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What's Behind Our Sector View  

Deferred maintenance will remain a driver of infrastructure deficiencies and likely result in impaired financial performance.   In 2024, S&P Global Ratings downgraded several water and wastewater utilities due to inadequate maintenance that influenced financial and operational performance. Both large and small systems are facing major asset deficiencies that could reduce access to water, create health and safety issues, or violate regulatory guidelines. The Environmental Protection Agency's (EPA) Drinking Water Infrastructure Needs Survey and Assessment recently reported that the 20-year need for water infrastructure is $625 billion. When including wastewater, the needs assessments total $1.2 trillion. Post-pandemic deferred maintenance has boosted unbudgeted capital expenses as well as reduced project flexibility, which we believe will increase capital costs.  Given the essentiality of water service, infrastructure deficiencies typically require immediate remediation. Therefore, ongoing deferrals shift the urgency of projects, making utilities "price takers" in a tough construction and cost environment, which leads to exponentially more expensive repairs. These expenses can crowd out other system needs, compromise financial health, and create a liquidity crisis, which was a contributor to the Clyde, Texas, default in 2024 and to a quarter of the multinotch downgrades we took last year.

A critical aspect of our operational management assessment will remain evaluating whether there is a minimal level of asset management planning, including an asset inventory, identification of required maintenance, and a connection to financial planning to ensure cost recovery and sufficient liquidity to meet risks.

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Climate hazards could stress system resiliency and increase leverage as utilities address mitigation and adaptation goals.   As witnessed during Hurricane Helene, "Green Swan" events (that is, weather-related events with an extreme impact) are becoming more common and can have catastrophic effects on infrastructure and communities, even in areas where such risks are less common. Although some regions have greater vulnerability to climate-related hazards, we view all utilities as having weather-related risk, which is becoming increasingly unpredictable. That said, utilities have been relatively resilient, generally returning to full service within a short time and receiving substantial support from the Federal Emergency Management Agency (FEMA). As an example, Asheville, N.C., was able to rehabilitate its system in two months, a notable feat given the nature of the damage.

However, it remains unclear how such disruptions will influence the customer base and infrastructure in the future. Furthermore, FEMA disaster relief funding is increasingly strained by the rising incidence of climate disasters and risk and underwriting standards that are evolving. We expect acute physical risks such as flooding, storms, and wildfires will still require infrastructure hardening, increased redundancy, and changes to operational and emergency response. In addition to causing evaporation, extreme temperatures have severely compromised existing assets, shortening their useful life, especially when these assets aren't properly maintained.

Longer-term risks such as sea-level rise and water scarcity aren't imminent for most utilities, but may threaten reliability in the future. Sea-level rise will influence water quality and treatment costs and may spur costly relocation of critical assets. Water stress has been compounded by dwindling groundwater basins and population growth throughout the western U.S. and we expect this will continue. For example, the Colorado River's ongoing supply imbalance, caused by both reduced snowpack and evaporation, will likely necessitate meaningful curtailments after Dec. 31, 2026, when key operating guidelines expire.

Climate variability has been a perennial credit risk, consistently driving utility performance, which we expect will continue. Addressing climate vulnerability will remain an integral aspect of our operational management assessment, including sound emergency planning, vulnerability assessments, and building in system redundancy. Failure to adequately plan and respond will negatively affect credit quality, as we have observed that such omissions can expose utilities to significantly greater recovery and litigation costs and inadequate planning can drive higher insurance costs and liabilities following a climate-related catastrophe, potentially stressing liquidity needs.

We expect the pace of regulatory activity will moderate, which could be neutral to positive for utilities.   Utilities have faced several years of heightened regulatory mandates, including replacing lead service lines (LSL) and addressing emerging contaminants and nutrient removal, as well as several other mandates. While dedicated funds are available through the Investment Infrastructure and Jobs Act and Inflation Reduction Act, we expect more than 90% of the cost will fall to the rate base, furthering affordability pressures.

If past practice is indicative of future priorities, we believe lead lines and per- and polyfluoroalkyl substances (PFAS) will remain strategic priorities since the former Trump administration issued the initial rule on LSL and was evaluating and advising on PFAS. However, we expect the pace and approach to these regulations will shift, given the incoming administration's regulatory philosophy and ongoing litigation and legislation related to the existing PFAS rule. Given the complexity and associated costs, the sector might benefit from slowing the implementation timeline to allow for continued evaluation and to address existing concerns. Legislation has been introduced both in the Senate and House (Senate Bill 1430 and HR 7944) that aims to provide utilities with liability protection from Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) liability. In the interim, we expect state standards will remain influential, guiding compliance requirements.

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In addition to the federal government's slowing the pace of some regulation, a rollback of federal protections for streams and wetlands seems likely. The resulting shift of oversight back to the states may transfer costs from polluters to utilities, raising future treatment burdens. We expect this will be litigated, as has been the case in the past, especially given the Supreme Court's recent decision overturning the Chevron doctrine (see "What The Loper Decision May Mean For U.S. Public Finance," published Aug. 14, 2024, on RatingsDirect). Overall, we believe slowing the pace of some of the regulatory initiatives could benefit utilities' budgets in the near term, but it's too soon to tell if this will introduce future costs or lead to negative implications for longer-term water quality, environmental health, and public safety.

