By William Atkinson
Capital Expenditures
Janney Montgomery Scott (JMS; www.janney.com), a financial services firm, divides water into four demand channels: municipal, construction, industrial, and agricultural. "We are very bullish on municipal," said Ryan Connors, managing director, Equity Research. "In fact, our major message to our customers these days is that they want to own stocks that are tied to the municipal market because this is the one of the four markets that is finally working its way off the bottom and will be a nice source of growth going forward."
The firm has substantiated this through a number of different surveys of municipal governments in terms of their capital expenditure spending plans for water. "On average, they are planning to increase this spending 8 to 10 percent per year for the next two years," said Connors.
The reason for increased capital expenditure spending is somewhat of a "perfect storm," as Connors described it. There was a lull in project activity that began in late 2011 and early 2012, he explained. Because a lot of cities took a financial hit during the recession, they had to delay projects. However, these projects can't be delayed indefinitely, so there is currently a lot of pent-up demand for projects that were on the books but never happened. In 2013, the finances of a lot of these cities started to rebound. Tax receipts began reaching new record levels. "Now that they have the funds again, they are beginning to move ahead with the projects that they had previously delayed," he said.
Funding Challenges
Still, though, there are likely to be some funding challenges, according to Geoff Buswick, managing director and lead analytical manager for the U.S. Public Finance Infrastructure Group of Standard & Poor's (S&P; www.standardandpoors.com). "Standard & Poor's continues to see a slowdown in the amount of capital market debt being issued, despite the fact that the sector's needs are as large as they have ever been," Buswick said. In 2010 -- a year that was admittedly very busy due to the availability of Build America Bonds associated with the stimulus package -- total capital market municipal utility bond activity was about $45.3 billion, he noted. In 2013, that had fallen to just over $30.2 billion.
Because municipal-owned water and sewer systems tend to derive virtually all their operating revenues from local ratepayers, they are less impacted by the recession. "Simply put, they did not have to worry about flat property tax bases or year-over-year declines in local option sales taxes, or even cuts in state funding," said Buswick.
However, the flip side of that is that, as operating costs continue to increase and capital budgets grow larger with reinvestment and growth-driven needs, utilities look primarily to local ratepayers to fund those costs. S&P has noted in several recent articles that the average bill to a typical residential customer, while still relatively affordable, is increasing faster than the rate of inflation and income growth -- and even other utility services.
"In an effort to leave no stone unturned, the sector has responded with a number of innovations to help manage these costs," he said. For example, in 2014, DC Water and Sewer Authority issued the sector's first-ever "Century Bonds," with a 100-year maturity schedule -- far longer than a typical 20- to 30-year municipal repayment schedule. The Authority's logic was that, since the assets themselves (CSO storage tunnels) will last at least that long, and since future generations will also benefit from them, the financial treatment should match the useful life.
What is becoming a growing trend across the entire U.S. municipal bond universe is the use of direct bank loans. "While these direct loans were executed because they probably represented the most expedient and low-cost option of borrowing for the utility, they are not without risks -- to the utility as well as to the bondholders of debt that the utility has already issued," said Buswick.
S&P believes that the Water Infrastructure Financing and Innovation Act (WIFIA) will help, as will the U.S. Department of Agriculture's $10-billion rural infrastructure public-private partnership (P3) fund.
WIFIA, one of the provisions of the Water Resources Reform and Development Act, is a program co-administered by the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers to provide secured loans and loan guarantees to government and non-government entities for up to 49 percent of eligible project costs. WIFIA is patterned after the Transportation Infrastructure Finance and Innovation Act (TIFIA). Projects financed through WIFIA must exceed $20 million in total cost and must be deemed creditworthy by either the EPA or Army Corps. The projects must also be rated as investment-grade by at least one rating agency. The total five-year appropriation for WIFIA is $350 million, split 50-50 between the EPA and Army Corps, with 2015 being the first year of funding (to the tune of $40 million).
