Independent Thinking^®

It Never Rains in California

Financial pressures are rising on California water utilities as the state confronts its fourth year of drought with expanded restrictions. Rate increases are inevitable if credit quality is to be maintained.

Background

California has for the first time implemented mandatory statewide water restrictions. The executive order issued in April 2015 by Governor Brown requires the California State Water Resources Control Board to target a 25% statewide reduction on 2013 usage levels. This order was precipitated by the state’s fourth consecutive year of drought, which has significantly reduced water availability in key reservoirs.
 
For water enterprises, maintaining sufficient revenue is a greater risk in the near term than actually running out of water to sell. Most urban water enterprises have some remaining storage, or access to a fair amount of storage, through their wholesale provider. Drought mitigation requires continuous planning, however, and current efforts are being sorely tested.
 
The effects of the drought are being felt differently around the state. As bond investors, we are focused predominately on the major metropolitan areas in Southern California and the Bay Area, which are still relatively well supplied, thanks in large part to significant investments in conservation. Per capita water use in Southern California has dropped 25% since 1990, mostly as a result of reductions in its use in landscaping. All told, California cities account for 10% of water usage in the state.
 
The drought has had far more severe implications on the agriculture sector, which is exempt from the recent state executive order. Efficient markets and pricing are necessary to combat scarcity as a whole, however. They are essential to induce both conservation and investment in water-saving technology, and to steer water to where it is valued most. Because 40% of usable water in California goes to agricultural purposes, mostly through irrigation, it is important to understand how water is priced, and traded to and by farms. (The remaining 50% is categorized as environmental, such as allowing water to flow to rivers for fish spawning season and to ensure that saltwater doesn’t seep in and contaminate drinking water, particularly in the Sacramento-San Joaquin River Delta.)
 
Farmers pay if the government brings the water to the farm, say via an aqueduct from the Colorado River, but the fees are minimal. This subsidized arrangement explains why many farmers use inefficient irrigation methods such as flooding fields. Also, a farm that doesn’t use its full allotment of water risks forfeiting it for not putting it to beneficial use. Any water saved automatically goes to other farmers with junior rights.
 
While agricultural water prices matter to investors in California debt, what matters more is the value of the water in crop production, especially at the margin. California farmers have shifted markedly in recent years to thirsty but profitable fruits, nuts, vegetables, and nursery crops. This has reduced the farmers’ ability to withstand intermittent water shortages as bushes and trees needs continuous water.
 
In 2014, growers lost about 6.6 million acre-feet (an acre foot is approximately 326,000 gallons of water or enough water for four families for one year) of surface water because of the drought. A significant increase in groundwater pumping made up for 75% of that loss, and farm-to-farm water sales helped farmers keep valuable orchards and vineyards in business. However, large cuts in crop acreage were unavoidable. Farmers had to fallow about 500,000 acres, or 5%, of the irrigated acreage.

State Bonds

Six state general obligation bonds, voter-approved debt reimbursed with general fund taxes, were approved between 2000 and 2006, providing roughly $15 billion for water projects. (See our piece from October 2014, “California Goes to the Polls, Again”). In November, voters approved Proposition 1, a $7.5 billion bond that extends this support.
 
State bonds are important, but they actually play a minor role in financing California water. State bonds provide approximately $1 billion of the more than $30 billion in annual water-related spending. Local revenue, from water and sewer bills to taxes, provides the majority at 84%. The state contributes 12%, and the federal government just 4% of the total.
 
Not surprisingly, the rating agencies have begun to express some concern about the long-term effects in the drought on the financial condition of water utilities around the state.

Crisis Fosters Conservation

Droughts encourage better water management, including increased conservation and investments in new supplies, such as recycled wastewater, groundwater storage and storm water collection. In 2014, significant reforms were signed into law, laying the basis for more sustainable management of groundwater.
 
Cities are also focusing on water pricing to improve conservation, particularly tiered rates that charge higher per-gallon rates for greater water use. However, cities must be careful in how they structure these tiered rates following a recent ruling by a state appeals court¹ that cities and water agencies can charge only as much as it costs them to provide services to customers. In other words, tiered rates are legal only when additional water costs more to supply.
 
Clearly, water agencies need to figure out the true cost of water, not simply draw lines based on water budgets and conservation goals. At the same time, their rates also need to provide revenue streams that are stable when water sales fall, so that utilities can still cover their fixed costs. Ideally, rate structures should allow per-gallon prices to increase during droughts to deal with the decline in usage while maintaining debt service coverage and funding capital needs.

