Municipal water and sewer systems were remarkably resilient and even the unsung heros of the municipal market during and immediately after the worst of the pandemic-related recession. Most systems have, to date, not experienced a material financial impact. Utility managers are in fact used to unfavorable variances to budget, albeit nearly always because of the weather. In our view longer-term headwinds are on the horizon; for every rate adjustment that is scaled back or deferred so too will there be deferred maintenance. Further, challenges associated with potential drought conditions, rate affordability, and regulatory changes may pressure the sector. The impact of President Biden's administration and a Democrat-controlled Congress through at least 2022 is probably slightly credit positive but far from fully defined. Utilities will, however, remain the darling asset class for ESG investors, even as they are also on the front line for dealing with climate change.

Our view on 2021 highlights three key questions that matter for the health and stability of credit quality of municipal water and sewer systems. While there remain challenges, the risk profile still points to balanced credit performance. The lack of a unified federal response to COVID-19 and varying recessionary--and recovery--impacts means that among the nearly 50,000 community drinking water systems in the U.S., there are nearly as many stories. Immediate-term disruptors still loom, on top of the longer-term challenges of aging infrastructure and workforce and how to pay for it all.

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Questions That Matter

1. Why has S&P Global Ratings revised its sector view to stable from negative?

The impact of COVID-19 on communities has clearly been uneven, but fortunately not ruinous. For those that have experienced a dip in revenues and a spike in late-paying customers, we have observed that even the biggest dips are mostly high single digits. For many communities--generally suburbs with revenues mainly from single-family residential customers who could work from home--there were no impacts at all. The immediate dip in financial capacity--including the ability to meet an additional bonds test--has thus far not played out for most of our rated systems.

How this will shape 2021

Scaling back or even postponing larger rate adjustments.  Many local governments and utility boards did not blink when it came to inflationary-sized rate adjustments for fiscal 2021. But for others in which the magnitude of a considered adjustment was going to be larger, we observed instances in which a lesser rate increase--or no increase at all--was ultimately part of the final adopted budget. This will also greatly influence the preparation of the fiscal 2022 budget and the multi-year capital plan.

Continued preservation of cash.  For most systems we rate, the capital budget is supported by a variety of financial resources. Most commonly it is a mix of borrowing and use of annual operating revenues. In 2020 it became increasingly common for utilities to postpone pay-as-you-go projects (which are usually more discretionary in operational priority) in an effort to maintain or even build available reserves in the face of economic uncertainty and cash flow deviations. For those few systems whose operating revenues were materially disrupted in 2020, they will need to see a return to normalcy sooner than later to avoid another bad year of financial performance.

Magnitude of impacts, and management's responses, will vary by service area.  Rating-relevant factors such as declines in median household effective buying income and an increase in the number of households below the poverty line are likely in at least some communities. In addition, loss of major employers or a bankruptcy could be a risk in a prolonged recovery in certain sectors. We are seeing utilities responding through assistance programs to lessen the effect on lower income rate payers.

What we think and why

Revisiting rate adjustments heightens the risk of deferred maintenance.  We expect the tempered recovery to result in continued elevated delinquencies and potentially more rate increases. In most cases we believe this will be only modestly impactful to credit. However, the recovery among certain sectors and states may lag and thus service areas with exposure to industries that have outsized effects from the pandemic will be more exposed to consumption declines and political headwinds associated with rate increases. S&P Global Ratings' criteria includes an operational assessment that examines the condition and adequacy of assets as a direct input into our ratings. The sector continues to use, and share, best practices such as effective utility management and asset management. But even a brief pause in rate increases, no matter how compassionate the intention, means that improvements that had to be done anyway are going to be more expensive and more critical to operations by the time they are finally addressed. We previously estimated that this sector's fixed and capital costs generally rise by 4% to 6% per year (see "U.S. Municipal Water And Sewer Utilities 2019 Sector Outlook: Stable, Although Potential Disruptions Are Not Making Planning Easy," published Jan. 15, 2019, on RatingsDirect). This all heightens the odds that while 2021 may lean toward fiscal stability, the three to five years that follow could be a great deal tougher.

Some utilities might increase their pace of borrowing.  On the heels of a year in which operating revenues generally didn't suffer as badly as originally feared, utilities may look to preserve cash even further and rely more on debt financing to address projects to which they are still committed. So, even after the record issuance in the municipal market last year, 2021 could be just as busy since the essential service nature of utilities and historically low rates could allow the same level of system reinvestment while still maintaining cash reserves. A federal infrastructure package will be influential, too (see below). The continued ability to procure lines of credit will be important for utilities that operate with a more narrow cash cushion.

