In August 2021, the U.S. Bureau of Reclamation declared its first-ever "tier one" Colorado River water shortage, after Lake Mead water levels fell to their lowest level since the 1930s, when it was first filled after the Hoover Dam's construction. The bureau's Sept. 22, 2021, report was even more dire: It outlined reduced storage capacity, greater risk of hydropower failure, and a higher probability of California receiving meaningful water curtailments by 2025. In addition, the 20-year historical river flow data suggest that the Colorado River inflow assumptions embedded in the current allocation levels are overstated and will be further squeezed by the increase in extreme heat days. Furthermore, the river's water allocation is based on inflows of 17.5 million acre-feet (MAF) but the river's actual average flow from 2000 to the present has only been slightly more than 12 MAF. As a result, we believe that water scarcity is emerging as an even greater credit risk for utilities, states, and municipalities in the western U.S., given the consequences of climate change, particularly absent long-term planning to ensure an adequate and resilient water supply.

S&P Global Ratings evaluated the 306 water issuers it rates in the seven-state area (Nevada, California, Utah, Arizona, Colorado, Wyoming, and New Mexico) to determine how drought-related effects such as increased leverage, rising operating costs, pressured rate affordability, and narrowed coverage could influence rating transitions. Stress tests suggest these issuers have considerable cushion to withstand the potential pressure given strong financials and affordable rates. We also looked at five states as case studies to illustrate some of the best practices and most acute challenges that influence the near-term and future credit quality of the sector.

Given the more frequent and severe physical risks associated with climate change like drought and extreme heat, the supply and demand imbalance will worsen if water managers do not actively address both demand and supply side management. Many highly rated issuers, such as the Southern Nevada Water Authority, Central Arizona Project, the cities of Phoenix and Denver, the state of Utah, and the Metropolitan Water District of Southern California, among many others have been preparing for this reality for decades through well-designed conservation programs, infrastructure upgrades or enhancements, storage development, and supply development. Issuers with strong long-term planning are best positioned to withstand the current drought and address longer-term variability and scarcity. However, we believe this drought will stress even the most prudent water supply managers.

While hydrological volatility is not uncommon, the increasing magnitude and frequency of droughts and the consequences of climate change will have negative implications for issuer credit quality if not managed effectively. For more information, see our report "Could The Western U.S. Drought Threaten Municipal Credit Stability?" published Aug. 18, 2021, on RatingsDirect. Developing alternative (and drought resistant) long-range supply solutions and financing such projects cannot be accomplished overnight. Issuers will need to reassess their allocation assumptions for Colorado River water availability. Furthermore, issuers may also benefit from restructuring their rates to favor higher fixed charges or incorporate drought-specific surcharges to shield utilities from the financial effects of prolonged drought. From a credit perspective, S&P Global Ratings will be reviewing issuers' long-term supply assumptions and financial forecasts and stress testing them to identify whether they have appropriate supply assumptions under different hydrological and growth environments.

Stress Testing the Portfolio: Something Has To Give--Or Does It?

Financial metrics in the water sector have historically been resilient through difficult economic cycles and hydrological environments. Many utilities have tried to address downside financial implications of drought through the implementation of a higher fixed component to the rate structure or an additional drought charge. The median debt service coverage level in the west's seven-state region is 2.2x, with 600 days' cash on hand. This level of financial strength provides a substantial cushion for operating constraints and has been the hallmark of one of the highest-rated sectors in public finance. That said, affordability has come under pressure as rate increases continue to outpace inflation. Given that capital and operating costs will increase if issuers need to augment their supplies with significantly more expensive alternatives, we believe customers may be unable to afford the increases necessary for issuers to maintain historical financial margins.

S&P Global Ratings expects water scarcity and hydrological volatility to eventually affect nearly all the issuers in the western region served by the Colorado River. Therefore, we stress tested the utilities/organizations to determine how sensitive ratings could be under various hypothetical stress scenarios, specifically for those issuers we believe will most likely be exposed to prolonged drought conditions.

When Leverage And Affordability Combine To Stress Finances, It Increases The Likelihood Of More Severe Rating Changes

The three stress scenarios demonstrate that leverage or rate affordability alone will not drive significant rating actions but when leverage and affordability both affect financial performance, the outcome is more severe.

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When The Time Comes, Who Takes The Cutbacks?

The Colorado River supplies water to 40 million people across seven states, Mexico, and many tribal communities. Providing this essential service is not only critical to an area's health and safety but also to its economic development. In 2020 alone, the drought contributed up to $1.3 billion in economic losses--or $23 billion if wildfires are included, according to a recent National Oceanic and Atmospheric Administration (NOAA) report.

