California’s municipal utilities are well-positioned to meet the state’s stringent environmental agenda in the next five years, according to Fitch Ratings.

The credit ratings company gave the sector a stable outlook, saying financial margins are recovering, and most utilities have rate flexibility to deal with increasing costs.

“The combined effects of the economic recession, California housing crisis, and multiple years of cooler temperatures resulted in lower electric sales from 2009–2011 and meaningful revenue disruption,” analysts said in a 25-page report. “Demand began to stabilize in 2012, bringing recovery to financial margins.”

Most utilities were able to offset the financial effect of lower sales during those four years through the use of cash reserves, cost cutting of operational and capital spending, and increasing rates. Among utilities that lacked rate flexibility, the effect on financial margins was more severe.

Fitch said it views favorably recent efforts to implement rate restructuring design to improve direct cost recovery.

Rates to consumers will increase to absorb additional costs, and rate flexibility exists in most service areas, the report said.

California’s utilities face the most stringent environmental policies in the nation. The state’s environmental legislation, most of which was enacted in 2006, set broad policy goals and empowered state regulatory agencies to designrules to reach them.

“Utilities are positioned to meet the state’s environmental agenda due to early investments, requirements that appear more manageable than initially assumed when legislation was initially adopted, and a multiyear compliance timeframe,” analysts said.

While compliance costs are estimated to be sizeable, Fitch believes municipal utilities will have sufficient time and support to phase in changes and recover related costs in order to maintain current credit quality.

The new regulations include renewable energy requirements and the implementation in 2013 of a cap and trade carbon allowance market.

Fitch rates 14 public utilities in California, ranging from A to AA-minus. All but two have stable outlooks, one has a positive outlook, and one has a negative outlook.

Modesto Irrigation District was upgraded to a positive outlook from stable in March, based on its healthy operating margins in fiscal years 2011 and 2012, as well as its improved financial metrics. Fitch assigns the district an A rating.

Glendale Water & Power, rated A-plus, had its stable outlook lowered to negative in February. Fitch said the outlook reflects the view that the utility may not have sufficient support from the city council to implement rate increases big enough to restore financial metrics to historical levels.

The report was written by Fitch analysts Kathy Masterson, Matthew Reilly, Stacey Mawson, and Dennis Pidherny.

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