Water Risk in the Municipal Bond Market

the report: The Ripple Effect: Water Risk in the Municipal Bond Market

authors: Ceres: National coalition of investors, environmental groups and other groups with a passion for sustainability challenges.  Pricewaterhouse Coopers: Big company focusing on audit and assurance, tax and advisory services. Water Asset Management: A global equity investor in public and private water related companies

why?: Municipal bonds are bought based on their credit ratings. This report contends these ratings "take little account of utilities’ vulnerability to increased water competition, nor do they account for climate change, which in many areas is rendering utility assets obsolete. Consequently, investors are blindly placing bets on which utilities are positioned to manage these growing risks".

The big three examples in the report:

• The City of Atlanta’s water supply and the possibility that supply could be cut by nearly 40 percent as early as 2012 due to the ruling of a federal judge.
• Lake Mead and the possibility of reduced water deliveries to Arizona and Nevada;
• Hoover Dam and the possibility of the reduction of electricity production as soon as 2013 if water levels in Lake Mead don’t begin to recover

Some Southeast examples noted:

• During the last drought, Southern Company was forced to buy $33 million in fossil fuels to replace lost power in Atlanta when hydropower generation declined by half due to low water levels
• Hilton Head has abandoned eight of the island’s 12 supply wells since 1990 due to saltwater intrusion.
• In August 2010, the Tennessee Valley Authority (TVA) reduced generation at three of its facilities in Alabama and Tennessee when a heat wave pushed water temperatures to the permitted maximum temperature.

The Beef: The report says the credit rating methods "obscure the vulnerability of water utilities to water risks, and may even discourage utilities from taking necessary steps to manage a sustainable system". They reviewed credit risk assessment methodology by Standard & Poor’s, Moody’s, and Fitch and found the following faults with their assumptions:

• Water flows are assumed to be consistent with the recent past. Basically, credit ratings typically do not consider "the revenue effects of natural reductions to water supply, or the likelihood of such reductions".
• Supply projections are not stress-tested to consider impacts on rate and revenue.
• Water constraints are not assessed across the supply chain between wholesale and retail providers.
• Unless a utility is in the midst of severe supply constrictions, credit agencies are almost hostile to conservation pricing and demand-side management.

 Report Recommendations: Water Utilities

• Improve disclosure of material water stresses such as exposure to persistent drought or long-term climatic changes, interstate legal conflicts over shared water resources, and potential and existing regulatory actions related to environmental flows. 
• Implement strategies to manage demand and reduce leakage, such as cost- effective infrastructure improvements to reduce water loss, and deployment of conservation incentives and new pricing strategies that reflect water scarcity and reward water-savings.
• Invest in infrastructure that reduces risk such as “closed loop” alternative supplies (including indirect potable reuse), and green infrastructure.

Rating Agencies

• Employ water risk stress tests to understand an issuer’s sensitivity to stresses such as legal rulings over contested resources, restrictions for environmental reasons, or changing climatic conditions.
• Factor water intensity into rating opinions for electric utilities.
• Reward with higher opinions utilities that manage water demand through pricing in anticipation of future supply constraints.