Water allocations have been problematic from the start. They were developed (in 1928 for the Lower Basin and 1948 for the Upper Basin) following some of the wettest years on record. Given their baseline of overstated inflows, water allocations for the upper and lower basins have been tough to meet and will become increasingly strained given climate conditions and continued population growth.

Under the bureau's Drought Contingency Plan (DCP) and shortage guidelines, the supply realities under a tier one shortage are clear:

• Arizona will receive the largest curtailment, losing 192,000 acre-feet (AF);
• The Central Arizona Project (CAP) is at the front of the line to receive cutbacks equivalent to 30% of CAP's supply, 18% of Arizona's total Colorado River supply, and 8% of Arizona's total water use;
• Nevada will take a 7% cutback; and
• Municipal and industrial use is not expected to be affected.

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While the 2022 operating curtailment primarily affects Arizona agriculture, every state in the upper and lower basin has exposure over the long term, given rising temperatures, variable hydrology, declining storage, and dwindling groundwater alternatives. For six of the seven basin states, water levels from January 2020 to present are the lowest on record since 1895, with temperatures reaching the third-highest on record, leading to the designation of exceptional drought, according to the NOAA. Due to the ongoing issues associated with climate change, we expect these trends will continue.

Creating A Drought-Resistant Water Supply Has Its Challenges

Success in addressing water scarcity requires both demand and supply side tools. We consider drought-resistant supply development, such as recycled water and desalination, important to managing dwindling supplies. However, these innovative supply options are not without their problems, including significantly higher costs that could pressure rate affordability. Similarly, leveraging conservation will be critical to demand management, but can stress issuers' financial margins. If conservation results in consumption declines while debt levels increase to harden infrastructure or develop supply, financial margins could be weakened. However, we generally believe that rate structures with fixed charges and drought surcharges have proven to be beneficial in stabilizing financial performance during periods of conservation and drought.

State and federal lawmakers will also influence how issuers fare in addressing future water supply challenges. The current infrastructure bill contains $8.3 billion for western water projects--including water recycling, updating aging infrastructure, supply development, water movement/transfers, and other asset resiliency projects. Grants or low-cost capital would improve borrowing costs and potentially decrease leverage outcomes, supporting potentially higher coverage. In addition to direct financial support, the federal government recently enacted the Low-Income Household Drinking Water and Wastewater Emergency Program (LIHWAP) to help low-income households. While this program may be "one-time" in nature due to the pandemic, assistance programs such as this could soften the impact of rate increases on lower income ratepayers, which could improve rate-setting flexibility. Lastly, state and federal governments will be critical in setting regulatory parameters and expediting environmental reviews to support innovative supply projects, such as recycled water for potable use and desalinated water. We believe thoughtful and timely regulatory communication will be critical to effective long-term drought planning. S&P Global Ratings incorporates these challenges and opportunities into its rating analysis, particularly to evaluate whether long-term planning is sufficient to mitigate the evolution of environmental risks.

Five States, Five Stories

Issuers throughout the western region have historically faced hydrological volatility difficulties. Incorporating all available options to balance their supply and demand needs will best position issuers to meet future obstacles. The case studies below illustrate how five of the seven western states--and the issuers within them--have addressed hydrological volatility and long-term planning through conservation, rate design, supply development, water movement, regional partnerships, and growth challenges.

Nevada: A conservation story

Southern Nevada Water Authority (SNWA), the wholesale water provider to most of the state, utilizes scenario planning that evaluates a range of conditions over a 50-year horizon, including dry conditions and more severe scenarios that cover the potential effects of climate change. Under the climate change scenarios, conservation is key to balancing the authority's supply and demand dynamics. The SNWA is a leader in conservation efforts, reducing non-functional turf acreage, improving landscape watering compliance, enhancing evaporative cooling efficiency, and promoting water efficiency in future development. In addition, it has a very successful "return credit" recycling program in place: Nearly all water used indoors is recycled back into the system. Conservation is a low-cost demand management strategy but can be difficult to directly control and has a corresponding revenue effect. Nevada has demonstrated support for conservation by passing legislation mandating compliance (rather than just recommending it), which we believe suggests greater potential for success. Nevada Assembly Bill No. 356, approved by the Nevada State Legislature in 2021, restricts Colorado River use for non-functional turf by 2027, which could yield up to 29,000 AF of water savings annually. Given the state's substantial conservation success thus far, additional gains in conservation could be more complicated.

