CreditWeek - CFA Institute · By Aneesh Prabhu, CFA, FRM, New York For centuries, man has known that water is key not only to life but also to economic development. As populations

Water May Swamp Power Sector Credit Quality (p. 30)

Water Utility Ownership’s Shifting Dynamics (p. 25)

Water Needs Hard On Municipal Utility Credit (p. 40)

Benefits Of Desalination Come At A Price (p. 35)

CreditWeek®

The Global Authority On Credit Quality | March 7, 2012

WAter The Most Valuable Liquid Asset? (p. 12)

Special RepoRt

Every Drop Counts:Is Water The Most Valuable Liquid Asset?By Beth Ann Bovino, New York

Is water the new oil? It isn’t yet. But it’s easy to envision a time in the not-too-distant future when water will be as avidly sought after, as importantto economic development, and as intertwined with international anddomestic policy as oil is today. To be sure, some regions around the worldhave long thirsted for enough water. But now this need has spread farbeyond the traditional dry or impoverished areas of the world.

2 www.creditweek.com

Features16 Is The U.S. Water Sector Approaching

A Tipping Point?

By Aneesh Prabhu, CFA, FRM, New York

For centuries, man has known that water is key not onlyto life but also to economic development. As populationsand economic output have grown, so has the demand forwater. In the past century, worldwide demand for watertripled, and currently it is doubling roughly every 20years. And as higher standards of living have led togreater per capita water use, demand in many parts ofthe world has begun to outstrip available supplies.

25 From Public To Private And Sometimes Back Again:

The Shifting Dynamics Of Water Utility Ownership


The history of ownership of water systems in theindustrial world has been dynamic. Public interest—andownership—has been a constant even as it has swungfrom passive involvement to active ownership. Threeprincipal reasons are based on the central tenet thatwater is unique: public health, increasing cost of delivery,and the monopolistic nature of water management.Governments have been wary about cedingresponsibility for such an essential commodity.

30 U.S. Power Sector: Heavy Demand, Limited

Supplies, And More Regulation Could Swamp

Their Credit Quality


Little attention has beengiven to the large amountsof water that power plantsuse to generate electricity.Of the total amount of wateron the planet, only 3% isfresh water. Of that, onlyabout 1% is in free-flowingrivers, streams, and lakes.The huge amounts of waterrequired for powergeneration are beginning tojeopardize utilities’ ability tomeet demand for electricity. Proposed regulations alsomay require facilities to minimize harmful effects onthe environment.

35 Worth Its Salt? Desalination In The

U.S. Offers Benefits, But At A Price

By Robert Hannay, San Francisco

In some communities in the U.S., population growth hasled to water demand outpacing supply. In others,vulnerability to droughts has led to scarce supply in dryyears. And environmental concerns and increasingregulation have resulted in reduced water availability insome parts of the country. Local factors determine howutilities can deal with supply issues. But for areaslocated near the coast, utilities are turning to anotheroption: desalination.

contents

12

March 7, 2012 | Volume 32, No. 9

Special Report

40 From Droughts To Conservation,

Water Can Have Big Effects On U.S.

Municipal Utility Credit Quality

By Theodore Chapman, Dallas

National attention has beenfocused on U.S. municipalinfrastructure quality andcapital needs. Manypolicymakers viewinfrastructure investment as apotential economic stimulus tool.While some are trying to figure out what they need tofix and how much it will cost, the general consensus isthat needs are large and federal funding is scarce.

46 U.S. Municipal Water And Sewer Utilities: Funding

Long-Term Needs Remains Their Biggest Risk

By Theodore Chapman, Dallas

Debt issuance declined for the U.S. water, sewer, anddrainage utility sector last year. Still, the sector needsinfrastructure investment due to aging systems;regulatory issues; and migrating populations to theSouth and West, stressing existing water supplies inthose regions. Utilities will have a tough yearaddressing these issues.

52 U.S. Flood Insurance: While The Government Is

Treading Water, Private Insurers Are Just Getting

Their Feet Wet

By Blake Mock, New York

Whose earnings and balance sheet are most at riskwhen catastrophic flood losses hit the U.S.? U.S. floodshave limited impact on earnings, capital, or, ultimately,credit ratings on private insurance companies. In theU.S. such coverage is nationalized through the NationalFlood Insurance Program. The future of the program isuncertain, however, and the proposed amendmentsmay encourage private participation.

Credit FAQ57 How Water Shortages In Eastern England Could

Increase Costs For U.K.-Based Utilities

By Michael Wilkins, London

The east of England is experiencing a drought, withreservoir levels 20% lower than normal. The region islikely to face severe water shortages due to significantchanges in rainfall patterns on account of climatechange and an increasing population. This could lead towater shortages, increased energy prices, and floodrisk. It could also lead to operating and financialchallenges for utilities and energy-intensive businessesoperating in the region.

Standard & Poor’s CreditWeek | March 7, 2012 3


features special report


Is water the new oil? It isn’t yet. But it’s easy to envision a

time in the not-too-distant future when water will be as

avidly sought after, as important to economic development,

and as intertwined with international and domestic policy as oil

is today. To be sure, some regions around the world, from the

deserts of the southwest U.S. to the arid provinces of northwest

China, have long thirsted for enough water. But now this need

has spread far beyond the traditional dry or impoverished areas

of the world. Even as industrialization and population growth

explode in the developing world, more people in the U.S. are

now living in dry areas once considered only marginally

habitable. And to fund the significant water utility and

infrastructure projects needed to meet growth, borrowers

across the globe will increasingly turn to the capital markets.

Is Water The Most ValuableLiquid Asset?

■ Demand for water is quickly outstripping supply in many parts of the world, and theimbalance will only grow as industrialization and population growth continue to expand.

■ Some estimates place the share of the world’s freshwater supply devoted to growingfood at about 70%, with industry and human consumption accounting for the rest.Demand in all three categories is growing.

■ Questions about the institutional framework for allocating water, whether public,private, or some combination of the two, will likely become more pressing if the costof providing clean water becomes harder to bear.

Overview

Every Drop Counts

At the same time, efforts to boost theglobal water supply are likely to be influ-enced by concerns about environmentaldegradation, cyclical droughts, long-termclimate change, and, paradoxically, evenflooding. The critical question of what theinstitutional framework for allocating thisincreasingly scarce resource will looklike—whether public, private, or somecombination of the two—will inevitablycome to the fore as nations, and regionswithin nations, compete to provide water.

The United Nations projects that undermoderate fertility estimates global popu-lation will grow 33% between 2010 and2050, and even more if birthrates don’tfall as much as it expects. But even now,the imbalance between global watersupply and demand is growing.According to the 2030 Water ResourcesGroup, the existing sustainable globalwater supply currently stands at 4,200billion cubic meters, while withdrawalsare already at 4,500 billion cubic meters.That deficit will only grow as usage keepsrising—to a projected 6,900 billion cubicmeters by 2030. But steps to reduce con-sumption or demand through betterwater conservation, recycling, desalina-tion of seawater, and technological inno-vations in industries that use greatamounts of water could narrow, or per-haps even eliminate, this gap.

These measures will cost money, how-ever, and it isn’t clear where the fundingwill come from. Already, the cost ofwater is rising: In the year ended July2011, the price for water rose an average6.8% around the world, according toGlobal Water Intelligence, and about8.1% in the U.S. Standard & Poor’sRating Services expects that as with oil,the world could eventually face volatileprices, uncertain supplies, and increasingsocial unrest related to water, as well asthe prospect of stunted economic growthas its water shortages deepen.

Where Does The Water Go?

Water is interwoven with the globaleconomy to a degree that might at first behard to imagine. The greatest use of waterby far is agriculture: Some estimates placethe share of the world’s freshwater supplydevoted to growing food at about 70%,

with industry and domestic use accountingfor the rest. But the share of water devotedto agriculture could rise with a change inthe mix of agricultural production. Thedeveloping world’s growing middle class,for instance, has begun to move toward amore Western diet, with its emphasis onmeat. Conservationists and the cattleindustry differ on how much water is nec-essary for beef production, for example.But some midpoint estimates concludethat it takes about 2,000 gallons of waterto make one pound of beef—as opposedto 500 gallons for a pound of chicken or100 gallons for a pound of potatoes.When total current and future irrigationneeds are considered—especially for suchwater-intensive staples like rice orcotton—it’s clear that water supplies arelikely to be strained.

The growing world population willalso require more electricity, and powerproduction consumes the lion’s share ofwater for nonagricultural industry. Thatincludes not only hydroelectric power, butwater for cooling and other uses at powerplants. As recently as 2005, the U.S.Geological Survey estimated that produc-tion of electricity (excluding hydroelectricpower) uses about 201,000 million gal-lons of water each day, accounting for49% of total water use in the U.S.Moreover, power plants draw about 70%of this water from freshwater sources—and they sometimes return it to the envi-ronment either polluted or too hot (orboth), which causes environmentaldamage and further diminishes supply.

The saying that “oil and water don’tmix” can be more than just a metaphor.Take the example of shale oil. Although itis not yet a major source of oil, shale-oilproduction is growing: A 2006 reportfrom the U.S. Dept. of Energy Office ofPetroleum Reserves estimated that pro-ducing one barrel of shale oil in theAmerican west requires from one to threebarrels of water, depending on the processused. (One barrel is the equivalent of 42gallons.) Therefore, a field producing 1million barrels daily would require atleast 42 million gallons of water each day.In addition, the U.S. government believespopulation growth around new shale oilfields would further boost water needs.

Assuming that this growth eventuallytotals another 177,000 people across agiven 1,000-barrel-a-day region, the gov-ernment estimates the need for another 24million gallons of water per day. Thus,producing 1,000,000 barrels a day trans-lates into a total need for at least 86 mil-lion more gallons of water each day, andas much as 150 million gallons. And thesenumbers go up as production increases.There is no assurance that the industrywill always have the water it needs, espe-cially in regions where supplies arealready subject to the competing needs ofagriculture, industry, human consump-tion, and periodic drought.

A similar trend holds for the newer tech-nology of hydraulic fracturing, orhydrofracking, of shale formations for nat-ural gas. Hydrofracking is already abooming business in some states and willlikely grow, considering natural gas’s repu-tation as one of the more environmentallyfriendly fuels for power production. But asingle well can use anywhere from 3 mil-lion to 9 million gallons of water,according to scientists at the New YorkState Water Resources Institute. A wellrequiring 4.5 million gallons of water, forinstance, would use the same amount ofwater as all of New York City draws inseven minutes, according to one energycompany estimate. But industry observersexpect the number of hydrofracking oper-ations to keep growing. Moreover, becausefracking involves chemicals as well aswater, environmentalists have raised vig-orous concerns about the potential of theseoperations to contaminate groundwater.

While power production accounts forthe lion’s share of water consumption inindustry, other sectors are also vulnerableto water shortages. Semiconductormakers, mining companies, beverage com-panies, and chemical manufacturers allhave a vested interest in securing enoughwater. When production facilities are inareas where water availability is at risk,these companies can face lost production,higher costs, and lower profits.

Who Will Control

The Water Supply?

In the U.S., the largely public ownershipof water has often offered an implicit



assurance that it will be readily avail-able, relatively cheap, and usually safe.But in some cases the cost of providingclean water may become more thanpublic authorities are willing or able tobear. Rather than raise taxes or floatdebt, the government (in the U.S.,often a municipality or county) can sellits waterworks to investors, use theproceeds to cover other budget short-falls, and let the private sector raisefunds for capital improvements. Theflip side is that as with the privatiza-tion of other public infrastructure, thecost of service tends to rise. Advocatesof privatized systems say the costincreases are due, in part, to publicauthorities’ past underinvestment.

While the U.S. water utilities remainlargely investor-owned, England hastaken a different road, privatizing all itswater utilities in 1989 under PrimeMinister Margaret Thatcher, whobelieved that they would operate moreefficiently under private ownership.These privately owned waterworks,however, are still subject to regulatoryoversight. And some nations, such asFrance, operate most of their water-works through a system of public-pri-vate partnerships where, for example,the private sector takes on the costs ofmaintenance and distribution undercontract from the state.

How to best allocate water is aphilosophical question with no clearanswer. Practically speaking, anysystem can deliver the goods. The man-dates for safety and delivery will besimilar. And in both industrialized anddeveloping nations, investor-owned,public, and public-private systems haveall been tried with varying degrees ofsuccess. But since water is a necessity,one can argue that the governmentshould subsidize its price sufficiently toensure that everyone gets what theyneed, rather than let the free market setthe price. Theoretically, pricing wateraccording to market forces will allowfor greater investment in water utili-ties, more efficient operations, and abias toward conservation when wateris scarce. But such a system can alsorender some people or industrial users

unable to pay, while public ownershipmay result in lower water prices.

Too Much Water, Or Too Little?

While the need for water is onlygrowing, the impact of drought,flooding, or long-term climate changeon availability complicates the ways inwhich the world will learn to addressthis demand. Some scientists are alreadyblaming global warming for the years-long drop in the Colorado River, one ofthe largest water sources in the westernU.S. Droughts have taken their toll inTexas and parts of the southeast U.S. aswell in recent years. Similarly, scientistsworry that a drought in eastern Englandthat has spanned many years might bepartly attributable to climate change.This drought could hurt the region’seconomy without additional supply orsignificant conservation measures, andoperating costs for local power andwater companies could increase enoughto affect their credit ratings.

Too much water can be a problem aswell. Eastern England faces the doublewhammy of both drought and floodrisk. While flooding from rivers isexpected to be limited, rising sea levelsare a risk, as much of the area is belowsea level and on a flood plain, andNorfolk and Suffolk have some of thefastest eroding coastlines in Europe.

Many parts of the U.S. are also inflood areas, where the problem is toomuch rather than too little water. Yetresidential and business constructionhas gone forward in these areas, inpart, because since 1968 the U.S. gov-ernment has taken the lead in pro-viding flood insurance through theNational Flood Insurance Program. Bycontrast, private insurers offer virtu-ally no flood insurance, citing the dif-ficulty in modeling for flood losses.They offer only limited coverage onsome high-value properties. Thatraises questions about what the eco-nomic impact of higher rates amongprivate insurers would be if theyoffered flood insurance more widely.The NFIP is set to expire on May 31,2012, although efforts in Congress toextend it are underway.

Would less flood insurance or sharplyhigher rates deter further developmentin flood-prone areas of the country?Might the political pressures on thegovernment to cut spending encouragepolicymakers to reduce or even elimi-nate its involvement in flood insurance?If, as some scientists believe, changingweather patterns are increasing the riskof U.S. coastal flooding, the only surething is that however the issue playsout, it is likely to result in significantfinancial losses for someone. The onlyquestion is for whom.

The U.S. is at a point where conserva-tion measures are beginning to level outwater use. And new sources of water canalso help ease shortages. Several areas inthe U.S. have begun planning to desali-nate water, either from the sea or frombrackish water (saline, non-oceansources). Operations to render salt waterdrinkable have been more commonplacein parts of the world where freshwaterwas always in shorter supply, such as theMiddle East, but are rarer in the world’stemperate zones. The drawbacks are stillcost and operational complexity. Andwhile those are definite credit risks, thesuccessful operation of a desalinationplant can also enhance a water utility’scredit quality because it can assure itscustomers of adequate supply.

