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Michael Ferguson, S&P Global Ratings

Rating US hydropower risk

Michael Ferguson (pictured), director, US Energy Infrastructure, S&P Global Ratings, writes that despite fears that Donald Trump's ascent to The White House could be a major blow to renewable energy, the US is currently experiencing a financing renaissance in one particular source: hydropower.

The recent election of US president Donald Trump has cast doubt over the country’s priorities for power generation and, not least, the future of the Obama administration’s Clean Power Plan. In particular, the appointment of climate change sceptics to key positions in Trump’s administration denotes a deviation from his predecessor’s commitment to reducing carbon emissions through a large scale shift towards renewable sources. 

Although hydropower’s future role in the US’s energy strategy is unclear, instead of a diminishing role, we expect the US’s 2,200 hydro facilities to remain resilient. Indeed, we are experiencing something of a renaissance for hydro asset financing – not least because recent transactions in the space have commanded substantial prices.

Such high multiples, we believe, stem from hydropower’s numerous advantages with regard to asset longevity, its low variable cost structure and, importantly, flexible generation capabilities that can meet changes in demand patterns. 

Donald Trump’s ascent to the Oval Office does not represent the beginning of the end for hydro assets – instead, we believe the renaissance will likely continue. With this in mind, we aim to address questions around how we assign ratings to this asset type. As such, we place significant focus on the asset age resource risk and whether the plant enjoys sufficient liquidity features, such as access to revolving credit facilities, in order to determine the accurate level of risk for infrastructure investors. 

While mass hydro plant closures in the foreseeable future remain unlikely, the construction of new hydro assets is impractical in the US due to siting and planning concerns and, not least, the large capital costs during construction. 

That said, any suggestion that political shifts could alter hydropower’s significance is somewhat overstated given most of the US Northwest is dependent on hydropower, especially with large coal retirements already planned in Oregon, Washington and Idaho. Indeed, any of the aforementioned risks to hydropower have not prevented a flurry of capital injection to improve and rejuvenate the country’s existing portfolio. For instance, between 2005 and 2013, more than USD6 billion of capital spending contributed to upgrading the US’s hydro fleet’s capacity by nearly one and a half gigawatts (GW), and we anticipate seeing similar spending during the next decade. 

So, why has this hydropower resurgence occurred? The key advantages are the resource’s very long asset life and its comparatively low variable operating cost, as well as its ability to capitalise on pricing peaks. 

From the 6.8 GW Grand Coulee Dam on downwards in size, the majority of North American assets have either eclipsed or are approaching our presumed asset lifespan of 50 years. Such project longevity provides one crucial advantage to energy ratepayers: insulation against a volatile commodity price – both in terms of power pricing and capacity costs. 

In this respect, we expect hydro financing to remain robust in the face of any exogenous political or market forces. The more pressing question, however, is how to accurately ascertain the credit risk of US hydropower assets. 

Of course, with hydropower facilities’ unique characteristics in mind – notably, their advancing age and potentially substantial capital expenditures – achieving an investment grade rating criteria can be challenging without appropriate risk mitigants. 

To assess these risks, we do not forecast how long a plant might operate in a vacuum – but how its cost-effectiveness and performance could change in the long-term and how likely it will remain financially economical in the wider marketplace; this is a key component of assessing refinancing risk. 

Thankfully, with few newly-constructed hydro assets in North America to consider, many plants have a comprehensive and lengthy track record – some of which have decades of hydrological data available to determine what constitutes either a high or poor performance year. 

Complicating this, however, is that certain regions of North America – particularly on the West Coast – are experiencing meaningful year-to-year variations in water levels on a magnitude that can affect the asset’s debt service coverage ratio (DSCR). In order to mitigate this challenge, S&P Global Ratings will assess the degree to which a hydro generator will reserve part of its capacity in order to gird against underperformance during periods of peak usage. 

For hydro assets, which are typically burdened by seasonal water levels, fluctuating cash flows are a concern. Often, hydro assets utilise longer debt service reserves of around a year – while six months for investment grade project finance is a market standard. What’s more, in order to protect against unexpected – and often substantial – maintenance costs that accompany ageing infrastructure, an idle revolving credit facility is available that, if necessary, that could cover the plant’s operating costs for one year. 

Of course, while unfavourable market conditions, such as the current lower gas and power price environment, have dampened hydro’s relative profitability and cash flow, hydro facilities are able to survive slump periods in the commodity cycle and retain profitability in the long-term. And as we move into a period during which demand patterns could become less predictable, hydropower’s operational flexibility will be crucial to meeting unexpected spike or troughs in future energy demand. 

With this in mind, although the election of Donald Trump may change the Clean Power Plan’s course, the favourable economics of hydro generation coupled with the market’s willingness to support upgrades are continuing unhindered. In terms of hydro assets’ future, we believe that the ongoing financing renaissance is a promising signal.

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