The Strong Performance Should Continue This Year

We expect credit quality in the U.S. municipal utilities sector to remain sound in 2022, building upon the strong performance in 2021. While some utilities postponed rate increases and suspended shutoffs during the height of the pandemic, most have resumed planned rate increases as well as shutoffs and late fees for nonpayment which we expect will contribute positively to 2022 performance. We expect supply chain disruptions and workforce issues to remain a challenge in the current environment, but we believe most of our rated utilities are positioned to cope with these near-term disruptions.

From a financial perspective, utilities have been extremely resilient throughout the pandemic. Their cash balances will be critical in 2022 as they face pressures from rising inflation, increased operating expenses, and growing capital needs related to emerging ESG risks, potential regulatory changes, and deferred maintenance.

Operating margins:  This year should continue to see healthy operating margins as many utilities are expecting above-average rate increases following a "pause" during the height of the pandemic. Rating actions in 2021 were positive in nature, with 48 upgrades, 29 downgrades, and 16 reversals of negative outlooks assigned early in the pandemic.

Climate trends:  Climate considerations have always been at the forefront of the water and sewer sector. Hydrological volatility, for example, affects both supply and demand as well as operations, all of which influence financial performance. Navigating these patterns is not new to the utility industry, but the increased frequency and severity of physical climate risks, including droughts, severe storms, wildfires, and flooding, are likely to increasingly pressure utility operations and capital spending. Hardening infrastructure will be critical to mitigating rising climate-related risks, which we expect will lead to additional debt issuance.

Balancing affordability and needed investment:  Most utilities have sufficient financial capacity to increase leverage without weakening financial margins. However, as utilities build additional capital (and operating) costs into the rate base, rate affordability may be pressured, especially for smaller utilities or those with weak demographics. Balancing affordability and resiliency will be a critical task. Affordability considerations may lead to some decline in coverage over time but given the strong median coverage levels nationally (1.9x), there is considerable cushion to maintain high credit quality, even with slightly less robust financial performance. We do not expect additional leverage to negatively affect credit quality if managers pass through these costs, but management teams that fail to identify and plan for potential climate-related risks are significantly more exposed to operational and financial risk in the future and thus vulnerable to credit deterioration.

Meeting the investment challenge:  We expect underinvestment in water and sewer infrastructure to continue to be a challenge for the sector. A substantial percentage of existing system assets are nearing the end or already past their useful life and are vulnerable to failure or operating issues that directly affect financial performance (an example is water loss). Issuers with a practice of postponing repairs and maintenance in order to meet budget funding levels may be most at risk of credit deterioration. While funding from the Infrastructure Investment and Jobs Act (IIJA) 2021 will help, as discussed in "Construction Ahead: Roughly $1 Trillion Infrastructure Act Tackles Backlog And Future Risk," published Nov. 10, 2021, on RatingsDirect, the federal government's contribution to water and sewer infrastructure is relatively low at approximately 10%. This pales in comparison to levels seen in the 1970s, when the federal government accounted for over 60% of related investment. We expect utilities to bear the burden for most infrastructure costs, but near-term federal support may allow utilities to preserve cash or defer debt issuance for 2022 and 2023. Full cost recovery for asset investment will be a focus in our analysis.

Regulatory uncertainty remains:  While the regulatory direction is more certain than in prior years, some uncertainty remains. The federal government's roadmap to address emerging contaminants in drinking water foreshadows expected regulatory tightening of certain contaminants. Nearly half of states are staying ahead of these changes and have already begun to modify standards for contaminant levels beyond the federal EPA health advisory. Stricter standards will increase capital requirements and operating costs for treatment for those with meaningful exposure. In addition, revisions to the EPA's Lead and Copper Rule are expected to reduce potential risks and community exposure but we expect the program will pressure financial margins and rate affordability for some, especially given that the highest degrees of exposure are in the most disadvantaged communities with lesser rate flexibility. Federal funding will offset some, but not all, costs.

The best long-term foundation:  In our view, issuers with strong long-term planning and rate flexibility are best positioned to face the challenges in 2022 and beyond. Proactive asset management programs and strong emergency responsiveness will provide the best foundation for addressing risks and recovering the cost of service over time. This also should lessen the likelihood of major asset failures, which cost significantly more to remediate than if the assets were maintained. The foresight to build in redundancy and resiliency in advance of event risks best supports response to emerging risks. We also believe that issuers with sophisticated financial forecasting and rate management (prudent rate structures, multiyear rate increases, and full cost recovery) will maintain the strongest credit quality. In addition to climate and regulatory uncertainties, the economic recovery could falter, all of which could affect financial and operational performance in 2022. Scenario analysis and rate planning support strong performance through challenging or uncertain periods.