What could change the trajectory

The "K-shaped", or bifurcated, recovery is about the have and have-not utilities just as much as it is about have and have-not Americans.  Many factors that helped steady utility finances in 2020 may be different in 2021. The "safer at home" lockdowns were most widespread during the spring and summer, which are normally the peak operating revenue seasons anyway due to outdoor watering. Based on the $900 billion package signed into law in December, stimulus checks directly to households plus supplements to unemployment benefits both appear to be more restrained in 2021 than in 2020. Eventually the eviction moratorium and suspensions of service shut-offs and disconnections will end and the rental assistance package will run out. Many small businesses won't ever come back. Utilities most at risk of credit quality headwinds are those that have large operating revenues from multi-family residential customers and small businesses (two customer classes that have a high overlap of the same actual people).

Local governments may need to plug a budget gap.  We begin 2021 with 11 of our state ratings carrying a negative outlook. In addition, some local tax revenues are also exhibiting meaningful weakness. This is expected to lead to pressure on future local government finances. If local governments need to lean on their cash to offset weakness in current revenues, city managers could look to their enterprise units for relief. Just as in the private sector, public sector entities that have robust cash reserves draw attention. Even those utilities that we rate 'BBB-' had a median days cash on hand over the last three years equivalent to about five months of operating expenses. This suggests that the utility funds of local governments were reasonably well-situated heading into 2020. For those local governments for whom budget gaps are profound, probably due to sharp declines in key tax revenues (down 17% just in the first two quarters of 2020) or the collapse of convention and tourism business, they might look to surplus net revenues and/or cash reserves of their own utility to maintain service levels.

2. What is the federal role and how might it affect credit quality?

The razor thin blue wave is both auspicious and inauspicious. Environmental rulemaking may increase, as will enforcement actions, including those related to environmental justice. That drives up costs for the local ratepayers already worried about the affordability of a service needed to support life, let alone public health and safety. What could serve to blunt the costs, at least a little, would be increased federal government participation in the total cost of those investments. During his campaign, President Biden announced intentions for a $2 trillion package, as both a means to improving physical infrastructure and as an economic stimulus measure.

How this will shape 2021

Deferring capital projects has a cost, but it might still happen anyway.  Postponing projects for any reason moves the utility operationally closer to the "run to fail" moment when something breaks. We think utility managers will continue to be cautious in how they deploy cash in 2021, especially if downside scenarios to our GDP forecast play out. Deferrals could be further exacerbated if utility managers are content to sit on the sidelines with projects that are already "shovel ready," waiting to see how much the federal government might share costs.

Environmental rulemaking will get a shot in the arm in 2021 too.  Pun intended. With the years-in-the-making update to the Lead and Copper Rule finally completed, attention is likely to turn to other unregulated and emerging contaminants. For example, there seems to be consensus to explore setting a maximum contaminant level for per- and polyfluoroalkyl substances (PFAS); initial work began last year. PFAS compounds are not just "forever" chemicals, they're also "everywhere" chemicals in more than just fire retardants and non-stick cookware. They're in your moisture-wicking clothes, food wrapping paper, and even non-stick dental floss. Not all utilities suffer PFAS the same. The infrastructure investment to treat such contaminants is not necessarily cost-prohibitive but the requirements associated with shutting down wells and relying on purchased water or other options may strain budgets or create supply constraints.

What we think and why

Believe in unicorns.  There has long been bipartisan support for an infrastructure bill, held up mainly by how the federal government would share costs. With the Democrats--who have been supporters of large and direct federal participation in an infrastructure stimulus package--now in control of Congress and the White House, we believe there could be greater momentum for funding a comprehensive infrastructure program before 2022. S&P Global Economics notes that a $2.1 trillion boost to public infrastructure spending over 10 years could add as much as $5.7 trillion to U.S. GDP in a decade. That's 10 times what was lost during the COVID-19 recession. It would also create 2.3 million jobs by 2024 as the work is being completed, and the additional 0.3% boost to productivity generated per year would add a net 713,000 jobs by 2029 (see "Economic Research: Georgia Gains Give Biden A Legislative Leg Up; The Pandemic And Economy Are First Priorities," Jan. 7, 2021).

Discussion of water affordability could reach a fever pitch.  The federal government in the early 1980s implemented the low-income home energy assistance program (LIHEAP) to assist Americans with home heating and energy efficiency costs and which can be used to help with heating and cooling bills in qualified homes. While never making it out of committees, proposed bills--as recently as in the 116th Congress--included a water version of LIHEAP. It could become even more pressing because of the impacts of COVID-19 and the decades-long rise in water and sewer bills (see chart 2). We include affordability as a direct rating factor, both as a percentage of household disposable income and also incorporating how many people in the county live below the federally defined poverty threshold.

Chart 2

What could change the trajectory?