If nothing else, meeting the world’sgrowing need for water will be expen-sive. The funding necessary to build theinfrastructure to meet that need, fromdams and desalination plants, to localpipelines, will be enormous—and gov-ernments, private investors, and individ-uals alike will bear the cost. Some maybalk. But water is life itself. And for life,somehow, we suspect we will all find away to pay. CW

Writer: Robert McNatt


Contacts:

Beth Ann Bovino, Deputy Chief EconomistNew York (1) 212-438-1652

Kaustubh PandeyCRISIL Global Analytical Center, an S&P affiliate, Mumbai

For more articles on this topic search RatingsDirect with keyword:

Water



For centuries, man has known that water is key not

only to life but also to economic development. As

populations and economic output have grown, so has

the demand for water. In the past century, worldwide

demand for water tripled, and currently it is doubling

roughly every 20 years. And as higher standards of living

have lead to greater per capita water use, demand in many

parts of the world has begun to outstrip available supplies.

Is The U.S. WaterSector ApproachingA Tipping Point?


Based on its current projections of pop-ulation and economic growth, The2030 Water Resources Group projectsthat by 2030, water use will be 40%greater than the current sustainablesupply (see table 1), and that a third ofthe world’s population—mostly indeveloping countries—will face a deficitlarger than 50%. Such a projectedsupply gap would be alarming underany conditions, but it is even more soconsidering that the water utility sectorhas historically been afflicted withinsufficient planning, underinvestment,and inefficient markets.

Water availability is almost always alocal or regional issue, and supplies varywidely based on surface distribution, cli-matic conditions, and chemical quality. Thephysical scarcity of water in some areasand the inequitable distribution of it inothers could push the growing waterscarcity into a full-blown global crisiswithin the next decade. Although these fac-tors are relevant globally, they pose thegreatest risks in sub-Saharan Africa, severalcities in India, the great plains of China, theMiddle East, southeastern Australia, andthe western and southwestern U.S., wherewater is already scarce.



Bil. cubic meters

Current Existing 2030 withdrawals sustainable supply projected use Deficit (%)

Global 4,500 4,200 6,900 (39.10)

*Assumes no efficiency gains. Source: The 2030 Water Resources Group.

Aggregate Water Demand/Supply Imbalance*Table 1

Combined tariff price* Domestic use($/1,000 gal.) Change (%) (gal./person/day)

Denmark 33.43 0.10 30

Australia 21.88 11.50 160

Germany 20.29 1.80 40

France 17.26 (0.60) 61

United Kingdom 16.18 3.90 37

Czech Republic 13.74 5.70 56

Canada 11.89 7.50 205

Poland 11.81 17.80 39

United States 10.27 8.10 163

Japan 9.69 0.20 98

Portugal 8.59 0.60 81

Turkey 8.10 10.50 63

Italy 6.85 11.60 127

Russia 3.76 21.90 97

South Korea 2.88 0.20 146

Mexico 2.61 2.80 53

China 1.74 5.70 25

India 0.57 1.80 37

*Average price among cities. Combined tariff includes water and wastewater tariffs. Source: Global Water Intelligence.

Average Water Tariffs In Select Countries, 2011Table 2

Overuse Of Groundwater

Is Causing A Supply/Demand

Imbalance

Of the total amount of water on theplanet, only 3% is fresh water. Of this,70% is frozen in glaciers or under thepermafrost, 29% is in undergroundaquifers (groundwater), and only about1% is in free-flowing rivers, streams,and lakes (surface water; see note 1).

These crucial groundwater reserves areincreasingly being drawn in nonsustain-able ways. In many places around theworld, withdrawal rates from ground-water aquifers are exceeding replenish-ment rates, resulting in land sinkage.Agriculture has been a key cause of thisoveruse because a significant proportionof the water drawn for agricultural pur-poses is lost to evaporation and runoff.

Agricultural yields in both rain-fed andirrigated areas grew about 1% annuallybetween 1990 and 2004 (see note 2).Industrial output using water improvedby a similar rate. If agriculture andindustry sustain this rate through 2030,the increase in supply through efficiencyimprovements would offset only 20% ofthe expected increase in demand.Similarly, a business-as-usual supplybuild-out, assuming constraints in infra-structure rather than in the raw resource,would offset an additional 20% of thegap. What’s more, closing the supply anddemand imbalance using nontraditionalsupply measures—such as desalination,rainwater harvesting, gravity transfers,and national river-linking projects—isunlikely to work because such measuresface a steep marginal cost curve (the pro-duction cost of the highest-cost producerrequired to serve demand).

Urbanization and climate change put water supplies at riskThe recent trend of large population move-ments into arid and semi-arid regionsaround the world has put additional strainon existing water supplies. By 2030,urbanization is expected to result in 60%of the world’s population living in cities(see note 3). Replacing vegetation andopen land with impervious surfaces suchas roads, housing, etc. constrains a river’snatural runoff, essentially damming up the

river within the city. Thus, urbanizationcompounds water scarcity by putting stresson water supplies, leading to floods insome areas and droughts in others.

There is also a tremendous focus onhow future climate change will affectthe planet. In 2011, some of the worstfloods in history hit Thailand,Australia, and Cambodia, causing wide-spread destruction and economic dis-ruption. For instance, Thailand’s GDPwas slashed as much as 1.5% after itsflood. In addition, severe droughts haveaffected regions in Australia, China, theMiddle East, East Africa, and thesouthern U.S. The 2007 drought insoutheastern Australia’s Murray-Darling basin knocked 1% off thatcountry’s economic growth that year(see note 4).


Chart 1 Total 20-Year Needs Of U.S. Public

Water Systems, By ProjectType

Other ($2.3)

Storage ($36.9)

Source ($19.8)

Treatment ($75.1)Transmission anddistribution ($200.8)

Bil. $

Source: U.S. Environmental Protection Agency.© Standard & Poor’s 2012.

(500 or less) (56%)(3,301–10,000) (9%)

(10,001–100,000) (7%)Very large (>100,000) (1%)

(501–3,300) (27%)

Source: U.S. Environmental Protection Agency.© Standard & Poor’s 2012.

Chart 2 Water System Size Category

By Population Served

Why governments give lower priorityto water-related issues than to climatechange issues is unclear, especially con-sidering that most scientists believe themajority of water-related risks are rela-tively near-term compared with thedamage expected from global warming.Climate change will, however, likelyexacerbate the problem of local wateravailability in many countries becauseof expected rises in sea level that wouldlead to significant changes in the timingand magnitude of water runoff.

Investment in infrastructure is crucialAccess to water in many parts of theworld is limited based on natural con-straints and infrastructure capacity.Without an equitable approach toclosing the supply and demand imbal-ance, The 2030 Water Resources Groupestimates that a supply-only solutionwould require an additional $200 bil-

lion investment annually in upstreamwater resource spending above currentspending levels. This is about five timesthe current annual global expenditureon supply infrastructure.

In the U.S., for instance, infrastructureis failing at an increasing rate each year.The Environmental Protection Agency(EPA) estimates that the public watersystem will need about $335 billion ininvestments over the next 20 years—morethan double the estimate from as recentlyas 2002 (see chart 1). And industryexperts estimate that at the current rate ofinvestment, it would take about 900 yearsto replace the U.S. water infrastructure.

Water Is Still Undervalued

As An Economic Resource

Water is a finite resource, and it has nosubstitute. Its sustainability depends on itbeing valued properly to pay for infra-structure upgrades and to stimulate



Combined tariff* ($/1,000 gal.) Year-over-year change (%)

Atlanta, Ga. 23.42 12.4

Seattle, Wash. 21.35 N/A

Portland, Ore. 20.45 7.0

San Francisco, Calif. 17.27 6.8

Columbus, Ohio 14.54 6.8

Boston, Mass. 12.56 2.8

New York City, N.Y. 10.98 7.5

Detroit, Mich. 10.62 9.7

Philadelphia, Pa. 10.61 6.2

Washington, D.C. 10.54 16.0

Nashville, Tenn. 10.50 5.3

Minneapolis, Minn. 10.21 4.3

Los Angeles, Calif. 9.38 9.0

Cleveland, Ohio 9.23 24.0

Indianapolis, Ind. 9.08 14.8

Louisville, Ky. 8.50 4.7

Dallas, Texas 7.73 2.8

San Antonio, Texas 6.47 (1.9)

Memphis, Tenn. 4.20 41.6

Chicago, Ill. 3.73 0.0

Average of 20 cities 11.57

*Combined tariff includes water and wastewater tariffs. N/A—Not available. Source: American Water Intelligence.

Combined Water Tariffs In Select U.S. CitiesTable 3

exploration for new supplies. In an effi-cient market, a supply and demandimbalance and constraints on a valuableresource should normally draw newinvestments and spur regulatory policiesthat augment supply. Yet, no new invest-ments are being made, and the supply anddemand gap is widening. Why?

In many parts of the world, includingthe U.S., water allocation is handled bygovernments rather than by free markets.Local government policies have often keptwater prices below the cost of service,resulting in a financing gap that is usuallymade up by intra-governmental cash trans-fers or taking on new debt (or reducingfuture spending for operation and mainte-nance). And when a commodity’s trueprice is not reflected in the rates consumerspay, the commodity is often overused. Wehave identified two main reasons whywater has not been viewed as an economicresource in the U.S.: asset ownership and afragmented industry.

Asset ownership affects the cost of creditIn the U.K., privatization starting in1989 has resulted in 10 large investor-owned water utilities, representing morethan 85% of the country’s total sys-tems. But in the U.S., only 16% of thewater systems are investor-owned. Thevast majority are local municipality- orgovernment-owned systems, which havehitherto relied on municipal tax-exemptdebt to finance their capital needs. Bytaking advantage of the credit supportfrom a city or state government, these

systems have been able to access debtcheaply, and the cheaper sources of cap-ital have tended to crowd out moreexpensive private capital. Now, becauseof economic conditions, state and localgovernment budgets are constrainedand their credit strength is under pres-sure just when the water sector needscapital to fund growing maintenanceand expansion programs.

In addition, the water industry gener-ally is the most capital-intensive of thevarious utility sectors; the capital-invest-ment-to-revenue ratio is about 3.5x(partly because rates are kept artificiallylow; see note 5). This means that awater utility must invest $3.50 for everydollar it expects to generate, almosttwice that of electric utilities, the next-highest capital-intensive industry. It isnot unusual for a water utility to spendthree times its annual depreciation oncapital expenditures. As a result, mostwater systems need continual access toexternal funding sources.

Fragmentation has led to inefficiencyThe fragmented nature of the U.S. waterindustry underscores the large capitalneeds. According to the EPA, the U.S. has52,873 community water systems sup-plying most people’s drinking water. Ofthese systems, 4,217, or 8%, serve morethan 246 million, or 82%, of the totalpopulation (see chart 2). Small systemsare less able to raise the capital to meetregulatory requirements. It is no coinci-dence that most regulatory violationsoccur in systems that serve fewer than

20,000 customers. Although competitiontends to encourage consolidation, waterassets in the U.S. are relatively difficult tobuy or sell because most water systemsare so small that it is uneconomical topurchase them without significant regula-tory support. Only if a single companycaptured the entire market and exploitedall the potential for lower unit coststhrough increases in scale could produc-tion be organized as cheaply as possible.

Prices Have Started

Reflecting Scarcity

In the U.S., the largest locations facingwater stress are, predictably, the country’smost arid areas: the Colorado Riverregion, California, and the Great Basin inNevada. These regions have experienceddrought conditions resulting from cyclicalweather patterns, but the real concern isthat in many places, water woes are nowstructural. For instance, according to theTexas Water Development Board (TWDB;see note 6) Texas needs about 18 millionacre-feet of water per year. However, asaquifers become depleted, the existingwater supply is expected to decline toabout 15.3 million acre-feet from analready inadequate 17 million acre-feet.

In areas where demand has begun tooutpace supply (see chart 3), market mech-anisms are being structured so water can beallocated where it is needed the most. Forinstance, organized markets for tradablewater entitlements or rights have emerged(see sidebar 2) in Phoenix and in theMurray-Darling Basin in Australia. Pricesfor wholesale water (also called “raw”


Physical Water Scarcity

Arid regions are most often associated with phys-ical water scarcity. Yet, water can be scarce eventhough it seems to be abundant becauseresources are overcommitted from overdevelop-ment of hydraulic infrastructure, most often forirrigation. In such cases, there simply is notenough water to meet both human and environ-mental demands. Symptoms of physical waterscarcity are declining groundwater and water

allocations that favor some groups over others(see also sidebar 2).

Economic Water Scarcity

Economic scarcity results from a lack of investmentin water infrastructure that prevents people fromgetting enough water for agriculture or drinking.Even where infrastructure exists, water may be dis-tributed inequitably. Much of sub-Saharan Africa,for instance, faces economic scarcity.

Types Of Water Scarcity

water) are increasing as water is reallocatedfrom irrigation to municipal consumption.

The cost of supplying water servicesvaries with local labor rates, the rate ofinfrastructure maintenance and replace-ment, and water scarcity, among otherfactors. Data from the Bureau of LaborStatistics shows that the cost of waterand wastewater treatment services hasrisen faster than the consumer priceindex (CPI; see chart 4). Although laborcosts generally rise with GDP, infra-structure-related spending varies bysystem age and size, regulatory service

mandates, and the ebb and flow offinancing. Water scarcity can force autility to spend more on expensive mar-ginal sources of drinking water (such asdesalination and wastewater reuse) orreduce the volume available to cus-tomers, which means utilities must raisethe price per unit of water sold so totalrevenues will cover fixed costs.

Tariffs On Delivered

Water Are Also Rising

Prices for delivered water vary widelyaround the world (see table 2).



Source: "Energy and Water in a Warming World" initiative (Union of Concerned Scientists).© Standard & Poor’s 2012.

No measurable stressLow stress

High stress

0.00.1–0.20.3–0.40.5–0.60.7–0.80.9–1.01.1–6.4

U.S. Regions Experiencing Water StressChart 3

1996 1998 2000 2002 2004 2006 2008 2010 2011100

150

200

250

300

350

400

450

(1984 = 100)

Source: U.S. Bureau of Labor Statistics.© Standard & Poor’s 2012.

CPI Water

Chart 4 Average U.S.WaterAnd Sewage Cost Increase Compared With CPI.

According to Global Water Intelligence,water tariffs globally rose an average of6.8% (at constant exchange rates) forthe 12 months ended July 2011. Overthe corresponding period, average com-bined tariffs in the U.S. rose about8.1% even as the CPI rose 3.6%.

Although average U.S. tariffs are up,the increase is primarily the result of afew cities pursuing large rate hikes,typically to fund major capital pro-grams (see table 3) . Most capitalexpenditures, in fact, are undertaken toenable compliance with federal man-dates, such as for water and waste-water disinfection, water storage, and

sewer overflows. Cities have had toraise water prices because otherfinancing options have disappearedsince the economic slowdown.