However, according to Buswick, WIFIA and the P3 are small in relation to the totality of the sector's need. For example, WIFIA for now is only a five-year pilot program, and the immediate concern is that any utility using WIFIA funds is currently not allowed to fund the remainder of the project's total costs with tax-exempt bonds, which are historically the most common municipal utility financing tool. "However, we believe that, if WIFIA works like its transportation counterpart and demonstrates that it is, at the very worst, cost-neutral to the federal budget, then it will likely gain a permanent place in the federal budget," he said.
S&P anticipates that, over time, the industry will continue to innovate financially and regionalize operationally when it makes sense to do so. "WIFIA may help to drive large projects such as what we have seen in California and Texas," said Buswick. "State revolving funds, which are probably the cheapest cost of borrowing for any utility, will become increasingly competitive should EPA appropriations continue to be pressured." Ultimately, however, according to Buswick, drought conditions will reprioritize capital improvement programs that, for many urban areas, are currently being driven by EPA mandates. "The obvious risk of reprioritization is that deferral of a project can mean that it becomes more expensive when it comes time to finally do it," he said.
In addition, according to Buswick, it seems as though environmental regulators are trying to be more cognizant of utilities that are in the middle of large, enforcement-driven capital improvement programs. In recognizing that some of the utilities addressing these date-certain cleanup efforts sometimes have a rate base that reflects limited local financial resources, the EPA and its state equivalents have at times granted deadline extensions. "While extensions are still the exception and not the rule, and EPA has noted that it will still expect full compliance without exception [with] both the Clean and Safe Drinking Water Acts no matter what, it does indicate a less unilateral enforcement environment," he said.
Connors of JMS also identified two key points the industry needs to consider going forward into 2015 in terms of cap-ex funding. "One is the real estate market," he said. "Most of the taxes that municipal governments collect come through real estate taxes. So, if there is a really hard reversal in home prices, that could impact tax revenue and thus the scaling back of projects." The other is the job market. That is, two additional sources of revenue are income taxes and sales taxes -- both of which are tied to the economy. "So if there is a pullback in the economy, this would affect the job market, which would affect tax revenues," he said.
Sweltering in the Southwest
While water utilities in all parts of the nation have funding concerns for new projects, those in the Southwest have the most to gain -- or lose. "The U.S. Environmental Protection Agency's needs assessment surveys for drinking and clean water infrastructure point to over $600 billion that we need to spend over the next 20 years just to maintain the status quo," said James Breeding, senior director and analytical manager for the U.S. Public Finance Infrastructure Group of S&P. "Standard & Poor's is not alone in believing that number greatly underrepresents total needs, given the criticality of water supply issues in so many places in the United States, especially in the Southwest and West," he said. "California's drought is now so profound and prolonged that the state water board in July 2014 declared a state-wide water emergency, including mandatory water conservation measures. The economic impacts of the drought are staggering."
According to Breeding, for drought-stricken areas out west like California and the Colorado River Basin, utility managers will be watching the 2014/2015 winter closely and hoping for precipitation to increase snow pack, refill reservoirs and replenish groundwater supplies. "However, if dry conditions continue, we believe focus will be turned to further conservation programs and perhaps mandatory water restrictions," he said. "With drought on people's minds, we believe we may see accelerated planning for future supplemental water supply and water storage projects."
Voters in California approved a $7.5-billion general obligation bond measure in November that will support state-side water projects, with $2.7 billion of that slated for water storage projects. "We will also see continued progress on supply projects conceived in the past and under construction today, such as the large Poseidon desalination plant in the San Diego area, as well as Southern Nevada Water Authority's third intake at Lake Mead," said Breeding.
About the Author: William Atkinson is a correspondent for WaterWorld Magazine. He has been a full-time freelance business magazine writer since 1976, specializing in infrastructure, sustainability, supply chain, risk management, and safety/health.
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