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The pandemic was credit neutral, as many utilities were able to cut or defer costs while continuing to meet state and federal health and safety requirements. Moreover, access to federal cash helped support year-end balances even as some utilities deferred rate increases. In fact, because many utilities outperformed expectations, with demand rebounding to pre-pandemic levels more quickly than anticipated, we saw a relatively large number of upgrades over the last year. However, as most of these upgrades were to credits that were exhibiting significant positive credit momentum prior to the pandemic, we do not expect the recent rate of upgrades to continue. Without disciplined rate increases, some utilities may face a fiscal cliff.

The rapid escalation in operating costs over the last 12 months--with prices of chemicals, electricity, and pipes, valves, and other replacement parts rising at levels we haven't seen over the last decade--contributes to our view of potential fiscal strain. Further, the payment culture has changed in some markets, the result of economic stress and the decision by some utilities to limit collection practices such as shutoffs and liens.

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At the same time, infrastructure needs in the sector are substantial, both with respect to hardening efforts and state-of-good-repair investment. As 2022 demonstrated, inadequate infrastructure investment can result in catastrophic costs and resulted in several downgrades. We continue to observe a clear financial cost to deferred maintenance; further, we believe the reduced reliability associated with infrastructure failures increases political risk and harms ratepayer relationships as well. We will continue to focus on the sufficiency of operational and fiscal management policies and practices, especially given the rising operating risks in the sector. Vulnerable practices may cap the rating outcome given the operational and financial implications of asset failure--which have recently resulted in health and safety risks, litigation, and ratepayer discord.

Given that many pipes were installed in the 19th century, many utility assets are nearing the end of their useful lives. Although we saw certain utilities electing to defer capital spending during the pandemic, overall, the rate of pipe replacement and repair is growing. In 2015, utilities were replacing, on average annually, 0.5% of their pipes, but by 2019, the replacement rate modestly increased to between 1% and 4.8%, a rate that matches the lifecycle of the asset (according to American Society of Civil Engineers standards). While considerable progress has been made and historic federal funding is expected to supplement rate revenue, the gap between available funds and infrastructure need is meaningful, estimated by the Environmental Protection Agency (EPA) to be over $80 billion. Rising climate and regulatory demands will also drive up capital requirements.

Escalating construction costs are also expected to contribute to weaker financial metrics in 2022-2023 and beyond, especially as bids continue to come in 20% to 30% higher than what many utilities were forecasting just a year ago, which we have observed has driven some issuers to seek project delivery methods other than the traditional design-bid-build method, which can also add risk. While federal support is at historical levels, the benefit is being partly eroded by inflation and rising interest rates. Even so, we believe federal support may be the catalyst that propels several large-scale water supply projects forward. Given that much of the identified capital needs within the sector are either regulatory-driven or necessary from a climate resiliency or water supply diversification perspective, we expect rising capital costs to eventually be passed through to consumers if not this year, then certainly eventually. We expect limited positive rating action in 2023 given the economic headwinds and sector-specific challenges.

2022 Rating Performance Was Largely Positive 

Positive rating actions outpaced negative in 2022, primarily driven by criteria implementation and sustained improvements in financial performance. As a result, the median rating increased to 'AA-' from 'A+'. Negative rating actions were primarily driven by weak management and financial deterioration, generally reflecting rising operating expenses and delayed rate increases. Negative outlooks are concentrated at the lower end of the investment grade spectrum, as shown in chart 4.

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Sector Top Trends In 2023 

Will inflationary pressures and higher rates persist?

Construction cost inflation is reaching levels we have not seen in decades. The Producer Price Index figure for building materials and supplies increased 38% between November 2021 and November 2022. In addition to increased project costs, we expect construction cost inflation will result in higher bids from contractors, larger contingencies in new contracts along with wider cost escalation ranges for materials, and a shift away from fixed-price contracts. While materials costs may begin to stabilize as supply chain issues subside, the shortage of skilled labor may be more enduring given the systemic shortage of new workers entering the construction trades, which will keep labor costs elevated.

Further, tax-exempt borrowing rates increased nearly 200 basis points year-over-year. To put this into context, a $100 million, 30-year issuance is now $2 million per year more expensive and $60 million more expensive (in future dollars) over the life of the debt. A $1 billion project costs $20 million more per year or $600 million over the life of the debt. This dynamic has arrived at an inopportune time, as capital needs are mounting. Federal loan costs are also escalating. Many issuers have benefited from low-cost federal funding through the Water Infrastructure Finance and Innovation Act (WIFIA) loan program. To date, WIFIA has closed 95 loans totaling $16 billion in credit assistance to help finance over $35 billion for water infrastructure projects. Since inception, loan requests have well exceeded program capacity, highlighting the importance of the program to the sector. Given that the cost of borrowing is tied to treasuries, which are roughly 175 basis points higher than a year ago, we expect WIFIA costs to rise commensurately. Even so, we believe the WIFIA program still provides attractive features such as the deferred repayment, prepayment at any time without premium, and only a one basis point spread on the Treasury's State and Local Government Series rate.