Even though water prices in the U.S.have risen faster than elsewhere in theworld, U.S. tariffs are still about halfof those in northern Europe, forexample. Still, because American con-sumers use nearly twice the water percapita as northern Europeans, theactual household water bills in the tworegions are not much different.However, the result is that operatingsurpluses that go toward paying forcapital projects are typically smaller in

the U.S. than those in Europe. It isinevitable that all U.S. water andsewer utilities will eventually have toincrease their operating surpluses toEuropean levels because the historicalreliance on municipal, city, or statefunding has simply dried up.

Credit Implications For The Sector

From a credit perspective, the U.S.investor-owned water utility industry isone of the most stable and highly ratedsectors among U.S. industrials. Yet, weexpect to see plenty of ripples in theoverall water sector as it grapples withits considerable challenges.


Water rights and water allocation arrangements reflect dif-fering traditions and conditions. Where water is con-

cerned, when demand exceeds supply, the challenge for gov-ernments is to allocate it fairly.

Water rights and water allocation programs in the U.S. havelargely been under the states’ purview. Broadly, there are threetypes of water rights, and groundwater allocation policies mayoften incorporate some combination of these options.

Riparian Rights

Riparian rights are the basic rules used to allocate water in theeastern U.S. (broadly defined as the region east of Kansas City).Under this doctrine, the right to use water from a stream or lakebelongs to whoever owns the land on the bank. Every riparianowner is entitled to use water as the stream flows through thelandowner’s property. These policies evolved in an area wherewater is generally plentiful and government involvement is minimal.

Two rules generally govern how much water a riparian ownermay use. The older rule holds that a landowner must leave thenatural flow of the river unchanged, without altering the rate offlow, the quantity, or the quality of water, so that downstreamriparian owners have the water in its natural condition. The newrule of reasonable use states that each riparian owner may usethe water, regardless of the natural flow, as long as their use doesnot cause unreasonable harm to any downstream riparian user.

Regulated Riparian

Increasing population and development in the eastern U.S. havemagnified the problems of water distribution. In response, moststates have overlaid the traditional riparian system with newadministrative schemes, such as permit systems, for regulatingwater use. These schemes have been dubbed “regulatedriparian.” The most important feature of these statutes is that

direct users of water must have a permit from a state adminis-trative agency to use water. However, the concept of reason-able use may be applied differently from the common lawriparian doctrine.

Appropriation System

The arid climate of the western U.S. is less conducive to theriparian system. It was obvious that most of the land in the Westrequired irrigation for settlements. Limiting the use of streamsonly to those on adjoining land would have drastically curtailedthe settlement and development of the new lands, rendering non-riparian lands practically useless. As a result, early western set-tlers developed an appropriation system, which was later codifiedby court decisions, constitutional provisions, and state statutes.

In contrast to a riparian right, an appropriation right is inde-pendent of land ownership. Users may buy a certain quantity ofwater for a beneficial use. The major concept here is “beneficialuse,” which is a fundamental aspect of western U.S. water law.The appropriator can use only the amount of water it currentlyneeds, allowing excess water to remain in the stream. Once thewater has served its beneficial use, any excess or runoff must bereturned to the stream. Unlike riparian rights, which remain ineffect whether the landowner uses the water or not, appropria-tion rights are held only as long as the user continues properbeneficial use. These rights can be traded and are subject to for-feiture for non-use. The Northern Colorado Water ConservancyDistrict and the middle Rio Grande market in New Mexico aretwo of the most actively traded water rights in the U.S.

Appropriation rights are never equitable because first-in-timeappropriators are guaranteed an ascertainable amount of waterand have priority over later appropriators during water shortages.

Source: American Water Works Assn. (Manual of Water Supply Practices).

What Are Water Rights?

In sharp contrast to the U.S. electricand gas utility sectors, which are largelyinvestor-owned, about 85% of thewater sector and almost the entirewastewater segment is municipallyowned. Water departments have beencash cows for municipalities and cities,and financing to fund capital spendingprograms was readily available. Now,these issuers are witnessing a seachange. Repair and maintenance expen-ditures are increasing as water systemsage and become less compliant with

EPA regulations, and many municipali-ties have not initiated financing for theupkeep of their facilities because ofdeteriorating balance sheets and bur-geoning deficits. Given the current lowlevel of interest rates, we think defer-ring such spending is a lost opportu-nity. We believe the American Recoveryand Reinvestment Act, which providedstimulus money to a number of waterand wastewater systems, has onlydelayed the inevitable. To generatepublic-budget revenues or to reducepublic outlays, taxes, and borrowingrequirements, we expect to see privateenterprises increasingly buying midsize(10,000 to 20,000 customers) munic-ipal systems. Midsize water systemsaccount for about 10% to 15% of theU.S. water sector.

As with electric and gas utilities, weconsider the state regulatory environmentto be the most significant credit variablefor investor-owned water utilities. Somecharacteristics that we consider critical toour evaluation of a water utility’s regula-tory risk are the timeliness of rate orders,the use of forward-looking financialmeasures, and the application of variouscost and investment tracking mecha-

nisms. Standard & Poor’s views suchrecovery mechanisms, under which com-panies recover capital investments out-side of traditional rate cases, as particu-larly beneficial to credit quality becauseof the scale of the cash flows affected bythese investments. Such mechanisms cur-rently exist in California, Connecticut,Delaware, Illinois, Indiana, Missouri,New Hampshire, New York, Ohio, andPennsylvania, and were recently intro-duced in New Jersey. The regulatorycompact has thus far worked well.

The viability of the regulatory com-pact is becoming increasingly critical inenabling water utilities to access thepublic debt markets because all waterentities have large capital spendingrequirements and need a continualsource of financing. However, achievinga viable compact may be easier saidthan done. Water still remains the mostaffordable utility; a typical bill repre-sents only about 0.5% to 1.0% of U.S.disposable household income. As aresult, cost increases thus far have notfaced significant regulatory or polit-ical resistance. In the case of publiccompanies, we often do not knowwhat the cost of delivered water isbecause the cost is buried under subsi-dies and sunk costs of municipal andregional water departments. Yet, evi-dence is mounting that water stress isincreasing, and water prices in theU.S. will inevitably have to rise. Overtime, as stress turns into scarcity andregulators face requests for significantrate increases, economic decisions willhave to be depoliticized.

Still, we believe that as prices rise,so will incentives for technologicalinnovations, ways to reduce demand,

and opportunities to recycle and reusethis commodity. Innovations will alsooccur in the financial markets and inthe structure adopted by sponsoringentities. For example, the introduc-tion of public/private partnershipssuch as leases and concession con-tracts can introduce competition andprovide greater flexibility for private-sector providers to meet the needs ofmunicipally owned water utilities. CW

Notes

(1) Source: “The Water Problem,” Global PolicyForum (Oct. 8, 2007).

(2) Source: The 2030 Water Resources Group.(3) Source: “World Urbanization Prospects,”

Department of Economic and Social Affairs,population division, United Nations (July30, 2007).

(4) Like their counterparts elsewhere in theworld, Australian engineers pockmarkedthe Murray-Darling basin with dams, weirs,and locks. By the 1990s, the drawbackswere evident: States were allowing irriga-tors to use too much water. By 1994,humans were consuming 77% of the river’saverage annual flow. The mouth of the riverbegan to silt, and the city of Adelaide,which draws 40% of its municipal suppliesfrom the river and up to 90% when otherreserves dry up, started experiencing waterscarcity.

(5) Source: “A Fresh Look At U.S. Water AndWastewater Infrastructure: TheCommercial And EnvironmentallySustainable Path Forward,” DavidHaarmeyer (Journal Of Applied CorporateFinance, Summer 2011).

(6) Source: “Water for Texas 2012 State WaterPlan,” Texas Water Development Board.



Analytical Contacts:

Aneesh Prabhu, CFA, FRMNew York (1) 212-438-1285

Manish ConsulNew York (1) 212-438-3870

Richard W. Cortright Jr.New York (1) 212-438-7665

Stephen CosciaNew York (1) 212-438-3183


Water

We consider the state regulatoryenvironment to be the most significant creditvariable for investor-owned water utilities.

The subtitle for “The Hobbit”—the famous fantasy

novel by JRR Tolkien, and a prequel to “The Lord Of

The Rings”—is “Or, There And Back Again.” The plot

follows the quest of a “hobbit” named “Bilbo Baggins” to

win a share of the treasure guarded by the dragon, “Smaug.”

Similarly, as water becomes an increasingly scarce resource,

the industry’s structure too has had its version of “there and

back again” in its quest for unlocking the value of this

“precious” commodity.


From Public To Private AndSometimes Back AgainThe Shifting Dynamics Of Water Utility Ownership

■ Water utilities around the world pro-vide one of mankind’s basic needs.

■ Public ownership versus privateownership of water utilities hasbeen debated since the rise of theindustrial world.

■ Ultimately, it seems public ownershipwill retain its dominance in the U.S.

Overview

The history of ownership of water sys-tems in the industrial world has beendynamic. Public interest—and owner-ship—has been a constant even as it hasswung from passive involvement toactive ownership. We believe that thereare three principal reasons for this, allbased on the central tenet that water isunique: public health, increasing cost ofdelivery, and the monopolistic nature ofwater management (see note 1).Governments have been wary aboutceding responsibility for such an essen-tial commodity, arguing that anythingvested with so critical a public interestis best retained under the auspices ofcity authorities, free from concern forprofit motive. But there has been noconsistency in practice of maintainingownership at all times and in all places.

Indeed, the ownership of water utili-ties, both in the U.S. and Europe, hascycled back and forth between publicand private. At certain times, politicaldemands of public health have promptedmunicipal authorities to claim controlover water supplies and then to findsome means—such as taxes or fees—ofpaying for their maintenance andgrowth. At other times, authorities haveconcluded that the cost of clean andaccessible water was simply too high tobear alone and too risky as an invest-ment. In these cases, the authoritiesturned portions of their public serviceover to private firms, leaving them tobear the costs of capital investment. Butneither approach solved the underlyingissue: whether public or private, sup-pliers were left struggling with how topay for an increasingly expensive com-modity that consumers seemed unwillingto treat as an economic resource butregarded instead as a community need.

Because consumers wanted access towater without having to pay for it—andexpected their governments to complywith that expectation—by the end of the19th century the policy pendulum onwater in the industrial world had shiftedsquarely in favor of government owner-ship and away from the numerous privateowners until that time. By 1915, the U.K.had nearly 800 public waterworks, servingan estimated two-thirds of the population.Similarly, by the outbreak of World War I,France was supplying two-thirds of itsmajor cities through municipal régies (seenote 2). By the 1920s, the U.S. had 9,850public systems serving most people’s waterneeds. The low proportion of investor-owned water utilities contrasted sharplywith the nearly all-private pattern in theelectric and gas utility sectors.

In contrast, we find that waterworksin present-day U.K. are entirely private.In France, many municipalities havetransferred water services to privatecompanies; the waterworks are essen-tially privatized through delegation ofoperations. In the U.S., water supplyremains largely government-owned, withinvestor-owned utilities supplying onlyabout 15%. However, because of theimpact of the recession and its aftermathon state and local government budgets,the U.S. could see some move towardprivate operations, in our opinion.

European Countries

Try Different Models

At one end of the spectrum, a munici-pality can entirely own and operate awater system. At the other end, a pri-vate entity both owns the infrastructureand operates the supply network. In theEU, the U.K. is the only country wherepublic authorities have completely

transferred the provision of operationalservices to the private sector (see note 3).In between those two extremes aremany models of public-private partner-ships (PPP). For example, a city mighttransfer the operations of water net-works for certain periods of timethrough contractual arrangements, as ispracticed in France. The transfer is tem-porary because of the vital importanceof the water system, which the city doeswant to eventually control.

FranceThe first franchise contract for waterdistribution in France was in 1782,when authorities granted the Perrierbrothers exclusive distribution rights inParis for 15 years. Since 1950, manymunicipalities, including Paris, turnedto private companies to manage theirsystems. Today, private companiessupply about 72% of drinking water inFrance, usually under a franchise, lease,or management agreement through aPPP. Yet, even in France, the debate onpublic versus private ownership con-tinues. In a symbolic move, watersupply management in Paris—whichindustry observers view as the birth-place of water privatization—returnedto public hands in 2010 when the thenongoing contracts with major playersVeolia Environnement S.A.(BBB+/Stable/A-2) and SuezEnvironnement (a unit of GDF SuezS.A.; A/Stable/A-1) expired. The remu-nicipalization was part of MayorBertrand Delanoë’s electoral promise in2008 triggered by rising water prices.

The franchises and the privatizationof water supply have generally takenone of three forms in France. The first isa franchise agreement called a conces-sion (essentially, full-service con-tracting). In this system, a private com-pany contracts with the government tohave the exclusive right to operate,maintain, and invest in the waterworksfor a given number of years. Such asystem is especially advantageous whenthe municipality lacks funds for majorcapital spending. The concessionaireadvances capital for construction andoperation, assumes full responsibility



The history of ownership of water systemsin the industrial world has been dynamic.

and risk for management and mainte-nance of facilities, and collects paymentdirectly from users. The duration of theagreement is generally long term—20 to30 years—to enable amortization of theoriginal capital outlay. A user pays a setmonthly fixed charge for access to asupply pipe along with a variablecharge based on the number of cubicmeters of water consumed.

The second is a lease agreement,which the French call affermage. In thisform of privatization, the private oper-ator does not bear the costs for newinvestment. The local government bearsexpenses for installing major civilworks, and the private firm subse-quently manages the completed facili-ties and provides working capital. Suchsystems are popular when municipali-ties provide financing at preferentialinterest rates. The contract period istypically shorter than a concession,usually lasting 10 to 15 years. The con-tract also details specifications formaintaining or upgrading facilities.Usually, ongoing day-to-day expensessuch as electromechanical, hydraulic,and metering equipment is the oper-ator’s responsibility, while capital out-lays such as civil works, water collec-tion, and facility expansion are theresponsibility of the municipality. As inthe concession system, a formula fixesthe price of water.

Other forms of contracts betweenpublic and private entities, namelymanagement contracts, are closelyrelated but differ in the rights of theoperator. These forms transfer onlypartial performances to the privateside and generally involve relativelylimited responsibilities for the privatefirm (see note 4). Under a managementcontract, the operator collects the rev-enue only on behalf of the governmentand in turn receives a fee. The dura-tion of the agreement is also shorter,about six to 10 years.

The main players in France are pub-licly listed Veolia, Suez Environnement,and Saur S.A.S. (unrated). Veolia andSuez also dominate international mar-kets, serving an estimated 110 millionwater customers and 85 mill ion

wastewater customers. They bid forconcessions from municipalit iesaround the world. The concessionsare usually long term, but these com-panies face a risk when they renewconcessions because the city can rene-gotiate prices or award the contractto another player. In addition, wehave seen lately a tendency for somelarge cities to start operating theirnetworks themselves. The level ofcompetit ion seems to have beenincreasing in the past few years, witha pressure on costs.

