Fitch Rates San Diego Gas and Electric Company's First Mortgage Bonds 'A'

Fitch Ratings has assigned an 'A' rating to San Diego Gas and Electric Company's (SDG&E) $800 million 5.350% issue of first mortgage bonds series ZZZ due 2053. SDG&E's Long-Term Issuer Default Rating (IDR) is 'BBB+'.

The Rating Outlook is Stable.

Key Rating Drivers

Largely Supportive Regulation: In Fitch's view, California's utility regulation is supportive. The California Public Utility Commission (CPUC) allows pre-approval of capital investments, bifurcation of general rate case (GRC) and cost-of-capital (COC) proceedings, forward test years, revenue decoupling and the use of balancing accounts to manage cost fluctuations and reduce regulatory lag. A GRC establishes multiyear revenue requirements, providing greater visibility of earnings and cash flow. A traditional GRC filing is still the primary recovery mechanism, which can be subject to lengthy review. However, rates are retroactive.

Lower ROE Credit Negative: In December 2022, CPUC issued an order that reduced the ROEs for all four investor-owned utilities by 25 bps while maintaining the 52% equity layer. SDG&E's new ROE has been decreased to 9.95% from 10.2% effective Jan. 1 2023 to Dec. 31, 2025, which may result in a $16 million reduction in 2023 revenue requirement. The ROE and equity layer remain higher than the national average. However, the change in ROE is negative from a credit perspective in light of the rising interest environment and higher operating risks facing California electric utilities.

Approximately 40% of SDG&E's rate base is regulated by the Federal Energy Regulatory Commission (FERC), which provides a 10.60% authorized ROE with a 56.34% equity ratio.

Wildfire Risk Mitigation: SDG&E's fire prevention and mitigation investments contributed to a strong safety record over the past decade. Investments include nearly 200 weather stations, a high-resolution camera network, proactive de-energization and one of the world's largest fire-fighting heli-tankers. These investments also help obtain favorable insurance terms and coverage.

The enactment of state Assembly Bill (A.B.) 1054 protects SDG&E against catastrophic wildfires at a reasonable cost. The legislation established an option to create a $21 billion insurance fund, split between the three investor-owned utilities and a bond issued by the California Department of Water Resources. Fitch views AB1054 favorably, but SDG&E's risk profile is upwardly constrained because the availability of the insurance fund is subject to mitigation effort and claims by other utilities. Additionally, inverse condemnation can still be applied in California.

Approximately 60% of SDG&E's system is underground. Senate Bill 884 was enacted in September 2022, which would expedite the process to permit utilities to place power lines underground, further reducing the wildfire risk.

2024 General Rate Case: In May 2022, SDG&E filed its 2024 GRC, requesting revenue requirements for 2024 and attrition year adjustments for 2025 through 2027. The requested revenue requirements for 2024 is $3.0 billion and the post-test year revenue requirement could range from 8% to 11%. A decision is expected in the second quarter of 2024; however, rates are retroactive to Jan. 1, 2024. SDG&E expects to submit separate requests in its GRC for review and recovery of its wildfire mitigation plan costs in mid-2023 for costs incurred from 2019 through 2022 and in mid-2024 for costs incurred in 2023.

Credit Metrics: SDG&E's credit metrics position it well in the rating category. In the last three years, FFO leverage at SDG&E averaged in the mid-3x. The credit metrics are expected to weaken due to high capex, but remain in line with its ratings. Fitch projects SDG&E's FFO leverage to average 4x in the next three years.

SDG&E has Environmental, Social and Governance (ESG) Relevance Scores (RS) of '4' for Exposure to Environmental Impacts and ESG RS of '4' for Exposure to Social Impacts. SDG&E's service territory is susceptible to wildfires, which could lead to potential adverse impacts to its relationship with ratepayers and regulators. The ESG RS scores are therefore relevant to SDG&E's credit profile in conjunction with other factors. Nevertheless, the wildfire legislations and SDG&E's robust wildfire prevention and mitigation measures alleviate the social and environmental impact.

Derivation Summary

The enactment of A.B. 1054 mitigates the regulatory risks associated with the recovery of catastrophic wildfire liabilities for SDG&E and other IOUs in California, such as Southern California Edison

(BBB-/Stable). SDG&E's exposure to wildfire risks is much less severe than its peers, due to its 60% underground distribution system, a smaller service territory, and robust fire prevention and mitigation programs.

SDG&E does not have material financial exposure from major fires in recent years, whereas SoCalEd faces significant financial pressure related to the third-party liabilities from several large wildfires in 2017 and 2018. SDG&E's historical credit metrics are stronger than its peers. Fitch estimates SDG&E's FFO leverage will average around 4x in the next few years due to a very large capex program. SoCalEd's credit metrics are projected to average 4.3x in the next three years.

Key Assumptions

Adopted the newly approved ROE 9.95% and 52% equity layer.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

A track record of successful implementation of AB1054 in providing appropriate cost recovery for SDG&E or its peers, combined with FFO leverage that is sustained below 3.8x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Major fires break out in SDG&E's service territory leading to substantially unrecoverable liabilities;

The implementation of the wildfire recovery framework is unfavorable in providing sufficient cost recovery in a timely manner; and

FFO leverage above 5.0x on a sustained basis.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate 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 four 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.

Liquidity and Debt Structure

SDG&E has adequate liquidity. It has a $1.5 billion five-year revolver expiring in 2027. As of Dec. 31, 2022, the revolver had $1.295 billion available. The credit facility has a rating-based pricing grid and limits debt/total capitalization to no more than 65%. Unrestricted cash balance was $7 million. Debt maturities are manageable in the next two years. $450 million 3.6% first mortgage bonds is due on Sept. 1, 2023 and a $400 million term loan is due in February 2024, both of which are expected to be refinanced.

Issuer Profile

SDG&E is a regulated public utility that provides electric services to a population of, at Dec. 31, 2022, approximately 3.6 million and natural gas services to approximately 3.3 million of that population, covering a 4,100 square mile service territory in Southern California, encompassing San Diego County and an adjacent portion of Orange County.

Date of Relevant Committee

29 March 2022

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.

ESG Considerations

SDG&E has Environmental, Social and Governance (ESG) Relevance Scores of '4' for Exposure to Environmental Impacts and ESG RS of '4' for Exposure to Social Impacts. SDG&E's service territory is susceptible to wildfires, which could lead to potential adverse impacts to its relationship with ratepayers and regulators. The ESG RS scores are therefore relevant to SDG&E's credit profile in conjunction with other factors. Nevertheless, the wildfire legislations and SDG&E's robust wildfire prevention and mitigation measures alleviate the social and environmental impact.

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