Overview

California municipal water and sewer utilities continue to demonstrate stronger operational and financial profiles than their national peers, due in part to the state's comprehensive institutional framework, which compels forward-looking resource planning and transparency regarding drought resiliency, affordability, and utility service costs (see table 1). However, we believe utility credit quality in California could be tempered by emerging regulatory requirements, affordability pressures associated with accelerating capital spending, and relatively high cost of operations. Consistent with our negative sector outlook, we project weakening pro forma financial performance through 2025 and the increased risk for structural imbalance for any utility in California without a close alignment between demand and fixed-cost recovery.

Table 1

Sector Trends

Increasing climate and hydrological volatility stresses infrastructure, spurring new legislation, mega-partnerships, and regional collaboration

We see fiscal 2023 as an inflection point for California utility credit quality. Following the three driest years ever recorded, the state experienced two historically wet winters with intense storms, which shifted much of the public dialogue to emergency management related to flood mitigation, landslides, and overflowing reservoirs from water scarcity, mandatory conservation, and groundwater wells running dry. The change in weather mitigated the risk of operational difficulties that a fourth-straight year of drought could have brought on. The surge in runoff also increased storage in Lake Powell and Lake Mead in the Colorado River basin--giving a temporary reprieve to a system that supplies critical water to Southern California. However, the rain spurred vegetation growth followed by near-record heat, which contributes to increased wildfire risk, necessitating mitigation measures that include vegetation management, hardened flume construction, and maintenance of a wildfire-specific property insurance policy.

California's existing water supply and flood infrastructure requires additional renovation and improvements to respond to increasing climate volatility, which we believe could be costly. The Department of Water Resources forecasts that the combination of increasingly intense droughts, decreased snowpack, and a shift to more rain than snow indicates that State Water Project (SWP) supply availability could decline by 22% during the next 20 years. (For more information, please see "California Department of Water Resources" published Nov. 29, 2023, on RatingsDirect.) In addition, the SWP faces ongoing service disruption risk due to sea level rise and seismic activity. Moreover, the Colorado River's ongoing supply imbalance suggests that ongoing negotiations between users will result in meaningful curtailments after Dec. 31, 2026, when key operating guidelines for lower basin shortages established in 2007 expire.

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Per capita water consumption has been flat to declining in much of the state, partly because of the state's emergency water conservation restrictions that were enacted at the height of the drought in October 2021, and because of the wet spring weather in both 2023 and 2024 reducing outdoor water consumption. We believe lower consumption levels will be perpetuated due to the state encouraging removal of non-functional turf in commercial spaces and changing consumer behavior patterns. This reduced consumption and hydrological volatility underscore the importance of utility rate design, particularly related to fixed-cost recovery.

California has not built large-scale water reservoir infrastructure in 45 years. However, the tide may be turning, partly due to the governor's infrastructure streamlining law, promulgated in July 2023, which is intended to reduce delays caused by California Environmental Quality Act litigation. One such beneficiary is the $4 billion Sites Reservoir project, which upon completion (anticipated in 2033) would be the eighth-largest reservoir and the second-largest "off-stream" reservoir in the state and will capture water during wet seasons and store it for use during drier seasons--holding up to 1.5 million acre-feet (AF) of water, enough for 3.0 million households' yearly usage. Another key reservoir project that could be greenlit this year is the 130,000 AF expansion of San Luis Reservoir. However, a third reservoir project, the Los Vaqueros expansion, was abandoned in September 2024 due to cost pressures.

We also expect utilities in California will continue to develop new, innovative underground water storage projects and strategic partnerships, like the Antelope Valley-East Kern Water Agency and Metropolitan Water District of Southern California's (MWD) 280,000 AF capacity High Desert Water Bank, which is expected to be fully operational in 2027, as well as regional recharge and recovery projects like those already established in the Santa Ana rivershed and Chino basin. Finally, the state water control board approved direct potable reuse in December 2023, which will likely catalyze new recycled water projects, including those in development in Los Angeles and San Diego.

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Escalating costs and increased spending may challenge affordability

We believe rate affordability in California will become more pressured as the cost of future supply and storage projects--and the extensive water conveyance infrastructure that goes with them--will exceed historical spending levels, especially as nondiscretionary capital spending also continues to rise. As projects come to fruition, we expect to see more innovative financing structures (and, potentially, tax alternatives) to help mitigate the cost burden on individual retail customers, but we expect overall service rates to rise on an accelerated basis.

An additional challenge, as discussed in Economic Outlook U.S. Q4 2024: Growth Rates Start Shifting To Neutral," published Sept. 24, 2024, is that housing affordability and negative net domestic migration--in addition to labor disputes and technology sector contractions having localized repercussions in Los Angeles and Silicon Valley, respectively--have hindered job growth and economic output in California. S&P Global Market Intelligence forecasts that the state's employment, population, and real income will continue to lag national indicators through 2025.

