new facilities. Utility rates are usually set by a governing board like a city council, but in some cases the utility has unlimited rate-setting power. The rate-setting power of the publicly owned utility model is a very strong credit positive. We see this power in the balance sheets of our credits and in the sector. For instance, days-cash-on-hand on average exceeds 200, debt service coverage ratios (DSC) on average are steady at 1.6x (very strong credits have DSCs in excess of 2.5x) and overall debt levels are relatively low for a capital intensive sector. Overall, the tension between shifting sector trends, strong rate-setting ability and robust balance sheets supports our neutral sector weight and stable ratings outlook for the next 12-18 months.
Source: U.S. Energy Information Agency, California Energy Commission – 2016 Energy Almanac, SNWAM Research