How Will California’s Drought Affect Water Utility Revenue Bonds? by Ty Schoback, Columbia Threadneedle Investments
- The effects of the California drought will last for decades as residents adjust to using less water while paying more to support necessary water infrastructure to ensure adequate supply.
- Key factors when assessing credit quality of water utilities are water supply sources and rate flexibility.
- The credit-differentiating factors will come down to which systems are willing to raise rates enough to shoulder the additional infrastructure and water supply costs.
California is in the midst of its worst dry spell in over one hundred years. The severity of the drought has forced water utilities to curtail consumption via stringent usage restrictions and rate hikes 1) to offset lost revenue from less water sold and 2) to better align rate structures with the rising cost of providing water. Recently, Governor Brown instituted the first mandatory water restrictions in California’s history, requiring all local water utilities to curtail consumption in their service areas by 25%. We offer background on the drought as well as the effects on California water utility revenue bonds.
Background
Water has a long history in California, with deep political divides running between northern and southern California, rural and urban use, and a multitude of environmental concerns. It may surprise some to learn that California is actually a water-rich state. The challenge is that while over 75% of California’s rainfall occurs north of Sacramento, 75% of water demand is south of Sacramento. California, never lacking ingenuity, has dealt with this challenge by developing one of the world’s largest and most complex water supply storage, delivery and treatment systems. This vast water infrastructure system has allowed California’s economy to continue to thrive four years into what has been deemed the worst drought in the past century. California residents have not sat by idly since the onset of the drought in 2011. Per capita water usage has been in decline for some time (Exhibit 1).
Exhibit 1: Per capita urban water use has been falling since the mid-1990s
Source: Author calculations using data from California Water Plan Update (California Department of Water Resources, various years).
Notes: The figure shows applied water use — the amount delivered to homes and businesses — and excludes energy use, conveyance losses, and active groundwater recharge. Outdoor water use is much higher in inland areas because of hotter temperatures and larger lot sizes. The low-desert Colorado River region, including areas such as Palm Springs, has especially high per capita use, in part because of golf-based tourism.
Unfortunately, conservation measures will be insufficient as long as the drought persists, which water scientists expect. Despite the unsustainable nature of the state’s current level of water consumption, it would be remiss to assume the state and its vast array of local water agencies will not adjust to the new realities posed by the drought. California is not at imminent risk of running out of water. Solutions to the water crisis exist, and a state known for its ingenuity will ultimately adapt.
Exhibit 2: California’s drought level at second week of May
Source: Los Angeles Times’ Drought Graphics, 2015
California Water Utility Bond Credit Strength: Should bondholders be worried?
From a credit quality perspective, California water utilities have generally remained stable due to a political willingness to exercise their unlimited authority to adjust rates to offset the rising costs of supplying water and meet infrastructure demands. Yet, this stability and political fortitude has not been the case for all water utilities. Some have experienced downward rating pressure from rating agencies on narrowing fiscal performance due to rate increases not keeping pace with increasing costs.
Despite the lack of legal and regulatory restrictions on rate increases, there are political considerations. California water utilities already have among the highest rates in the country. This is due in part to the need to support the vast infrastructure required to transport water from northern California to southern California or from the Colorado River to the Los Angeles River basin. Taking the political element into consideration, we view utilities with high existing rates as most at risk for credit deterioration. These utilities will require additional rate increases to keep pace with the rising costs of imported water and infrastructure maintenance. The risk lies in the politicization of rate increases, with city councils being pressured to not raise rates further. At this point, we are not concerned with defaults. Rather, we are concerned with potential credit quality deterioration among systems unwilling to raise rates sufficiently to avoid smaller operating margins and narrowing debt service coverage ratios.
What do we consider when analyzing a California water revenue bond?
While there are general attributes we assess in our analysis of any water revenue bond, it is difficult to draw defining lines on what types of water revenue credits we like or avoid. While we generally favor water credits with a diverse water supply and rate flexibility, there are many variables to consider.
Many factors contribute to the vast dispersion of municipal water rates throughout California, with geography, climate, service area and infrastructure all playing a role. Systems fortunate enough to be over one of California’s vast groundwater basins have relatively low infrastructure costs, as groundwater is typically inexpensive to pump and requires minimal treatment, resulting in relatively low customer rates. However, water systems entirely reliant on groundwater risk overpumping their basins during droughts and need to adequately raise rates to pay for new infrastructure to augment supply needs. Alternatively, systems without local water supplies are reliant on imported water which is often transported over long distances and typically requires heavier investment in infrastructure. This greater need for infrastructure is borne out in higher consumer water rates and potentially leads to less rate flexibility among ratepayers who already have high rates. At first glance, we tend to favor systems with a good local water supply and, if necessary, an ability to augment with imported water, due to their low consumer rates and a perceived flexibility to raise rates. However, we have witnessed a political aversion to raise rates in some systems with low existing rates, while some systems with no water of their own have repeatedly shown a willingness to raise rates to maintain operating profitability and debt service coverage ratios.
With conservation and added water infrastructure, California will remain a water-rich state for years to come.
California is not in danger of running out of water. While continued conservation efforts will be necessary as long as the drought persists, further investment will be required to increase reservoir storage capacity or create new water supplies through more wastewater treatment and recycled water plants. Desalination is likely to play a role as well though we do not view it as the sole answer. The effects of the drought will remain long after the drought relents, as California residents adjust to using less water while paying more to support necessary water infrastructure to ensure adequate supply for decades to come. The credit-differentiating factors will come down to which systems are willing to raise rates sufficiently and quickly enough to shoulder the additional infrastructure and water supply costs.
Important disclosures
The views expressed are as of June 2015, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
Fixed-income securities present issuer default risk. Funds that invest substantially in municipal securities will be affected by tax, legislative, regulatory, demographic or political changes, as well as changes impacting a state’s financial, economic or other conditions. A relatively small number of tax-exempt issuers may necessitate a fund investing more heavily in a single issuer and, therefore, be more exposed to the risk of loss than a fund that invests more broadly. The value of a fund’s portfolio may be more volatile than a more geographically diversified fund. Prepayment and extension risk exists as a loan, bond or other investment may be called, prepaid or redeemed before maturity and that similar yielding investments may not be available for purchase. A rise in interest rates may result in a price decline of fixed-income instruments held by a fund, negatively impacting its performance and NAV. Falling rates may result in the a investing in lower yielding debt instruments, lowering the fund’s income and yield. These risks may be heightened for longer maturity and duration securities. Non-investment-grade (high-yield or junk) securities present greater price volatility and more risk to principal and income than higher rated securities. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. Federal and state tax rules apply to capital gain distributions and any gains or losses on sales. Income may be subject to state or local taxes. Liquidity risk is associated with the difficulty of selling underlying investments at a desirable time or price.