In 2022 and 2023, rated California utilities, like many across the country, experienced significant inflationary-related pressures. For example, the cost of construction rose by as much as 30% for materials such as concrete. Delivery times extending from nine months to one year were not uncommon for iron piping, electrical equipment, and large machinery. Although delivery times have moderated, there are still some items suffering from extended delivery delays, such as sophisticated electrical gear and generation equipment. Although recent Consumer Price Index data shows some inflationary indicators moderating, we expect energy and labor and benefit expenses to remain elevated, particularly as pandemic-era vacancies are filled.

Since California has relatively high median household incomes, utility bills remain generally affordable, according to S&P Global Ratings' affordability metric (see table 1). However, we also recognize that this assessment potentially understates the cost pressures on households in the lowest 20% of state median household effective buying income level, especially as much of the state faces overwhelming housing costs, and sizable electric and gas service rate increases due to its ambitious energy transition plans. Finally, State Farm and Allstate recently announced that they will no longer sell new home insurance policies in California. With housing costs already among the highest in the nation, increasing insurance premiums will only exacerbate affordability challenges facing state residents.

State's institutional framework for utilities is favorable and comprehensive, but certain regulatory requirements could have rating implications

As required under state water code, municipal water utilities that serve more than 3,000 residents are required to prepare urban water management plans every five years that consider the adequacy of their water supply through 2045 in relation to projected water demands and must include a water shortage contingency plan. This, coupled with Proposition 218, which compels strong transparency around rate design and service costs, we view as credit supportive.

While more balanced groundwater usage increases supply reliability and reduces land subsidence, we believe the transition to sustainable groundwater use, per the Sustainable Groundwater Management Act, could create long-term downward rating pressure on municipalities and water districts serving farms and agricultural communities. Local subbasins may be compelled to cap how much water its users can pump. Moreover, the mandatory water conservation requirements "making conservation a California way of life" adopted in July 2024 could have varying credit implications for those utilities facing the steepest cuts. Mountain and desert communities, much of the Inland Empire, stretches of the Central Valley, and the remote, sparsely populated areas of northeast California could face mandatory demand reductions of 30% or more. 

Regional Spotlight

Below, we discuss key credit drivers and trends by hydrologic region, including those related to growth demands, water sources and uses, major contaminants of surface and groundwater, and water rights.

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Inland Empire

As residents move inland from the coastal cities, the Inland Empire continues to experience steady growth, owing to its comparatively inexpensive housing, lower land prices, and more affordable costs of living. Our ratings in this region also reflect San Bernardino and Riverside counties' diverse water supply, which ranges from local runoff from the San Bernardino and San Jacinto mountains, surface water from the SWP and Colorado River, existing recycled water, and local groundwater. Those with more groundwater in their overall portfolio tend to have some of the lowest rates in the state; however, the Inland Empire's per capita consumption tends to be significantly greater than other regions, which offsets some of the advantages of a lower-cost supply. We believe matching water supply and wastewater treatment capacity to future growth is important to credit quality.

Further east, we recognize that about 75% of the Imperial Valley's urban and agricultural water supply comes from the Colorado River, which we consider a credit risk as it could be subject to future curtailment. These areas are known for year-round agricultural production, with alfalfa the leading crop. The federal government recently offered farmers about $800 per AF to convert alfalfa fields to alternative crops, but future water curtailments (and compensation) have not been formalized.

South Coast

About 40% of the state's population lives in this region, which would not exist in its current capacity without access to imported surface water from the SWP, Colorado River, and Owens Valley (through the Los Angeles Aqueduct). However, given the variability of these supplies, much of the region has long-term sustainability goals to reduce its reliance on imported water through local water initiatives that include recycled water, stormwater capture, groundwater remediation, and water conservation. Many of these projects will be supported by MWD's local resources program--however, we recognize that the cost of water in this region will rise exponentially as many of these projects come online.

This region also has the highest detection of man-made chemicals, such as perchlorate, chromium-6, volatile organic compounds, and other chemicals from industrial activity, which can drive up groundwater treatment costs. Another challenge is how to balance existing supplies as these new projects come online; the San Diego County Water Authority has been selling back some of the water it purchases from Imperial Irrigation District, and we believe the ability to exchange or sell water to buyers states like Arizona and Nevada would be credit supportive, but would require federal approval.

Bay Area

Much of the Bay Area benefits from access to imported surface water from tributaries of the San Joaquin River though large purveyors like the San Francisco Public Utilities Commission (SFPUC, population: 2.7 million) or East Bay Municipal Utility District (population: 1.4 million), or from the SWP and Central Valley Project (CVP) through wholesale agencies like Valley Water (population: 2.0 million) and Contra Costa Water District (population: 500,000); those systems without access to these sources, such as those in Marin County, have tended to face larger drought restrictions historically. We are monitoring SFPUC's ongoing negotiations with the state regarding the San Joaquin-Sacramento River and the Bay-Delta Water Quality Control Plan, which calls for potentially large increases in environmental water releases, adversely influencing future water availability; we understand that Senate Bill 389 (signed in October 2023) could sharpen focus on how those with pre-1914 water rights (like the SFPUC) could be influenced. Like many systems across the U.S., most wastewater treatment providers in the Bay Area are in the midst of large plant modernizations, including for nutrient removal.

