Mary Tiger is the Chief Operating Officer of the Environmental Finance Center at University of North Carolina at Chapel Hill.
Testing the Waters
Measurements, benchmarks, and metrics. We’re no stranger to them at the Environmental Finance Center. In fact, we’re fans. (Have you seen our dashboards?) Credit rating agencies are also big fans of metrics. But when assessing a utility’s credit worthiness, credit rating agencies look at more than metrics to inform their ratings. This subjectivity can be challenging for a utility that wants to make sure that it is in the best position to go out to the debt market, making sure all of their financial t’s are crossed and i’s are dotted. The following blog post summarizes some of the most commonly cited themes in a review of recent credit rating summaries for water utilities in the U.S.
In general, credit rating agencies define a resilient utility as one that has revenue and resource flexibility, capacity, and predictability. Of course, these attributes are also important when assessing costs as well. The following excerpts from credit rating summaries highlight areas where flexibility, capacity, and predictability were addressed in general guidance or specific summaries from credit rating agencies.
Flexibility
As natural monopolies, governance structure and pricing strategy largely govern the flexibility of a utility. Credit rating agencies are looking for evidence of a utility’s will to utilize this flexibility in order to:
Increase Rates. Credit rating agencies are assessing whether or not political leaders and utility officials have, and will, raise rates.
- Alameda County, CA. “The district has historically raised rates annually, which has led to increased operating revenue over time and has offset some of the effects of conservation in recent years.” (Hannay and Dyson 2012). AAA/Stable
- Fort Worth, TX. “The downgrade reflects weak financial performance stemming from the city’s lack of willingness to raise rates in the current fiscal year to offset reduced water sales. Given this unwillingness, Fitch is concerned that the city may be reluctant to implement the magnitude of rate increases needed to regain historical margins.” (Seebach and Wenck 2013) AA
Absorb Temporary Financial Shocks. Reserves are commonly cited as a financial positive because they allow a utility to absorb temporary financial shocks, such as those caused by the implementation of watering restrictions in response to an unexpected water shortage. The number of “days-of-cash” on hand that a utility maintains indicates how long it could operate with absolutely no new revenue. Despite placing high value on the existence of these reserves, Standard & Poor’s cautions against the reliance on reserves, as they provide a limited amount of additional security and are sometimes used as a political “backdoor” to making unsustainable financial decisions (Chapman 2012).
- Daphne, AL. “Although the board may draw down unrestricted cash and investments from 458 days of operational expenses, one of the board’s financial principles is to maintain unrestricted cash equal to at least 120 days’ expenditures (Sagen and Waite 2012).” AA-/Stable
- Glendale, CA. “The negative outlook reflects our view that if unrestricted cash remains near $0 during the next two years as debt service and debt levels increase, we will likely lower the rating. In the nearer term, we believe the currently high debt service coverage (3.5x) and the ability of the water fund to borrow from the electric fund provide the water system some financial flexibility (Chapman and Hannay 2011).” AA/Negative
Adapt to Environmental Regulation. Credit rating summaries typically view and discuss regulation as a driver of capital costs outside utility control that can compromise a utility’s ability to increase rates and cover costs. “External regulations, government intervention, or scrutiny over affordability can limit an issuer’s ability to direct their own operations” (Medina et al. 2012)
- Jackson, MS. “The sewer system is under a state order from the Mississippi Commission on Environmental Quality (MCEQ) to address sewer overflow and sludge violations. …. Although consent decree requirements will likely allow the city multiple years to address identified sewer issues, the capital costs are expected to be large and could total as much as $600 million. The city’s ability to handle this amount of capital requirements given the lack of rate-raising history and financial / capital planning is reflected in the negative outlook. ….We will continue to monitor the outcome of the consent decree and management’s ability to plan for and manage the expectedly large capital requirements.” (Moody’s Investors Service 2011) Aa1
Capacity
To Increase Rates. Credit rating agencies are assessing how “high” a utility’s rates are by comparing its rates to those in surrounding areas and similar utilities. Low rates, when considered in the context of service area income levels, indicate a capacity to increase rates. If a utility is deemed to have high rates, affordability pressures may arise that could significantly decrease a utility’s capacity to increase rates. Credit ratings take into consideration capital improvement plans (CIPs) and approaches large CIPs with caution – weighed very heavily against the capacity of the utility to increase rates.
- Austin, TX. “Despite rate increases, the $71 residential bill for 8,000 gallons of combined service is especially competitive because of the water supply agreements already in place (Chapman and Murphy 2011).” AA/Stable
- Raleigh, NC. “Management has demonstrated a willingness to adjust rates….Despite annual increases, the system’s rates are still affordable relative to service area wealth levels. We expect management to continue to adjust rates as needed (Pezzimenti and Costa 2012).” AAA/Stable
To Meet Demand. Credit rating agencies are also viewing capital and resource plans of utilities to evaluate their capacity to meet demand. Under the current pricing structure of most utilities, demand equals revenue. In general, if a utility does not have the capacity to meet demand, it means lost revenue. The following excerpt provides insight into direct considerations of this relationship.