Conclusion

We still believe in the strength of these California enterprise systems, particularly in the state’s urban markets. The heightened attention to this issue, caused by these new restrictions, increases the likelihood that they will gain political support for raising rates.
 
California is such a large, economically diverse state, with such a variety of municipal debt securities available, that investors can limit holdings primarily within California and still achieve some diversification. This also applies to water revenues bonds based on the different regional economies and varied sources of water.
 
At Evercore Wealth Management, we focus most of our investments in this sector on the large water utility systems that enjoy certain advantages, including the ability to spread fixed infrastructure costs over a wide customer base.
 
These systems, including the California Department of Water Resources, Metropolitan Water District of Southern California, Los Angeles Department of Water and Power, San Francisco Public Utility Commission, and the San Diego County Water Authority, which have several water sources and extensive technical expertise. In recent decades, they have expanded connections with neighboring utilities, which allows water sharing during shortages. By contrast, smaller, more rural or agricultural systems are often geographically isolated and face high costs per customer for new investment. They usually rely on local groundwater.
 
Our expectation is that the largest water agencies in California will manage their operations in a manner that ensures the payment of debt service in a timely basis while financing continued maintenance and improvements to their capital plant.
 

¹ The court ruled that attempts by local governments to structure rates to encourage conservation is in violation of Proposition 218, the revision in the state constitution that prevents fees unless a service is actually used by the property owner.

Water and Pricing:

The current drought does not necessarily herald a long-term change in the amount of rainfall California can expect in future years. The National Oceanic and Atmospheric Administration, or NOAA, has not identified a discernable pattern in the precipitation data since 1895 and instead attributes the changes to natural internal atmosphere-ocean variability. However, the warmer weather in California exacerbates the severity of the current drought by reducing snowpack levels. In short, it looks like water will be an issue on the minds of investors in California for the foreseeable future.

Los Angeles Department of Water and Power Water Enterprise System (LADWP): A Large Urban Water Supplier

LADWP was selected as a typical California water system we continue to invest in along with other large urban water providers with varied water sources. LADWP serves approximately four million people. It has three principal water supply resources: Metropolitan Water District’s (MWD) Colorado River water and state water project purchases, the most costly resource available to LADWP; the Los Angeles Aqueduct, which conveys Owen Valley and Mono Lake water; and, local ground water. The utility’s dependence on MWD ebbs and flows based on Sierra Nevada snowpack conditions with allocations increasing during drought periods. Potential new supply sources include aggressive conservation initiatives, clearing of contaminated ground water supplies, increase storm water capture, and development of water recycling facilities and related recycling infrastructure to recharge aquifers and substitute recycled water for potable water where possible.
 
Despite the ongoing drought that pressures water supply and costs, LADWP continues to show bond trading resiliency. As the spread chart indicates, over the last year-and-a-half, LADWP 9-10 year paper traded within a very tight range of approximately 20 basis points compared to the AAA scale demonstrating a comfort by investors that the utility has the ability and resources to manage under the current drought conditions and expected large future water supply fluctuations.

Growth in Desalination:

Desalination, the process of forcing seawater at high pressure through special membranes to remove salt, has emerged as a potential solution in California in the face of the current drought. San Diego County Water Authority is in the midst of constructing the largest desalination plant in the western hemisphere, a $1 billion project on a coastal lagoon in Carlsbad. It is due to open in 2016, delivering up to 50 million gallons of water a day – enough to supply about 7% of the county’s water needs. Another 15 seawater-desalting plants are in the design or planning phase around the state.
 
The desalination process is very expensive, as it requires large amounts of energy. The technology requires so much electricity that the resulting water cost twice as much as water from other sources. Desalinated water from the Carlsbad plant will cost just under $2,000 per acre foot to produce. That’s compared to roughly $1,000 for treated water from the Metropolitan Water District of Southern California, the wholesale provider of water using northern California and Colorado River water.
 
The viability of desalination should be reviewed as part of a range of measures that include increased conservation, wastewater recycling, and storm water recapture. Besides desalination’s cost, there can be environmental drawbacks, such as harm to marine life from intake pipes and the concentrated brine that gets discharge back into the ocean. Of course, the alternative is diverting freshwater from rivers and streams and pumping it into urban area. It could solve one aspect of the drought while exacerbating greenhouse gas emissions from increased electricity production.

 
Howard Cure is Director of Municipal Research at Evercore Wealth Management. He can be contacted at [email protected].