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Questions That Matter

1. Why is the water and sewer sector view stable for 2022?

Throughout the pandemic, most water and sewer utilities remained financially and operationally stable with improved coverage and liquidity metrics which we expect to continue. Federal funding increases will provide a much-needed infusion for critical infrastructure projects. These positive trends are offset by significant deferred maintenance needs, growing climate risk, as well as inflationary and operating uncertainties.

How this will shape 2022

Water and sewer utilities enter 2022 in a strong credit position.  Most water and sewer utilities that we rate ended fiscal 2021 with positive operating results, improved coverage, and robust liquidity. We attribute the stable operating environment to the essentiality of water and sewer service and to utilities continuing to recover costs through rate increases. Recovery has been slower for some utilities, such as those with significant commercial or industrial concentration or those in regions where business closures were more pronounced or have taken longer to fully recover, such as tourism driven economies. Most of these utilities have returned to performance commensurate with pre-pandemic levels.

Multiple recessionary driven pressures remain.  Inflationary challenges, supply chain challenges, and staffing shortages could pressure capital planning costs and operations, especially for smaller operators with less staffing redundancy. Labor and supply issues could also delay progress on capital projects. We believe strong liquidity positions, affordable rates and prudent management, will allow the sector to remain stable despite these continuing economic uncertainties.

What we think and why

Rate-setting flexibility is key.  Despite consistently outpacing inflation, water and sewer rates (on average) are affordable, in our view. However, given the challenges on the horizon, we believe some utilities will begin to face resistance to the level of rate increases needed to recover capital and operating expense increases. Certain regions will have greater affordability pressure going forward. For example, the West, which is currently the region with the highest water rates, will see them pressured even higher as it braces for more frequent and prolonged droughts by investing in drought tolerant (and more expensive) supply sources. In addition, we expect regions with older infrastructure, such as the Midwest, to experience higher relative rate increases. Regions with lower income levels, higher poverty levels, or lower growth may have greater affordability issues, which will challenge rate-making flexibility. The ability to adopt multi-year rate increases, incorporate automatic rate adjustments, and add fixed components to rate structures to offset volumetric risk will be increasingly essential.

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The IIJA pilot program for low-income support, which is similar to the assistance program in the energy sector may mitigate some affordability concerns but it is unclear whether the program will be permanent. A program such as this could increase revenue certainty and rate making flexibility given that it would provide funding for the most vulnerable segments of a service area. Generalized federal support for low-income households doesn't necessarily flow to utilities during periods of economic distress. This was apparent during the pandemic as numerous utilities attributed minimal benefit from CARES Act funding.

Federal funding is expected to support infrastructure backlog, but not enough.  The IIJA will provide low-cost funding to issuers throughout the sector. However, the level of funding is not expected to be nearly sufficient to meet the substantial deferred maintenance needs in the sector, especially when including climate resiliency needs. As shown in chart 4, when comparing the assumed five-year allocation of federal funding to an estimated five-year capital need, it is clear that federal funding will cover only a fraction of the need. Reduced state and local matching requirements for some programs may lessen the need to borrow or allow managers to preserve cash that would have otherwise been leveraged as matching funds, both of which we view positively.

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Sticker shock.  Construction cost escalations pose the biggest near-term risk for issuers under state or federal mandates and will likely remain a pressure point beyond 2022. We continue to monitor both the 20-city construction cost index (CCI) compiled by Engineering News Record and data for individual markets; we note that CCI annual escalation is up 8% year-over-year. Moreover, ENR's materials cost index, which tracks the weighted price movement of structural steel, portland cement and 2x4 lumber, is up 33%.

Severe weather will continue to drive operating and financial performance.  Utility managers are well-versed in navigating weather-related budget variance, which is part of the reason the sector tends to maintain such robust cash positions. That said, the new climate reality suggests that weather volatility will increase in frequency and severity driven by climate change, requiring greater investment in resiliency and adaptation efforts and potentially requiring even greater contingency planning. The western region is in unprecedented territory as water utilities navigate the first federal curtailment of Colorado River entitlements and a zero percent allocation from the California Department of Water (see "How The Western States Plan Is Critical To Ratings As Colorado River Flows Slow To A Trickle," Oct. 18, 2021). The allocation reductions exacerbate persistent drought conditions that require advance planning and financial resources to secure drought resistant supply sources as options may dwindle as conditions become more pervasive. Similarly, severe storms throughout the country stress stormwater systems, requiring significant infrastructure hardening to protect residents. We expect this volatility to continue if not increase which will necessitate stronger strategic planning and financial cushions.