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In addition to rates increasing, credit spreads are also widening considerably, increasing financing risks for issuers lower on the credit spectrum. Widening credit spreads may result in significantly higher relative borrowing costs, further pressuring already weak credits on the lower end of the investment grade portfolio or lead to greater deferred maintenance if market access is threatened. While we believe it is possible that the scope of some projects may be reduced or cancelled as the cost of materials and labor escalate, given that a sizable proportion of the sector's projects are non-discretionary, utilities may not have the flexibility to wait out the current environment. We believe the effect will be higher capital budgets and thus rate increases, potentially threatening affordability for issuers in lower income areas--many of whom have the greatest capital investment needs. We expect to stress capital plans and financial forecasts to account for these headwinds and assess whether issuers have the financial capacity to significantly increase their cost basis.

How will climate considerations influence financial performance?

Utility operations and financial performance are inherently linked to weather and other climate hazards. The EPA cites drought, storms, flooding, source water quality, and sea level rise as current and future climate threats in the utility sector. Wildfire incidence is also a rising concern for utilities--especially in the West. Adaptation and mitigation efforts are critical and usually require greater initial investment, typically without the knowledge of how effective these measures will be in offsetting the long-term risks from the exposure. For example, the cost to develop new or alternative water supplies to mitigate drought risk can be orders of magnitude more expense than traditional supply. Failure to prepare for climate events can have severe operational and financial implications for utilities, influencing supply and demand as well as operating and capital costs. Climate events can also influence the underlying economy and service area, including population migration or relocation, employment shifts, or difficulty obtaining insurance which can reduce home values (affecting issuers that receive property tax revenue). From 1980 through 2022, climate related disasters have cost states $2,298 billion (see chart 6).

Chart 6

With storms, droughts, and other climate events increasing in frequency and magnitude, events previously deemed unprecedented are becoming the norm. For example, uneven precipitation, aridification, and extreme heat are expected to continue to challenge the western region's water supply, necessitating significant changes to how utilities in the western states use, store, and conserve water, as detailed in our report "Western U.S. Drought: Declining Supply, Rising Challenges," published Aug. 16, 2022, on RatingsDirect. We believe there is a rising likelihood for federal intervention and potential water rights litigation, which increases supply uncertainty and may have negative implications for issuers with significant exposure to Colorado River supply. Similarly, adverse weather, such as hurricanes, extreme temperatures (both hot and cold), and floods have also compromised infrastructure, not only in Jackson, Miss. following heavy rains, but also after the flooding and mudslides in Kentucky and Missouri, and catastrophic damage caused by hurricanes Ian and Fiona--three other severe weather events that caused more than $1 billion in damage in 2022. Significant investment will be required to mitigate and adapt to climate related challenges, which needs to be planned for well-before a climate emergency takes place.

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We believe that most of our rated U.S. public finance water and sewer utilities are well positioned to meet these challenges. Financial capacity in the sector is extremely strong, including median coverage of 1.97x, liquidity of 519 days on hand, and manageable leverage of 36% debt to capitalization. We view liquidity as critical to bridge reimbursements and revenue loss during recovery and rebuild. As we noted in "Hurricane Ian: Most Municipal Utility Ratings, Bolstered By Significant Liquidity, Are Expected To Be Unaffected," published Sept. 29, 2022, rebuild and recovery in the hardest hit areas can take months, and some communities may be displaced, requiring liquidity to cushion reduced collections and to bridge the period until Federal Emergency Management Agency loans are available. Most of the issuers in areas with hurricane exposure tend to have extraordinarily strong reserves. Considerable management acumen is critical for utilities with above-average event risk. In the higher-grade portion of the portfolio, issuers have robust risk management, forecasting, and infrastructure maintenance, which contributes to the stability of the sector during periods of heighted climate events. Supportive rate structures are also beneficial for credits exposed to physical climate risks. The flexibility to manage demand and stabilize financial stress from lower usage is important in managing scarcity, for example. From a credit perspective, we view rate structures that promote cost recovery and revenue stability positively. 

While most utilities will be adept at managing through the current environment, we believe issuers with narrow financial margins or limited rate-setting capacity could experience a disproportionate effect on their credit ratings from these challenges. Affordability may increasingly become a challenge for utilities, given the magnitude of required system investment and the significantly higher cost of developing alternative supplies, compounded by inflationary pressures and a higher interest rate environment. Further, those with marginal liquidity are more exposed to financial stress and covenant breeches if a climate-related event weakens demand due to population displacement or usage restrictions.

