Water seems to be as steady a business as they come. After all, it’s an essential service we all need.
But the operating environment of water providers is changing, and bondholders should be sure that the issuers whose debt they hold are changing their business models accordingly.
For those who are skeptical, a few things to note:
Water sales are down across the country. Since the 1970s per capita water use has dropped steadily, a decline that has grown even sharper in the last five years.
The primary reason is the influx of high-efficiency indoor appliances into the market, a passive efficiency that, believe it or not, many water systems continue to ignore when projecting future demand.
Combine this passive efficiency gain with the widespread adoption of inclining block rates designed to move customers down the demand curve, and it’s clear that the age-old adage that water use increases with population is ready for retirement.
This change in demand is a big concern to water providers whose costs are largely fixed but whose revenues are highly variable. It is not unusual for a water system to have 80% of its revenue dependent on volumetric use.
While the cost of water services is still cheap — the typical American pays less than $1 for one ton of water — customers’ total water bills are rising faster than the cost of any other basic service.
One of the reasons why: too few water systems fund depreciation over time, meaning that necessary replacements in failing infrastructure can only be implemented through major rate adjustments.
In places where supply is scarce, rising costs reflect the economic reality that new water supplies — often brought on to satisfy peak demand — are orders of magnitude more expensive than existing water sources.
On top of this, climate change is wreaking havoc on water infrastructure. Storm drains in cities like Seattle, Boston, Chicago and New York are more and more frequently finding themselves overwhelmed by what used to be 100-year rainfall events.
Saltwater from rising seas is encroaching on freshwater supplies across the Eastern Seaboard. In Florida the repercussions are difficult to imagine: Miami-Dade County is planning for seven inches of sea level rise by 2030. (By way of comparison, that is the same amount of rising that South Florida experienced over the last 100 years).
Some water systems are tackling these challenges head on, getting smarter about planning for demand uncertainty, price responsiveness of their customers and risks to their water supplies. But for every system that is adapting to this new century’s water challenges, there are several more that are doing business as usual — as if demands aren’t changing, as if pricing doesn’t matter, as though supply reliability can be judged by historic experience.
And frankly there is little incentive for them to do otherwise. Water rates are the product of politics, decisions by mayors and city councils that have every incentive to keep rates low.
In theory the market should be the one place where water systems really get asked the hard questions on the reliability of their supplies and the uncertainty of their demand projections. But few in the market — the credit rating agencies, the bond insurers, the buyers themselves — seem to really understand how the water sector is changing. Moody’s has not even changed its credit assessment methodology for the water sector since 1999. A lot has changed since then.
For bondholders, that means price that might not reflect the risk. And for issuers who are adapting their business model to this century’s water challenges, the failure of the market to recognize their superior risk profile means a higher cost of capital than they should be paying.
But even if bondholders and credit rating agencies wanted to assess the risks of revenue shortfalls, supply failure or climate-driven stranded assets, how could they? Few water systems discuss these factors in their financial documents. Without better disclosure, it’s impossible to adequately assess these risks.
This market failure is why Ceres just released a disclosure framework for water enterprises, a framework that investors with $40 billion in assets have asked the National Federation of Municipal Analysts to incorporate into their disclosure guidance.
This framework represents achievable improvements in disclosure. The Cascade Water Alliance in Washington has already made use of the framework in its December 2012 bond issuance, consistent with its belief that disclosure and transparency of its long-term sustainability strategies is essential for buyers needing to make risk-based decisions in purchasing bonds.
It is time to bring transparency to the water sector. But better disclosure isn’t enough. Market participants need to understand how the business is changing, and how to value the sustainable business models that are emerging.
With better disclosure, we are taking the first step toward a market that reflects the financial integrity of managing for the long-term benefit of all of us who depend on public water systems.