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Water Scarcity a Bond Risk, Study Warns

By Felicity Barringer and Diana B. Henriques
The New York Times
The municipal bonds that help finance a major portion of the nation’s water supply may be riskier than investors realize because their credit ratings do not adequately reflect the growing risks facing the water industry, according to a new Ceres study.

The municipal bonds that help finance a major portion of the nation’s water supply may be riskier than investors realize because their credit ratings do not adequately reflect the growing risks of water shortages and legal battles over water supplies, according to a new study.

A new tunnel is being built to continue drawing out water from Lake Mead.

As a result, investors may see their bonds drop in value when these risks become apparent, and water and electric utilities may find it more expensive to raise money to cope with supply problems, the study warned.

Looking at significant water bond issuers across the southern part of the country, the report concluded that Wall Street’s rating agencies had given similar ratings to utilities with secure sources of water and to those whose water sources were dwindling or were threatened by legal battles with neighboring utilities.

Among the seven cities and agencies examined in the report, Los Angeles and Atlanta were identified as the ones whose water systems faced the greatest risk in the years ahead.

“Municipal bonds are bought and sold on the basis of their credit ratings,” the report said. “Yet today these ratings take little account of utilities’ vulnerability to increased water competition, nor do they account for climate change, which is rendering utility assets obsolete.”

Consequently, the study warned, “investors are blindly placing bets on which utilities are positioned to manage these growing risks.”

The report, one of the first to assess the potential impact of water shortages on the municipal bond market, was jointly produced by Ceres, a national coalition of investors, environmentalists and public interest groups, and Water Asset Management, an investor in water-related businesses. Its analysis relied on a new measure of risk developed exclusively for the study by a unit of PricewaterhouseCoopers.

The report implicitly echoed criticisms leveled at the ratings agencies after the collapse of the subprime mortgage market in 2008, and for similar reasons. Just as mortgage ratings reflected historical patterns but didn’t capture recent market changes, water bond ratings tend to reflect a past when water was plentiful, and not a future when supplies of fresh water may be less abundant, the study noted.

The major bond rating agencies — Moody’s, Standard & Poor’s and Fitch Ratings — all disputed the study’s general conclusion that they did not give enough weight to water supply trends in establishing their municipal water bond ratings. “Water has been scarce in the West since the area was first settled, and Moody’s has long incorporated an analysis of the adequacy of water supplies into our ratings,” said Eric Hoffmann, a senior vice president and municipal ratings analyst at Moody’s Investors Service.

While the ratings agencies all noted that an issuer’s future financial health would be shaped by more than just its sources of water supply, they insisted that the cost and availability of water supplies was already an important element in their analysis.

Standard & Poor’s rating analysis “explicitly addresses how water sufficiency and quality issues are likely to affect business and financial risk,” said Ana Sandoval, a spokeswoman for that rating agency. And at Fitch Ratings, “water supply risk has consistently and transparently factored into Fitch’s ratings and analysis of municipal bonds,” said Eric Friedland, group credit officer and managing director of its United States public finance group.

The utilities examined in the report said the analysis was flawed by basic misunderstandings about demand and supply. A response from the Los Angeles Department of Water and Power called the study’s conclusions “uninformed and miscalculated.”

The Tarrant Regional Water District in Texas, another issuer studied in the report, has “supply now to meet projected demand through 2030,” said Wayne Owen, its planning director.

And the city of Phoenix, another subject of the study, said in a statement that the report’s concerns about the fact that it imported some of its water were “unjustified and unjustifiable.”

The lead author of the study, Sharlene Leurig, defended the bias against imported water by noting that water was heavy and moving it was “incredibly energy-intensive” and expensive.

Electric utilities and investors who buy their bonds rely on water to drive hydroelectric generators or cool nuclear power plants and are subject to some of the same risks, the report said.

Water problems in California and Georgia have attracted significant attention the last few years. On Sunday, Lake Mead, the Colorado River reservoir that supplies Los Angeles and other parts of the southwest, dropped to its lowest point since it was first filled in the 1930s. And at one point during a drought in 2007, Atlanta’s main reservoir, Lake Lanier, held only a three-month supply of water.

As the study notes, the cost of tapping new supplies and repairing old infrastructure would bear down on the country’s 54,000 utilities just when consumers, squeezed by a weak economy and high unemployment, were already balking at significant rate increases to cover payments to bond investors.

Municipal bonds are not subject to federal rules that require public corporations to disclose their vulnerability to climate change, but issuers nevertheless must make sure that the information they give investors is accurate and current, said Lynnette Kelly Hotchkiss, executive director of the Municipal Securities Rulemaking Board, which regulates the dealers, underwriters and advisers in the municipal bond market.

“Municipal issuers are required to disclose all material facts when they offer bonds for sale,” Ms. Hotchkiss said. “The possible effect of climate change can be a material fact if it affects the revenue sources that support the bonds.”

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