Sector Top Trends   

Regulations and climate-related risks will remain top of mind and continue to underpin operating pressures.   Shifts in regulation and climate patterns generally require both capital investment and higher operating costs. For example, the Colorado River renegotiations are intensifying with significant competing interests and limited resources. Although we don't believe supply sufficiency will be a credit driver, we do think developing alternative supply, such as recycled or desalinated water, will be a critical part of the solution. This will significantly alter the cost of water in the region, given that resilient supply options are magnitudes more expensive than traditional supply sources, which could pressure affordability, and thus credit quality. This has already occurred in California, where the cost of water has increased threefold in southern California. Given projected water stress in Arizona, Florida, and Texas, more expensive supply augmentation will likely raise costs in these states as well. Other physical risks such as flooding and wildfires also increase operating costs by contaminating existing supply, adding operating difficulties that persist for years after the event.

Beyond climate issues, meeting regulatory standards also increases the expense burden. The processes to treat emerging contaminants or remove nutrients such as phosphorous likely will be more expensive than current treatment processes. We expect this to be a critical and emerging risk, given the recent designation of PFAS as a hazardous substance under CERCLA.

Furthermore, the cost of biosolids handling for wastewater systems probably will increase if systems are forced to shift from biosolids application to incineration or landfill waste. This will be compounded by insufficient landfill capacity and relatively few incineration options, given that biosolids application has been the primary approach for decades.

Project execution and construction difficulties could persist, necessitating changes to procurement and project delivery.   Although S&P Global Economics forecasts the rate of inflation for construction materials will moderate to 4% net growth, proposed immigration policies may serve as a headwind to the economy. Labor supply, which rose 1.6% on average in the past two years, is projected to slow in the coming years, especially in the construction sector (see "Economic Outlook U.S. Q1 2025: Steady Growth, Significant Policy Uncertainty," published Nov. 26, 2024. In addition, although delivery times have moderated, some items, such as sophisticated electrical gear and generation equipment, are still struggling with extended delivery delays.

In response to the supply chain issues of recent years, the most sophisticated utilities have made changes to procurement and inventory practices, which we view favorably. In addition, the bidding environment remains tough/intense given labor shortages, supply chain uncertainty, and fewer bids. In general, we've observed an increase in design-build engineering to mitigate some of these risks. For utilities that leverage federal funding, prevailing wage and "Build America, Buy America" requirements will continue to pressure costs; and for FEMA, administrative and reimbursement complexities influence project execution.  

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Affordability struggles will require thoughtful management practices.   In the past decade, water and wastewater rates have outpaced inflation and wage gains, increasing over 40% over the past decade. While rates for the average ratepayer remain affordable, the more vulnerable 20% of the income spectrum faces significant affordability struggles. Affordability sharply diminishes further down the income distribution scale (see chart 6).

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The most sophisticated management teams are taking a multipronged approach to addressing affordability, incorporating customer support programs, innovative technology, and SMART infrastructure design. Given the essentiality of water, ensuring access for the most vulnerable portion of the population is an emerging focus for water managers. In 2020, this was also a focus of the federal government, with approval of the Low-Income Household Water Assistance Program (LIHWAP) legislation, which was signed into law by the previous administration. LIHWAP supported nearly 2 million low-income households and 13,000 utilities. The program was unfunded in 2023, and we believe reinstituting it would be beneficial for utility credit quality and would align it with the energy sector.

Managing affordability supports better rate-setting flexibility and reduces political risk. Building funding for customer assistance into the basic cost recovery model improves budget predictability and transparency and broadens affordability throughout the income spectrum. In general, we believe that in addition to financial support, implementing alternative and sophisticated technologies can provide long-term operational cost savings but there could be up-front capital costs. Leveraging the use of production byproducts such as reclaimed water and methane gas could also provide compelling economic and environmental benefits. We expect some margin compression to meet affordability goals and as long as sophisticated forecasting underpins the performance, it's not necessarily a credit risk.

Rate structure is important to cost recovery and revenue stability.   Several downgrades in 2024 were related to the inability to recover rising costs in a timely manner. Rate structures with automatic pass-throughs to support energy, chemical, or wholesaler costs, for example, fared better than those that were reliant on only a preapproved rate increase that may have been set well before the current operating environment became stressed. In addition, given flat consumption trends and hydrological volatility, increasing fixed revenue composition has increased revenue stability and budget predictability.

In addition, several innovative issuers have leveraged passive revenue sources such as property and sales taxes to support resiliency projects because the benefit is spread uniformly regardless of use. We view these innovative financing structures favorably, as they can mitigate the cost burden on individual retail customers and diversify revenues. We believe aligning cost recovery structures with long-term capital, operational, and strategic needs provides utilities with funding advantages because projects can be funded through incremental rate adjustments rather than large, one-time hikes to the customer base.    

Small systems continue exhibiting greater vulnerability from lesser economies of scale and staffing limitations.   Most downgrades this year were to systems with less than $25 million in revenues. Financial performance, particularly coverage and liquidity, for smaller systems tends to be nearly 20% more volatile than for larger systems year over year.

Furthermore, management teams for small systems have greater key person risk and typically demonstrate weaker management practices, exposing the systems to greater event risk and often rate-setting problems during management transition. Given the complexity of regulatory mandates, the construction environment, and lesser economies of scale benefits, we believe small systems will continue to face credit quality stress. Regionalization and privatization could provide benefits for smaller systems but there hasn't been large-scale adoption of this to date. 

Ratings Performance

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