Fitch Ratings has assigned a 'AA' rating to the following bonds issued by the Sacramento Municipal Utility District, CA (SMUD).
Approximately $158.0 million electric revenue bonds, 2022 series J (senior lien)
Bond proceeds will refund outstanding 2012 series Y bonds; fund a potential termination payment for a swap entered into to hedge the interest rate on this anticipated refunding transaction; and pay issuance costs. The bonds will be sold via negotiated sale on June 8, 2022, subject to market conditions.
Fitch has also affirmed the following SMUD obligations at 'AA':
$1.97 billion electric revenue bonds (senior lien);
$200.0 million electric revenue bonds, series 2019A and series 2019B (subordinate lien);
Bank bonds corresponding to CP Notes, Series L-1, L-2, M-1 and M-2;
Issuer Default Rating (IDR).
In addition, Fitch has affirmed at 'AA' the following SMUD obligations issued by joint powers agencies (JPAs):
$101.2 million revenue refunding bonds, series 2015, issued by the Sacramento Municipal Utility District Financing Authority (SFA).
The Rating Outlook on all bonds is Stable.
The 'AA' rating reflects SMUD's very strong and stable financial profile in the context of its 'aa' revenue defensibility assessment and 'a' operating risk assessment. The 'aa' financial profile is expected to persist over the medium term, with leverage, calculated as net adjusted debt to adjusted funds available for debt service (FADS), remaining between 5x and 6x, which remains supportive of the rating.
Higher than anticipated costs resulting from the implementation of SMUD's ambitious 2030 Zero Carbon Plan, adopted in April 2021, could push operating costs higher as energy purchases increase from clean technology. However, Fitch anticipates that costs will be recovered in a timely manner to preserve the utility's financial profile, or the target date delayed if costs are significantly higher than anticipated.
The 2030 Zero Carbon Plan target date represents an acceleration of the trend already underway at SMUD, given the State of California's 2018 legislative requirement for utilities to reach 100% clean energy by 2045. SMUD generated 34% of its 2020 energy supply from California-renewable resources, with another 30% provided by carbon-free sources. SMUD's five natural gas-fired power plants remain an important source of capacity and flexibility. Strategies to replace or repower these plants with renewable energy and storage alternatives are under development.
SMUD is a community-owned electric utility district providing generation, transmission and distribution electric services to a 900 square-mile area that includes the City of Sacramento (the state capital) most of Sacramento County and small portions of adjoining Placer and Yolo counties. The district's approximately 650,000 retail customers are largely residential, commercial and governmental users with limited industrial exposure. SMUD is one of the largest public power retail systems in the U.S. in terms of total customers served.
As a municipal utility district formed under the California Municipal Utility District Act, SMUD is independent of the City of Sacramento and is not required to make transfer payments to the city or county of Sacramento. The board is responsible for rate-setting and all executive decision-making. The governance structure includes a seven-member board of directors, with members serving staggered four-year terms. Board members are elected by geographic ward within the service area. The board has shown a healthy degree of stability.
KEY RATING DRIVERS
Revenue Defensibility: 'aa'
Very Strong Revenue Defensibility and Competitive Rates
SMUD's very strong revenue defensibility assessment reflects its largely monopolistic revenue sources, independent rate-setting authority, highly competitive rates and very high rate affordability. Service area characteristics are strong, as evidenced by customer growth averaging 1% annually and income and unemployment levels in line with national levels. Unemployment levels increased notably above national levels at the height of the pandemic, but Fitch does not expect the temporary weakening to reduce the revenue defensibility assessment in the near term.
Operating Risk: 'a'
Low Operating Costs that Could Increase Over Time
The district's low operating cost burden of approximately 11 cents per kWh is supported by a primarily natural gas-fired, hydroelectric and renewable power supply. Owned and contracted hydroelectric resources remain valuable and provide flexibility despite variability in generation levels based on water conditions.
Costs could increase over the medium term, with SMUD's accelerated pursuit of a carbon-free power supply by 2030 to its retail customers. The 2030 target includes the planned retirement or repurposing of SMUD's five natural gas-fired generation plants. SMUD intends to procure replacement solar, battery, wind and geothermal replacement resources. These planned additions should enable SMUD's compliance with California's increasing renewable requirements.
