Until just a few weeks ago, municipal investors were growing increasingly concerned about the prolonged drought in the Western United States. The Western U.S. is experiencing the longest drought in 1,200 years¹, and the seven U.S. states that are a part of the Colorado River compact did not meet their end of January 2023 deadline to determine a joint plan for water-use reduction². The U.S. Bureau of Reclamation (USBR) may formerly declare a new allocation of water among the states, an event unprecedented since the signing of the Colorado River compact in 1922³. Water could become more expensive for millions of households and businesses throughout the West. In theory, municipal credit fundamentals for water and sewer systems, as well as tax backed issuers, could be negatively impacted.

Above-average snow and rain in California this winter has replenished many of the parched state’s shallow aquifers.⁴ This has sated investors’ near-term concerns about water-related credit risk. But the long-term picture for the Colorado River basin, and elsewhere in the U.S., remains focused on scarcity. Drought, water supply shortages, and regulatory risks bear monitoring.  

Drought

Drought is defined by exceptionally low precipitation, usually over an extended period of time⁵. During a drought, rain and snow are lower than normal, and water supply levels may be affected as snowfall and/or rainfall decreases, streamflow decreases, reservoir levels drop, and/or groundwater levels are adversely impacted. Breckinridge defines drought risk, therefore, as the risk that precipitation decreases in the region, leading to a shortage in water that reaches the water table, streams, rivers, and municipal water supplies.

Drought can negatively impact credit fundamentals by reducing water use and revenues. During a drought, even if the water supply is not immediately threatened, utility leaders and local governments sometimes instate mandatory cutbacks or reductions in water use, reducing revenues from metered sales.

Water supply

Supply risk can arise from drought risk, but it isn’t necessarily the same thing. Breckinridge defines supply risk as the risk that the primary, secondary, and other backup water supplies are reduced in availability or have a higher likelihood of disruption. Supply risk can arise not only from drought but from overuse or contamination of stable water resources as well as political battles. For example, governments not facing drought risk sometimes face risks associated with too few rights to water resources, water quality deterioration, or infrastructure failures. Supply risk can also be amplified by temporary or secular changes in water demand. For example, in hot and dry conditions, households with outdoor irrigation often increase their outdoor water use, putting more of a strain on water supplies⁶.

It is important for municipal bond investors to understand the distinction between drought risk and supply risk. In some cases, such as Phoenix, Arizona, using drought risk as a proxy for supply risk can dramatically overstate the water supply risk, as the city of Phoenix has secured its water better than many western counterparts⁷. Supply disruptions can also represent material risks to bondholders, as finding additional water supplies can be costly and politically contentious.

Drought and supply risks are not solely material for water and sewer system investors. They are also important risks to consider when investing in local GO bonds. Water underpins the cost structure of multiple industry sectors (in addition to agriculture) that drive local economies. Water is an essential component of power generation, many manufacturing processes, and for much of the cloud computing and storage that powers the modern technology sector⁸. Data service centers, which have grown in popularity in recent years, are highly water intensive, as water is used consistently to cool servers⁹.

Regulatory risks 

Water is both a public and private good, and all at once a local, state, and national resource. Water governance in the U.S. exemplifies the federalist system at work¹⁰. Investors benefit from understanding the interplay among the governmental units involved with each component of water management, insofar as they can influence credit fundamentals via supply and water quality regulation.

For the Colorado River basin in particular, states have played a central role in water management since the inception of the compact in 1922. Still, the federal government and the USBR remain involved, due to the presence of major dams such as the Hoover Dam¹¹, and the explicit ability to declare water shortages. State governments can also play a role in economic development and securing water rights. In California, for example, state growth and economic priorities in the agricultural sector partly explain California’s senior rights to Colorado River water (California has rights to more Colorado River water than any other state^{12, 13}).

Local governments play a role, too. Critically, at the municipal level, municipal governments often hold water rights, and have the power to secure additional or alternative water supplies. Water utilities and water districts are usually in charge of sending conservation signals via rate setting (such as inclining block rate structures) or cutbacks, and ultimately manage water distribution networks and end water users. It is not possible to consider water without thinking about all levels of government.

Conclusion

Municipal bonds issued by water utilities (and sewer utilities) are broadly considered among the safest in the market. They exhibit exceptionally low historical default rates¹⁴. The services they provide are highly essential. Most systems are monopolies with pricing power, strong legal protections for bond holders, and general immunity to political changes. A large majority of municipal water utilities are still reporting very strong cash and reserve positions following federal pandemic aid.

Nevertheless, water risks are still worth monitoring. We believe water risk should be evaluated alongside energy and carbon emissions as a major sustainability and credit consideration. We anticipate that water risks may become increasingly important to municipal credit fundamentals, over the long-term, for some issuers.

 
[1] https://www.weforum.org/agenda/2022/09/western-america-megadrought-climate-change-weather-affects/#:~:text=The%20current%20megadrought%20in%20the,and%20the%20summer%20of%202021.

[2] https://www.moodys.com/research/Public-Finance-US-States-failure-to-agree-on-Colorado-River--PBC_1356744?WT.mc_id=AM%7eTmV3X01hbmxfVVNQRkdf%7e20230207_PBC_1356744

[3] https://sgp.fas.org/crs/misc/R45546.pdf

[4] https://nasagrace.unl.edu/

[5] https://education.nationalgeographic.org/resource/drought/

[6] https://agupubs.onlinelibrary.wiley.com/doi/full/10.1029/2007WR006722

[7] https://www.phoenix.gov/waterservices/resourcesconservation/drought-information#:~:text=Phoenix's%20Water%20Supply%20Portfolio&text=Salt%20River%20and%20Verde%20River,Arizona%20Project%20(CAP)%20canal.

[8] https://fortune.com/2021/10/05/big-tech-water-use-environmental-impact-klir-ceo-david-lynchmore-must-read-commentary-published-by-fortune-historically-black-colleges-cant-solve-techs-diversity-problem-alone-three-simple-steps-for-m/

[9] https://time.com/5814276/google-data-centers-water/

[10] Both the federal government and state governments are involved in water management, in different ways depending on the specific jurisdiction. For example, aquifers often stretch across state boundaries, but are not managed at the federal level (https://www.yalelawjournal.org/note/state-water-ownership-and-the-future-of-groundwater-management). Rivers and streams, however, if navigable or meeting certain tributary definitions, are considered “waters of the U.S.”, and adhere to federal Clean Water Act standards (https://www.epa.gov/wotus/about-waters-united-states).

[11] https://www.usbr.gov/projects/facilities.php?type=Dam

[12] https://wrrc.arizona.edu/publication/sharing-colorado-river-water-history-public-policy-and-colorado-river-compact

[13] https://www.nytimes.com/2023/02/23/opinion/colorado-river-california-arizona-drought.html?searchResultPosition=3

[14] https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/fixed-income/moodys-investors-service-data-report-us-municipal-bond.pdf

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