At the beginning of July California released data on its water conservation efforts. It is reported that residential water consumption fell 28.9% in May, which is better than the 25% mandated reduction. The credit impacts from reduced water and waste water (W/WW) consumption should be limited in the mid-term. Mid to large W/WW credits exhibit robust covenants, flexible financial capacity, strong capital positions and generally conservative management practices. Mid to large systems rank higher in our credit process than small systems because they are more robust operators and their service areas typically have median household incomes above the national average. System characteristics also measure asset condition. Asset Condition is the useful life of fixed asset in years. Low asset lifespans is a credit negative because it presents operating risks such as failing pipes or an inability to meet environmental regulations. Systems that have delayed upgrades need capital infusions, which generally means more debt and rate increases. When new debt is issued, most often it is backed by a net revenue pledge and debt service covenants of greater than 1.1x coverage. While legal protection and covenants are important, our credit analysis is more vigorous.
California W/WW credits also exhibit significant financial capacity. The drought and conservation efforts have reduced water consumption, which means less sewage needs treatment and revenues fall. Debt service coverage ratios are calculated on net system revenue basis (net of maintenance and operating cost). Coverage ratios can be relatively stable even as revenues fall because maintenance and operating (M/O) costs fall as well. For example, between FY’13 and FY’12, when water usage began to fall, San Diego Sewer M/O costs dropped 5.7% while revenue from charges for services only fell 2.3%. W/WW credits have significant financial flexibility to maintain pledged coverage ratios in the face of falling consumption. The question then turns to, what if all the efficiency gains are captured and revenues continue to fall due to reduced consumption? In this event, prices can be increased to cover the fixed costs so that minimum debt service coverage ratios are met. So while CA residences are reducing water use their water bills could still increase. In all, the drought conditions in California are projected to get worse before they get better but the good news is W/WW credits should maintain their position as a high credit quality municipal sector for clients in our California specific municipal strategy.
Source: SNWAM Research