England and WalesIn 1989, under Prime Minister MargaretThatcher, the British government priva-tized the nation’s waterworks and cre-ated 10 multipurpose investor-ownedwater companies. The waterworks priva-tization was the largest stock offering inhistory at that time. In addition, therewere also about 30 companies thatavoided earlier nationalization andjoined the newly formed investor-ownedutilities in the deregulated market. TheOffice of Water Services regulates the10 water and sewerage companies and11 water-only companies that existtoday in England and Wales under asingle regulatory framework. Theprice-cap regulation sets price limitsover a five-year price-control cycle andenables util it ies to profit fromincreasing efficiency. Regulators com-pare utility performance across a rangeof benchmarks and reward or penalizecompanies accordingly.

The larger private companies that werate in the U.K. are United UtilitiesPLC (BBB-/Stable/A-3) and SevernTrent PLC (BBB-/Stable/A-3), thesecond- and third-largest of the 10water and sewerage companies, respec-tively, in England and Wales by regu-lated asset value. We also rate the classA bonds issued by Thames WaterUtilities Cayman Finance Ltd., whichreflect the underlying credit quality ofThames Water Utilities Ltd., the largestwater and wastewater company in theU.K covering Greater London and theThames Valley, and the structural fea-tures of its corporate securitization.

In the past 10 years, remarkablechanges have occurred in these compa-nies’ ownership structures. Institutionalinvestors hold a growing pool of publicand private capital that is looking forexactly the kind of stable and pre-dictable returns that water infrastruc-ture investments offer. So, conglomer-ates or financial firms own most of thelarger players. For instance, in 2006,Kemble Water Ltd. (unrated), a consor-tium Australia-based MacquarieInfrastructure Fund led, purchased theU.K.’s biggest water company, RWEThames Water PLC (unrated), from theGerman RWE AG group for £8 billion.Hastings Funds Management Ltd., anAustralian infrastructure investmentfund, bought South East Water Ltd., theU.K.’s second-largest water-only utility.Similarly, Malaysia-based infrastructureconglomerate YTL Corporation Berhad(unrated) owns Wessex Water ServicesLtd. (BBB+/Stable/—).

The rest of EuropeOther EU countries largely follow thepublic model, with municipal compa-nies controlling water supply. We ratea few that perform water and sewerageservices, as well as other related serv-ices such as heating. Still, private own-ership has developed to some degree inGermany (Stadwerken) and finds sup-port in Spain, Italy, and Denmark. TheGerman privatization model prefersthat a supervisory body regulates theprivate entity. The companies normallyraise rates in accordance with munic-ipal law, and local governments mustapprove the increases. GelsenwasserAG (A-/Stable/—) is the largest inde-pendent drinking water serviceprovider in Germany’s Ruhr region andhas long-term service contracts withabout 40 municipalities.

Beyond The Politics

Of Privatization…

Because water delivery is a key publicservice, privatization is extremely con-troversial. Our discussions with stateregulators in the U.S. have indicatedthat despite their small size relative toelectric and gas utilities, water utilities


draw the most active customer partici-pation. Basically, people just don’t likepaying for water.

The arguments for and against privati-zation are clear-cut. Detractors claim that:■ Private companies aren’t necessarily

interested in protecting watershedsand natural ecosystems;

■ Past privatization projects have led tomassive employee layoffs to cut costs;

■ Rates have increased despite lack ofinfrastructure investment;

■ Private companies generally make deci-sions without the public’s input; and

■ Companies have compromisedservice and water quality in the drivefor profits.

However, there is also an inherentconflict when the government sets stan-dards for water service and takesresponsibility for following those stan-dards. If no one presses water utilitieson regulatory standards, they may notpress the government for extra invest-ments. Privatization advocates claimthat rates have been kept low becauseof a chronic underinvestment in thesystem or through subsidies. While it istrue that rates tend to rise after thesigning of a concession agreement, theargument goes, it is often because thenew operator finally addresses theunderinvestment (see note 5).

There is no clear-cut superior per-former between the two. Some of thebetter service providers in the world, likethe Public Utilities Board of Singaporeand Phnom Penh Water Supply Authority,are publicly owned and operated.Similarly, many, like Manila Water, areprivately owned and operated.

The franchise concept, too, has hadmixed performances. In Manila, the twoconcessionaires—consortiums of United

Utilities/Bechtel/Ayala Corp. and BenpresHolding/Suez Environnement (formerlyLyonnaise des Eaux) have provided watersupply and wastewater services for 25years. However, in 2003, the city ofAtlanta terminated its 1999 20-year joint-venture operations and maintenance con-tract with United Water Resources and itsparent Suez Environnement because ofalleged quality violations, even as ratesrose significantly.

…Economic Conditions

Lead To Privatization

By the turn of the 19th century, changesin finance had enabled a robust andstable municipal bond market to emerge

in the developed world. That drew awilling pool of investors, and citiesrushed in to borrow funds to buildinfrastructure, including waterworks. Inthe U.S., municipal debt continues to betax-exempt, while privately issued debtremains taxable (see note 6). Therefore,public utilities enjoy lower capital coststhan privately owned utilities. By takingadvantage of this tax advantage as wellas the credit support from a city or stategovernment, municipality-owned watersystems have been able to issue debt rel-atively cheaply. This source of capitalhas tended to crowd out more expen-sive private capital. The result is thattoday municipalities own as much as85% of the U.S. water system.

Now, these municipal issuers aregoing through a sea change. The reces-sion and its aftermath have constrainedstate and local government budgets,which is weighing on credit strength.Also, historically, waterworks used tobe cash cows because most of thesystem was already built and the cost ofadding new customers was minimal.

Now, the water sector is entering aphase requiring capital to replace agingpipes, to meet growing maintenanceexpenses related to evolving U.S.Environmental Protection Agency (EPA)rules, and to meet expansion programs.Yet, because of deteriorating balancesheets and burgeoning deficits, manymunicipalities have not even initiatedfinancing for maintaining facilities.

With costs of maintaining water-works increasing, municipal ownershave three choices: raise water rates tomeet operations and debt servicerequirements, cut operating expenses tooffset higher debt service costs, or pri-vatize the utility. While privatizationmay have several objectives, the onemost likely to dominate a municipality’sdecision to privatize its waterworks isthe political resistance to raising ratesthat support the required investmentsneeded by the waterworks (depolitiza-tion of economic decisions), in ouropinion. To produce public-budget rev-enues or to reduce public outlays, weexpect to see increasing divestitures ofmidsize (10,000 to 20,000 customers)municipality-owned systems to privateenterprises. These represent about 10%to 15% of the U.S. water sector.

That’s where we think PPPs couldincreasingly step in, as they have inEurope. For instance, pension fundshave invested in water indirectlythrough infrastructure funds, such asthose that Macquarie manages in theU.K. Public sector pension funds needlow-risk, high-yield investments to meetgrowing liabilities, and water invest-ments meet this requirement. Sellingwater assets to pension fund investorsalso helps restore municipal balancesheets, while at the same time meetingpensioners’ needs. Some early foraysinclude the March 2010 purchase ofSouthwest Water Co. (unrated) byJPMorgan Asset Management andWater Asset Management LLC.Southwest Water has utility and con-tract operations in California and otherWestern states. Similarly, in December2010, the Carlyle Group announced itspurchase of Park Water, a family-owned, California-based water utility.



With costs of maintaining waterworksincreasing, municipal owners have three choices…

A Question Of Efficiency

And Equity

We can essentially separate privatization ofwater systems into questions of efficiency(i.e., the lowest-cost method of achievingan outcome) and questions of equity (i.e.,the fairest way to achieve the outcome).Efficiency demands that the price of waterreflect the cost of gathering, purifying, anddistributing safe drinking water to con-sumers. A price increase is justified on suchgrounds because higher water bills willinvariably reduce demand, allowing watersystems to defer or downsize costly addi-tions to supply-side capacity. Based solelyon the issue of efficiency, privatizationseems a rational decision.

Equity, however, is an altogether dif-ferent matter. According to EPA guide-lines, water is such an essential com-modity that no family should have toallocate more than 2% of its householdincome to it. The resistance to what islikely to be higher unsubsidized waterbills has caused local reformers and politi-cians throughout history to resist priva-tizing municipal water works. The resulthas been, and remains, a market in whichpolitical demand largely dictates price.We often do not even know what the costof delivered water is because the cost isburied under subsidies and sunk costs ofmunicipal and regional water depart-ments (see note 7). The price of waterbears little relation to either the availablesupply of water or the cost of delivering itto a customer’s tap. Thus, seen throughthe prism of equity, water perhaps oughtto remain under the purview of municipalsystems, and reflect what the government,rather than the market, can bear.

How pressing the need for municipalrevenue becomes will likely go a longway toward determining whether issuesof efficiency or equity predominate—and how far U.S. water systems godown the path of privatization. Europe,like Tolkien’s hobbit, has been there andback again with no conclusive answers.But no matter what municipalitiesdecide, one thing is certain: As popula-tions grow and demand climbs, whichdirection to take in managing this essen-tial global resource is likely to becomean increasingly critical question. CW

Notes

(1) “To the Tap: Public versus Private WaterProvision at the Turn of the TwentiethCentury,” Debora Spar and KrzysztofBebenek (Business History Review 83,Winter 2009).

(2) The high fixed-cost component in thesupply of water makes the laying of parallelnetworks by a competing bidder unprof-itable, and a monopoly naturally results.

(3) More specifically England and Wales; inScotland and Northern Ireland publiclyowned companies provide water services.

(4) One form of management contract inFrance is “Regie interressee.” In this form,the private firm shares the revenues orprofits with the municipality.

(5) The financial players who acquired waterutilities in Europe didn’t help alter theimage of unconscionable profits by lever-aging the holding company and distributingthe proceeds as dividends.

(6) The U.S. Treasury Dept. issued new taxregulations in 1997 enabling long-termprivate contracting for water operationsand management. Under previous rules,if a publicly owned water facility wasunder contract operation for more thanfive years, it was deemed to be for pri-vate use and ineligible for tax-exemptcapital financing. With longer-term con-tracting now practicable, it’s possible toincorporate long-term capital invest-ments into operating and maintenanceagreements and amortize them over aperiod that makes such agreements morecost-competitive.

(7) Economically, an income transfer pro-gram, such as the Low-Income HomeEnergy Assistance Program, could helplow income water customers cover thecosts of higher rates without distortingthe market for water.




Steven J. DreyerWashington, D.C. (1) 202-383-2487

Richard W. Cortright Jr.New York (1) 212-438-7665


Water




The threat of global climate change has focused considerable

attention on the types of fuel used for power generation, but

little notice has been given to the large amounts of water that

power plants use to generate electricity, despite the more immediate

nature of dwindling water supplies. Thermoelectric power plants

accounted for approximately 45% of the total water withdrawn from

U.S. surface water sources in 2009 (see note 1). Every day in 2008,

water-cooled power plants in the U.S. withdrew, on average, 60

billion to 170 billion gallons of water from lakes, rivers, and streams

and consumed 2.8 billion to 5.9 billion gallons of that water (see note

2). Of the total amount of water on the planet, only 3% is fresh

water. Of that, only about 1% is in free-flowing rivers, streams, and

lakes (surface water); 70% is frozen in glaciers or under the

permafrost, and 29% is in underground aquifers (groundwater; see

note 3 and the related article, “Is The U.S. Water Sector Approaching

A Tipping Point?” published Feb. 27, 2012, on p. 16).

Heavy Demand, Limited Supplies,And More Regulation CouldSwamp Their Credit Quality

U.S. Power Sector

■ The huge water requirements for electric power generation are beginning to jeop-ardize some utilities’ ability to meet demand.

■ A plant’s choice of cooling system can make a big difference in how efficiently it oper-ates and the amount of water it uses, and thus the plant’s effect on the environment.

■ The Environmental Protection Agency issued proposed standards that would coverroughly 1,260 existing facilities that each withdraw at least 2 million gallons of waterper day for cooling.

■ The incremental effect of capital spending on an industry already reeling from signifi-cant environmental-related spending can be substantial.

Overview

The huge amounts of water required forpower generation are beginning to jeop-ardize utilities’ ability to meet demandfor electricity. For example, the ElectricReliability Council of Texas noted in anOctober report that approximately 9,000megawatts (MW) of generation in Texasis dependent on water rights fromsources that are at historically low levels.In 2011, Texas suffered one of the driestsummers since the state began keepingrecords in 1895. The hot weather wasextreme, sustained, and widespread.

Dallas’s daily highs exceeded 100°F everyday in August but two and reached 110°Fon Aug. 2 and 3, 2011. Peak powerdemand reached a record 68,294 MW onAug. 3, exceeding the previous record by2,518 MW, or 3.8%. Temperaturesthroughout the state that month brokerecords. As the demand for power rose,so too did the demand for water bypower plants.

Water is used extensively in the electricpower sector, primarily for cooling tocondense steam as part of the process

that drives the steam engine. This steam-cooling step accounts for virtually all thewater used in most power plants, giventhat the steam itself circulates in a closedsystem. The amount of water a powerplant needs depends on which of threebasic cooling technologies it uses (seesidebar). As a result, the cooling tech-nology a power plant adopts, and theplant’s choice of fuel mix, can ease orexacerbate the stress on the water supply.

The U.S. Power Fleet’s

Water Profile

Power plants use water in two ways:withdrawal and consumption.Withdrawal is the water a power planttakes in from the source. After use,most of the water is returned back tothe source. Consumption is the waterlost to evaporation.

Although the consequences of waterloss from consumption are apparent,withdrawal is no less important becausea power plant’s intake structure cantrap fish and other aquatic life.Moreover, the water returned to thesource is at a higher temperature andmay harm aquatic life again.

In addition, a power plant’s waterrequirements can vary greatly dependingon the fuel type and the cooling technologyit uses. For instance, a nuclear power plantwith a once-through cooling system with-draws 25,000 to 60,000 gallons of waterper megawatt-hour (MWh) of electricityproduced but consumes 100 to 400 gal-lons per MWh (see note 4). On the otherhand, a nuclear plant using closed-looptechnology withdraws only 800 to 2,600gallons per MWh but consumes 580 to845 gallons per MWh (see chart 1).

Overall, 53% of the electricity gener-ating capacity in the U.S. comes fromclosed-cycle cooling systems. Once-through cooling was the conventionaltechnology until the early 1970s but isnow uncommon for new power plantsbecause of section 316(a) of the CleanWater Act, which regulates water intakestructures and thermal pollution dis-charges. As a result, the average age of aclosed-cycle cooling system is 29 years,compared with 50 years for once-through systems.



Nuclearonce-through

Coalonce-through

Natural gascombined-cycle

once-through

Nuclear tower Coal tower Natural gascombined-cycle

tower

0

10,000

20,000

30,000

40,000

50,000

60,000

Withdrawals (gal/MWh)

MWh—Megawatt hour.Source: National Renewable Energy Laboratory.© Standard & Poor’s 2012.