SMUD's five-year CIP is estimated at approximately $2.1 billion, compared with $1.5 billion spent over the last five years. Capex beyond the next five years may increase further, as the incremental final steps needed to reach zero carbon by 2030 could be the most expensive.
Financial Profile: 'aa'
Very Strong Financial Profile; Stable Leverage Trend
SMUD's financial profile is consistently very strong, with Fitch-calculated coverage of full obligations above 1.8x over the last five years and robust liquidity. Leverage declined to 3.8x in 2021, from 5.0x in 2020, as a result of strong wholesale electric and gas sales. Leverage may return to between 5.0x and 6.0x in future years, which continues to be supportive of the rating.
Asymmetric Additional Risk Considerations
California's strict application of inverse condemnation poses an asymmetric additional risk consideration to credit quality. However, Fitch considers the likelihood of a massive wildfire event remote in the service area, and SMUD continues to take steps to reduce wildfire risk. The asymmetric risk does not currently constrain the rating.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Upward rating movement is unlikely. However, a sustained decline in leverage that persists through SMUD's pursuit of restructuring its power supply portfolio, without a material impact on operating costs, could result in an upgrade.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Leverage approaching 7.0x in consecutive years in Fitch's base and stress case scenarios, with no demonstrated trend of decline.
Political action that prioritizes the Zero Carbon Plan or rate affordability over preservation of the financial profile.
Prolonged slowdown in economic activity within the service area, resulting in weaker overall revenue defensibility.
Extraordinary wildfire liability that results in long-term dilution of the financial profile.
Best/Worst Case Rating Scenario
International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
The bonds are secured by net revenues of the electric system of SMUD. The senior and subordinate lien bonds are rated on par with the IDR given the very small amount ($200 million) of subordinate lien bonds.
Debt outstanding at SFA is rated based on SMUD's IDR as a result of the absolute and unconditional pledge of revenues from SMUD under its 2015 power purchase agreement with the JPA for all capacity, energy and environmental attributes of the Cosumnes Project. Ownership of four other natural gas plants was consolidated at SFA in 2021 from the four distinct joint action agencies that owned each of those projects previously. SMUD has similar, unconditional purchase power agreements with SFA for those projects, but there is no remaining debt associated with those projects.
SMUD derives the vast majority of its operating revenues from retail sales and other sources that Fitch considers to be monopolistic. Revenues from wholesale sales accounted for approximately 8%-9% of total operating revenues over the prior four fiscal years, but increased to 14% in 2021 with higher wholesale energy and natural gas prices. Wholesale revenues also includes the sale of solar energy at the projects and the purchase of replacement energy closer to Sacramento. Fitch views revenue defensibility as 'aa' given SMUD's practice of not including opportunistic wholesale sales in either its budget or rate-setting methodology, in addition to margins from those sales typically being a modest component of overall revenues.
Service Area Characteristics
The district benefits from a growing customer base in an economically sound service territory that includes the state capital. SMUD's service area has strong attributes with respect to customer growth trends, income levels and unemployment rates. Although median household income approximates national levels, the city's unemployment rate has historically trended slightly higher than the national average. The city's unemployment rate increased to 140% of the national average in 2021, but Fitch expects it to return to more typical levels as pandemic related shut-downs have ended.
SMUD has the independent legal ability to determine rates without being subject to external regulatory approval. Fitch views the district as having strong rate flexibility with competitive average retail rates that are very low, at 79% of the state average. The district's affordability level is considered very high, with an average annual electric bill equal to approximately 2.0% of median household income.
Recent Rate Changes
The district approved two rate increases in 2021: a 1.5% rate increase on March 1, 2022 and a 2.0% rate increase scheduled for Jan. 1, 2023. These increases follow multiple, small rate increases in 2019 and 2020. Additionally, commercial rates were restructured in 2022 to align to updated time of use rates, and higher fixed charge amounts and solar net metering charges were restructured to allow utility revenues to be neutral to the addition of new rooftop solar installations.
SMUD's ability to implement rate increases, as necessary, is important to maintaining adequate financial metrics and recapturing costs in a timely manner. Its rates should remain competitive following the expected rate increases and higher fixed demand charges added to the rate structure over the past decade should provide revenue stability in the face of declining per capital electric usage and energy efficiency progress.
