The Ripple Effect: Water Risk in the Municipal Bond Market

Growing water scarcity in many parts of the United States is a hidden financial risk for investors who buy the water and electric utility bonds that finance much of the country's vast water and power infrastructure, according to this first-ever report by Ceres and Water Asset Management. The report evaluates and ranks water scarcity risks for public water and power utilities in some of the country's most water-stressed regions, including Los Angeles, Phoenix, Dallas and Atlanta.

Water is a linchpin of the U.S. economy, but its availability is being tested like never before. More extreme droughts, surging water demand, pollution, and climate change are growing risks that threaten water supplies in many parts of the United States. In some regions, water scarcity is already crimping economic production and sparking interstate legal battles. The stresses are especially severe in regions experiencing rapid population and economic growth, including the West, Southwest and Southeast. Among the most immediate threats:

• The City of Atlanta’s water supply could be cut by nearly 40 percent as early as 2012 due to the ruling of a federal judge;

• Lake Mead, the vast reservoir for the Colorado River, is quickly approaching a firstever water shortage declaration that would reduce deliveries to fast-growing Arizona and Nevada;

• Hoover Dam, which provides hydropower to major urban centers in California, Arizona, and Nevada, may stop generating electricity as soon as 2013 if water levels in Lake Mead don’t begin to recover; 1

• More regular droughts and heat waves are likely to increase the operating costs of power generators in the Southeast, among them the Tennessee Valley Authority, which was forced to slash power generation for two weeks at three of its facilities in Alabama and Tennessee because of heightened water temperatures, costing the utility an estimated $10 million in lost power production. 2

These trends have enormous implications for the thousands of public utilities—utilities managed by municipalities and counties—that supply water and electricity to households and businesses across the country. Water utilities generate revenue through the delivery of water to their commercial and residential customers. Electric utilities use water for hydropower production or to cool equipment in their generating facilities. The power sector is enormously water-intensive and accounts for 41 percent of the nation’s freshwater withdrawals.

Investors who provide the vast amount of capital to build and maintain the nation’s water and power infrastructure are also threatened by these trends. Municipal bonds—the debt instrument of choice for public utilities—are bought and sold on the basis of their credit ratings. Yet today these ratings take little account of utilities’ vulnerability to increased water competition, nor do they account for climate change, which in many areas is rendering utility assets obsolete. Consequently, investors are blindly placing bets on which utilities are positioned to manage these growing risks.

This report will demonstrate why investors should treat water availability as a growing concern for both public water and electric power utilities, and how associated risks are not currently reflected in public utility bond ratings. Because these ratings assess utilities’ ability to repay debt, their failure to include growing water risks neglects a key factor essential to the financial viability of utilities—and to the institutional and retail investors who own their bonds.

Water shortfalls can undermine water and electric power utilities’ short-term liquidity and financial leverage—key elements of credit risk. Yet water risk “stress tests” and other evaluative measures are not currently being used by ratings agencies.

This report demonstrates that in order for utility bond ratings to convey a public utility’s true credit risk, the rating opinion must incorporate the system’s vulnerability to water availability risks. Today’s credit rating agencies fail to incorporate these metrics consistently, leaving investors with insufficient information for managing their potential exposure in holding such bonds.

The report provides a quantitative framework for evaluating water risks of public utility bonds. Eight investment-grade utility bonds are analyzed in the report, all of them issued by utilities in regions facing water stresses, including California, Texas, Arizona, Alabama, and Georgia.

The report includes specific recommendations for water and electric utilities, underwriters, investors, and rating agencies to better evaluate, quantify, and disclose water risks in utility bonds.

Assessing Water Risk: A Model

This report includes an innovative quantitative model, developed by PwC, to assess both water and electric utility water risk exposure by comparing their available supplies with projected water demand from 2011 to 2030. Drawing on public information gathered from federal reports, bond statements, and utility planning documents, the model generates a set of water risk scores that can be used by investors and credit rating agencies to better understand relative water risks among utility bonds. By coupling the water risk scores with other financial information already available in credit rating opinions and bond documents, investors can gain a more complete picture of a bond’s total risk profile.

The water risk scores were designed to give a sense of the relative risk of undersupply of water over a 20-year period based on the utility’s present supply mix as described in bond official statements. The water risk score is not an indicator of the likelihood of default.

The model was applied to eight investment-grade public utility bonds: six water bonds and two electric power bonds. The 30-year bonds are all in regions with growing populations and increasing pressures on water supplies. Other public utility bonds not modeled in this study may also face water risks.