- Metropolitan Water District, CA. In dealing with short-term water shortages, like drought, Standard & Poor’s praised the Metropolitan Water District of Southern California for engaging effective drought policies to match demand to supply. “MWD implemented a 10% reduction in water available to customers in 2009 due to drought and reaffirmed it in April 2010. –However, they built up storage capacity to fill up when conditions are wet so that they can sell water during drought (Dyson and Hannay 2011).” AAA/Stable
Predictability
In addition, credit rating agencies take into account decision-making and financial arrangements between a utility and its governing body. Obviously, the governance structure of a utility and established contracts fall out of the exclusive control of utility management, but the credit rating agencies are also assessing the process and predictability of the arrangement. For example, S&P does not necessarily view a transfer from a public enterprise fund to the general fund of the governing body as a negative factor, as long as the transfer policy is “well-researched, flexible, consistent, and well-communicated (Standard & Poor’s 2007).” How a utility reacts, or better yet, how it anticipates its operating environment largely factors into its rating.
Certainly, credit rating agencies use a suite of quantitative criteria against which they benchmark and assess a utility’s credit worthiness, but they also place high value on utilities whose “day-to-day operations are relatively free from political interference” (Scott et al. 2013) and utilities that display “rate flexibility”; that is, they are willing and able to increase rates as necessary to cover costs (Dyson 2011). In a 2012 report, Moody’s discussed this “willingness” as a combination between the flexibility and capacity of organizations to manage rates and costs (Medina et al. 2012). For better or worse, in some circumstances, it may come down to professional “gut.”
References
Chapman, T. and R. Hannay. July 2011. Glendale, California; Water/Sewer Rating for Standard & Poor’s. Long Term Rating: AA(SPUR)/Negative. San Francisco, Calif.: Standard & Poor’s.
Chapman, T. and P. Murphy. November 2011. Austin, Texas; Water/Sewer Rating for Standard & Poor’s. Long Term Rating: AA/Stable. Dallas, Tex: Standard & Poor’s.
Chapman, T. 2012. U.S. Municipal Water and Sewer Utilities: Funding Long-Term Needs Remains Their Biggest Risk. Standard & Poor’s Credit Week, March 7.
Dyson, P. 2011. Global Credit Portal: Metropolitan Water District of Southern California; Water/Sewer. San Francisco, Calif.: Standard & Poor’s.
Hannay, R. and P. Dyson. January 2012. Alameda County Water District Financing Authority, California Alameda County Water District; Water/Sewer Rating for Standard & Poor’s. Long Term Rating: AAA/Stable. Unenhanced Rating: AAA(SPUR)/Stable. San Francisco, Calif.: Standard & Poor’s.
Medina, J., J. Aingorn, K. Krummenacker, M. Matesanz, D. Aschenbach, C. M. Hu and J. Hempstead. 2012. US Public Infrastructure: Slow Economic Recovery Tests Willingness to Manage Rates and Costs, October 23. New York, N.Y.: Moody’s Investors Service
Moody’s Investors Service. February 2013. Moody’s assigns Aa1 rating to Metropolitan Water District of Southern California’s Water Revenue Refunding Bonds. New York, N.Y.: Moody’s Investor Services, Inc. [Online]. Available: <http://www.mwdh2o.com/mwdh2o/pages/finance/PDFs/Moody’s_Report.pdf > [cited May 1, 2013]
Pezzimenti, J. and P. Costa. March 2012. Raleigh, North Carolina: Water/Sewer Rating for Standard & Poor’s. Long Term Rating: AAA/Stable. New York, N.Y.: Standard & Poor’s.
Scott, D., K. Masterson, A. Booker, and A. DeStefano. 2013. US Water and Sewer Revenue Bond Rating Criteria. New York, N.Y.: Fitch Ratings.
Sagen, S. and J. Waite. February 2012. Daphne Utilities Board, Alabama; Combined Utility Rating for Standard & Poor’s. Long Term Rating: AA-/Stable. Dallas, Tex: Standard & Poor’s.
Seebach, J. and T. Wenck. April 2013. Fitch Ratings downgrades its rating on the following Fort Worth, Texas (the city) outstanding revenue bonds: –$530.7 million water and sewer system (the system) revenue bonds to ‘AA’ from ‘AA+’. Austin, Tex: Standard & Poor’s.
Standard & Poor’s. 2007. Public Finance Criteria: Financial Management Assessment. New York, N.Y.: McGraw-Hill.
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