Consumption (left scale) Withdrawals (right scale)

1,200

1,000

800

600

400

200

0

Consumption (gal/MWh)

Power Plant Water Use By Fuel Type And Cooling TechnologyChart 1

Coal Natural gascombined-cycle

Other natural gas Nuclear Other

Fuel type

0

50

100

150

200

250

300

350

(Gigawatts)

Source: Energy Information Administration.© Standard & Poor’s 2012.

Once-through (water) Closed-loop (water) Dry air cooling and other

Chart 2 U.S. Power Generating Capacity By CoolingTechnology

And FuelType

Once-through systems are moreprevalent in the eastern U.S. (broadlydefined as the region east of KansasCity), and closed-cycle systems aremore common in the West. As a result,plants in the East generally withdrawmore water per MWh generated thanthose in the West.

Fuel Mix Also Determines

Water Needs

U.S. power plants have widely rangingwater-use and carbon emissions pro-files. For instance, because nuclear unitsare the most water-intensive, a genera-tion company with a large fleet ofnuclear plants that uses fresh water foronce-through cooling will have highwater requirements but a small carbonfootprint. Utilities with high water

requirements put more stress on localwater resources, while utilities withhigh carbon footprints will eventuallycontribute to long-term water scarcity(see charts 3 and 4).

Water Intake Regulations

Are Coming

On March 28, 2011, the EnvironmentalProtection Agency (EPA) issued its pro-posed standards for comment. The rule,Section 316(b) of the Clean Water Act,requires that facilities with cooling-water intake structures ensure that theirlocation, design, construction, andcapacity reflect the best technologyavailable to minimize harmful effects onthe environment, specifically damage toaquatic life. The rule covers roughly1,260 existing facilities that each with-

draw at least 2 million gallons of waterper day for cooling. The EPA estimatesthat approximately 670 of these facili-ties are power plants. Moreover, newunits that add electrical generationcapacity at an existing facility would berequired to incorporate technology thatis equivalent to closed-loop cooling.

Although the MW that may requireconversion to closed-loop cooling isuncertain, the Electric Power ResearchInstitute estimates the capital cost ofclosed-loop/cooling pond technology tobe about $30 per kilowatt (see note 5).The proposed rule delegates implemen-tation to state environmental regulatorsand allows them to consider both thecosts and benefits of cooling systemdesign in their application of its require-ments at each facility.


Once-Through Cooling

As the name suggests, a once-through cooling system useswater as a coolant once—running it through the system to con-dense steam from the turbine—before discharging it back intothe water supply.

The advantages of this technology aretwofold: the relatively low capital andoperating costs, and low net water con-sumption. The disadvantages are disrup-t ions to local aquatic wi ldl i fe, onceduring water intake and again during thedischarge downstream, when the waterreleased could be about 20°F higher.Notably, although net water consump-tion is low, the high volumes required forthe plant to operate could be a con-straint during a drought. For instance, acoal-f ired power plant with a once-through cooling system will consume10x more water than coal (by weight)and many times more than a plant with aclosed-loop system. This also makes pumping water to theplant very expensive.

Closed-Loop Cooling

Also known as “recirculating cooling,” “cooling towers,” or“wet cooling,” closed-loop cooling has become the tech-nology of choice for most power stations built since the early1970s. Cooling water exits the condenser, goes through a

cooling tower, and is then returned to the condenser. Thesesystems take in a fraction of the water that once-throughcooling systems do. However, a closed-loop system can con-sume more than twice as much water as a once-throughsystem because much of the recirculated water evaporates to

condense the steam. Closed-loop coolingsystems are the most effect ive atreducing the number of aquatic animalssucked into cooling systems.

Dry Cooling

These systems are similar to closed-loopsystems, except that towers cooled only byair are used instead of an evaporativecooling tower. The system blows dry airacross steam-carrying pipes to cool them,essentially eliminating water loss throughevaporation. A significant downside of drycooling is that ambient temperatures andhumidity determine the effectiveness of drycooling. The net result is that plants using

wet cooling are more efficient than dry cooling plants, espe-cially in a hot, arid climate. The average loss of output by drycooling plants is approximately 2% annually. But at the peak ofsummer, when demand is at its highest, a wet-cooling plant canbe as much as 25% more efficient than a dry one.

For this reason, some power plants rely on a hybrid coolingsystem, in which the plant operates in dry-cooling mode much ofthe time but switches to wet cooling during hot weather.

Cooling Technologies In Thermoelectric Power Plants

Inundated (no pun intended) by thepotential effects of the Cross-State AirPollution Rule (Casper) and the MercuryAnd Air Toxins Standards (MATS) on itsoperating fleet, the U.S. power industryhas thus far put off facing water intakerulemaking effects into future years. Butthe incremental effect of capital spendingon an industry already reeling from signif-

icant environmental-related spending canbe substantial. For instance, New Jerseyregulators wanted Exelon Corp. to buildexpensive new cooling towers at theOyster Creek nuclear station. But Exelonsaid the towers’ cost—estimated at morethan $800 million—would be more thanthe 45-year-old plant was worth.Consequently, Exelon announced in

December that it will shutter Oyster Creekin 2019, 10 years before its license expires,in a deal with the state that will allow thereactor to operate until then withoutrequiring cooling towers to be built. Theclosure of the 620 MW base-load unitcould affect both capacity and the energymarkets in New Jersey, and require theNew Jersey Board of Public Utilities toexplore alternative generation proposals.

We expect other utilities to make sim-ilar decisions once the rules are morecertain. Although we expect the effecton reserve margins to be minimal, thecombined effect of Casper, MATS, and316(b) water intake rules could notonly impinge on the credit profiles ofpower companies, it could also alter thedispatch profiles of the Mid-Atlanticand southeastern markets.

Still, the industry thinks it unlikelythat the EPA’s proposed rule will man-date the use of closed-cycle cooling atall plants, but will apply only to powerplants in coastal or estuarine areasinstead (see note 6). We expect the EPAto issue a final rule later this year. CW

Notes

(1) Source: U.S. Geological Survey 2009.(2) Source: “Freshwater Use By U.S. Power

Plants—Energy and Water in a WarmingWorld” (EW3, November 2011).

(3) Source: “The Water Problem,” Global PolicyForum (Oct. 8, 2007).

(4) Source: National Renewable EnergyLaboratory, March 2011.

(5) Source: “Water Consumption of EnergyResource Extraction, Processing, andConversion” (Harvard Kennedy SchoolBelfer Center, October 2010).

(6) New Jersey wanted Exelon to install aclosed-loop cooling system that uses muchless water from the Barnegat Bay. BarnegatBay is a brackish estuary that empties intothe Atlantic Ocean.



(Tons of CO2/MWh)

1.00

0.80

0.60

0.40

0.20

0

Consumption intensity (gal/MWh)

Source: “Freshwater Use by U.S. Power Plants,” Union of Concerned Scientists (November 2011).© Standard & Poor’s 2012.

100 200 300 400 500 6000 700 800

PPLFirst Energy Corp.

American Electric PowerSouthern

Xcel

ProgressDominion

Tennessee Valley Authority

Calpine

NextEraEntergy

Exelon

Ameren

Duke

NRG

U.S. Power Company Carbon Intensity Versus Water ConsumptionChart 4

(Tons of CO2/MWh)

1.00

0.80

0.60

0.40

0.20

010,000 20,000 30,000 40,000 50,000 60,0000

Withdrawal intensity (gal/MWh)

Source: “Freshwater Use by U.S. Power Plants,” Union of Concerned Scientists (November 2011).© Standard & Poor’s 2012.

NRG

PPLFirst Energy Corp.

American Electric PowerSouthern

XcelProgress Dominion

Tennessee Valley Authority

Calpine

NextEraEntergy

Exelon

Ameren

Duke

U.S. Power Company Carbon Intensity Versus Water WithdrawalChart 3



Stephen CosciaNew York (1) 212-438-3183


Water

Water, just like any other natural resource, doesn’t

come in an infinite supply. That means keeping up

with demand can be difficult for some public water

utilities in the U.S. In some communities, population growth

has led to water demand outpacing supply. In others,

vulnerability to droughts has led to scarce supply in dry years

and a surplus in wet ones. And environmental concerns and

increasing regulation have resulted in reduced water availability

in some parts of the country.


Worth Its Salt? ■ As water ut i l i t ies in the U.S.

grapple with rising populations,demand, and water supply needs,they are expressing more interestin desalination.

■ U.S. util it ies have had varyingsuccess in developing and runningdesalination plants.

■ The use of desalination plants canimprove credit quality throughenhanced supplies and reliabilitybut can also hurt utility credit qualitythrough high capital costs,construction risk, and higheroperating costs.

OverviewDesalination In The U.S. OffersBenefits, But At A Price

Utilities can deal with supply issues inseveral ways depending on local factors,including conservation, participation inregional surface water projects, waterpurchases and exchanges, use of recycledwater for irrigation, acquisition of newwater rights, and development of addi-tional wells. But for communities locatednear the coast or by other untapped salt-water sources, some utilities are turningto another option: desalination.

The logic is simple. A community withwater supply needs that is reasonablyclose to the ocean can “de-salt” the waterand add it to its supply. Desalination canalso work for inland communities nearsources of brackish water (water with saltcontent not suitable for drinking butbelow that of seawater). While advancesin technology and energy recovery havelowered the cost of desalination, startupand operating expenses can still be high.Desalination plants also face regulatory

hurdles and often environmental opposi-tion. And the financial risks of developinga facility can be significant.

Both the benefits and the drawbacksof a desalination project can affect autility’s credit quality. Successful proj-ects can bring diversification to watersupply portfolios, make the supplymore reliable, and provide emergencysupplies during droughts. This can helpstabilize operations and, potentially,credit quality. Conversely, the costs andrisks of desalination can also increase autility’s financial risk profile.Desalination projects can require sub-stantial new debt or a drawdown incapital reserves and expose a utility topotential cost overruns. The cost tooperate the plant, or purchase water ifthe plant is privately owned, can lead tohigher overall operating costs, evenafter the savings from reduced relianceon other sources are taken into account.

We expect interest in desalination to con-tinue over the next decade. While desalina-tion will likely represent only a limited por-tion of water supplies in the U.S. for theforeseeable future, it can be an importantelement of a utility’s water portfolio.

The Alchemy Of Making

Saltwater Drinkable

Desalination technology is not new, butadvancements in recent years havereduced energy use and costs, making ita more viable option. Internationally,most desalination plants use eitherthermal or membrane technology toremove salt. Thermal desalinationplants use heat to distill water. Theseare common in areas with abundantfossil fuels, such as the Middle East,which is home to some of the largestthermal desalination plants. Membrane-based plants use semipermeable mem-branes to remove salts from a saltwaterfeed supply. Large membrane-based sea-water desalination plants have recentlybeen built in Israel and Australia to pro-vide drought-proof supplies. In the U.S.,most municipal desalination plants—either currently in operation orplanned—use membranes through aprocess called reverse osmosis that sepa-rates saltwater into product water andconcentrate (or brine). Most of the cur-rent desalting capacity in the U.S. treatsbrackish water rather than seawater,although interest from utilities in sea-water applications is on the rise.

The main elements of a reverse-osmosis desalination plant are:■ The intake system,■ The pretreatment system,■ The reverse-osmosis process (using

membranes),■ The post-treatment system, and■ The concentrate disposal system.

For brackish water desalination, theintake system is similar to that of a typicalwater treatment plant that uses ground-water or surface water. For seawaterdesalination, the intake system is usuallyeither a screened open-ocean intake or asub-seafloor intake (such as beach wells).Water is pretreated to remove particlesand organic matter and protect the mem-branes. The quality of the intake water



Source: "Energy and Water in a Warming World" initiative (Union of Concerned Scientists).©Standard & Poor’s 2012.

No measurable stressLow stress

High stress

0.00.1–0.20.3–0.40.5–0.60.7–0.80.9–1.01.1–6.4

U.S. Regions Experiencing Water Stress

Desalination technology is not new, butadvancements in recent years have reducedenergy use and costs, making it a moreviable option.

dictates the level and type of pretreat-ment. The reverse-osmosis process usespressure to pass the pretreated waterthrough the semipermeable membranes,which produces product water and leavesbehind concentrate (brine). Product wateris delivered to the post-treatment system,where it is treated as needed to make itsuitable for the utility’s potable distribu-tion system. The concentrate is conveyedto the disposal system, which uses a dedi-cated discharge pipeline, a shared dis-charge pipeline (such as with a waste-water treatment plant or power plant),deep-well injections, or other methods.

Much of the cost of operating areverse-osmosis desalination plant is asso-ciated with its high energy use. The waterintake system, the reverse-osmosisprocess, other required treatments, andconveyance to the water distributionsystem all require energy. The reverse-osmosis process in particular requireshigh pressure to force water through thesemipermeable membranes. Althoughrecent advancements in membranes andenergy recovery mechanisms have low-ered energy requirements, operating costscan still be high. And energy use increasesas salt concentration rises, which meansbrackish water desalination plants typi-cally have lower energy requirementsthan seawater desalination plants do.

Why Use Desalinated Water?

For water utilities in costal areas facingsupply shortages or water reliabilityissues, seawater desalination offers adrought-proof, reliable, virtually limit-less water supply. For communities withaccess to a brackish water source, desali-nation offers a new, untapped supply.

Often, utilities consider desalinationto diversify and expand their watersupply portfolios. For utilities thatdepend on imported water, desalinationcan offset wholesale water purchasesand reduce their exposure to increasingwholesale costs or wholesale reliabilityissues. For example, many SouthernCalifornia water utilities rely onimported water from the ColoradoRiver and San Joaquin/SacramentoDelta to cover demand. The availabilityof these sources is affected by variable

hydrologic conditions and increasedenvironmental regulation. And whole-sale water rates have been on the rise.

The Metropolitan Water District ofSouthern California (MWD; ‘AAA/Stable’revenue bond rating), a major wholesalewater provider, currently charges $794 peracre-foot for Tier 1 full-service treatedwater, up from the $478 per acre-foot itcharged only five years ago. The San DiegoCounty Water Authority (‘AA+/Stable’ rev-enue bond rating), MWD’s largest cus-tomer, is involved in several potential sea-water desalination projects to diversify itswater supply and reduce its reliance onMWD. Several MWD customers alreadyoperate brackish water desalination proj-ects, which help reduce their importedwater use, with others in the planningstages. Although many SouthernCalifornia utilities are pursuing supplydiversification to reduce their reliance onimported MWD water, we believe MWD’swholesale supply will remain extremelyimportant to utilities in the region.

Rather than offsetting importedwater use, some utilities are planningdesalination plants to reduce their over-reliance on certain local supplies.Desalination can be an attractive choicefor utilities experiencing falling ground-water levels or seawater intrusion inlocal aquifers. Tampa Bay Water, Fla.(‘AA+/Stable’ revenue bond rating) builtits large, 25 million gallon per day(mgd) seawater desalination plant toreduce pumping in its well fields. SoquelCreek Water District (‘AA/Stable’ rev-enue bond rating) in Santa CruzCounty, Calif., is jointly studying apotential 2.5 mgd seawater desalinationplant with the City of Santa Cruz(‘AA/Stable’ water revenue bond rating)to offset pumping from its overdraftedgroundwater basins.

