WASHINGTON — The U.S. faces several significant challenges in the water sector including aging infrastructure, a water supply-demand imbalance and an unsustainable funding gap, according to a report by Ernst & Young.

The report, “The U.S. Water Sector on the Verge of Transformation,” examines the water sector and the future of water financing as it relates to local municipalities.

It paints a sobering view of the present state of water resources primarily due to decaying infrastructure and says the related funding gap remains unsolved and underemphasized by politicians and rating agencies.

Water systems across the U.S. are reaching the end of their service lives and as a result an estimated $1 trillion in new investment is needed just to rehabilitate current water infrastructure over the next two decades, the report said.

“Regulation has imposed substantial obligations and costs on operators, while at the same time leaving efficiency-focused measures voluntary and unenforced,” the report said. “Utilities have lacked a sense of urgency to revamp managerial and financial practices. This lackluster approach stems from reliance on perceived water abundance, an ability to raise prices and continued capital availability through municipal bond markets.”

Water utilities continue to deliver reliable water supply despite budget constraints that have held back capital expenditure and research and development investment.

“Water utilities have made every effort to maintain high bond ratings and benefit from the related savings, but adverse conditions may soon pose additional financial challenges and affect water utilities’ credit worthiness,” the report said.

The report noted that while investors have stable demand for muni bonds to finance water projects during the economic downturn, “it is questionable whether debt will stay as affordable and accessible to water utilities in coming years.”

State and local governments are still struggling with high levels of debt raised for other governmental functions and having difficulty meeting non-debt obligations.

“Municipalities whose creditworthiness is downgraded due to such factors as political resistance to raising water tariffs, high fiscal deficits and dwindling water resources may have difficulty selling water-related debt,” the report said.

Bond prices and credit ratings have yet to reflect declining water utility revenues that are a result of improving water conservation. However, bond markets may not fully reflect substantial capital needs for infrastructure rehabilitation and higher expenses as a result of increased regulatory requirements.

Part of the test as to whether or not the muni bond financing is feasible will be whether municipal managers will be open to taking on substantial amounts of new debt given the already high levels of state and municipal deficits.

In order to meet growing financial needs, some utility companies have explored new financing options including: private activity bonds issued by or on behalf of local or state governments for the purpose of financing the project of a private user; special subsidized bonds by the federal governments such as Build America Bonds; financing from infrastructure equity funds; water-focused loans from federal government entities; and investments from state revolving funds.

Utilities are also considering how to improve access to debt, such as providing government loan guarantees and related insurance options to improve credit ratings, the report found. Using revolving funds or bond banks to group together a large number of small borrowers and assign a collective credit rating is another tool being used to encourage investors to the water market.

“The primary objectives of financing water have been to reduce the transaction costs per deal and improve the information and transparency of the borrower’s credit risk,” the report said.

Separately, the report highlighted that public funds to finance water infrastructure may not suffice and therefore private sector participation is expected to gain momentum especially because they allow for a degree of fiscal stability and measurable returns. There are already more than 2,000 community water or wastewater facilities in the U.S. that are designed as public-private partnerships.

“There is potential to further develop and improve PPP arrangements,” the report said.

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