More residential energy consumers are turning to natural gas, but gas consumption growth is trailing the increase in customers due to energy efficiency and conservation, Fitch Ratings said. Still, the outlook for local distribution companies (LDC) is good, given an improved regulatory environment and the adoption of revenue decoupling and weather normalization mechanisms.
LDCs have typically enjoyed high investment-grade ratings, primarily driven by low operational risks, supportive regulatory treatment, favorable capital market conditions, and low commodity prices that alleviate pressure on customer bills and accommodate robust capex and rate base growth, Fitch said.
Gas utilities are usually allowed adequate return on equity (ROE) relative to their business risks and they have often been early beneficiaries of revenue decoupling or stabilization mechanisms.
“Fitch expects the divergence in customer and consumption growth to continue in the intermediate term, which underscores the importance of revenue decoupling, weather normalization and other rate-stabilizing mechanisms for LDCs to recoup their fixed costs, the ratings agency said.
Although authorized ROEs have continued to inch downward, Fitch research shows that gas LDCs typically fare better than their electric peers. Additionally, 38 states now have rate mechanisms that allow partial recovery of pre-approved pipeline upgrade and replacement costs between rate cases, according to the American Gas Association.
Despite all the attention authorized ROEs garner in rate case proceedings and the persistent trend of declining authorized ROEs, Fitch believes the regulatory environment for LDCs has improved over the last decade.
“Periodic rate-adjustment mechanisms that provide LDCs with timely recovery of a variety of operating costs have become increasingly common in various state regulatory jurisdictions,” Fitch said. “Thirty-two states have instituted either partial or full revenue decoupling or weather normalization mechanisms that insulate revenues from volume risk due to declining usage per customer or mild weather.”
The divergence of residential gas customer growth and gas consumption will continue to be a challenge for the sector, Fitch said. Natural gas consumption has largely lagged behind customer growth, primarily as a result of energy conservation and efficiency over the past decade.
Fitch said in a note Monday that it expects mergers and acquisitions activity to continue in the sector as gas utilities seek scale and diversify to offset muted consumption patterns and drive earnings growth. Aggressive valuations and increased use of debt in acquisition financing are credit concerns. Since 2010, the enterprise value/earnings before interest, tax, depreciation and amortization (EV/EBITDA) multiples for gas LDC acquisitions have often exceeded 10.0x. In comparison, electric utility transactions generally reflect 7.0x-8.0x EV/EBITDA multiples.
LDCs’ capex growth will continue to be robust. Fitch’s data indicates that aggregate capex will grow by 17% in 2015 following a 13% growth in 2014. Although current data suggests capex will decline in 2016, a likely scenario is that forecasts will be revised upwards for 2016 and beyond. Pipeline safety programs and aging infrastructure replacement are primary drivers of growth, supported by widely adopted infrastructure cost recovery mechanisms.
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