Some utilities pursue desalinationprojects to prepare for supply emergen-cies, namely droughts. Santa Barbara,Calif., commissioned a desalinationplant in 1991 to serve as a temporaryemergency supply source after experi-encing severe drought conditions; how-ever, sufficient rainfall since 1991 leftthe facility mostly idle. The plant hasbeen decommissioned, although the

basic infrastructure remains in case offuture droughts. Santa Cruz, Calif., isparticipating jointly in the study of thedesalination plant with the SoquelCreek Water District in preparation fordrought years that could affect its sur-face water supply. The Florida KeysAqueduct Authority (‘A+/Stable’ waterrevenue bond rating) has two seawaterdesalination plants with a combinedcapacity of 3 mgd for an emergencysupply, if needed.

Utilities have also developed brackishwater desalination plants to unlock unusedlocal supplies. These projects have theadded benefit of helping restore ground-water basins and protecting freshwatersupplies. El Paso, Texas, (‘AA/Stable’ waterand sewer revenue bond rating) owns a27.5 mgd desalination plant, which allowsthe city to use the brackish groundwater inits arid service area and increase its overallsupply. Some other utilities operatingbrackish water desalination plants include:■ Eastern Municipal Water District,

Calif. (‘AA/Stable’ revenue bondrating);

■ Chino Basin Desalter Authority,Calif. (‘AA-/Stable’ revenue bondrating);

■ San Juan Capistrano, Calif. (‘A/Stable’water system certificates of participa-tion rating); and

■ Alameda County Water District,Calif. (‘AAA/Stable’ water systemrevenue bond rating).With existing and planned desalina-

tion projects, the need for and suit-ability of each project depend on spe-cific characteristics of the utility.Seawater desalination is most viable forcoastal communities (although long-dis-tance distribution pipelines have beenproposed). Brackish water desalinationrequires a local water source and ameans of disposing the brine. Both offerproject participants an expanded watersupply portfolio.

The Limits Of Desalination

With all the benefits a desalinationplant has to offer, one might wonderwhy the coasts are not dotted with facil-ities or why more inland utilities are notrecovering brackish groundwater.


The answer lies with the many chal-lenges of successfully developing andoperating a desalination plant:■ The planning and environmental per-

mitting process can be long and com-plex;

■ The projects can be expensive andentail construction risk;

■ The cost of operating the plants canbe high;

■ Some plants have experienced opera-tional issues, limiting capacity forperiods of time; and

■ Projects can face local opposition onenvironmental or other grounds.

Desalination projects face a myriad ofenvironmental hurdles that can affect theproject’s costs, timing, and feasibility.Seawater desalination facilities, in partic-ular, are often located in sensitive areas,and feed water intakes and brine dis-charge can affect marine habitats. Localopposition on environmental groundscan stymie the political will to followthrough on a project. Projects must alsoseek approval from a number of regula-tory bodies. Some of the agenciesinvolved in the permitting process fordesalination plants in California,according to the California Departmentof Water Resources DesalinationPlanning Handbook, include: theNational Marine Fisheries Service, U.S.Fish & Wildlife Service, CaliforniaCostal Commission, State Department ofPublic Health, State Department ofWater Resources, State Water ResourcesControl Board, California Public UtilitiesCommission, and various local agencies.

In addition, desalination plants oftenentail large capital costs and the risk ofcost overruns for the project sponsors.The operating costs of a desalinationplant can also be high and can be a

deterrent to pursuing a project. Muchof the operating cost is associated withthe high energy requirements of areverse osmosis plant, with typicallyhigher costs for higher salinity seawatercompared with brackish water. TampaBay Water’s seawater desalination plantsuffered from contractor bankruptcies,delays, operational issues, and costoverruns before final completion. SanJuan Capistrano’s brackish ground-water desalination facility has sufferedfrom a number of operational issues(partly due to the discovery of methyltertiary butyl ether in the groundwater),

lowering its output and leading to con-tinued reliance on imported water.(Methyl tertiary butyl ether, or MTBE,is a gasoline additive.)

The costs of building, operating, andmaintaining a desalination facility mustalso be weighed against the cost ofimported water (if available), of devel-oping alternative sources, or of pur-suing conservation within a servicearea. And all-in costs must be consid-ered, including debt service, requiredmaintenance, and future renewal andreplacement work. Often, other alterna-tives may be more attractive thandesalination. Although the NipomoCommunity Services District (‘A/Stable’revenue bond rating) commissionedstudies of a potential desalinationproject to reduce its reliance on an over-drafted groundwater basin, the districtis instead pursuing an intertie pipelinewith another utility at this time todiversify its supply. The MarinMunicipal Water District (‘AA+/Stable’revenue bond rating) had been planninga desalination plant in the SanFrancisco Bay, operated a small pilotplant in 2005 and 2006, and finalized

an environmental impact report in late2008. But as of April 2010, the district’sboard said it put the project on holddue to a drop in demand in recent years.

A Sampling Of Completed And

Planned Desalination Projects

El Paso, TexasThe need to reduce pumping fromfresh groundwater sources and theabundance of brackish groundwaterprompted the City of El Paso, jointlywith nearby Fort Bliss, to construct abrackish water desalination plant.Completed in 2007 at a cost of about$87 million, the Kay Bailey HutchisonDesalination Plant uses reverse osmosisto treat brackish groundwater from theHueco Bolson aquifer. The plant canprovide up to 27.5 mgd of treatedwater to the El Paso water system andhelps prevent salt intrusion of thefreshwater supplies at the HuecoBolson aquifer. Disposal of the concen-trate is achieved through deep-wellinjection. Desalinated water is now akey supply source in this arid region.Standard & Poor’s maintained a ‘AA’rating on the city’s water and sewerrevenue bonds throughout the develop-ment and completion of the plant.

San Diego County Water Authority, Calif.San Diego County Water Authority(SDCWA) is a wholesale waterprovider to member agencies inwestern San Diego County. SDCWArelies heavily on imported water fromMWD and—as part of i ts supplydiversification strategy—is exploringa number of desalination projects.The efforts include participation inthe Carlsbad Desalination Project andpotential projects at Camp Pendleton(50 mgd to 150 mgd) and RosaritoBeach in Mexico (initially 25 mgd).The Carlsbad project is a fully per-mitted 50 mgd desalination plant andconveyance pipeline that PoseidonResources Corp. is developing pri-vately. The project site is adjacent tothe Encino Power Station in Carlsbad,Calif., which allows the plant to usethe power plant’s cooling water for its



Desalination plants often entail large capitalcosts and the risk of cost overruns for theproject sponsors.

seawater intake and to share use ofthe discharge channel. SDCWA is cur-rently negotiating a water purchaseagreement with Poseidon and antici-pates bringing a draft agreement to itsboard in the summer of 2012. A pre-liminary term sheet agreed upon inJuly 2010 commits Poseidon to pro-vide water at $1,661 per acre-foot (in2010 dollars), although these termsare not final. This compares withMWD’s treated wholesale water costsof $794 per acre-foot for Tier 1 waterand $920 per acre-foot for Tier 2water. Under its urban water manage-ment plan, the authority projects 6%of its water supply will come fromseawater desal ination by 2035.Standard & Poor’s maintains a ‘AA+’rating on the authority’s water bonddebt outstanding.

San Juan Capistrano, Calif.San Juan Capistrano has historicallyrelied heavily on imported water fromMWD to meet its demand. In an effortto reduce its imported water purchases,the city entered into a contract with aprivate developer in 2002 to design,build, and operate a 5.14 mgd reverse-osmosis brackish water desalinationplant, known as the GroundwaterRecovery Plant. The plant was com-pleted in 2005 and was expected to pro-vide 4,800 acre-feet of water per year.However, operational issues and the dis-covery of MTBE contamination at thewells led to the plant performing belowcapacity. In addition, disputes betweenthe city and contractor led to both mutu-ally terminating the long-term operatingagreement in 2008. The city now runsthe plant with in-house staff. The plant’sreduced operating capacity resulted inthe city’s continued reliance on expensiveimported water. It also reduced the city’sgrant revenue from MWD, which wasbased on the volume of groundwaterrecovered, to below expectations. OnJune 29, 2011, Standard & Poor’s low-ered its rating on the city’s water systemcertificates of participation to ‘A’ from‘AA’ based on the system’s weak finan-cial performance, which largely stemmedfrom the ongoing operational issues with

the Groundwater Recovery Plant. Atthat time, the city was working toremedy the plant’s issues and bring it upto full capacity.

Santa Cruz, Calif. and Soquel CreekWater District, Calif.Santa Cruz and the neighboring SoquelCreek Water District are collaboratingon the planning and design of a 2.5mgd seawater desalination plant. Thesupply issues confronting each utilitydiffer, but both see benefits in the jointproject. Santa Cruz relies heavily onsurface water supplies, which are sus-ceptible to periodic droughts. TheSoquel Creek Water District reliesexclusively on groundwater from twoaquifers that have a history of overdraftconditions, raising the risk of seawaterintrusion and decreasing yields. Underthe current conceptual operating agree-ment, Santa Cruz would have priorityuse of the output in drought periods,when surface water supplies are lessreliable. Soquel would have priority useduring nondrought periods to reducereliance on its aquifers. The project is inits evaluation phase, with an estimatedcost of $113 million. If approved, bothutilities will be exposed to the high cap-ital costs and potentially high operatingcosts of the plant. However, we believethe desalination plant could serve as amodel of regional collaboration,bringing benefits to both partners withunique needs.

Tampa Bay Water, Fla.To reduce groundwater pumping and todiversify the Tampa Bay region’s watersupply, Tampa Bay Water constructed a25 mgd seawater desalination plant, thelargest in the U.S. Originally plannedfor completion in 2002, the project suf-fered delays, contractor bankruptcies,operational issues, and cost increases. In1999, Tampa Bay Water selected a pri-vate consortium to design, build, own,and operate the plant. Tampa BayWater originally intended for the con-sortium to finance the project with aconduit bond issuance. However, by2002 one of the consortium partnersfiled for bankruptcy and Tampa Bay

Water decided to purchase the projectand finance its completion with its ownrevenue bonds. In 2003, a contractorbankruptcy and operational issuesresulted in Tampa Bay Water termi-nating its construction contract andhiring a new contractor to perform sub-stantial remedial work. Finally, inJanuary 2008, the plant was deemedcontractually complete. During thisperiod, the project’s cost increased froman estimated $110 million to a finalcost of $158 million. The utilityreceived substantial financial assistancefrom the Southwest Florida WaterManagement District. Standard &Poor’s raised its long-term rating to‘AA+’ from ‘AA-’ on Tampa BayWater’s bonds in 2008. The raisedrating was partly due to the completionof the project. Today, desalination is animportant element of Tampa BayWater’s supply portfolio. Althoughsince completion, the plant has experi-enced periods of below-capacity opera-tions due to maintenance needs.

The Risks And Benefits

To Credit Quality

In general, many public water utilitieshave maintained strong credit qualityand ratings while implementing sub-stantial capital plans. Typically monop-olistic service positions, customer priceinelasticity, and rate autonomy are fac-tors that have supported strong ratings,in our view. We also believe that utilitiescan undertake desalination projectswithout experiencing deterioration intheir credit quality as part of a well-managed capital plan. Desalination canbe an important element of a utility’swater supply strategy. But the risks thatcome with pursuing desalination proj-ects are real, and the experience in theU.S. is still limited. CW



Robert HannaySan Francisco (1) 415-371-5038

Theodore ChapmanDallas (1) 214-871-1401


Desalination




National attention has been focused upon U.S. municipal

infrastructure quality and capital needs. Many policymakers

also view infrastructure investment as a potential economic

stimulus tool. U.S. weather patterns that ultimately affected utilities or

their demand in 2011 only served to focus attention on these needs.

While some are trying to figure out exactly what they need to fix and

how much it will cost, the general consensus is that needs are large

and federal funding is scarce.

Water Can Have Big Effects OnU.S. Municipal Utility Credit Quality

■ Intense competition for potable water means that while water in most of the U.S. isnot yet priced like a commodity, it could be, and sooner than many might think.

■ Although conservation efforts affect utility financial risk profiles, they can bebeneficial.

■ Making the most of increasingly scarce federal funds for infrastructure renewal andprudent risk management, including raising rates as needed, will be vital for utilitiesto maintain credit quality.

Overview

From DroughtsTo Conservation

For U.S. waterworks and sanitarysewer util ities, most of which aremunicipally owned and operate inde-pendently of each other, the main cap-ital investment needs relate to rehabili-tation, regulation, and growth. Theseare also the categories of projects thatare most likely to be eligible for alter-nate funding sources, such as DrinkingWater State Revolving Fund (DWSRF)or Clean Water State Revolving Fund(CWSRF) loans or possible limitedgrant money. Typically, federal andstate sources such as CWSRF loanshave a below-market cost of bor-rowing and are sometimes subordinatein repayment lien to the utility’s debt,although in some cases they requiresome level of local matching.

Not eligible for CWSRF funding arecertain projects to enhance raw watersupply, although for some utilities thiscan be a considerable component oftheir capital improvement programs.While the Environmental ProtectionAgency (EPA) has begun incorporatingclimate change into its long-term needsassessment, this area remains at man-agement’s opinion as to whether theutility’s supply is adequate to meetdemand, or whether certain projects are“climate ready.”

Water utilities are no stranger todoing more with less. Of al l thepotable water in the U.S., only a frac-tion of end-use consumption is actu-ally for municipal needs. Competitionwith power plants, farmers, andindustry, as well as al locationbetween and among other municipali-ties, means that while water in mostof the U.S. is not yet priced like acommodity, it likely could be withinour lifetime. Between the effects of

supply and demand and the need tofund the infrastructure likely fallingon local ratepayers, affordable priceswill be a hot topic for policy anddecision makers.

Standard & Poor’s Ratings Servicesnotes that municipal water and sewerutil ity revenue bonds continue toexhibit ratings stability (for moreinformation, see “Funding Long-Term Needs Remains The BiggestRisk For U.S. Municipal Water AndSewer Utilities,” published Jan. 31,2012, on RatingsDirect , on theGlobal Credit Portal). The stability isthere regardless of federal funds,which seem to be in shorter supplythese days. In fact, even the some-what paradoxical goal of conserva-

tion for utilities can benefit creditquality. While there are many key fac-tors that are important to creditquality, Standard & Poor’s believesthat having a secure, firm, long-termwater supply and the capacity andwillingness to make tough decisionsregarding rates continue to be twoimportant credit factors.

Utilities Have No Lack Of

Infrastructure Needs

In 2011, the EPA conducted its once-every-four-years survey of water utili-ties across the U.S. The aim of thequestionnaire was to help the agencygauge the cost of infrastructurerequirements for the nation’s drinkingwater systems for 2011 to 2030 andreport the results to Congress. Theprevious survey, in 2007, and theassociated report in 2009, identifiedmore than $334 billion in infrastruc-ture investment—just to maintain theexisting infrastructure. The EPA sur-

veyed al l 584 (as of 2007) largepublic water systems (which served apopulation of greater than 100,000),2,266 medium systems (servingbetween 3,301 and 100,000 people),and 600 small systems ( less than3,300) with response rates of wellabove 90% in each group.