What we're watching.   For issuers that have accomplished meaningful conservation, is incremental additional conservation more difficult to achieve? Should conservation be paired with rate structures that stabilize revenues and thus, financial performance? Could modifications to the inclining block rate structure encourage additional conservation and bolster revenue, which can improve conservation success--both from a usage and financial performance standpoint?

California: An innovation story

California has a history of innovative water supply management, largely borne out of necessity. Water utilities throughout the state have pursued drought resistant supply alternatives to meet the challenges of the state's variable hydrology, the demands of a $50 billion agricultural sector, and ongoing population increases. Supply alternatives are critical to providing reliable water to residential, commercial, and industrial users during periods of drought. To manage their water assets, California's water managers have continually looked for creative strategies, such as the development of localized sources, including recycled water and desalination.

Metropolitan Water District of Southern California (MWD), for example, has decades of experience building substantial storage facilities, conjunctive use programs, and transportation infrastructure. MWD recently initiated the environmental review of what could be the largest recycled water project in the country, potentially supplying 150,000 AF of additional water to augment surface and ground supplies. Of importance, MWD is working with SNWA and potentially Arizona to support parts of the project. This collaboration could result in MWD shifting some of the state's Lake Mead allocation to Nevada and Arizona, mutually benefiting the entire lower basin region.

Meanwhile, Orange County Water District's groundwater replenishment system is currently the world's largest advanced water purification system for indirect potable reuse, taking treated wastewater that is purified to produce high-quality water. Similarly, San Diego, Padre Dam Municipal Water, and Los Angeles are also examining large-scale recycled water projects. Leveraging an unused resource to augment supply is expected to aid the customer base as well as having environmental benefits.

Desalination has also infused the state with additional drought tolerant supply. There are 10 desalination facilities in the state, the largest of which is the Carlsbad Desalination Plant, which produces 56,000 AF of water annually. Desalination is a drought-proof, high-quality alternative but is more expensive than most options and highly energy intensive in a state that already suffers from energy intermittency issues. The California Department of Water Resources estimates that depending on size and scope, future desalination projects could cost $2,000 to $4,000 per AF of clean water produced and recycled water could cost $1,500 to $2,500 per AF.

What we're watching.   How will issuers balance their supply needs with the potential increased costs associated with delivering the alternative water supplies, which could pressure rate affordability and financial performance?

Utah: A growth story

Based on the Colorado River Compact, the Upper Basin states receive a percentage of the water that flows every year, while the Lower Basin states are guaranteed a set amount. Based on the 1922 agreement, Utah receives 23% of the Upper Basin's share after the Lower Basin's share is met. Utah's population is projected to double by 2060, and by 2030 water demand will outpace supply. Despite the future supply reality, Utah has not been taking its full allocation from the Colorado River and there is the risk of its allocation shifting, given that the state hasn't utilized the supply it currently receives. Water scarcity could also dampen further development, which could affect the state's long-term planning and growth potential, some of which already has infrastructure investment tied to it.

Given the 2026 renegotiations as well as pressures associated with climate change, the Utah Legislature created the Colorado River Authority of Utah in June 2021 to protect, conserve, and develop Utah's Colorado River system interests. The six members of the Colorado River Authority of Utah will oversee the state's negotiations on the drought plan and other rules that expire in 2026.

Given its rising population, Utah is also preparing for a $1.8 billion Lake Powell Pipeline Project (LPP), which would provide water for rapidly growing communities in southern Utah. A portion of Utah's Colorado River allocation (approximately 5%) is reserved for the LPP, which is expected to account for more than 30% of water deliveries in the fastest growing areas of the state. However, if water levels in either Lake Powell or Lake Mead fall further, water deliveries from this project could be limited.

Creation of the Colorado River Authority of Utah demonstrates the state's focus on maintaining its interests in the Colorado River, as well as the potential uncertainty around the renegotiations and future cutbacks. We believe the state's estimates of availability could be aggressive, given trends in hydrology and climate change, which we will continue to monitor.

What we're watching.   The most significant risk in higher growth areas may be that water supply projects take decades to execute with rigorous planning, design, regulatory, and construction requirements, as noted in the state's Prepare2060 report, and the investment in these projects may need to occur before water supply certainty is determined. This could result in a different set of problems related to supply or overbuild.