2. How will federal policy affect the utility sector?

Federal policy shifts present opportunities as well as potential risk. The long-awaited infrastructure bill certainly provides a cash infusion but not enough to address aging assets and anticipated changes to regulatory requirements.

How this will shape 2022

We expect the changing regulatory landscape and the current administration's initiatives will influence the priorities of the utility sector. We expect these priorities will be credit supportive with respect to addressing many ESG risks, especially with respect to climate resiliency and the effects of environmental and containment issues on traditionally under-served communities. However, these changes may have a near-term effect on operating costs and leverage.

What we think and why

Aggressive regulations around lead and copper, partnered with significant funding.  We expect the Lead and Copper Rule will be effective in eliminating lead service lines but the timeline for compliance is unclear and costs will be significant for issuers with substantial exposure. Lead and copper exposure has significantly greater impacts on certain states and communities relative to others, as chart 5 demonstrates. This is in part driven by the age of the infrastructure as well as the percentage of rebuild that has occurred. We will be increasingly focused on states with outsized exposures to measure their approach to addressing these infrastructure issues as well as the impact of assessing exposure, reporting it and securing funding.

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Direction on emerging contaminants is expected but uncertainty remains.  The Biden Administration has taken a more aggressive approach to "forever chemicals," including PFAS. While the EPA has only a health advisory in place, nearly half the states have implemented their own requirements and a few additional states are in the process of establishing requirements, in part to access the significant funding available for PFAS mitigation under the infrastructure bill. The EPA in October released a strategic plan to address these chemicals but clarity on guidelines will likely extend well beyond our outlook period given the prescribed process to institute new regulations. The roadmap is expected to improve transparency in reporting and should continue to encourage states to implement PFAS plans of their own. This clearly benefits health and safety; however, replacing wells, enhancing treatment, and securing new water supplies could be costly for those affected. We haven't taken action on credits that have been able to absorb these costs without expected long-term repercussions to financial performance or material increases to the cost of water. Negative credit action has been taken if financial metrics are expected to weaken or when there is an identified exposure without a clear plan to address it. We expect some credit deterioration due to PFAS-related costs and exposure, but most utilities will be able to sufficiently pass through treatment and remediation costs.

Will the federal government play a role in cyber security in the utility sector?  Given that water and sewer services are critical to health and safety as well as the economy, the sector is particularly attractive to bad actors and cyber-attacks, as discussed in "Cyber Risk In A New Era: U.S. Utilities Are Cyber Targets And Need To Plan Accordingly" (Nov. 11, 2021), we expect cyber-attacks to continue to increase in frequency. The Department of Justice recently issued an advisory saying the same thing. Failure to implement the most basic standards of cyber security will potentially result in a lower rating given that a cyber incident can cause financial, legal, and reputational risk and even result in loss of life. The federal government has provided various advisories and proposals as well as $17 million per state for cyber in the infrastructure bill but has not yet released a standard for the sector that would provide a floor for preparedness.

3. Does utility size influence credit quality?

While there are many highly rated and well managed smaller utilities, we believe that smaller utilities may be relatively more challenged by emerging risks throughout the outlook period. Smaller utilities are defined as those with less than $25 million in gross revenues (that receive a negative economies of scale adjustment in our criteria). In 2021, smaller utilities account for approximately 75% of the multi-notch rating movements, a six percentage point increase from 2020. We expect this trend will continue.

How this will shape 2022

Smaller utilities are more likely than larger ones to experience credit deterioration given the complexity of the risks and the lower and more volatile nominal cash positions among smaller systems. This will be more pronounced for those with weaker management policies or lesser rate flexibility.

What we think and why

Smaller utilities have similar or greater risks but more limited passthrough ability. Many smaller utilities are no less exposed to climate risks or infrastructure vulnerabilities, but smaller utilities often have more miles of pipe per customer which results in a smaller rate base from which to recover costs and less operating benefit given economies of scale.