Hydro Generation Adjustment in Rates
Due to the influence of hydro conditions on SMUD's cost of power and the lack of an automatic fuel cost adjustment in its rate structure, SMUD uses a Hydro Generation Adjustment (HGA) and an associated Hydro Rate Stabilization Fund (HRSF) to account for variations in hydro output. The calculation is performed annually by comparing actual precipitation to the median to determine the impact on budgeted commodity costs. During dry years, transfers are made from the HRSF to offset replacement purchased power costs. The transfers are reversed in wet years until the balance in the HRSF is equal to a cap of 6% of revenues. If the HRSF is depleted, the HGA will automatically increase to replenish the balance.
The HRSF has demonstrated significant volatility over the past several years due to the large swings in precipitation levels. The last significant California drought impact was evident in the HRSF's zero balance at the end of 2015. The HGA was applied to customer bills beginning in April 2015 at 1.3%. Wet conditions in 2016 allowed the district to replenish the HRSF and drop the HGA surcharge in April 2016. Additional transfers raised the HRSF's balance to a robust approximately $75 million prior to SMUD's transfer out of the HRSF of $19.1 million in April 2021 and $24.7 million in April 2022. The remaining balance is approximately $31.4 million, which should be sufficient to absorb another year of drought impact in 2023, should it occur.
The district's low operating cost burden as measured by total electric operating costs per kWh has been relatively stable, ranging from approximately 11.0 cents/kWh to 11.3 cents/kWh over the past three years. The stability of the district's operating costs reflects its diverse, predominantly natural gas-fired, hydroelectric, wind and solar power supply. The flexibility of the district's natural gas-fired resources has helped to offset cost impacts from the periodic droughts that lessen hydroelectric output.
Operating Cost Flexibility
Operating cost flexibility is neutral. The district's generation capacity in 2021 was predominantly natural gas-fired (33%), hydroelectric plants (29%) and short-term contracted purchases (24%). Renewable wind, solar and geothermal contracts provide the balance. This level of fuel diversity is relatively consistent with the energy supply in California that, with the mandated termination of coal-fired resources by 2026, has become fueled statewide predominantly by natural gas, hydroelectric generation and renewables.
SMUD owns or has contracted for 3,255 MW of generation capacity, which is sufficient to meet the 2020 peak load demand of 3,057 MW, experienced during the August 2020 heat event. SMUD did not have rolling blackouts during the heat event, as occurred in other areas of California. As a member of the Balancing Authority of Northern California (BANC), which operates as an independent balancing authority within the state, SMUD was insulated from requirements by the California Independent System Operator to shed load during the heat event.
SMUD's owned generation consists of the Upper American River Project (UARP; 685 MW), a series of hydroelectric facilities and storage reservoirs that received a 50-year operating license from the Federal Energy Regulatory Commission (FERC) in 2014; and the Solano Wind Project (average historical capacity: 120 MW). If the local natural gas generating plants, which are owned by SFA but are operated by SMUD and consolidated on SMUD's balance sheet (1,081 MW), are included, owned capacity rises to 58%.
SMUD maintains a comprehensive natural gas hedging strategy, given the district's reliance on natural gas-fired generation. Physical and financial hedging products are used to fix the price of the district's anticipated fuel supply by utilizing a layering strategy whereby the vast majority of the next year's fuel supply is fully hedged and a decreasing proportion of need is hedged two and three years out. This should provide some protection to the financial profile from the rapid increase in natural gas costs.
In addition to its hedging program, SMUD purchases biogas that produces eligible renewable electricity when used to fuel the natural gas plants. Biogas is typically generated by landfill gas methane collection. SMUD has used this supply since 2009 to generate renewable energy, and more recently, to make biogas sales into the market. SMUD has accumulated renewable energy credits that can be carried from year to year to meet California's renewable requirements, which provides flexibility in its use of the biogas supply in the near term.
