Fitch: California drought may pressure water utilities’ margins

california drought image

The current drought in California could cut into water utility revenues and pressure financial margins, Fitch Ratings says. Statewide water conservation mandates could be announced this fall, and some water agencies have already initiated cutbacks.

After two years of dry conditions, California is experiencing a moderate-to-exceptional drought, and an exceptional drought has been declared for over 88 percent of the state. The federal Central Valley Project (CVP) and California State Water Project (SWP) provide much of the state’s water from the Sacramento and San Joaquin river basins. The largest of the SWP reservoirs, Lake Shasta and Oroville, are only at 25 percent and 22 percent capacity, respectively, or 40 percent and 35 percent of historical averages. As a result, the SWP water allocation is just 5 percent of the requested amount, the lowest since the prior drought that ended in 2016. The CVP, which provides water to seven of the state’s top-10 agricultural counties, implemented a 0 percent allocation for agricultural contractors.

Certain areas are exercising locally imposed voluntary or mandatory water conservation. Sacramento announced a stage 2 ‘water alert’, which has targeted up to 20 percent voluntary water cuts. Marin Municipal Water District has a goal of a 40 percent reduction in water usage. Santa Clara Valley Water District declared water shortage emergency conditions requiring a mandatory 15 percent reduction in usage relative to 2019.

This is the second extended drought in California in the past decade. During the five-year drought ending in 2016, the governor imposed mandatory statewide water cuts of 25 percent, with each water agency required to cut 4 to 36 percent based on gallons per person per day consumed. Water utilities responded by increasing the fixed component of rate structures, increasing rates overall, and/or making continued significant investments in increasing water storage and diversification of supplies. While many utilities experienced one to two years of reduced financial margins, steps taken resulted in rebounds for most, and Fitch did not take any negative actions on water utility credits.

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However, due to ongoing droughts, utilities generally have less rate flexibility and fewer tools available to mitigate potentially lower revenues/sales. Utilities’ ability to absorb lower revenues is highly dependent on an individual utility’s supply portfolio, its financial picture going into a drought and rate affordability in the service area. Most Fitch-rated water utilities are highly rated, reflecting robust margins and rate setting flexibility. Those with margins that are low for the rating category may see greater credit pressures. Utilities that purchase most of their water supply can reduce purchases, somewhat offsetting lower water sales.

The enactment of water cuts under the Colorado River Drought Contingency Plan does not affect California utilities immediately, but material cuts could occur in early 2024 if reservoir levels do not stabilize or rebound.

California Gov. Gavin Newsom recently announced a $15 billion climate package, which includes $5.2 billion over three years for water and drought resilience. Funds may be spent on projects to secure and expand water supplies and support water and wastewater infrastructure, and should bolster utilities’ financial resources and ability to address drought preparedness.

With continued droughts occurring at more frequent intervals, conservation measures could become harsher, leading to even greater stress on water utilities. Forecasts for fall and winter 2021 increasingly reflect the potential for La Niña development, associated with drier conditions in southern California. Most California water utilities carry ESG Relevance Scores (ESG.RS) of ‘3’ for environmental impacts, as utilities are able to manage drought conditions at this time. Fitch’s ESG.RS are expressed on a ‘1’ to ‘5’ scale, with ‘1’ indicating irrelevance and ‘5’ being highly relevant for the rating.

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