Fitch Affirms PSEG and Subsidiaries; Negative Outlook for PSEG Power
A complete list of rating actions follows at the end of this release.
The Negative Rating Outlook for Power reflects Fitch Ratings expectation that credit protection measures will weaken over the next several years due to a more aggressive capex plan while EBITDA is pressured by weak merchant power prices and sluggish demand. Given Power's plan to invest $2 billion to expand its generation capacity, the amount of incremental debt issued over the next 12 - 18 months will be a key factor in resolving the Negative Rating Outlook. Fitch forecasts that Power's debt/EBITDA could weaken to 2.8x by year-end 2018 compared to 2.4x for the latest-12-months (LTM) ended June 30, 2016 with potential for further deterioration should energy prices and/or capacity revenues fail to recover. In any event, Fitch expects Power's ratings to remain solidly within the investment grade category if continued to be owned by PSEG.
PSEG's ratings and Stable Rating Outlook are anchored by the predictable operating earnings from its regulated business and its conservative financial strategy. Fitch's expects PSEG's credit metrics to remain commensurate with the current ratings through 2018, with adjusted consolidated debt/EBITDAR remaining below 3.5x. Despite a shared credit facility with Power, Fitch would be comfortable with a one-notch separation given Power's solid cash flow generation and ability to self-finance.
KEY RATING DRIVERS -- PSEG
The ratings on PSEG are supported by the credit profiles of its two principal subsidiaries: PSE&G, the largest regulated electric and natural gas distribution utility in New Jersey, and Power, a merchant energy company operating mostly in the eastern portion of PJM Interconnection LLC (PJM).
Conservative Financial Policies: PSEG's solid financial metrics reflect conservatively capitalized subsidiaries and modest parent-level debt. Fitch's base case scenario projects an increase in consolidated leverage, including incremental parent-level debt, to fund the elevated capex plan at both subsidiaries in 2016 - 2018 without equity issuance.
Incremental parent-level debt, while compatible with the current ratings, is a moderate credit concern. Fitch will monitor the amount of debt issuance. The agency anticipates that adjusted debt/EBITDAR will reach 3.3x by year-end 2018, compared with 3.0x at June 30, 2016.
Large Capex Program: PSEG's capex program is expected to total $11.5 billion in 2016 - 2018, including a peak of $4.4 billion in 2016, as Power expands its generation capacity by 1,800 MW and PSE&G aims to grow its rate base to $17.7 billion by year-end 2018. The extension of bonus depreciation and contemporaneous recovery on about 70% of PSE&G's investments partly offset the financial pressure of the planned capex investments on the capital structure.
KEY RATING DRIVERS -- PSE&G
Solid Financial Profile: PSE&G's ratings reflect credit metrics that compare favorably with Fitch' target ratios for the current rating level. While the planned capex program for 2016 - 2018 is elevated, Fitch expects adjusted debt/EBITDAR to remain around 3.0x over that period supported by the extension of bonus depreciation, contemporaneous recovery of the majority of investments and modest dividend payments. Fitch expects management to maintain an equity ratio of about 51% through 2018.
Large Capex Cycle: PSE&G is in the midst of an elevated capex program with $12 billion planned for 2016 - 2020, which should support an 8% compound annual growth rate (CAGR) of its regulated rate base during that period. The investment plan is centered on Federal Energy Regulatory Commission (FERC) regulated transmission projects, about 60% of the planned investments, as well as electric and natural gas infrastructure improvements. Capex plans also include further investments in energy efficiency and regulated solar projects.
Constructive Regulatory Environment: PSE&G's rate base is split roughly 45/55 between FERC and the New Jersey Board of Public Utilities, providing regulatory diversity despite the state-bound footprint. The FERC tariff structure offers comparatively high approved return on equity (ROE) at 11.68% and cash flow predictability with automatic annual updates to forward-looking rates, subject to an annual true-up. The regulatory construct in New Jersey is also supportive of the credit profile, with rider recovery mechanisms for the Energy Strong (ES) program and gas system modernization program (GSMP) as well as for investments in energy efficiency and renewable energy.
KEY RATING DRIVERS -- Power
Challenging Operating Environment: The primary credit concern for Power is its exposure to power price volatility. The operating environment for competitive generating companies is challenging, with abundant natural gas supply and energy efficiency initiatives constraining power prices. Upward price pressure from coal-fired asset retirements in eastern PJM has so far been negated by incremental gas-fired capacity and transmission lines. Forward power curves point to modest price recovery in PJM during 2017 - 2018.
Increasing Financial Leverage: The $2 billion investment to build three large gas-fired plants is weighing heavily on Power's credit protection measures. Based on Fitch' forecast for commodity prices, adjusted debt/EBITDAR is likely to reach 2.8x by year-end 2018, compared with 2.4x reported after second-quarter of 2016, and unlikely to improve until all new capacity becomes operational and capex investments abate. The higher debt burden will constrain Power's ability to make dividend payments to its parent and meet unexpected challenges in its operating environment.
Hedging Strategy: Power follows a three-year rateable hedging strategy to moderate its cash flow volatility. Power also benefits from having the majority of its capacity located in PJM and ISO New England Inc. (ISO-NE), where energy and capacity prices tend to be above other regions, and by its participation in New Jersey's Basic Generation Services auctions, which provides some stability to cash flows. Fitch would view positively the development of a competitive retail segment, as an incremental hedge to the long power position.