Will recessionary pressure and cost escalations result in rate affordability challenges?

Utilities are typically operated as self-supporting enterprise funds with revenues generated primarily through user rates and charges. In general, we believe utility rates and charges benefit from being recalibrated at least annually to reflect rising labor and material costs, as well as the potential influence of economic cycles and hydrology on demand. Well-managed utilities also set rates to ensure full cost recovery, including adequate renewal and replacement investment as well as consideration of proposed or future regulatory requirements, and typically manage this risk with appropriate financial performance metrics. Utilities that fail to do so are most exposed to credit stress over time. However, as utility cost of service increase rapidly, concerns over affordability are growing, which means that finding the right balance between how costs are allocated among customer classes is of critical importance, as is the overall demographics and purchasing power of the population served.

Rate increases have been consistently outpacing inflation for a decade. Despite this trend, market position and affordability within the sector has been strong. If a utility raised its rates in 2022, the average water and sewer bill increased by 8%. The average water and wastewater rates in our portfolio are $43.95 and $50.98, up from the prior year by 3% and 2%, respectively, which we consider low based on recent cost inflators. We anticipate these numbers will grow in the short term, which suggests likely coverage deterioration in 2023. Given the recessionary influence, rapidly escalating costs, and the increasing income disparity, we expect affordability to weaken and lead to the potential for reduced rate-setting flexibility, especially in areas where disadvantaged communities may be shouldering a disproportionate share of utility costs. About 7% of the sector could see weakening in our assessment of market position if rates were to increase by at least 10%.

With less discretionary income available, communities with relatively high poverty rates or low income levels may have more difficulty effectuating rate increases that fully recover costs. Within our portfolio, 36% of the rated utilities have more than 15% of their customer base at or below the poverty line. We have also observed greater member discord within wholesalers given differing demographic characteristics among members. We believe these dynamics could lead to greater rate-setting challenges. For utilities with significant portions of the customer base at or below the poverty line, customer assistance programs can reduce social risks and improve credit stability. We believe customer assistance programs can reduce political opposition to rate increases, improving the timeliness of implementation and reducing delinquencies. Customer assistance programs can be more challenging for smaller utilities given that there is a higher per-customer cost. Further, some utilities are prohibited from such programs given cost of service requirements.

We will continue to monitor the influence of federal, state, and local programs and how managers balance the critical infrastructure investments needed with customer rate affordability and the effect this has on rate-setting and thus financial performance.

Given the rising regulatory demands, will federal support provide meaningful benefit?

As public health and safety is the foundation of the sector, the regulatory landscape is a critical consideration. The sector is vastly different than it was 50 years ago when the Clean Water Act was promulgated. The EPA has ambitious regulatory objectives for lead and copper pipe replacement and nutrient removal. In addition, health advisories have been released for several emerging contaminants, such as PFAs, signaling that increased restrictions are imminent. From a credit standpoint, we are evaluating whether stricter standards will increase capital requirements and operating costs for treatment for utilities with meaningful exposure. We expect compliance monitoring costs to increase across the sector. We expect to also assess how expensive it will be to address both federal and state regulatory requirements, and what funding will be available.

S&P Global Ratings tends to look at regulatory compliance through a lens of financial affordability, transparency to the rate base, and progress meeting critical milestones, regardless of whether those milestones are outlined in a consent decree or other mandate. We recognize that there may not be a "one size fits all" approach to compliance, since there are so many factors that influence cost and the compliance timeline, from physical constraints at the treatment plant to density of the service area, and size. Nonetheless, from our perspective, reporting and disclosure is tantamount.

Broadly, the Infrastructure Investment & Jobs Act (IIJA) is expected to be credit supportive with respect to regulatory pressures--with dedicated funding for emerging contaminants and legacy issues such as lead. There is also significant funding for climate resiliency projects and small and disadvantaged communities which we view positively, given the potential for utilities serving these areas to have less rate making flexibility. Congress has directed that most IIJA funding for water projects be administered through state revolving loan fund (SRF) programs for drinking water and wastewater. SRFs are administered jointly by the EPA and state, tribal, and territorial agencies. 

Compared to cumulative SRF federal grants totaling almost $75 billion through the 2021 federal fiscal year, the $43 billion of IIJA funding to be administered through the SRF programs from 2022-2026 provides significant assistance for local systems. Most of the funds maintain a state match requirement of either 10% or 20%, providing additional leveraging of federal funds. Combining federal grants with state match, SRF bond proceeds, and recycling of assistance agreement repayments, SRFs are expected to aid communities in an amount well more than total federal grants. 