Arizona: An agriculture story

In Arizona, irrigated agriculture accounts for nearly three-quarters of the state's water use. This has been reduced from as high as 90% due to urbanization and innovation in agriculture--both on the actual farms and in the delivery, according to the Arizona Department of Water. The relationship between urban and agricultural water use has influenced policy decisions in Arizona for several decades. These considerations drove the CAP as well as programs such as the current "water savings accounts", which transfer water to irrigation districts from cities to mitigate the effects of Colorado River cutbacks. Arizona has been at the forefront of water supply planning and balancing agriculture and municipal/industrial use.

During the past 30 years, Arizona has doubled in population, with most of the influx around Phoenix and Tucson. The two major cities, as well as numerous agricultural users, other municipal users, and tribes draw water supply from CAP, which covers more than 23,000 square miles and 5.3 million people (80% of the population). We understand that under the current 1,075 AF cut, Arizona's water supply is the first to be curtailed and CAP will absorb 99% of the 192,000 AF reduction, primarily by agricultural customers. CAP has some of the most sophisticated long-term planning in the sector, utilizing three hydrologic models and robust financial models that inform strategy, policies, and recommendations. This planning acumen doesn't shield CAP from the effects of the drought given its junior water rights but it does better position CAP and its customers to withstand the initial cutbacks. The shortage may be perceived as primarily targeting agricultural users, but the financial effect will be felt by all CAP customers, since rates are projected to increase 20% to offset agricultural revenue loss.

In preparation for drought conditions, Arizona cities and irrigation districts created the Underground Storage Facilities to Groundwater Savings Facilities Program. This important partnership works to transfer water from cities to irrigation districts facing drought-related curtailments. The irrigation districts use the water transfers in lieu of groundwater. This arrangement is beneficial in the near term, given that many cities have significant storage. However, if drought conditions become more severe and prolonged, we believe this program could pressure urban supplies, leaving cities with less supply redundancy. This risk is especially acute if Lake Mead levels fall below 1,050 feet, which would trigger curtailments to several cities, including Phoenix.

Arizona has strong water supply management that addresses storage and conservation. The state has substantial groundwater storage, equivalent to several years of total demand. In addition, Arizona has responsible policies around water usage (conservation policies at the municipal, industrial, and agricultural sectors) and development, requiring identified water sources prior to new build in most urban areas. While groundwater storage is sufficient in the near term to offset curtailments, groundwater may not be sufficient to offset ongoing drought in the Colorado River basin, especially without degrading the groundwater aquifers by overdrafting them.

What we're watching.  While we believe these regional partnerships are prudent in the near term, if drought conditions persist, cities may need to maintain more robust storage to offset water supply variability. Furthermore, depending on water conditions the irrigation districts may not be positioned to repay these transfers if their supply does not recover quickly enough.

Colorado: A partnership story

Colorado's water supplies are highly variable, and its demands are growing. The challenge is that the state's Front Range region, with its growing population, needs to move water from the Western Slope to the Eastern Slope through trans-basin diversions. Utilities across the Eastern Slope transfer about 475,000 AF of water annually from the Colorado River basin to the Eastern Slope. The Colorado River Cooperative Agreement shifts Colorado away from a path of conflict to one of cooperation and collaboration in managing the state's water resources. The agreement provides greater certainty in developing a secure water future for Front Range water users, including Denver Water (which serves nearly 25% of the state's population and holds senior water rights) by resolving long-standing disputes regarding Denver's service territory, its ability to use Western Slope water, its ability to develop future water supplies in the Colorado River Basin, and other legal issues. It also allows Denver Water to progress with projects from the multi-pronged resource management approach that include water efficiency, recycling water, and responsibly sourcing new storage.

Denver Water has also partnered locally with other suppliers along the Front Range, including Aurora Water and the South Metro Water Supply Authority, to develop the Water, Infrastructure, and Supply Efficiency partnership. By reusing water imported from the Colorado River through Denver Water's water rights, the project provides a new sustainable supply without additional Colorado River diversions.

What we're watching.   If Colorado overdevelops the Colorado River system beyond the legal limits of the Colorado River Compact of 1922, curtailments loom for many water users, perhaps most significantly for current transmountain diverters.

Planning For A Drier Future Is Paramount

In an uncertain hydrological environment, there is only one certainty: that water scarcity is an increasingly pronounced operating stress for western states. Issuers that incorporate changing climate conditions in their resource planning will be best positioned to navigate changing supply conditions. Furthermore, while continued supply constraints could negatively pressure some of our ratings on western region water utilities, we believe most issuers will be able to manage through with prudent planning, regional partnerships, and responsible financial management.

Editor: Michelle Leary