By Doug Scott
U.S. water and sewer utilities will see some weakening in their financial profiles over the next several months, effectively reversing a trend of steadily declining leverage in recent years as utilities limited the rate of debt growth and posted robust operating margins. Part of the reason for the change is the wide-reaching ripple effect of the global coronavirus pandemic.
As a result, Fitch Ratings expects a reduction in cash reserves and a gradual rise in sector leverage through fiscal 2023 due to robust capital expenditure growth in fiscal 2021 and over the medium term. In Fitch’s base case scenarios, leverage is expected to rise by more than 20 percent across the rated portfolio from fiscal 2020 to fiscal 2023.
That said, Fitch views the sector as well positioned to absorb the added leverage without facing widespread downward rating pressure. The rise in leverage was not surprising, and was actually marginally less than Fitch originally predicted at the beginning of this year. Another encouraging sign for the sector is operating margins, which Fitch projects will improve in fiscal 2022 as rate adjustments take effect.
Capital spending has increased notably in recent years, particularly among small utilities, which increased yoy capital spending 22 percent in fiscal 2019 followed by another 36 percent increase in fiscal 2020. Financing of capital projects will come predominantly from borrowed sources at least initially, which is a departure from recent medians published by Fitch. However, as financial margins start to improve beginning in fiscal 2022, Fitch expects utilities will gradually start scaling back on debt issuances and utilize more pay-go funding sources.
Regional Takeaways
Utilities in the Far West and Southeast are set to produce slightly higher operating revenues relative to other regions, while North eastern and Midwestern utilities will, like in past years, see modestly lower relative growth through fiscal 2023. Southwestern water utilities, which traditionally generated relatively higher revenue gains are looking at the lowest among the regions over the scenario period.
As far as operating expenditures go, the Far West and Southeast have generally seen the highest rates of increase, while the Midwest and Southwest typically show the lowest escalations and the Northeast is at the midpoint. Fitch expects this trend to continue by and large through the scenario period.
Despite considerable year-over-year (yoy) fluctuations in capex growth, the Far West, Southeast and Southwest have seen the highest growth rates, which may be attributable to growth patterns in these regions and costs to develop additional supply sources. Financing of capital projects over the scenario period is projected to originate predominantly from borrowed sources in the Midwest, Northeast and Southwest, while the Far West and Southeast are expected to use pay-as-you-go funding for the bulk of their capital outlays.
Capital spending has increased notably in recent years, particularly among small utilities, which increased yoy capital spending 22 percent in fiscal 2019 followed by another 36 percent increase in fiscal 2020.
The Northeast and Midwest have generally produced moderately weaker debt service coverage and coverage of full obligation as well as higher leverage versus other regions (a trend likely to continue). Fitch anticipates the Southwest to perform at the midpoint and the Far West and Southeast having the most favorable financial profiles. Similarly, Northeast and Midwest credits will have the least rating headroom compared to the other regions, while Far West credits are expected to have the greatest.
Headline Headwinds Lie Ahead
The sector also faces some headline challenges over the next several months with much of it emanating from the Southwestern United States.
Mandatory water cuts from the Colorado River for the 2022 water year were recently announced by the U.S. Bureau of Reclamation (USBR) in its Colorado Basin August 2021 24-month study. The study states that Lake Mead will operate under a tier 1 shortage for the 2022 water year as required by the 2019 Drought Contingency Plan, the Congressionally approved water management plan for the Colorado River basin between the Department of Interior, USBR, and all seven affected states. The cuts primarily impact Arizona and Nevada, which will experience reduced water allocations from Lake Mead by 18 percent and 7 percent, respectively.
For Arizona, cuts will primarily be felt by the Central Arizona Project (CAP), managed by the Central Arizona Water Conservation District (CAWCD). CAP will see its allocations of Colorado River water cut by 30 percent of its normal supply, with these cuts borne by the agricultural community. Municipalities and tribes will not experience cuts to their water deliveries under the tier 1 DCP declaration, but their costs will rise as CAWCD increases rates to offset lost agricultural sales. CAP’s largest municipal purchasers include: Tucson, Phoenix, Scottsdale, Gilbert, Mesa and Peoria. Fitch does not expect any immediate credit effects from the tier 1 DCP declaration, though rising costs could eventually pressure rate affordability by CAP purchasers. Additionally, a continuing drought in the Colorado River basin could ultimately negatively impact CAWCD’s financial performance.
For Nevada, the 7 percent cut is not expected to have a near-term effect as the state had already reduced its deliveries, according to the Southern Nevada Water Authority.
For California, a tier 1 DCP declaration does not immediately impact Colorado River water deliveries. California would not be required to take cuts until Lake Mead levels are less than 1,045 ft (tier 2b). Lake Mead levels were 1,067 ft as of Aug. 16, 2021, equal to about 36 percent of capacity. Projections from the USBR’s study point to Lake Mead levels falling below 1,045 ft by mid-2023, which would reduce the state’s 2024 allocation. Despite cuts that would be triggered at the tier 2b, Fitch does not expect the reductions to substantially impact California’s supplies due to the diversity of its water sources, manageable demand and considerable water storage levels in Southern California. However, continued drought paired with variable State Water Project supplies could ultimately pressure water rate affordability.
Conclusion
Water and sewer utilities face numerous sectoral and region-specific challenges in the coming months that will marginally weaken the sector’s historically robust financial results over the next few years. Ratings of much of the sector, however, should remain intact.
Doug Scott is a managing director in Fitch Ratings’ U.S. Public Finance Group. He serves as manager and analytical head for both the U.S. water and sewer sector as well as the U.S. municipal bond fund sector, which includes state revolving funds and municipal bond banks. Scott has also served as manager of Fitch’s Southwest regional office, which covers local government credits.