What infrastructure might the federal government target?  Because previous discussions have focused on surface and air transportation as well as broadband internet, it is less certain that drinking and clean water programs such as the Water Infrastructure Finance and Innovation Act (WIFIA) and the state revolving fund loan programs will be increased should President Biden and Congress pass an infrastructure stimulus bill. President Biden has thus far hinted only at historically underserved communities to remediate environmental justice situations.

Policy inertia and "secret science."  EPA has always had a mandate that rulemaking be based in science and not science fiction--meaning the technology must exist to address the pollutant and the costs cannot be disproportionately burdensome compared to the environmental and public health benefits derived. With the early January 2021 adjustment in the methodology used for EPA rulemaking, cost-benefit analysis has become more politicized, making it more difficult to offer into evidence the documentation of certain public health benefits. It is not known how easily President Biden could change this given likely court challenges from states and the private sector, especially now that the rule change has already been published in the Federal Register.

3. Among public finance sectors, isn't water and sewer the asset class most correlated with environmental, social, and governance factors?

Yes.

How this will shape 2021

Blue is green, too.  According to S&P Global Ratings' research, 2020 saw a global explosion in the issuance of social impact bonds. Water and wastewater utilities were already one of the larger classes of green bond issuance, along with those who issue bonds for green energy purposes and energy efficient retrofits of existing buildings. President Biden has long stated his intention to re-commit the United States to the Paris Climate Accord goal to limit global warming. He announced Cabinet and Cabinet-level nominees to his team that will play a feature role. We anticipate that the near-term goals will involve direct greenhouse gas emitters. It is possible, however, that longer-term goals will include support of resilience projects that involve adaptation to and mitigation from climate change impacts, possibly including drinking water and stormwater; a federal stormwater task force report is expected to be submitted to Congress in 2021.

What we think and why

The sector continues to lead by quiet example.  Environmental stewardship and public health are the "business as usual" scenario that utility managers achieve simply by virtue of waking up and going to work each day. In 2020, as a response to the pandemic, we saw an explosion in the proliferation of new customer bill-pay assistance and other social programs, and a doubling down on those that already had such programs in place. This willingness to keep customers connected does not yet seem to be associated with a material sacrifice in revenues or a burn-through of cash on hand.

It is at the forefront in addressing climate change, because it is among the most exposed to the impacts of climate change.  As we noted in "Better Data Can Highlight Climate Exposure: Focus On U.S. Public Finance" (Aug. 24, 2020), large swathes of the U.S. already face water stress, defined primarily as a mismatch between supply and demand. This only gets more pronounced in droughts and will likely worsen over time. Currently about four in 10 Americans lives in a county that is on either the Atlantic, Pacific, or Gulf coasts. Sea level rise and more--and more severe--weather events will only exacerbate these exposures. Because water utilities must be able to serve uninterrupted every day, all day, contingencies and backups are common. The America's Water Infrastructure Act of 2018 went so far as to compel nearly all but the smallest systems to engage in vulnerability self-assessments, develop and certify emergency response plans to natural and manmade threats.

What could change the trajectory?

If Mother Nature transposes "2021" with "2012".

If extreme drought conditions return, such as that which already exists right now in the southwestern U.S., utilities that have high fixed "take or pay" costs or have to pivot to a more expensive alternate water supply, when combined with drastic water restrictions they'll likely have to mandate, will likely see financial capacity compressed. By summer 2012, more than 80% of the lower 48 states were in at least some stage of drought. Meteorologists believe La Niña conditions have returned this year, potentially introducing the same risks to operating budgets in 2021.

In Conclusion

With all due respect to Pete Townshend (Google him, TikTok-ers), meet the new year. Same as the old year. U.S. municipal water and wastewater systems showed remarkable financial resilience despite 2020 being 2020, just as in the years of and immediately following the Great Recession. Although downgrades outnumbered upgrades for the first time in years, the number of rating changes as a percentage of our more than 1,600 ratings was the lowest in decades. The fears in early 2020 of calamitous impacts from the pandemic (and later the ongoing but uneven recovery) were not unfounded. These negative credit factors thus far have been slower to present themselves (consumption patterns) and smaller in magnitude (declines in operating revenues and financial capacity) than in other sectors of U.S. public finance. Long-term credit stability will be driven mainly by management: scaling back or postponing rate adjustments is understandable as the economy continues its recovery. Similarly, increasing reliance on debt to fund projects to which the utility is already committed, in order to maintain or even build cash right now, is also understandable. In combination, however, both of those decisions serve to erode total financial capacity, all other things being equal, which could present credit headwinds in future years.

Rating Distribution And Trends

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Related Research

• Outlook For U.S. Local Governments: Revenue Pressures Mount And Choices Get Harder, Jan. 6, 2021
• Outlook For U.S. States: Symptoms Persist, But A Shot In The Arm Could Lead To Growth, Jan. 5, 2021
• Economic Research: Staying Home for the Holidays, Dec. 2, 2020