To quantitatively assess a utility’s exposure to water undersupply, the model simulates the projected levels of monthly water flows from water sources used by the utility and compares the available water to the utility’s monthly demand. Climate change presents many possible future scenarios with varying impacts. The simulations are conducted under four different climate change scenarios with varying expectations of wet and dry weather, and with various stress scenarios that would constrict water supplies for one- to five-year time frames.

The stress scenarios reflect risks such as prolonged drought, interstate or regional legal conflicts over water supplies, and regulatory actions aimed at protecting endangered species and preserving water flows. Many of these scenarios are not unexpected for these eight utilities, which are already aware of such threats. Yet, their current bond ratings do not reflect such risks—let alone encourage them to take the appropriate steps to reduce the risks.

The model draws on a resource planning software tool created in cooperation with water utilities, the Water Evaluation and Assessment Project (WEAP), to evaluate physical water flows, which were then combined with the shorter-term stress scenarios to produce specific water risk scores. The stress scenarios for water utilities range from a 10 percent supply reduction, to a more extreme scenario of a 30 percent supply reduction for three years at the utility’s most significant water source coupled with a 50 percent capacity reduction in storage for five years. For electric utilities, stress scenarios test the utility’s sensitivity to supply stresses, including a 30 percent reduction in available water for three years, and demand stresses that test the potential for major facilities to expand generation capacity to fuel growing electricity demand. 

Findings

The six water utility bonds that were modeled received wide-ranging water risk scores. Among the key findings for the six water utility bonds (see Chapter Four for details):

• The Los Angeles Department of Water & Power’s water system bond received the highest risk score of all water utilities, based on tight restrictions on local water supplies due to environmental regulations and prolonged drought. The municipal system, the nation’s largest, is also highly reliant on vulnerable water imports, including the Colorado River. The utility’s water bond was rated “AA+” and “Aa2” by Fitch and Moody’s, respectively, earlier this year.

• Atlanta’s Water and Sewer System received the second highest water risk score, a direct result of its reliance on one key local water supply whose future is jeopardized by a judicial order that may require the city to reduce its withdrawals by as much as 40 percent in 2012. The utility’s water bond received “A” and “A1” ratings from Fitch and Moody’s, respectively, earlier this year.

• The Phoenix and Glendale, AZ utilities—systems with high reliance on increasingly expensive and potentially volatile out-of-state water imports from the Colorado River—also received high water risks scores. The Phoenix bond is rated “AAA” and Glendale bond “AA” by Standard & Poor’s.

• Water risk scores for the Tarrant County, TX utility were double those of the neighboring Dallas system. The wide gap is the result of Tarrant County’s consistent drawdown on critical storage reservoirs to meet water demand, which makes the system more vulnerable to prolonged drought. Both utilities have identical credit ratings.

Based on other financial factors, the six water utilities profiled have far different capacities to manage their respective water risks, whether by borrowing more money to develop new water supplies or managing demand through more aggressive water pricing and conservation programs. A utility with high water risk scores and low debt capacity will likely have more difficulty managing water risk than a utility with similar risk scores and a higher ratio of revenue to debt service costs. Similarly, a utility with high water risk scores and relatively low water rates may be better positioned to reduce its water risks by managing demand, compared to a utility with similar risk scores but already higher water rates.

Among the key findings for the two electric utility bonds:

• Alabama’s PowerSouth Energy Cooperative, which provides power to 49 counties in rural Alabama and northwestern Florida, received the higher risk score, primarily due to the system’s potential vulnerability to increased water temperatures and lower flows in the Tombigbee River, the cooling water source for its largest coal-fired plant. The utility’s bond received “A-” ratings with stable outlooks from both Fitch and S&P last year.

• The Los Angeles electric power system‘s risks are driven in part by reductions in power generated at the Hoover Dam due to low water flows in the Colorado River Basin. The system may also see reduced power deliveries from one of its major coalfired power plants in Utah, due to heavy competition for dwindling cooling water flows. The utility’s bond received “AA” and “Aa3” ratings this year from Fitch and Moody’s

Investor Risks and the Role of Credit Rating Agencies

Reduced revenues caused by water supply shortfalls can compromise the value of utility bonds in two ways. First, reduced revenues can undercut a utility’s ability to make timely payments to bond holders, potentially leading to default. Second, diminished credit capacity of a utility may result in a negative outlook or financial stress that may reduce the price of the bonds when sold on the secondary market.

Utilities that fail to factor water stress into water or power pricing, debt reserves and capital expenditures may find themselves in a vicious cycle of credit stress as they face constraints on water supply, are unable to make key system investments to deliver services, and are increasingly reliant on tenuous pricing adjustments and tax referenda to maintain their financial position.