PJM Capacity Market Reforms: The roll-out of the capacity performance (CP) product in PJM, where the majority of Power's generating capacity is located, resulted in materially increased clearing prices during auctions held in 2015; however, PJM's subsequent revision of its load forecasting model, combined with new generation and transmission capacity, put downward pressure on clearing prices for the 2019/2020 delivery year. Fitch believes that PJM's transition to 100% CP product should support Power's capacity revenues in future auctions.
Favorable Competitive Position: Power's generation fleet is well distributed along the dispatch curve, with the nuclear fleet (approximately 55% of energy produced) likely to be dispatched under any price scenario. The generation fleet is concentrated in the constrained mid-Atlantic and New England markets and is close to load pockets, resulting in realized power prices slightly above that of the closest liquid hubs.
Fitch's key assumptions within our rating case for the issuer include:
--PSE&G: Earned ROE remaining roughly in line with allowed ROE in 2016 - 2018 through flat loads for electric and gas, tight O&M management and high proportion of investments in FERC-regulated and clause-recovered assets;
--Power: Energy prices in Eastern PJM and ISO-NE Connecticut of approximately $33/MWh and $35/MWh, respectively, for 2017 and 2018 (Fitch uses Wood Mackenzie as third-party consultant).
--Capacity revenues as per the results of auctions;
--Capex as per management's guidance for PSE&G and PEG Power;
--Debt financing and dividend payments balanced to maintain regulatory-approved capital structure at PSE&G (about 51% equity) and adjusted debt / EBITDAR at no more than 2.8x at Power;
--No equity issuance and 4% annual dividend growth at PSEG.
RATING SENSITIVITIES PSEG
Positive Rating Action: A positive rating action is unlikely given the elevated planned capex and significant exposure to the volatile merchant power sector.
Negative Rating Action: A change in financial management policies that incorporates a more aggressive use of leverage could lead to a rating downgrade. Ratings would be under pressure if adjusted debt/EBITDAR and/or FFO-adjusted leverage were to exceed 3.5x and 4.5x, respectively, for a sustained period. Fitch typically limits the notching difference between unregulated entities participating in a money pool to a maximum of one notch. Although not contemplated at this time, a downgrade of Power's Long-Term IDR below 'BBB' would likely trigger a ratings downgrade of PSEG.
RATING SENSITIVITIES PSE&G
Positive Rating Action: Fitch does not expect a rating upgrade as the large capex program will prevent, in Fitch's opinion, any meaningful improvement in PSE&G's credit profile. Positive rating action is also constrained by the 'BBB+' IDR on parent PSEG.
Negative Rating Action: Factors that could, individually or collectively, lead to a negative rating action include a rise in adjusted debt/EBITDAR above 3.6x and FFO-adjusted leverage above 4.5x on a sustainable basis. A change in regulatory policies that inhibits PSE&G's ability to earn a timely and adequate return on invested capital could also result in a rating downgrade.
RATING SENSITIVITIES POWER
Positive Rating Action: The Outlook may be revised to Stable if Power demonstrates a clear strategy to maintain its financial leverage at levels commensurate with its current ratings, including adjusted debt/EBITDAR of less than 2.8x. A positive rating action is unlikely given the inherent cash flow volatility of the competitive generation business.
Negative Rating Action: Low financial leverage is key to Power's ratings given the inherent operating risk of its merchant operations. Failure of power prices to rebound in Eastern PJM during 2017 - 2018, weak capacity clearing prices in forthcoming PJM auctions and/or elevated incremental debt issuance at Power resulting in forecasted adjusted debt/EBITDAR above 2.8x would lead to a downgrade. A downgrade of parent (PSEG) would also likely trigger a downgrade of Power. Any change in the current ownership structure could also lead to a downgrade.
PSEG, PSE&G and Power had sufficient liquidity and manageable debt maturity schedules at June 30, 2016. Liquidity was bolstered by debt issuances by Power and PSE&G earlier this year as well as a term-loan by PSEG in late 2015. Borrowings under the $4.2 billion syndicated credit facilities were modest at the end of second-quarter 2016, with nearly $600 million available under PSE&G's facility, $2.35 billion available under Power's facilities and almost $1 billion available under PSEG's facilities. All credit facilities are scheduled to mature between April 2019 and April 2020.
PSEG, Power and other unregulated subsidiaries participate in a money pool, while PSE&G does not engage in any intercompany borrowing or lending. PSE&G's credit facility, $600 million maturing in April 2020, serves as a backstop for its commercial program, while Power's $2.55 billion credit facility is primarily used to provide collateral for its forward energy sale and forward fuel purchase contracts. PSEG's credit facility includes cross-default provisions with PSE&G and Power. However, PSE&G and Power fulfil their respective financing needs without cross guarantees or cross-default provisions to each other or PSEG.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings with a Stable Outlook:
Public Service Enterprise Group
--Long-Term IDR at 'BBB+';
--Senior unsecured debt at 'BBB+';
--Short-Term IDR at 'F2';
--Commercial Paper at 'F2'.
Public Service Electric & Gas Co
--Long-Term IDR at 'A-';
--Senior secured debt at 'A+';
--Pollution control revenue bonds at 'A+';
--Short-Term IDR at 'F2';
--Commercial Paper at 'F2'.
Fitch has affirmed the following ratings with a Negative Outlook:
PSEG Power LLC
--Long-Term IDR at 'BBB+';
--Senior unsecured debt at 'BBB+'.