Overview

S&P Global Ratings believes that California school districts' credit quality will remain relatively stable, supported by a favorable state funding environment and the receipt of one-time stimulus resources as districts mitigate challenges arising from broad school-aged demographic declines that the pandemic has exacerbated. We expect this trend to continue in the medium term, but districts in the state face more-difficult budgetary tradeoffs as they expend their remaining Elementary and Secondary School Emergency Relief (ESSER) funding and begin to experience the financial impact of continued enrollment declines. In fiscal 2023, the state made upward adjustments to its per pupil equalization formula applicable to most districts. Districts can use the average daily attendance (ADA) of the current year, prior year, or the average of the three most recent years, whichever is highest, to determine operating revenue under the state funding formula, but we think that the revenue effects and operational and asset management complexities of declining local student populations will continue to challenge the budgets of many districts for the long term. Accordingly, we also are seeing a surge in compensation increases to an extent that affects districts' bottom lines, as bargaining groups make the case for addressing broad-based inflation, the state's comparatively high housing costs, and a limited pipeline of qualified teachers.

S&P Global Ratings maintains ratings on 688 school districts in California, including school facilities improvement districts. Fifty-five percent of California school districts are in the 'A' category, 44% are in the 'AA' category or above, and fewer than 1% are in the 'BBB' category or lower. In addition, 99% of the ratings have a stable outlook. Four school district ratings have a positive outlook, while two have a negative outlook.

What We're Watching In 2023 And Beyond

California has provided funding formula continuity throughout the pandemic, but projected revenue declines cloud the outlook

California closed a nearly $32 billion projected budget deficit by cutting, delaying, and shifting some expenditures to other funds while protecting kindergarten through 12th-grade funding. For the fiscal 2024 enacted budget, California's overall kindergarten through 12th-grade funding slightly declined compared with the fiscal 2022 level, but general operation funding has increased. In particular, the state budget creates the equity multiplier program, which would provide additional supplemental funding for socioeconomically disadvantaged students to help close the achievement gap, and includes a compounded cost-of-living adjustment of 8.22%, the largest in the history of the Local Control Funding Formula. This follows stable funding in fiscal 2023, although we think that the state's unprecedented revenue growth over the past two years could be coming to an end as funding remains uncertain given revenue volatility that the state is experiencing. As a result of the winter storms, California storm victims have until Oct. 16, 2023, to file state and federal income taxes. The state's heavy reliance on personal income taxes, which tend to be sensitive to economic cycles, often leads to a boom-and-bust cycle affecting funding formula revenue.

On a macro level, S&P Global Economics' baseline forecast suggests a slowdown in consumer spending and construction, meaning that policy rates will likely need to be raised or stay higher for longer, with a protracted growth slowdown rather than a recession. If a slowdown in consumer spending results in lower revenue collections and a higher unemployment rate, state revenue could plummet. Because personal income taxes account for nearly 57% of budgeted revenue, kindergarten through 12th-grade funding would likely be a target for expenditure reductions, although the state's "rainy day" fund has been reserved for use in the event of an economic downturn. For more information, see "Economic Outlook U.S. Q3 2023: A Sticky Slowdown Means Higher For Longer," published June 26, 2023, on RatingsDirect.

Maintaining credit quality will require a proactive approach, as enrollment declines continue to exceed expectations

For most districts, average daily attendance adjusted for specific student demographic criteria remains the most important factor influencing operating revenue under the state funding framework. Fiscal 2023 marked the sixth straight year of enrollment declines, and managing the revenue effects of demographic change is a common topic in our management discussions. In fiscal 2024, school districts will continue to have the option to use an average of the three prior years' ADA, current-year ADA, or prior-year ADA, but declining enrollment that accelerated during the pandemic will begin to materially affect revenue. Because average daily attendance declines are likely to continue for the foreseeable future for many districts, we believe that budget adjustments, including layoffs, are likely in the near future as districts grapple with uncertainties regarding the state's long-term revenue outlook and as districts realign budgets after the expiration of one-time federal stimulus funds. Based on our conversations with management teams across the state, we have determined that districts are aware of potential budget adjustments that they will need to make once one-time revenue has been expended, and that they have begun to make adjustments such as updating multiyear projections, factoring in attribution to reduce headcount to match enrollment, and managing personnel expenses.