Central Coast

The Central Coast region, with a population of about 1.6 million, is one of the most groundwater-dependent regions in the state, with groundwater being used to meet approximately 80% of agricultural and municipal water demands. Out of necessity, much of the region has had to impose extraordinary conservation measures in dry years and alternative supply projects, such as desalination and reuse, are being considered or leveraged.

Sacramento/Foothills

Most of this region benefits from robust surface water from the Sacramento River and its tributaries, which we believe better positions these systems in comparison to their state peers. However, much of eastern Sacramento and the Sierra foothills are designated either as having elevated or extreme fire threat by CalFire, which weighs on credit quality. In our view, higher unrestricted liquidity helps insulate utilities from financial risks and losses associated with wildfires, and we consider the replenishment of this liquidity as a key rating factor.

Central Valley

Prolonged and frequent droughts have negatively pressured water supply and agricultural production across the Central Valley. The region's most acute water quality problem is the accumulation of salts, including nitrates, which is compounded by the overdrafting of groundwater and importation of water from outside the basin, which concentrates salts within the remaining groundwater. Thousands of acres in the basin can no longer be farmed due to high salinity in the soil. Groundwater depletion from overpumping has caused land to physically collapse, damaging critical infrastructure. Moreover, we consider the relatively elevated expense of short-term water transfers (which have helped keep orchards alive during recent droughts) as a potential credit stressor, given that these purchases are often significantly more costly than traditional sources, both due to water scarcity and a complicated transfer-approval process. Given the complexities of supplemental water procurement for agriculture, having a management team with the commensurate skill and experience in the water industry will be important to ongoing credit quality. For more information, please see "Your Three Minutes In California Groundwater: Tulare Lake Subbasin's Probation May Herald More Restrictions, Rating Changes, ", published June 13 2024.

Wine Country/North Coast

This region primarily receives water from highly managed river systems with reservoir releases controlling river flows, especially throughout most of the summer and fall. During the most recent drought, diversions were reduced so significantly that several water systems were unable to fulfill adequate drinking water demand in their service area, resulting in a drought emergency. Much of Wine Country and Mendocino County is designated as having elevated or extreme fire threat by CalFire, which weighs on credit quality.

Tightening Regulations, Stricter Permitting, And Rising Costs Will Likely Widen Service Cost Discrepancies Between Utilities

We expect to see widening divergence in cost of service on a utility-by utility basis over time, primarily due to unique regional hydrological characteristics, as well as by utility size. As discussed in our national outlook, we believe that economies of scale remain an important determinant of cost, affordability, and credit quality. On average, smaller water systems charge more for the same volume of water when compared to medium and large regional water systems. We also have observed that smaller systems can face staffing challenges and may not have the technical expertise to navigate operational and financial demands on their systems, resulting in greater financial volatility and weaker overall credit ratings. They also are more likely to have unqualified bidders submitting on capital projects, and the limited competition can drive up construction costs.

We continue to track the development and costs associated with proposed drinking water regulations for contaminants such as per-and polyfluoroalkyl substances (PFAS) by the federal government, which are even tighter than those previously adopted by the state of California. We anticipate that once federal drinking water regulations are finalized, the Environmental Protection Agency may shift its efforts to the wastewater industry, which could also be costly. The National Assn. of Clean Water Agencies suggests operational costs for individual utilities could increase by more than 60% as a direct result of new PFAS regulations and potentially more if they receive a hazardous substance designation under the Comprehensive Environmental Response, Compensation, and Liability Act. 

We also foresee a tightening in local watershed permits for nutrient discharges to limit the release of algae-feeding by-products such as nitrogen. For example, the nutrient watershed permit for municipal wastewater dischargers to the San Francisco Bay requires the 40 sewage treatment plants that discharge into the Bay to collectively reduce nitrogen discharges by 40% during the next decade and could cost more than $11 billion.

Finally, we continue to monitor the development of several key "mega-projects" which could be influential to credit quality. This includes the $20.1 billion Delta Conveyance Project (the 36-diameter tunnel under the Bay Delta) that is intended to increase SWP deliveries by approximately 17%. This increase would largely offset the anticipated reduction in future water deliveries due to climate change-–18 of 29 state water contractors have expressed support for the project. In addition, sizable local recycled water projects have been proposed, including:

• PureWater Los Angeles Project (210 mgd): A partnership between the Los Angeles Department of Water and Power, Los Angeles Sanitation and Environment, and the Water Reclamation District of Southern California; and
• PureWater Southern California Project (150 mgd): A partnership between Metropolitan Water District of Southern California, the Los Angeles County Sanitation Districts, and Southern Nevada Water Authority.

When fully phased, both of these projects are likely to exceed $20 billion.

Appendix

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Related Research

• Through The ESG Lens 3.0: The Intersection Of ESG Credit Factors And U.S. Public Finance Credit Factors, March 2, 2022
• Economic Outlook U.S. Q4 2024: Growth And Rates Start Shifting To Neutral, Sept. 24, 2024
• Your Three Minutes In California Groundwater: Tulare Lake Subbasin's Probation May Heald More Restrictions, Rating Changes, June 13, 2024
• What The Loper Decision May Mean For U.S. Public Finance, Aug. 14, 2024