The EPA’s main goal with the latestassessment was to figure out how toallocate funds for the DWSRF programsin fiscal years 2014 through 2017. Butit also provides insight into the specificneeds and projected costs of the sector.Other attempts, such as from theCongressional Budget Office or theWater Infrastructure Network, tomeasure the sector’s investment needsreported similarly large, if not larger,costs. An American Water WorksAssociation report from February 2012estimated it could be more than $1 tril-lion by 2035.

However, long-term water supplyprojects don’t necessarily meet theEPA’s definition of being necessary toserve the existing customer base, soDWSRF funding excludes most newdams and raw water reservoirs. Thesurvey also excludes projects neededto meet demand beyond the existingcustomers (for instance, growth utili-ties expect or speculate on), even ifcurrent supply and demand are insync. Because speculative assumptionscould be the basis of those supplyenhancement projects, the $334 bil-lion estimate does not capture totaldrinking water system needs but onlythose that the agency believes aremore directly and immediately meas-urable within their definitions of eli-gibility. The 2011 survey results arenot yet available.

What is new to the 2011 survey waslittle more than a sidebar in 2007: cli-mate readiness. The survey does notseek to create a measurement ofsupply adequacy; rather, it asks man-agement for a subjective determina-tion as to whether the utility’s supplyis adequate to meet demand, as wellas a listing, but not a summary, ofprojects that are “climate ready.”Examples include projects related to



While water in most of the U.S. is not yetpriced like a commodity, it likely could bewithin our lifetime.

enhancing water quantity or qualitythat fell due to climate change andprojects to protect against increasedflooding vulnerabilities. Because it isa subjective sampling, the surveyresults might not reflect all long-termwater supply needs and could under-represent the total investment neces-sary for all projects.

Federal participation in fundingthese projects, aside from EPA appro-priations to the states for the DWSRFand CWSRF, to which the states alsoprovide funding, is limited. Bills to liftthe private activity bond cap for waterand sewer projects have stalled in eachof the past two legislative sessions. TheBuild America Bonds program, whichspurred a huge spike in municipalbond issuance ahead of its Dec. 31,2010, expiration, is unlikely to comeback in light of deficit reductionefforts. The Kerry-Hutchinson-WarnerBill would potentially create a self-sup-porting public-private partnership thatwould work like the U.S. Export-Import Bank, although the proposalwould start with $10 billion in publicmoney (with at least that in privateparticipation) and would also fundtransportation and energy projects (see“A National Infrastructure BankCould Support Investment-Grade U.S.Project Finance Ratings,” publishedSept. 9, 2011). Invariably, utility man-agers will be left with the difficult deci-sion of asking local ratepayers formore if they are to get any projectfunded, regardless of purpose.

Ground Water Still

Dominates For Utilities

According to the EPA and the U.S.Geological Survey (USGS), of theapproximately 51,000 communitywater systems in the U.S., almost fourout of five use ground water as itsmain or even sole source of supply.However, most of those systems aresmall; almost 43,000 of these utilitiesserve a population of 3,300 or lesseach (see chart 1). In terms of totalpopulation, a system in which surfacewater is the primary or sole source ofraw water serves 70% of the U.S.

From a credit standpoint, Standard &Poor’s does not endorse one type ofsupply over the other, because each hasits benefits and drawbacks. Forexample, ground water typically hasmuch lower capital investment andoperating costs and is less likely tosuffer in drought. However, groundwater is generally finite; drilling morewells is simply like putting more strawsin the same glass of water. Groundwater that does not naturally rechargefrom some surface source might alsodegrade (into brackish water or, if nearthe coast, from salt water intrusion).Subsidence could also occur, whichmeans the land above the well couldsink or even collapse.

On the other hand, surface water isgenerally more expensive to treat to Safe


No. of systems Population served0

102030405060708090

100

Source: EPA Factoids—Drinking Water and Ground Water Statistics for 2009.© Standard & Poor’s 2012.

Ground Surface

(%)

Chart 1 Surface And Ground Water

Systems—Comparison

All other (3%)Public supply (15%)Irrigation and farming (33%)Thermoelectric power (49%)

Source: U.S. Geological Survey: Summary of Estimated Water Use in theUnited States in 2005.© Standard & Poor’s 2012.

Chart 2 Water Use By Category

Drinking Water Act standards, both interms of operational costs and how cap-ital-intensive the infrastructure require-ments can be. For many utilities in theU.S., the source might not be near theutility. That leads to high pumping costsand water losses from evaporation andsoil absorption. Surface water is alsomore susceptible to drought. However,it is more plentiful and more likely to be

naturally recharged via snowpackrunoff, rain, and stream flows.

While we don’t expect the USGS tohave updated consumptive use datauntil 2014, the general distribution hasbeen remarkably consistent: electricpower generation accounts for half ofall water use in the U.S., and agricultureanother 30% (see chart 2). Domesticuse, which includes residential, com-mercial, and industrial (includingindustry with its own dedicated sup-plies), is at 15%. Growth pressuresexist within each sector. In the southand west, many cities continue to grow.And the U.S. is in the early phases of thenext wave of power plant construction.Many electric utilities, however, havedeferred the decision to construct newbaseload generation due to a combina-tion of factors, including lower demandfrom the recession and demand-sidemanagement, as well as looming envi-ronmental regulations. On the otherhand, much new natural gas-fired gen-eration, including combined cycleplants, has been announced or gone toconstruction, especially with pricesbelow $3 per million Btu.

However, unlike the power grid, inwhich electricity moves across regionsvia transmission lines, water suppliestend to be close to the users. To build anew multistate water conveyance

system on the order of the CaliforniaState Water Project or the New York orWashington Aqueducts would requirepolitical willingness, environmental andlegal approvals, and easements (inwhich governments would use the landwithout owning it). Even then, manywould likely view it as too costly. Large-scale water storage and delivery projectscan take, literally, a generation to finish.

Weather Can Affect

Financial Risk Profiles

In a typical year in the U.S., it is notuncommon for regions to have a pro-nounced or prolonged drought, orsuffer from excessive precipitation.Even if the actual climatologic andhydrologic conditions end up beingexactly what the utility’s managementhad assumed in its original budget,other factors (such as economicvolatility) can affect operating rev-enues. From a practical standpoint,predicting weather for the next fiscalyear can be difficult. Scientists mightpredict El Nino or La Nina patternsand Arctic oscillations, but that doesnot guarantee operational or financialcertainty for utilities that depend onconsistent water supply.

We have observed that one of themost common—but certainly not theonly—reasons for a utility to miss itsfinancial targets in a fiscal year isbecause of weather. Even utilities intemperate climates can have most oftheir revenues arrive only Maythrough September. This is especiallytrue in the Sun Belt. Should mildertemperatures and above-normal pre-cipitation happen, water sales andtherefore operating revenues could fallbelow budget. Conversely, a relativelyhot, dry summertime could lead to

robust sales. It could also lead to man-aging through a drought.

Utilities Face The Paradox Of

Utility-Led Conservation

Even if not mandatory, strong long-term financial and operational planningat the local and regional level can fosteroperational certainty and can lead tocredit stability for utilities. Many utili-ties have active long-term water supply,conservation, and risk managementplans. Sometimes these are from man-agement’s voluntary efforts. In othercases, regulations are the reason. Manystates, for example, require local utili-ties to at least identify future watersupply sources. California, Texas, andArizona have some of the strongest,typically requiring that the plans arealso updated regularly, often coordi-nated based on common populationcenters and watersheds.

While not every state has compre-hensive drought, supply, or conserva-tion policies, most have at least statedgoals. Some state water plans includeexplicit drought management plans. Inother states, contingency planning fordrought is a separate effort, possiblyeven synchronized with water conser-vation awareness. The EPA has pub-lished guidelines on water conserva-tion. The federal government itself hasa self-imposed mandate for its ownagencies and facilities to be conserva-tion-conscious. Some states, such asGeorgia, have even incorporated con-servation codes as requirements for autility to be considered for CWSRFloan eligibility.

Many municipal utilities have haddifferent types of resource efficiencyprograms for decades. For waterworksand sanitary sewer utilities, plumbingcodes, outdoor watering restrictions,and ongoing public education cam-paigns also establish conservation pat-terns. Regardless, the end goal seemscounterintuitive: Utility managementestablishes policies and or incentives toencourage its customers to buy less ofits service. So how can utilities main-tain a stable financial risk profile inthese circumstances?



We have observed that one of the mostcommon—but certainly not the only—reasons for a utility to miss its financialtargets in a fiscal year is because of weather.

Standard & Poor’s does not endorsea particular type of rate structure, nora certain strategy towards rate adjust-ments. However, a credible history ofadjusting rates proactively is a factorthat continues supporting rating sta-bility. This generally means that:■ Financial performance demonstrates

reasonable consistency and is likely tobe able to meet all revenue require-ments; and

■ The financial risk profile, comparablyspeaking, is commensurate with therating.Many utilities have implemented

water conservation rate structures.The most common we have seen is theinclining block rate structure, wherethe more water the retail ratepayeruses, the more that ratepayer pays perunit cost. While this encourages con-servation (as well as lower sales), itcan also allow the utility to identifycustomers who consume a lot of waterregardless of supply conditions.Depending on the utility, these sales atthe margin can help offset losses fromlower sales to other customers.

Conservation Can Benefit

The Bottom Line

A long-term benefit to the balancesheet can sometimes offset the near-term impact to the income statementfrom conservation. We have observedthat successful conservation programshave led to avoided, or at leastdeferred, capital costs for the utility.The uti l i ty might also be able todownsize to-be-built pumping and dis-tribution infrastructure assets; consis-tently lower variation betweenaverage and peak day demand usuallymeans smaller pipes and pump sta-tions, all other things equal. Less cap-ital-intensive requirements for infra-structure could mean less borrowing,given that capital expenditures aretypically 35% to 70% debt-funded formost municipal utilities that we rate.

Lower water sales, whether fromconservation or climatology, don’tnecessarily have to lower a utility’spledged revenues, either. Aside frompersonnel, the largest operating costs

for most utilities are usually electricity(for treatment and pumping) andchemicals (for treatment). Evenwithout a dollar-for-dollar offset, if autility sells less water, it might stillfind some corresponding relief in itsoperating budget. That, in turn, canfactor directly into financial risk pro-file stability, especially for utilitiesthat have fixed revenue requirementsregardless of operating revenues, suchas debt service, take-or-pay expenses,or off-balance-sheet obligations. Twoof the most common rate structureswe have observed are either one withflat fees, or one with a base chargeplus volumetric rate (a rate based onper-unit consumption). Either canallow utility management to maintaina consistent financial risk profile com-mensurate with the ratings, so wedon’t view either approach as morecredit positive.

Planning Is Vital For

Rating Stability

Standard & Poor’s incorporates manyfactors into its ratings on U.S. munici-pally owned utilities. Consistentlystrong enterprise and financial riskprofiles that are likely to remain soare the foundations for credit stability.It is unlikely that utility managementcan materially affect local or regionaleconomic characteristics. Standard &Poor’s believes, however, that manage-ment can take actions to support theratings, such as long-term operationaland financial planning, transparentdialogue with ratepayers about toughdecisions, and otherwise acting in amanner that reduces risk and managesthe volatility that they all inevitablywill face to some degree. CW




James BreedingDallas (1) 214-871-1407

Geoffrey BuswickBoston (1) 617-530-8311


Water



Debt issuance declined for the U.S. water, sewer, and

drainage utility sector last year. Overall, Standard & Poor’s

Ratings Services believes ratings in the sector will remain

stable. Still, the sector needs infrastructure investment due to

aging systems; regulatory issues; and migrating populations to the

south and west, stressing existing water supplies in those regions.

Utilities will have a tough year addressing these issues due to

funding constraints. Even as local economies start to recover,

however, utilities will still need to allocate limited capital dollars

among competing high priority projects.

U.S. Municipal WaterAnd Sewer Utilities


Funding Long-Term Needs RemainsTheir Biggest Risk

■ Our almost 1,300 ratings on U.S. municipal water, sewer, and drainage utility revenue-secured debt remain relatively high, with the most common rating at ‘A+’, and theoutlook mostly stable.

■ We made fewer rating changes in 2011 than in 2010, and the upgrade-to-downgraderatio decreased to 5-to-1 from 10-to-1.

■ Financial profile changes, in some cases due to weak local economies, were the pri-mary factor behind our rating actions in 2011.

Overview

We believe the funding of long-term needswill pose the biggest test for utilities. Wealso see several other issues, both shortand long term, for 2012. Utilities will needto meet annual revenue requirementsgiven the struggling national economy, aswell as the local service areas’ economicfundamentals, since they relate to assump-tions for consumption patterns of existingcustomer bases and any potential newmetered accounts. Meeting annual rev-enue requirements might also provetougher given annual climatology andhydrology patterns and trends. Moreover,utilities have to maintain regulatory com-pliance and fund employee-related obliga-tions such as pension and other postem-ployment benefits (OPEB).

Managing Risk And

Financing Issues

In our opinion, while few utilities canrealistically change the macroeconomicconditions in which they operate, strongrisk management of financial and oper-ational needs will likely be the keyfactor supporting rating stability. It’seasy enough for utility managers toidentify risks and system needs.However, it’s more difficult to fundthem. Decisions about annual operatingbudgets in general, and specifically rateadjustments, are tough enough to makein a normal year in which demandassumptions based on the economy,growth, precipitation, climate, and suchare grounded in reality; in a year wherethere is a recession, drought, and such,however, it is even harder to make thesedecisions. Therefore, once the AmericanRecovery & Reinvestment Act (ARRA)money was exhausted and federalbudget decisions in Washington focusedon reductions, it became evident to usthat if utilities were to make system

investments, funding would likely needto fall squarely on ratepayers’ backs.

We believe stability is somewhatinherent in this sector. That’s because utili-ties are generally self-reliant and fundedsolely by user charges. This continues tohold true. We have observed that annualoperating budgets for this sector do notdepend on intergovernmental transfers inthe same way a local school district or eventhe utility’s affiliated general governmentcan. Therefore, where substantial state aidcuts might have sliced large swathes fromtax-backed budgets, cuts have had less ofan effect on utilities. Therefore, these chal-lenges, while potentially considerable, arenot, in our view, beyond the utilities’ abili-ties to address.

Furthermore, it is our opinion thatutility systems will likely feel pressureto raise local service rates in thecoming years. We understand thoserate adjustment decisions will prob-ably compete with other inflationarypressures for scarce dollars. We alsobel ieve appropriately scoped andtimely rate adjustments could largelymitigate risks. In some cases, it mightbe even easier for city councilors,commissioners, or utility board mem-bers to pass rate increases rather thanraising taxes in a weak or barelyrecovering economy. Simply, thepublic perception of rate increasesmight be more benign or politicallypalatable than tax increases. We,however, take these risks into accountin our ratings.