Operational and financial policies tend to be weaker than larger counterparts.  Smaller utilities (serving a population of less than 3,300) are not subject to the EPA requirement to develop and prepare risk assessments. Thus, even though smaller utilities are no less prone to climate, cyber, and infrastructure risks, they may be less prepared. Based on our portfolio of credits, twice as many small utilities relative to large utilities have one or more vulnerable Operational Management Assessment (OMA) characteristic. Further, nearly 40% of the small utilities in our portfolio have a vulnerable score for one or more of the Financial Management Assessments (FMA), which compares to only 9% and 3% for medium and large utilities, respectively. The lack of long-range planning and asset management means that as assets continue to age it's just a matter of time before they fail and utilities haven't built the balance sheet to recovery costs adequately. Adopting more robust asset management and emergency preparedness policies coupled with rate making and budgetary controls would improve smaller systems' ability to react to system challenges which preserves consistent financial performance.

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Establishing strong partnerships with regional entities such as larger utilities, cities, and counties is beneficial in emergency response planning. States often provide funding for projects, guidance on risk management, emergency response support and in some cases, resources for asset inventories, cyber security, and climate mitigation.

Lower and more volatile nominal liquidity.  While many smaller utilities have robust cash on a "days cash" basis, the nominal levels are quite low and could be easily depleted with a major asset failure or catastrophic weather event. Based on utilities in our portfolio, the nominal liquidity for smaller utilities has been twice as volatile over the last six years as compared to their larger utility counterparts.

4. How are ESG factors incorporated into our ratings?

Shifting precipitation patterns, severe weather events, and rising social risks have brought into sharper focus a spectrum of environmental, social, and governance risks that will inform our credit analyses and ratings over the long term. We consider the adequacy of management's counterbalancing measures to plan for, mitigate, or adapt to these challenges is critical to credit stability. There were six downgrades, three negative CreditWatch applications, and 22 negative outlook revisions related to ESG factors in 2021; we expect 2022 will be similar.

How this will shape 2022

The number of climate and weather-related events that surpass $1 billion of damage continues to set new records, which we expect will continue. More than four in 10 Americans live in a county that was struck by climate-related extreme weather last year, according to a recent analysis of federal disaster declarations. Further, chronic issues such as sea level rise may not have an immediate impact but will require significant mitigation to protect systems from catastrophic events. In addition to severe weather, recurring wildfires threaten water systems throughout the West. Fires throughout 2020 and 2021 resulted in the destruction of treatment plants and distribution pipelines as well as contamination of water supply from chemicals associated with fire damage which we believe will continue to be an increased risk given the dry conditions in the prior year and projections for 2022.

The cost of building resiliency into operations and infrastructure to address these rising physical risks is expected to be borne by ratepayers, which may heighten affordability concerns which we see as a social risk. This is especially acute in areas where income levels are below average, or a significant proportion of the population is under the poverty line.

What we think and why

Physical risks expected to increase in frequency and severity.  In our view, the increasing frequency and severity of these events will weaken cost certainty for utility managers, which, if improperly addressed, can constrain credit quality or lead to credit deterioration. Likewise, communities' and politicians' sentiment toward future rate plans and capital spending may erode if the public perceives the utility was negligent or delayed in responding to an emergency, resulting in heightened political pressure. As hydrological volatility increases and frequent droughts and extreme weather become the "new normal," we expect a high correlation between credit quality and the existence (or lack thereof) of well-defined climate-adaptation policies, credible long-range resource plans, and achievable demand-management strategies. The most at-risk utilities are likely those whose lack of management or financial resources--or whose physical limitations--constrain their ability to interconnect with other systems in emergencies or manage water supply conjunctively (including the ability to store carryover water for use during dry years).

Social risks are becoming more pronounced.  In addition to more generalized affordability challenges associated with rate increases outpacing inflation (see "Rate Affordability Could Be Pressured As U.S. Public Utilities Tackle Aging Infrastructure And Climate Considerations," Dec. 15, 2021), minority and disadvantaged communities have faced outsized health and safety challenges related to groundwater contamination, failing infrastructure, and lead exposure. As a result, as rates are adjusted to absorb remediation of these issues, vulnerable populations could be disproportionately affected by affordability concerns. Despite efforts to increase standards for controlling chemical contaminants, actual enforcement and removal of contaminants is frequently slow and expensive, often hindered by high treatment costs and antiquated water infrastructure. We expect the IIJA to bolster important federal programs focused on social issues. However, many impoverished communities need far more funding than is currently available to address long-standing deficiencies, which could lead to financial, regulatory, or health and safety concerns in the near term.