DALLAS -- Texas utilities' debt levels should continue to rise as they invest in the diversification of their water supply portfolios, the rehabilitation or replacement of aging infrastructure and compliance with regulatory mandates, according to Fitch Ratings.

“Total debt for Texas utilities continued to grow in fiscal 2016, largely driven by the state’s expanding population and economy,” according to a team of Fitch analysts. “As systems issued debt to keep up with growing capital needs, debt to net plant ticked up to 49% from 44%. Capital spending as a percentage of depreciation was 131% for the year, and this is likely to rise with ensuing capital needs.”

Median user charges for public water utilities in the state rose 6.7% to $64 per month in fiscal year 2016 as utilities sought to offset weakening sales and provide enhanced financial capacity for infrastructure costs, analysts said. The average annual rate increase in the years 2012-2015 was only 3%.

"Texas water utilities operate in a challenging environment that pits the needs of a growing population against the trials of extreme weather," says Gabriela Gutierrez, Director of U.S. Public Finance. "As a result, water supply and infrastructure needs can be difficult to plan for."

Adjustments to rate structure are one option utilities have to combat lower revenues during times of drought and wet weather, which are becoming more prevalent. Sometimes that means the addition of a flat fee to customer bills, in addition to usual charges for use. Texas water rates remain at what Fitch considers generally affordable at 1.4% of median household income--below both the national median of 1.7% and Fitch's affordability threshold of 2%.

Changes to rates made during fiscal 2016 resulted in a 9.6% rise in operating revenues for the state's water utilities, even as consumption remained flat. That resulted in improved financial metrics including debt service coverage and days cash on hand.

Gutierrez and fellow Fitch analysts Teri Wenck, Doug Scott and Eva Rippeteau conducted research for the peer review that showed Texas water utilities operating in a stable environment after recovery from severe drought amid rapid population growth.

As of June 30, 2017, all rating outlooks are stable, Fitch said.

The lone downgrade during the 18-month period between Jan. 1, 2016, and June 30 of this year involved Killeen, Texas, which fell to AA-minus from AA.

Analysts attributed the Killeen downgrade to weakening of the system's financial performance over the past few years. A combination of weaker revenues, rising costs and large transfers out to the city's general fund caused debt service coverage, liquidity and free cash flows to decline from historically robust results, the report said.

Fitch also revised Austin’s rating outlook to stable two years after it had been revised to negative. The Austin utility’s financial performance improved after an 8.1% rate increase and modest changes in the rate structure designed to improve recovery of fixed costs given an ongoing trend of declining water sales, analysts said.

“Operating projections point to expected sustained improvement in the overall health of the utility’s financial profile,” analysts said.

Fitch has six utilities in the triple-A category, with the AA-minus category containing the greatest number of ranked utilities.

Since January 2016, Fitch has assigned new ratings to the revenue bonds of the cities of Dallas (AA-plus), Plano (AAA), San Angelo (AA−minus), and the North Harris County Regional Water Authority (A-plus).

Statewide, water reservoirs are currently at 85% capacity, while individually, many reservoirs are above their capacity, analysts noted.

“However, since Texas is a large and geographically diverse state, not all of Texas is flush with full reservoirs,” analysts said. “Extreme weather challenges water purveyors throughout the state to pursue ample water storage and diversify supply portfolios to contend with supply volatility.”

Utilities are expected to continue to invest heavily in long-term strategies to increase reservoir storage capacity and build infrastructure to diversify supplies over time, the report said.

“Moreover, the need for rehabilitation and replacement of aging infrastructure amid regulatory pressures will also require substantial investment and gradually drive debt levels higher, requiring additional and larger rate hikes to maintain a stable financial position,” analysts wrote.

The state’s population is projected to increase 70% by the year 2070, requiring extensive capital development to meet customer water demands. The State Water Plan, which is prepared and updated by the Texas Water Development Board every five years, details objectives to address the state’s water needs under a drought of record scenario.

The state’s worst drought lasted seven years, from 1950-1957. The most recent plan, published in 2017, identifies about 2,500 water management projects, including innovative technologies like desalination and aquifer storage and recovery, at a cost of $63 billion through 2070.

“Water supply developement is not the lone burden on Texas utilities’ capital plans,” the report said. “While the state has dealt with ensuring water supplies are adequate for its growing population, aging infrastructure and extreme wet weather events have strained infrastructure to the point that regulators have intervened in various cases to ensure utilities’ ongoing compliance with the federal Clean Water Act.”

San Antonio, Houston, and Corpus Christi utilities are currently either under a consent decree or in negotiations with the Environmental Protection Agency for an agreed order, although other utilities may face non-compliance with the Clean Water Act in the future, analysts said.

The San Antonio Water System, the state’s largest water utility, entered into a consent decree with the EPA in June 2013, six years after negotiations began. SAWS initially estimated that capital investment related to compliance was $850 million over a 10- to 12-year period.

Despite continued demand from growth, the 2017 legislative session was relatively uneventful for water issues, analysts said. Several bills affecting water and sewer utilities were vetoed on the basis that they could be performed without statutory mandates. The special session that began on July 18th doesn't cover any topics related to water or sewer issues.

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