Water utility bonds might not be as safe as everyone thinks.
A coalition of investors and activist groups in a report released Thursday argues that the credit ratings used to gauge the risks of investing in water utilities — seen as among the safest sectors in the bond market — ignore some important potential pitfalls.
The report suggested the ratings on at least two major water systems in the U.S. with billions of outstanding debt — those serving Los Angeles and Atlanta — do not adequately reflect all the risks they face.
Climate change and a surge in demand for water leave utilities vulnerable to imminent shortages many are unprepared for, says the report prepared by Ceres, a national coalition of investors and public interest groups.
Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings assess water utilities’ risk mostly based on financial metrics like liquidity and cash positions. Missing from the ratings, according to the report, is a major risk: not that the money will run out, but that access to water will be disrupted or cut off.
If a utility cannot access water, it might need to purchase water from another party, which is costly. It may need to build a new system for accessing a different supply of water, which is even costlier. In drastic cases it may simply run out of water.
“Investors are blindly placing bets on which utilities are positioned to manage these growing risks,” wrote Sharlene Leurig, the author of the report for Ceres.
With investors willing to pay a premium for safety, water and sewer debt has delivered a return of more than 7% this year, according to a Standard & Poor’s index tracking the sector. Ceres suggests those investors may be overpaying.
“Credit ratings typically do not consider the revenue effects of natural reductions to water supply, or the likelihood of such reductions,” the report asserted.
“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,” it said.
Rating agencies decried the report, arguing they are well aware of the fact that water utilities are selling a product and that access to the product is not guaranteed.
In its rating methodology, Fitch notes that the “availability of adequate water supplies is critical for a utility to meet its customer demands,” and said utilities “carefully should consider their water supply source capacity on an ongoing basis.”
Eric Friedland, group credit officer in Fitch’s U.S. public finance group, said in a statement water supply risk “consistently and transparently factors into Fitch’s ratings and analysis of municipal bonds.”
Standard & Poor’s in a statement responded that its credit analysis “includes an assessment of the utilities’ current and future sources of water and explicitly addresses how water sufficiency and quality issues are likely to affect business and financial risk.”
The firm went on to say that the reason water risks have not yet harmed utilities’ ratings is that “supplies are deemed to be sufficient to meet demand in the near to intermediate term, and it is our opinion that these issuers will continue making timely debt payments.”
“Moody’s has long incorporated a forward-looking analysis of the adequacy of water supplies into our ratings,” said Eric Hoffmann, senior vice president of regional ratings at Moody’s.
The report contends that the rating agencies’ approach to incorporating the supply risk into ratings is “uneven,” and that they do not use stress tests to examine a utility’s ability to withstand supply shocks.
The report proposes using a quantitative risk measure known as a “water risk score,” developed by PriceWaterhouseCoopers, which analyzes a water system’s capability to withstand droughts and other supply disruptions.
The model uses software known as the Water Evaluation and Assessment Project, which simulates how real bodies of water would behave under certain imagined conditions.
Taking into account what legal rights a utility has to water, the model places a utility’s water delivery through hypothetical stressful scenarios — such as years with very little rain or a spike in demand — through 2030.
The model allows the utility to deliver water from storage or buy water from another source during months when demand outstrips supply, until those sources too are exhausted.
The result is an examination of just how dramatic a scenario would have to be before a utility was unable to distribute water to customers. A utility is given a water-risk score based on its resilience to these modeled stress scenarios, with a higher score denoting more vulnerability.
Of the eight utilities run through this theoretical gantlet, the Los Angeles Department of Water and Power scored the worst. The city’s system is the nation’s largest public water utility. It serves more than four million people, and distributed 190 billion gallons of water in fiscal 2009.
The system’s water supply has dwindled, forcing it to import water from the Metropolitan Water District of Southern California. The system in fiscal 2009 bought 72% of its water, according to its financial statements. In 2006, it bought 33% of its water.
The PWC model suggests the system, whose debt is in the double-A category, could exhaust its water supply by the end of this decade.
The DWP in a statement called the report “uninformed and miscalculated.”
The report fails to account for several factors mitigating shortages, the department said, including water-sharing programs and contingency plans for what to do should a catastrophe cut off access to water.
“The model appears to use outdated information and does not take into account recent efforts implemented by LADWP and MWD to mitigate changed conditions,” the utility said. “We believe the Ceres report is fundamentally inaccurate as it is based on outdated, incomplete information and employed questionable methodologies.”
The Atlanta Water and Sewer System garnered the second-worst rating of the eight.
Robert Hunter, commissioner of the Atlanta Department of Watershed Management, in a letter to Ceres said its methodology suffered from “several potential problems.”
Hunter agreed that water scarcity could present an investment risk, but he argued the model did not accurately reflect storage capacity. Atlanta has some storage options should supplies run low, and Hunter contends the water risk score overstates the likelihood of a supply shock.
Water system debt traditionally has been considered very safe. Municipal water suppliers typically enjoy a monopoly on a product without which customers would not last long. They borrow money to build treatment plants, pipe systems, and other infrastructure for the storage and distribution of water. They charge customers rates for delivery of water to homes and businesses, and use the revenue from those charges to repay debt.
Investment managers have been touting such essential service revenue bonds as even more safe, in many cases, than general obligation bonds given the severe fiscal stress most states and many local governments are experiencing.
Of the $28.3 billion of water and sewer utility debt sold this year, one-third has been rated triple-A, according to Thomson Reuters. More than 70% was rated double-A or better.
Investors should regard these ratings warily, according to the report.
Citing the National Energy Technology Laboratory, Leurig said daily water consumption in the U.S. is expected to spike from 3.7 billion gallons a day in 2005 to 5.5 billion a day in 2030. More people have moved to arid regions of the country where water consumption is higher and rainfall is lower.
Water utilities normally manage their water flow based on historical rainfall averages over the past 50 to 100 years, according to the report.
But the past 100 years may have been an unusually wet era, Leurig said. A “growing number of hydrologists” believe the drought in the West right now is not a drought at all, but a reversion to normal from an uncommonly rainy century.
“Planning for times of shortage remains an underdeveloped practice,” Leurig said.
All this comes against the backdrop of enormous spending to refurbish and modernize public water systems.
Last year, the American Society of Civil Engineers gave the U.S. drinking water system infrastructure a grade of D-minus.
The system faces “staggering public investment needs,” the ASCE found, with $255 billion in investments required over the next five years.
Much of the financing for these expenditures comes from the bond market. Public water and sewer utilities have floated $184.9 billion of debt since 2005, according to Thomson Reuters.
The accelerated spending on upgrades gives utilities less flexibility to adjust should water supplies diminish, the report argued.
The report urged investors who provide the capital for these upgrades to place more pressure on utilities to share information about their water-supply risks with the market. Such disclosure now is “generally weak,” the report said.
The Securities and Exchange Commission this year instituted more stringent rules for “events” and material risks municipal borrowers must disclose to investors.
These events include a tender offer, merger, or a change in trustee. It is unclear whether a court ruling blocking access to a vital water source or two months without rain or a change in legal rights to water counts as a material event, under current interpretive guidance.
As an illustration, the report noted that the Atlanta Water and Sewer System is rated A by Moody’s and Standard & Poor’s, despite a 2009 federal judge’s ruling that the system has no legal right to draw from Lake Lanier, its primary water source.