A 10% reserve cap triggered for fiscal 2024 may weaken districts' reserves and financial transparency

The 10% reserve cap was enacted in 2014 and became law after voters approved Proposition 2, the state's rainy day fund. Fiscal 2024 will be the second year in which statute will limit certain school districts' ability to save assigned and unassigned general fund revenue in an amount above 10% of expenditures. The law also restricts reserves in excess of 10% within the special fund for purposes other than capital outlay, where districts often keep reserves for economic uncertainty. There are exceptions: small school districts with average daily attendance of fewer than 2,501 students, and "basic aid" districts. Districts able to demonstrate need or special fiscal circumstances may be able to receive an exemption for as many as two consecutive fiscal years within a three-year period from the state's local fiscal oversight office. Fiscal 2024 will be the last year in which many school districts will be able to receive an exemption for special fiscal circumstances. It's unknown whether the cap will be triggered in fiscal 2025 as a result of the revenue volatility the state is experiencing and revenue projections below forecast. We believe that the 10% reserve cap is likely to have an overall neutral-to-negative effect on credit quality by forcing many districts with reserves in excess of the cap to shrink their financial cushions.

We understand that many districts in fiscal 2023 were able to formally commit a portion of their previously unassigned fund balance to achieve compliance with the cap while keeping such resources practically available for unexpected challenges. School districts are required to formally comply with the 10% reserve cap on a yearly basis as long as the cap is triggered. This may prove to be difficult in fiscal 2024 as school districts face the deadline to spend all ESSER funds. County superintendents may subject some districts to additional scrutiny as they evaluate the special fiscal circumstances that the districts cite to justify retention of excess reserves. We believe that districts' attempts to comply with the cap could decrease transparency by making it difficult for internal and external stakeholders to understand a district's true financial condition. Under Governmental Accounting Standards Board Statement No. 54 guidelines, a "committed" fund balance has constraints that the reporting entity has itself placed on reserves but that only the governing body can remove. We will continue to incorporate into our analysis whether the governing body could legally or even politically choose to remove such constraints before determining whether or not such funds are also included as available.

Spotlight On Environmental, Social, Governance Factors

School districts are exposed to various physical risks, including acute events stemming from wildfires and droughts as well as chronic issues resulting from sea level rise. Although risks vary by region, our rating analyses incorporate an issuer's risk management efforts through review of long-term financial and capital planning documents as well as any specific resiliency or emergency plans. Furthermore, the state experiences natural disasters from earthquakes but has robust building codes to bolster resiliency, and we view this positively. We will continue to take into account the state's frequent severe weather events, including the atmospheric river that occurred from January through March 2023. We are also watching the evolution of the homeowners insurance market and how the potential for waning availability and higher costs could affect population and economic growth for the state and school districts over the long term.

We consider California's social capital risks elevated compared with those of other states given a shortage of affordable housing and high social service costs as a result of income disparity. California addresses this issue for school districts through concentration grants that provide additional aid under the state funding formula. Furthermore, declining birthrates, higher-than-normal death rates, a decline in international migration, and an increase in residents' moving to other states (likely related to high housing costs) have resulted in population declines. Should weaker demographic trends continue, this could significantly affect school districts that depend on the per pupil funding formula, especially as the state's pension managers project that contribution requirements are likely to rise through the middle of the decade, potentially encroaching on other spending priorities.

Finally, state oversight of school districts' financial health and disclosure requirements helps underscore credit fundamentals, and the state has an institutionalized practice of providing liquidity and assuming financial controls during periods of financial distress by appointing a state administrator to replace the district's superintendent and school board. We find this system generally effective in stabilizing districts' finances and operations, but the recovery period can be prolonged, which leads to our overall neutral view of governance for the portfolio.

California School District Local Governments Data

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