Chart 8

While IIJA, SRF grants, and USDA Rural Development loans have increased federal investment in water and sewer infrastructure, it is still a small portion of utility infrastructure funding, and we do not expect IIJA to be a panacea since authorization and appropriation risks remain. Further, federal provisions such as "Buy American" and the Davis-Bacon wage guarantee can also be challenging for project execution, though waivers are available in some cases. 

Are labor concerns enduring?

A growing number of utilities have cited a shortage of qualified professionals due to retirement and difficulty recruiting or retaining employees. Water and sewer employees carry out specialized tasks, critical to public health and safety. An estimated one-third of the 1.7 million workers in the sector are projected to be eligible to retire in the next 10 years. Additionally, technology is advancing, increasing the need for workers with sophisticated training and expertise. Insufficient staffing can be costly given the need to increase overtime pay and the inefficiencies associated with reallocating workers. Operational issues also stem from worker shortages including safety risks and compliance and reporting violations. Many major utilities have double-digit vacancy rates which we believe is unsustainable. We are monitoring labor strategies to determine how issuers are positioned and whether succession planning promotes critical knowledge transfers. We expect labor costs within utilities to increase at a higher rate than in recent years given the competitive job market and the need to retain skilled employees with critical roles. We assess labor strategy through the organizational effectiveness factor within our Operational Management Assessment. Lack of succession planning will generally limit the sub-score to no better than a standard.

How Will Credit Quality Be Affected? 

 Forward-looking financial data will be increasingly relevant.  Given the recessionary factors, including inflation, we expect to weigh forecast years more heavily than historic data when we believe it is more indicative of future trends. When issuers do not have forecasted data, we will incorporate projected coverage and liquidity assuming reasonable inflationary expectations. This is critical to understand the trajectory of the credit. 

Balanced credits may fare better in the current environment.  We will evaluate the enterprise and financial profiles, as those that have been less balanced in their overall credit profile may experience more pressure. Those credits that were more reliant on their strong financial performance to offset a more limited economy, for example, may be more vulnerable to rating pressure. At a particular rating, some utilities may have some flexibility to generate lower margins than historical levels given our holistic review of credit characteristics. 

Transparency will be increasingly important.  Most issuers in the water and sewer sector rated by S&P Global Ratings do not publicly report quarterly budget-to-actual performance trends and, in fact, many do not have audits until 270 days after the fiscal year end, creating a material reporting lag. While we may rely on our own forecasts to ascertain past-but-not-yet-reported financial performance, we expect issuers to disclose unanticipated events that may adversely influence credit quality, such as a flood, major pipeline or main failure, or extended boil-water notice, if the event is likely to affect operating margins. Transparency and accountability are influential credit drivers that can mitigate forward-looking risks and add credibility to issuer forecasts, as discussed in "Management Matters: As Risks Rise Across The Water And Sewer Sector, The Importance Of Transparency Surges ," published June 24, 2022. Failure to disclose potential risks could indicate that management does not have a full focus on its risk profile and may be less nimble in responding to these risks. In addition, insufficient risk disclosure can weaken relationships with key stakeholders, such as governing boards, market participants, and--most importantly--ratepayers. This potential discord can threaten confidence in management, hindering rate flexibility. In addition, although rare, insufficient, or misleading disclosure can result in fines, higher cost of borrowing, or limited market access, which may influence financial capacity and flexibility and thus credit quality. While ongoing transparency and disclosure practices are explicitly linked to only one component in our criteria, they influence nearly every aspect of our credit rating, informing our view of management's planning and leadership as well as the ability to respond quickly to an emergency. During the past two years, over 40% of the negative rating actions (outlook revisions and downgrades) in the water and sewer sector have resulted from weak transparency, lack of accountability, or risk management. We expect this trend to continue.

Small utilities may be more exposed.  We continue to view smaller utilities as having greater exposure to credit pressures given, on average, staff limitations, infrastructure deficiencies, and smaller (and often declining) rate bases across which to spread fixed costs. As we anticipated in last year's sector view report

("Outlook For U.S. Municipal Utilities: Stable, With Expanding Operating Margins," Jan. 19, 2022) smaller utilities accounted for 100% of the multi-notch downward rating transitions in 2022. We expect this dynamic to continue for several reasons. Smaller utilities are no less exposed to event risk or regulatory pressures than their larger counterparts yet have more limited staffing, resources, and management practices on average. Further, economies of scale benefits are not as easily recognized by smaller utilities as costs are borne by fewer customers and often significantly longer pipe per customer. Liquidity impairment also tends to happen more quickly for smaller utilities given the lower nominal amount of liquidity--despite many smaller utilities having relatively high liquidity on a day's cash basis. Finally, transparency and disclosure tend to be more limited and less timely given smaller staff and more lenient policies.