Environmental Considerations and Clean Energy Transition
California's 100% Clean Energy Act was enacted in 2018 as the latest iteration of California's clean energy transition requirements. It requires California utilities to reach 100% clean energy by 2045, in addition to the renewable portfolio standard (RPS) requirements of 44% by 2024, 52% by 2027, and 60% by 2030. SMUD generated 33% of its supply from renewables in 2020 and is well positioned to meet the RPS targets with the renewable purchased power agreements being added in order to achieve Zero Carbon by 2030.
In March 2021, SMUD's board approved the 2030 Zero Carbon Plan that followed the board's climate emergency declaration in July 2020. The Zero Carbon Plan prioritizes reaching a carbon-free power supply by 2030 but also considers reliability and affordability. Specifically, the plan seeks to limit rate increases to no higher than the rate of inflation. Fitch views this type of rate limitation target as a moderating influence on the pace of execution, provided financial ratios are not compromised in the pursuit of the goals.
SMUD has not yet updated its integrated resource plan to provide an in-depth and long-range view of the power supply resources and technology that will replace current thermal assets; however, it is envisioned that two of the older gas-fired plants will be retired while the other three are potentially repurposed to run on cleaner fuel technology. SMUD currently estimates that the McClellan (72 MW) natural gas plant could potentially be retired in 2024 and the Campbell Soup (170 MW) natural gas plant in 2025.
Sizable additional carbon-free resources will be needed to replace the 24% of SMUD's capacity that is currently provided by short-term contracts. Capacity is becoming scarcer in the California market due to the state's increasing shift towards intermittent resources. The optionality around repowering the remaining gas plants to run on clean biofuels or hydrogen could be important from a capacity standpoint.
Capital Planning and Management
Fitch views SMUD's capital needs as borderline moderate to elevated based on the 15-year, Fitch-calculated age of plant. SMUD's capital improvement plan totals approximately $2.1 billion from 2022 to 2026 and is expected to be predominantly with internal cash and revenues and approximately 40% through debt issuance.
Planned capex averaging just over $400 million annually is higher than historical levels of around $330 million in each of the last two years. A portion of the increased spending was outlined in SMUD's 2019 integrated resource plan (IRP) to achieve California's various environmental renewable and clean energy objectives. Capex is expected for distribution system improvements, generation investments and the planned development of the Solano Phase 4 wind project. Following the next update to the IRP, expected in 2023, projected capex may increase given anticipated alterations to the generation fleet and projects designed to shape load requirements that will accompany the Zero Carbon Plan.
Fitch analyzes the district and other public power utilities on a cash flow basis, meaning that SMUD's recognition and deferral of revenues under the rate stabilization fund and hydroelectric rate stabilization are reversed to show actual revenues available to bondholders in a given year. For this reason, Fitch's calculation of SMUD's financial metrics will fluctuate more than those reported by the district, which defers and recognizes revenues to help smooth financial performance. In addition, Fitch analyzes SMUD's financial performance on a consolidated basis, including JPA debt outstanding related to the Cosumnes Power Plant, but excluding nonrecourse prepaid gas debt.
SMUD's financial performance has remained consistently very strong over the past five years, with high coverage ratios, sufficient liquidity levels and declining leverage metrics. Fitch-calculated coverage of full obligations is consistently strong at 2.0x or above in four of the last five years. Operating margins were particularly strong in 2021, up to 19% from 13%-15% in prior years. Wholesale electric and gas sales revenues increased with market prices. Leverage declined to 3.8x in 2021 but was very low and stable over the prior four years due to relatively stable outstanding debt, net pension liabilities and cash flow levels.
Reserves and Rate Stabilization Fund
Liquidity levels are robust at the district. SMUD had approximately $819 million in unrestricted funds, including $189 million in the rate stabilization fund and HRSF at the end of 2021. Combined reserves were equal to 247 days of funds on hand in 2021, which Fitch additionally factors into the leverage ratio as an offset to outstanding debt.
The district's liquidity policy includes maintaining at least 150 days' cash available. Fitch expects the district's liquidity level to fluctuate given the district's tendency to reimburse itself for cash-funded capital investments, but remain above the 150-day minimum policy. SMUD transfers excess revenues, when available, into the Rate Stabilization Fund (RSF) to offset the need for future rate increases when costs increase. SMUD has transferred funds into the RSF in four of the last five years and transferred funds from the RSF the other year.
