Governor Brown held a signing ceremony on Treasure Island in San Francisco for an extension of cap-and-trade legislation.
California Gov. Jerry Brown said he wants to employ every method possible to ensure water is conserved in his parched state.

WASHINGTON — A California appellate court's decision could reduce the economic flexibility of local governments and water utilities already struggling to raise revenue in a historic drought.

The state's 4th District Court of Appeal in San Diego ruled April 20 in the case of Capistrano Taxpayers Association Inc. v. City of San Juan Capistrano that the city's tiered-rate structure did not pass muster with Proposition 218, which requires that government agencies not charge more for a service than the cost of providing that service.

The city, which operates as its own water utility, had introduced a fee system that sharply increased the price of water to its customers after certain usage "tiers" had been reached.

"The practical effect of the court's decision is to put a straitjacket on local government at a time when maximum flexibility is needed," Gov. Jerry Brown said in a statement this week. "My policy is and will continue to be: employ every method possible to ensure water is conserved across California."

Brown said the state's lawyers were evaluating the ruling. He issued an executive order at the beginning of April mandating statewide water conservation, the first such requirement in the state's history. California is suffering from a multi-year drought that has affected most of the state and reduced snowpack in the Sierra Nevada Mountains to a fraction of its typical level.

The appellate court sent the case back to the trial court for further consideration, but analysts said the drought itself is of far more impact to the credit quality of water bonds issued in California than the court decision.

Standard & Poor's analyst Tim Tung said in a new report this week that the court's decision is a further complication of the situation for water utilities, and that most water suppliers experiencing a drop in revenue from reduced water usage probably wouldn't see that decline fully balanced out by reduced expenses.

"Although utilities could see some expense reduction, many of their costs — including fixed payments to suppliers, rents, leases, and debt service — are independent from the volume of water sold and likely wouldn't change," Tung wrote. "A decline in water sales would likewise have little short-term impact on salaries, benefits, and maintenance costs."

Gurtin Fixed Income Management issued its own report Thursday, concluding that California water utilities face a dual risk of both running out of water and of being unable to maintain revenue levels.

"The first and most terrifying risk is that of a utility running out of water. Many utilities throughout the state are dependent on water from either the State Water Project or the federal government's Central Valley Project, both of which pump runoff from the Sierra snowpack through a vast plumbing infrastructure to end users throughout the state. Both the SWP and CVP are entering a second year of providing essentially no water to their customers."

The risk is lower for utilities that are less reliant on dwindling groundwater supplies, Gurtin said.

"The second credit risk is far more manageable, but no less concerning for investors," the report continued. "We believe the Governor's April announcement of the state's first ever statewide mandatory water reduction poses financial risk to water utilities that are unable to decouple water usage from their operating revenues. Utilities must recognize that they are likely to see diminished water usage given conservation, which unless off-set by higher rates, will result in declining operating revenue which is directly tied to usage."

Shannon Groff, an analyst at Fitch Ratings, said she expects that most government water utilities in the state have designed their rate plans to be compliant with the law, meaning that the court's ruling in the San Juan Capistrano case probably will not have wide-ranging implications.

"We expect the effects to be limited," Groff said.

Tung wrote that many utilities had already been through a Proposition 218 process, which includes public notice process prior to a rate increase. Those that have already done that likely have the flexibility to increase rates through internal action, he concluded.

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