Yet bond investors are largely unaware of these risks—and the uneven scrutiny of the credit rating agencies in evaluating these risks is a big reason why.

Our analysis shows that credit ratings agencies’ methodologies largely ignore water risk and may even unintentionally foster wasteful water consumption. Many credit ratings reward pricing and infrastructure plans that encourage increased water use and revenue growth with disregard for even near-term supply constraints and likely disruptions.

No current ratings methodologies reward water utilities for having water pricing that reflects scarcity and encourages conservation or for selecting supply alternatives that boost local resources in favor of risky water imports. Moreover, the ratings agencies routinely assume water supplies will be consistent with the recent past, and do not conduct “stress tests” on utility systems to understand the revenue effects of supply shocks.

Ratings agencies also fall short in scrutinizing water risks to electric power utilities. Many of these utilities are dependent on water supplies for cooling and are vulnerable to generation shutdowns if supplies are disrupted. Yet credit agencies focus little or no attention on the financial impacts of such risks.

Key Recommendations

Investors, rating agencies, and public utilities all need to do a better job of managing their exposure to water scarcity risks. Screening out utility bonds based on geography alone may be insufficient to shield a portfolio from water risks since it would have the effect of limiting investment in utilities with sound management practices. Improved information and disclosure of issuers’ exposure and sensitivity to water stress is critical on all fronts. Such disclosure will protect investors from such risks and drive improved management of ever-scarcer water resources.

Below is a summary of key recommendations for utilities, investors, and credit rating agencies to manage emerging water risks in utility bonds (detailed recommendations are in Chapter Five).

Water Utilities

• Improve disclosure of material water stresses such as exposure to persistent drought or long-term climatic changes, interstate legal conflicts over shared water resources, and potential and existing regulatory actions related to environmental flows. Disclosure should also include an assessment of potential capital costs, rate adjustments, and revenue effects from water supply risks.

• Implement strategies to manage demand and reduce leakage, such as cost effective infrastructure improvements to reduce water loss, and deployment of conservation incentives and new pricing strategies that reflect water scarcity and reward water-savings.

• Invest in infrastructure that reduces risk such as “closed loop” alternative supplies (including indirect potable reuse), and green infrastructure that restores natural hydrological systems, promotes rainwater harvesting and natural water capture, thus recharging aquifers and protecting water supplies.

Electric Utilities

• Improve disclosure of material water stresses caused by increased competition for water, emerging regulations, and changing climatic conditions. Such disclosure should also include information on key water sources, the water intensity of generation, as well as potential capital costs, rate adjustments, and revenue impacts from water risks.

• Invest in measures to reduce risk, such as strategies for reducing energy use and therefore water demand. These measures include investments in energy efficiency programs, rebalancing generation portfolios toward low-water intensity, clean energy, and investing in cost-effective alternative water supplies, including reclaimed water.

Bond Underwriters

• Assist utilities in disclosing their sensitivity to water stress and plans for mitigating their risk. To fulfill their duty to assist issuers in disclosing all material risks in official statements and reports, underwriters should ensure that issuers adequately disclose material water risks and water-related events—including legal rulings and regulatory actions—that may materially impair a utility’s revenue stream or impose significant capital costs.

• Help to secure competitive cost of capital for utilities managing water risk. Underwriters should help issuers that are undertaking strategies to reduce water risk—such as pursuing demand-side management or investing in more secure alternative supplies—to secure lower cost of capital.

Rating Agencies

• Employ water risk stress tests to understand an issuer’s sensitivity to stresses such as legal rulings over contested resources, restrictions for environmental reasons, or changing climatic conditions.

• Factor water intensity into rating opinions for electric utilities. Rating agencies can help investors understand this water risk by incorporating factors such as utilities’ water intensity, incidence of water-related shutdowns, and vulnerability of cooling systems to physical and regulatory risks into rating opinions.

• Reward, via higher ratings, utilities that manage water demand through pricing in anticipation of future supply constraints.

Investors

• Engage utilities on their sensitivity to water stress, principally by encouraging better disclosure of water risks.

• Encourage asset managers, who oversee their investments, to assess and engage utilities on water risks. Investors can ask for this via asset manager requests for proposals and annual performance reviews.

• Request guidance from financial regulators for better disclosure of water and climate-related risks by municipal utilities. Municipal issuers are not subject to the Securities and Exchange Commission’s (SEC) 2010 interpretive guidance, which directs corporate issuers to disclose material information related to the physical effects of climate change, including water risks. To ensure similar disclosure by municipal utilities, investors should engage the Municipal Securities Rulemaking Board and the SEC to provide guidance to issuers and underwriters regarding disclosure of material water and climate risks.