Fitch Analytical Stress Test (FAST) - Base Case and Stress Case Scenarios
Fitch's analysis considered SMUD's financial forecast as a starting point for its FAST base case scenario. SMUD's 2022 financial forecast assumes flat retail sales trends, minimal annual rate increases, capital spending of approximately $2.1 billion over the next five years and new debt issuance of approximately $770 million (up from $350 million in the 2021 forecast). Key ratios are projected to remain in line with historical performance, although with leverage in the 5.0x-6.0x range, slightly higher than last year's indications. With potential for greater capex needs following the current five-year capital projections, Fitch assumes leverage will remain in the 5.0x to 6.0x range over the longer term.
Fitch's stress case scenario assumes a demand stress in the first two years, with recovery in the remaining three years of the stress case. Even with an assumed reduction in purchased power costs, there is tightening in coverage, leverage and liquidity in the stress scenario. Leverage may increase into the 6.0x to 6.5x range, but should remain supportive of the current rating. Coverage and liquidity levels should remain consistent with SMUD's financial policies of a minimum 1.5x fixed charge coverage and 150 days' cash on hand.
The district's debt profile is neutral to the rating. SMUD had approximately $3.0 billion of long-term debt outstanding on a consolidated basis as of Dec. 31, 2021, including approximately $2.2 billion in senior and subordinate electric revenue bonds, $101 million outstanding at SFA and $703 million of nonrecourse gas and commodity prepayment bonds. The SFA debt is the last debt outstanding related to any of SMUD's thermal generation plants.
The subordinate 2019 series A and B bonds were issued as put bonds, with the initial tenders scheduled to occur in October 2023 and October 2025, respectively, along with a final maturity date in 2049. The bonds are callable six months prior to the put date. Liquidity concerns regarding remarketing risk are adequately addressed by the district's cash reserves, available CP capacity and market access implied by SMUD's long-term 'AA' bond rating.
SMUD has a portfolio of five interest rate swaps, three of which are forward starting swaps in 2022 and 2023 that were put in place to hedge interest rate risk associated with planned refunding transactions.
SMUD decreased its CP program to $300 million from $400 million in February 2022 and supplemented liquidity with the addition of a $100 million revolving line of credit. There were no CP notes outstanding as of YE21, but the program is used periodically to finance capex and support overall liquidity. Remarketing of the CP notes is supported by two LOCs totaling $300 million, both of which terminate in 2025. SMUD's repayment of its CP obligations is subordinate to both the senior and subordinate lien bonds.
Asymmetric Additional Risk Considerations
Wildfires have been more prevalent in California in recent years and present an ongoing business risk. This year is poised to be a potentially active wildfire season given the ongoing drought and expected summer heat. California's application of inverse condemnation could result in a large potential liability to SMUD if its lines or operations are determined to cause or contribute to the wildfire ignition, even if SMUD is not found to be negligent or at fault in its operations.
The rating is not currently constrained by the asymmetric additional risk presented by wildfires and California's interpretation of inverse condemnation. Fitch views the occurrence of a wildfire event catastrophic enough to result in a massive liability event as a low likelihood event.
SMUD's service territory does not include an area defined to present a high fire threat, as established by the California Public Utilities Commission statewide fire map in 2018. However, certain hydroelectric projects and transmission facilities are located in elevated (Tier 2) and extreme risk (Tier 3) areas of the state. The district has additional exposure due to its indirect ownership of transmission assets through the Transmission Agency of Northern California (TANC), which cross both elevated and extreme risk areas of the state. Through direct transmission ownership and TANC lines, SMUD has exposure to approximately 150 miles of transmission lines in Tier 2 areas and 24 miles in Tier 3.
SMUD manages the general risk of wildfires through its ongoing investment in the highest risk areas, including increased vegetation management practices and situational awareness through additional weather stations, the installation of materials that reduce the risk of sparking, undergrounding of certain infrastructure, increased monitoring, de-energization of lines during high risk wind events, and the elimination of automatic circuit reclosers, in addition to other measures. SMUD has $250 million in wildfire insurance and available capacity under its CP program to manage potential future liabilities.
In addition to the sources of information identified in Fitch's applicable criteria specified below, this action was informed by information from Lumesis.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg