DBRS Morningstar: Evaluating the credit impact of low-carbon alternatives on P&M energy companies

The move by North American pipeline and midstream energy (P&M) companies to invest in low-carbon businesses and activities represents a strategic response to increasing environmental scrutiny and a concerted effort to reduce green house gas (GHG) emissions.

While P&M companies continue to invest in maintaining and growing their existing assets, the challenges in obtaining approvals for new conventional pipelines are also influencing their foray into low-carbon businesses. Moreover, the recognition that fossil fuel consumption, especially in North America where most of the P&M companies rated by DBRS Morningstar are currently located, will decline at some point over the next couple of decades is another contributing factor. In this commentary, we provide an overview of the new low-carbon businesses that P&M companies are evaluating/investing in and outline the possible credit considerations of these investments.

Government regulations and incentives expected to spur low-carbon investment

In the push to reduce GHG emissions, governments in North America are tightening regulations related to GHG emissions and incentivising industries to invest in cleaner energy, thus creating investment opportunities for P&M companies. In 2022, the US federal government introduced the Inflation Reduction Act (IRA), which is expected to direct government funding of approximately US$369 billion to combat climate change and support carbon sequestration efforts.

For midstream companies in particular, the IRA introduced 45Q tax-credit adjustments and incentives to accelerate carbon capture, utilisation, and storage (CCUS) projects. The IRA also provides tax credits and grants that support infrastructure related to biofuels. Simultaneously, governments are tightening regulations related to GHG emissions. For instance, the federal government of Canada is contemplating the introduction of legislation mandating the oil and gas (O&G) sector reduce GHG emissions by 40% by 2030 relative to 2005 levels. Given this backdrop, DBRS Morningstar expects P&M companies to continue to invest in lower carbon businesses.

CCUS

CCUS involves the capture of carbon dioxide (CO₂) from oil and gas activities, compression, and transportation through pipelines and injecting the captured CO₂ deep underground. CCUS appears to be the preferred option for North American O&G companies to reduce GHG emissions.

Midstream companies hold the unique advantage of being able to leverage their existing infrastructure of pipelines to store and transport CO₂. While capturing CO₂ is a complex and capital-intensive endeavour, it can be achieved by using existing materials to build pipelines to handle corrosion caused by CO₂. Also, the technical expertise gained through the existing pipeline business can be translated to the CCUS domain.

The capability to capture and transport CO₂ emissions for underground storage or further utilisation (such as enhanced oil recovery by O&G producers) fits well within the core competencies of a P&M company. This competency has paved the way for midstream companies to form new strategic partnerships with different industries, albeit on a small scale currently. Moreover, CCUS projects most likely can align with legacy business models of P&M companies where long-term take-or-pay contracts with CO₂ emitters can underpin the investment.

Low-emission fuels

As the push for cleaner energy sources gains momentum, hydrogen has been heralded as a promising alternative fuel on account of its high energy content and zero-emissions profile. For midstream companies, it represents another opportunity to leverage their existing infrastructure with technical modifications as hydrogen can be blended with natural gas and transported (with modifications) through existing natural gas pipeline infrastructure.

Secondly, alternatives such as biofuels are also gaining traction with P&M companies. Biofuels derived from organic materials can produce renewable natural gas (RNG), which can be transported by midstream companies using their liquid pipeline infrastructure. The degree of exposure for midstream. The more traditional fixed/take-or-pay contracts could result in a stable revenue stream.

Regulated utilities, renewable power generation, and power storage

Some P&M companies in North America are venturing into and/or growing their investment in regulated utilities. The regulated nature of the utilities business provides highly stable and predictable cash flow that aligns well with the risk profile of their existing businesses. However, regulated utilities tend to be fairly mature businesses. From a credit risk point of view, diversifying into a new line of business with stable cash flows under a regulated environment is seen as credit positive, provided companies don’t increase leverage substantially to fund the upfront investment and can demonstrate their ability to mitigate the risks related to the utility business.

Experience gained through the construction and maintenance of a complex network of pipelines would also be applicable for the development of large-scale renewable energy projects linked to solar, wind, pumped hydro, and nuclear energy assets. With their expertise in energy storage, P&M companies are also exploring energy storage solutions to serve renewable energy projects. While these projects are likely to be underpinned by long-term contracts that provide cash flow stability, the operational risk profile of the power-generation assets is likely to be different compared with their existing businesses. We consider these investments riskier relative to their legacy rate-regulated pipeline businesses.

P&M companies that have made some notable clean energy investments over the last couple of years include:

• Enbridge Inc., which has invested considerable capital in utilities along with its traditional pipelines business, recently announced a US$19 billion deal to buy three US based gas utilities. The company has also ramped up its presence in renewable energy with the acquisition of offshore wind projects in Europe. Enbridge, along with its recently acquired gas utility companies, has committed to achieve net-zero carbon emissions by 2050, and plans to leverage its energy infrastructure to transport low-carbon energy sources.
• 1PointFive, a subsidiary of Enterprise Product Partners L.P. that specialises in CCUS technology, recently leased 55 000 acres across the Texas Gulf Coast to develop a carbon capture and sequestration hub with the capacity to store approximately 1.2 billion t of CO₂. The company is also working on providing solutions for the transportation of CO₂ from regional emitters to its CCUS hub.
• Aurora Hydrogen, a technology startup company that develops technologies to convert natural gas to hydrogen resulting in zero emissions, has received funding from Williams Companies, Shell Ventures, and Chevron Technology Ventures.
• Kinder Morgan, as of 30 September, 2023, had a US$3.8 billion committed growth capital project backlog, of which lower carbon investments constitute nearly 84% of the backlog. The company also acquired the RNG company Kinetrex in 2021 for US$310 million.
• Pembina Pipeline Corp. and TC Energy are jointly developing a carbon capture and sequestration grid with the capacity to transport 20 million t of CO₂ annually.

Credit rating implications

For P&M companies that have invested in low carbon activities and businesses, the credit impact depends on the significance of the new business to the company’s overall cash flow, the nature of its cash flows (contacted vs uncontracted), the quality of counterparties if contracted, and operational risk. The credit ratings of P&M and midstream companies have typically benefitted from (1) reasonably stable profitability and cash flow, (2) high levels of regulation, (3) commercially secured fixed-term transportation contracts, and (4) modest competition.

If low carbon investments can replicate these benefits, the impact on the credit profiles of P&M companies could be minimal or even positive through the benefit of diversification. Additionally, investments in low-carbon activities could potentially reduce the political risk that may be associated with their existing P&M businesses. Furthermore, if the operating risk profile of the low-carbon business is very different from the existing business, like a regulated distribution utility or renewable power generation, then we may use other industry methodologies such as the Global Methodology for Rating Companies in the Regulated Electric, Natural Gas, and Water Utilities Industry or the Global Methodology for Rating Companies in the Independent Power Producer Industry.

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