By Dennis Pidherny & Audra Dickinson
U.S. water utilities fared remarkably well during the coronavirus pandemic and appear to be withstanding the effects of inflation on operations and capital spending thus far. This is not to say the sector hasn’t struggled.
Operating costs are up across the board following a decline in fiscal 2020, but year-over-year operating revenue growth has largely kept pace. Capital spending has also increased as a percentage of depreciation for retail and wholesale issuers in recent years, likely as a result of greater needs and higher pricing for labor and materials. The five-year average median ratios for retail systems are above 150 percent for the third year in a row, whereas the ratio for wholesale systems totaled 170 percent last year.
Despite increasing costs, financial performance has been very strong. Leverage fell slightly for retail systems in 2021, and rose only modestly wholesale systems. Moreover, liquidity for water utilities remains robust with solid COFO levels over 2.0x and current days cash on hand well over 550 days, which should buffer the effects of higher inflation and position water utilities quite well to absorb higher costs through 2022 year-end.
That said, a pivotal question for water utilities’ inflationary resiliency heading into next year is “For how long?”
‘Mild Recession’
The historical evidence on monetary policy tightening resulting in U.S. recessions is too compelling to ignore. Fitch is now expecting GDP growth of 1.7 percent this year and only 0.5 percent in 2023 with a “mild recession” now in the cards for mid-2023. This is shaping up to be one of the fastest monetary policy-tightening cycles in US history with the trough-to peak hike in rates taking only 10 months. The Fed is now expected to take rates to 4 percent by year-end and hold them there through 2023.
In contrast to the role of quantitative easing in the pandemic, central bank policies are no longer supportive of fiscal easing to protect households and firms from economic shocks. With liquidity conditions tightening, large-scale fiscal easing could push up long-term real interest rates.
In summation inflation is making its presence more resoundingly felt across the U.S. and throughout the world with harsher-than-expected fallout. Fitch now expects inflation to remain at 7.0 percent through 2022, up from expectations of 4.5 percent in March of this year.
So what does this mean for water and sewer utilities throughout the country? With Fitch recently raising inflation estimates and downshifting on its U.S. GDP growth projections as a result, water utilities are in for a tougher test in the coming months.
A closer look at some pillars of Fitch’s water utility analysis reveals the following:
Operating Costs will continue to rise: On the labor front, utilities have faced staffing challenges like many other industries. This is pushing personnel costs higher as utilities implement significant cost of living pay increases for existing employees and face the necessity of offering higher pay to recruit new employees. Energy costs have also skyrocketed with electricity prices in some regions more than double compared to last summer. Decreased availability and supply chain disruptions have pushed the cost of chemicals higher, as well.
On the capital side, utilities have reported 50-60 percent increases in steel costs over the last year. Rebar, concrete and lumber prices are also up anywhere from 10 to 35 percent. Contractor costs have increased so substantially that, in some cases, existing bids are being renegotiated as increases cannot be absorbed by contingency budgets. To date, most utilities have been able to absorb the higher costs as appropriated capital budgets often exceed actual spending by a healthy margin, but future spending flexibility will certainly be limited.
Days cash on hand will fall; Debt will rise: Utilities will likely tap their strong cash reserves to cover higher costs and capital spending over the near term. The draw down in cash along with higher daily operating costs will both contribute to weaker cash on hand metrics. Additional debt issuance could help restore cash balances, but with long-term revenue bond interest rates up roughly 200 basis points since the end of 2021 borrowing could be delayed. Nevertheless, higher capital costs and spending will trigger higher than anticipated debt issuance over the next several years as infrastructure is appropriately funded with long-term debt.
Affordability will be pressured: Larger and more frequent rate increases necessary to offset rising costs, together with higher inflation and lower economic growth, will almost certainly strain affordability measures. Despite strong employment and robust nominal wage growth, real household income has fallen modestly since 2019 and is projected to remain flat over the next few years. Higher water and sewer charges, even after adjusting for inflation, are therefore likely to account for a higher percentage of household income going forward, and could be particularly burdensome for the most vulnerable and economically sensitive households.
Conclusion
Water and sewer utilities entered 2022 in the strongest financial position in over a decade, but current market events and economic pressures will test the sector’s resiliency. The lingering effects of supply chain disruptions, a tight labor market, sustained higher inflation and a diminished appetite to debt-finance capital projects in light of higher interest rates have all contributed to an increasingly challenging operating environment.
Very strong liquidity and ample borrowing capacity will help utilities manage these challenges through 2022, but absent diligent cost controls and proactive rate-setting prolonged pressures could erode financial buffers and have a more profound impact in 2023.
Dennis Pidherny is a managing director at Fitch Ratings. He oversees analysis for Fitch’s U.S. Public Power and Water & Sewer groups. In his current role he is also responsible for presenting and disseminating Fitch’s research to a wide variety of institutional investors, lenders and other financial intermediaries.
Audra Dickinson is a senior director at Fitch Ratings, sector head for its Water & Sewer group, and is based in Austin, Texas. She previously served as a senior utility financial analyst for Austin Water where she focused on debt-related matters specific to Austin Water, and related water revenue bond issuances.
