Fitch Ratings said Dec. 6 that it has affirmed certain ratings of PPL Corp. (NYSE: PPL) and each of its domestic subsidiaries, and also revised PPL Energy Supply‘s (PPL Supply) outlook to negative from stable.
Simultaneously, Fitch affirmed the stable outlook for all other domestic subsidiaries of PPL, including the heavily coal-dependent Kentucky Utilities and Louisville Gas and Electric.
The ratings and outlook for PPL, the parent, reflect its transformation from a company heavily reliant on commodity sensitive businesses to one that is highly regulated with substantially less business risk, Fitch noted. Driven by the acquisitions of Central Networks in April 2011 and LG&E and KU Energy LLC (LKE), the parent of Kentucky Utilities and Louisville Gas and Electric, in November 2010, regulated operations are expected by Fitch to provide over 75% of consolidated EBITDA by 2013. By comparison regulated operations accounted for about 30% of EBITDA prior to the two acquisitions.
Rising capital expenditures in PPL’s regulated segment pose a potential credit risk, Fitch added. PPL is investing heavily in its regulated businesses and expects to grow the regulated rate base by about 7.6% annually over the next five years. The investments will require on-going rate increases in both Kentucky and Pennsylvania and equity support from parent PPL.
Expenditures in Kentucky are primarily to install environmental upgrades on coal-fired plants to comply with new U.S. Environmental Protection Agency (EPA) standards.
In Pennsylvania the new investments are largely to replace aging infrastructure and for transmission upgrades.
The risks with this capital expenditure program are mitigated by regulatory provisions that provide near real time cost recovery of invested capital for about two-thirds of projected expenditures, including FERC jurisdictional transmission in Pennsylvania, environmental compliance in Kentucky and all capital investments in the United Kingdom.
Weak power prices a factor for PPL’s merchant segment
In PPL’s merchant power segment, a weak power price environment is the primary challenge in the next two to three years, Fitch noted. Also, several unplanned plant outages due to hardware failure adds more downward pressure and raises concern with regard to the chronic nature of these incidents. However, Fitch said it believes that the weak performance in this business segment is manageable for PPL as the segment becomes less critical to PPL’s consolidated financial strength going forward.
PPL Supply’s negative outlook reflects the expected decline in credit ratios over the next two to three years due to lower hedge prices and gross margin, despite anticipated deleveraging and modest capital requirements. The outlook also reflects Fitch’s concerns over plant performance and required compliance costs at PPL Supply’s nuclear Susquehana facility. The plant has experienced outages due to hardware failure in the past two years and is expected to receive a more permanent solution starting 2013, Fitch said.
“Given the importance of Susquehana to PPL Supply as a generation source (it represents 33% of power output in 2011), its performance is crucial to credit quality especially during the market downturn,” Fitch wrote. “Albeit to a lesser degree, the Negative Outlook also considers the uncertainty associated with safety related compliance cost. The weak positioning of PPL Supply in its rating category makes it vulnerable to any substantial compliance requirements.”
Fitch said it believes that over the long term, PPL Supply is well positioned to benefit from any power price rise associated with environmental compliance costs. It has invested heavily in pollution control equipment and its generating fleet is well positioned on the dispatch curve. Earnings and cash flow also benefit from operation of the PJM capacity market and the hedging policy that limits earnings volatility, Fitch added.
The ratings of Kentucky Utilities (KU) and Louisville Gas and Electric (LG&E) reflect strong credit metrics and constructive regulatory policies that limit cash flow volatility and business risk, Fitch said. The ratings also benefit from the Kentucky Public Service Commission’s (KPSC) track record for timely rate increases. Constructive regulatory policies include a monthly fuel adjustment clause (FAC) and an environmental cost recovery mechanism, Fitch said. Statutes also permit the inclusion of construction work in progress (CWIP) in rate base.
The ECR mechanism is particularly important given the two utilities’ reliance on coal generation and the substantial investment that will be required to meet EPA’s newest regulations. In June 2011, KU and LG&E filed an ECR plan requesting recovery of the expected $2.5bn of environmental compliance costs as well as operating expenses as incurred. In December 2011, $2.3bn of the plan was approved.
Additionally, the utilities’ results could benefit from a recent rate case settlement. If approved, it will allow for LG&E’s electric rates to increase by $33.7m and gas rates to increase by $15m and allow for KU’s electric rates to increase by $51m with a 10.25% ROE.