Ratings Should Stay

Stable In 2012

Standard & Poor’s maintains revenuebond ratings on about 1,270 U.S.municipal or quasipublic utilities that

provide some combination of water,sewer, and drainage services. These donot include tax-backed or other nonu-tility revenue debt that an affiliated gen-eral government might have issued onthe utility’s behalf.

The sector’s most common ratingremains ‘A+’, and nearly all of the rat-ings currently maintain a stable out-look. We believe this trend is likely tocontinue in 2012 (see table). In addi-tion, we maintain medium investment-grade or higher ratings on the majorityof the issuers in the sector. The ratingsdistribution remains nearly unchangedcompared with 2010.

Keeping Up With

Infrastructure Requirements

FundingWith federal and state assistance lim-ited at best, we believe utility man-agers will likely ask more of their cus-tomers, especially in the form of rateadjustments. In our view, in 2012 andbeyond, rate increases will likely be amajor funding source for many utili-ties’ key projects, as well as theirability to maintain consistent finances,which we believe is important torating stability. In our experience, theutilities most successful in asking moreof their customers are active in mean-ingful and substantive long-term plan-ning for operating and capital budgets,as well as educating the public to buildawareness and support.

While higher capital market bor-rowing costs did not play out asutility leaders feared in 2011, munic-ipal volume was off by more than25% compared with 2010 levelsdespite historically low borrowingcosts. We, however, believe it’s unfairto compare 2011 debt issuance to2010 issuance because market activitywas extraordinarily high in 2010 dueto a fourth-quarter avalanche of BuildAmerica Bonds so issuers could takeadvantage of federal subsidies beforethey expired. Once the sector realizedthe 111th Congress would not extendthe direct-payment Build AmericaBond subsidy program beyond itsDec. 31, 2010, expiration, many



With federal and state assistance limited atbest, we believe utility managers will likelyask more of their customers, especially inthe form of rate adjustments.

issuers accelerated their bonding plansand issued debt in the third or fourthquarters of 2010 rather than in 2011.

Despite all the bond issuances of thepast two years, we believe the sectorstill has infrastructure needs to fund in2012 and beyond. Many local govern-ments, however, are likely to prioritizetheir limited capital, especially in diffi-cult economic circumstances. Therefore,they will probably fund essential serv-ices ahead of other projects that offi-cials might characterize as less criticalor even discretionary.

In fact, many widely publishedstudies and anecdotes—such as thosefrom the American Society of CivilEngineers, the U.S. EnvironmentalProtection Agency (EPA), and industry-related professional organizations—have recently noted there is a need tocontinue to fund critical water, sewer,and drainage infrastructure. Even if thecost of borrowing for many issuersmight be higher, whether because of alack of subsidies or generally higherinterest rates, we believe the utilities’essential service nature will eventuallyovercome any near-term decisions todefer revenue bond issuance.

In 2011, the EPA conducted itsonce-every-four-years survey of waterutilities across the nation. The EPAintended the eight-page questionnaireto provide data so it could gauge thecost of infrastructure requirements forthe nation’s drinking water systems forthe next 20 years, from 2011 to 2030;in turn, the EPA would report the datato Congress. While it might be sometime before the EPA reports the 2011survey results, the 2007 study identi-fied more than $334 billion of invest-ments just to maintain the existinginfrastructure’s integrity. Because long-term water supply projects are harderto measure under the EPA’s definitionsof what is needed to serve existing cus-tomers, those projects are generallynot included in the costs.

Survey results also help the EPA allo-cate clean water and drinking waterstate revolving funds (SRFs) to thestates as well as identify the sector’sgeneral needs. While SRF allocations

spiked temporarily in 2009 and 2010due to the ARRA, the general trend hasbeen for SRF appropriations to be flat,if not slightly declining. This meanslow-cost state loans might be harder forutilities to acquire.

Whether Congress implements a fed-eral option remains up in the air sincefederal discussions currently appear tocenter on federal debt and the BudgetControl Act of 2011. A bill cospon-sored by Senators Kerry andHutchinson, however, is one possibility;it would create the AmericanInfrastructure Financing Authority, inessence a public-private partnership thatwould provide loans and loan guaran-tees for public infrastructure projects,including water, energy, and transporta-tion. The bill is currently still in com-mittee, but federal priorities might beelsewhere in 2012.


Non-investmentgrade (0.7%)

‘BBB’ (2.4%)

‘AAA’ (6.9%)

‘AA’ (46%)

‘A’ (44%)

© Standard & Poor’s 2012.

U.S. Municipal Water And Sewer Utilities

Rating Distribution By Category

As of Dec. 31, 2011

— Year-end Dec. 31 —2011 2010

Total number of ratings 1,270 1,252

% of ratings that changed during the year (upgrade or downgrade) 8.9 14.5

Upgrade-to-downgrade ratio 4.7 to 1 10.4 to 1

Number of positive outlooks 13 2

Number of non-stable outlooks 25 17

A Snapshot Of Standard & Poor’s Rating

Actions Taken In The U.S. Municipal Water

And Sewer Utility Market

Economic recoveryFrom a municipal utility’s point ofview, growth has positives and nega-tives. It creates more revenue-payingcustomers and higher densities (morecustomers within the same geograph-ical space); therefore, it makes theutilities much more efficient. Growthalso creates more accounts and gal-lons sold that utilities can spreadtheir fixed costs across. It, however,can also drive up capital expendi-tures. And for some utilities, growthcan create an overreliance on nonre-curring revenue, such as impact orconnection fees.

As economic growth slowed in manyplaces in the U.S. from 2007 to 2010, insome cases, we saw income statementstake a dramatic turn for the worse asconnection fee revenue growth stopped.In extreme circumstances, recurring rev-enue also dried up due to housingmarket woes. Standard & Poor’srecently noted in its 2011 economicoutlook and the U.S. S&P/Case-ShillerHome Price Index (20 cities) that whilehousing sales and starts appear to bestabilizing, foreclosures and pressure onhome values will likely remain an issue.In fact, Standard & Poor’s attributes allof the downgrades in 2011 to the weak-ening of utility finances, specificallydebt service coverage (DSC) and avail-able liquidity.

In some cases, it was steady erosiondue to the economy. In other cases,some utilities had over-relied on newconnection fees just to generate the bareminimum of net revenue available fordebt service. Once revenue growthstopped, however, the bottom line suf-fered. For the entire sector of issuersStandard & Poor’s rates, however, both

of these instances have generally provento be the exception.

The Long-Term Challenges

Regulatory issuesThe 1996 amendments to the SafeDrinking Water Act were some of thebiggest changes to drinking water sincethe law’s 1974 creation. The regulatoryprocess, however, is not static. Newrules and updates continue. The EPA’snew strategy is to address drinkingwater contaminants as a group—suchas volatile organic compounds—ratherthan one at a time. The EPA hopes newtechnology can broadly address man-

dates. While various studies and reportson pharmaceuticals, chromium-6,hydraulic fracturing (fracking), andeven fluoride in the water are more of a“headline” risk rather than somethingmeasureable and material to creditquality, they serve as a reminder thatutilities should not take regulatory com-pliance for granted.

In November 2011, the EPA announcedthat it would not deliver its final researchplan on fracking until 2014 and that itwould take any regulatory or legislativeaction well after that, if at all. We do notbelieve anything the EPA identified as newinitiatives in the most recent EPA strategicplan through 2015 could have an effect onthe sector’s credit quality since the focusareas are primarily goals and master plansrather than specific regulations.

The water industry’s response to reg-ulations is similar to that of utilities reg-ulated by the Clean Air Act of 1963,which Congress has amended severaltimes since. The industry generally sup-ports regulations as long as the sciencethe regulations address exists and ispractical, both operationally and finan-

cially. The best available technologyincludes the acknowledgement that thescience must be economically achievableto meet or get below the maximum con-taminant level of more than 80 contam-inants identified in national primarydrinking water regulations. Fortunately,water and sewer treatment technologygenerally has a long and proven recordwith newer techniques also operating atutility scale. Therefore, we view tech-nology risk in this sector as very low.

Over the past decade, we have seenthe most prominent example of regula-tory impacts in systems dealing withsanitary or combined sewer overflowsthat led to Clean Water Act of 1972(CWA) violations. Aging infrastructure,growth-related bottlenecks, and inflowand infiltration are the main overflowculprits; these problems can be expen-sive to address. Standard & Poor’smaintains ratings on a number of mid-size and large cities dealing with somekind of regulatory mandate for over-flow remediation.

As a response, in October 2011, theEPA released a new planning process thattargets urban areas where the violationsare most common and prominent. Theidea is that sanitary and storm sewersystem improvements for some citiescould address more than one problem,allowing the municipalities to make betteruse of capital and still be compliant.

Municipal systems such as District ofColumbia Water & Sewer Authority(AA-/Stable); Atlanta (A/Stable); Austin,Texas (AA/Stable); Northeast OhioRegional Sewer District (AA+/Stable);Kansas City, Mo. (AA/Stable); LosAngeles (AA/Stable); and Honolulu(AA/Stable) are among the many largesystems that are facing, or have alreadyfaced, multibillion dollar capital plansfor sanitary or combined sewer over-flow remediations. CWA-drivenimprovements carry the force of law tobe completed within a determinedperiod. Such fixes, however, usuallycompete with all of the other identifiedand approved capital projects for theutility’s limited dollars.

Large-scale regional regulatory man-dates will also probably continue to



We believe pensions and OPEB obligations represent material long-term risks to governments.

have an effect on utilities. As far back asthe 1980s, six states plus the District ofColumbia have had to address more-stringent wastewater treatment plantpermit requirements because they dis-charge their treated wastewater into theChesapeake Bay watershed and its trib-utaries. Because of regulatory deadlinesthat stated utilities had to address manyof the newest effluent limitations by2010, we saw increased wastewatertreatment capital expenditures strictlyfor those efforts in recent years. TheEPA constantly reminds utilities oper-ating in common watersheds and deltasthat they need to be good environ-mental stewards of those bodies ofwater, but the utilities bear the costs ofdoing so themselves. In December 2011,the EPA finalized its strategy for coastalareas along the Gulf of Mexico forecosystem restoration; the initial federaloutlay was just $50 million.

Pension and OPEB obligationsWe believe pensions and OPEB obliga-tions represent material long-term risksto governments. Although 2011 and2010 helped those fiduciary funds ortrusts to rebound, the corpus of theassets compared with actual obliga-tions, especially as baby boomers startto retire, in many cases still shows a biggap. Utilities are often beholden to theultimate decisions of city councils, com-missions, or other local officials onthose subjects since utility employeesusually participate in larger and oftencivil service retirement systems.

Officials can make the full annualrequired contribution to the pensionor risk a larger unfunded liability; ifthey don’t make the contribution,they can always hope for extraordi-nary rates of return in the pensionfund to make up for not paying theannual required contribution. Or theycould try to contain the growth ofexisting liabilities by reducing benefitlevels for all newly hired governmentemployees. While pension and OPEBobligations are not necessarily alwayscompeting for immediate require-ments, such as debt service, the riskremains of having such obligations

become a larger percent of the budgetover time; we will continue to mon-itor this issue.

Climatology, hydrology, and long-term water supplyWhile climatology, hydrology, and long-term water supply are all slightly dif-ferent concepts, they are highly interre-lated and remain important to creditquality. In our experience, the mostcommon reason in any year for a utilityto miss its budgeted DSC ratio is due toweather-related events.

Since many U.S. utilities make thelion’s share of water sales betweenMemorial Day and Labor Day, a tem-perate summer with more rain thannormal can quickly cause a utility todeviate from budgeted operating rev-enue. Conversely, a very hot and drysummer can be a boon to the bottomline as long as the utility has the watersupply and the corresponding infra-structure to accommodate the increaseddemand. Each year, some regions of theU.S. experience droughts, sometimesprolonged and pronounced. As ofJanuary 2012, the seasonal droughtoutlook by the National WeatherService’s Climate Prediction Center indi-cates the persistence or even worseningof droughts in Gulf Coast states and thedesert Southwest with drought condi-tions likely to develop in Nevada andSouthern California. Such was the casein 2011 in Texas, where a recorddrought devastated raw water reservoirsand some sectors of the economy, suchas agriculture and ranching.

Conversely, 2011 was kind to a dif-ferent high-profile water supply as sub-stantial Rocky Mountain snowpackpushed Lake Mead’s, in Nevada, levelup by 30 feet. As of January 2012, thelake was at 57% of capacity comparedwith below 40% just several years ago.That U.S. Bureau of Reclamationstorage system is critical to a number ofColorado River states for their drinkingwater supply. It remains highly regu-lated and periodically contentious; itcould have—no pun intended—a trick-ledown effect on municipal systems thattake water from it, mainly in the form

of higher operating costs but also plan-ning and water conservation purposes.

Sometimes litigation is the de facto solu-tion to regional problems. In June 2011,Georgia saw temporary relief in the so-called “Tri-State Water Wars” by suingover the use of Lake Lanier, a key supplysource to Atlanta. The courts ordered theArmy Corps of Engineers to develop anew allocation plan by mid-2012, a deci-sion we will closely monitor. In January2012, however, Georgia Gov. NathanDeal announced the state would sell $300million in general obligation bonds overfour years for the development of new andexpanded water sources.

Many other states have collaborative,if not mandated, water supply planningprocesses. We believe this is positive forcredit, even if the effect on utilities is notimmediately measurable given that itcan take decades—as much as a genera-tion—to put a new surface water supplysource into place. Even with imple-menting water reuse systems or waterconservation ordinances and buildingcodes, it takes time to reap the rewards.

We have observed that highly ratedutilities tend to have a well-devel-oped long-term planning process andstrong risk management. Risk man-agement might include allowances forcontingencies and emergencies, suchas approved drought managementplans or connections with neigh-boring systems. In our experience,however, most rated utilities have along-term plan in place, even if theytypically implement projects withinthose plans just in time to avoid over-building or “white elephant” (some-thing that is expensive to have, hardto get rid of, and not returning itsvalue) projects. CW




James BreedingDallas (1) 214-871-1407

Geoffrey BuswickBoston (1) 617-530-8311


Water




Whose earnings and balance sheet are most at risk when

catastrophic flood losses hit the U.S.? The federal

government’s are. In the U.S., private insurance companies

exclude flood coverage under most residential and commercial

property insurance forms. Automobile insurance excludes flood

coverage unless the insured elects the more costly comprehensive

coverage. Given the current coverage structure, U.S. floods have

limited impact on earnings, capital, or, ultimately, credit ratings on

private insurance companies. Although the U.K., Germany, and others

have privatized insurance coverage for flood losses, in the U.S. such

coverage is nationalized through the National Flood Insurance

Program (NFIP). The future of the program is uncertain, however, and

the proposed amendments may encourage private participation.

While The Government IsTreading Water, PrivateInsurers Are Just GettingTheir Feet Wet

U.S. Flood Insurance

■ Flood insurance in the U.S. is predominately provided by the federal government, lim-iting the effects on the financials of private insurers; however, this practice is cur-rently under scrutiny.

■ Private insurers have cited difficulties in modeling the risk, generating sufficient pre-miums, and overcoming adverse selection as reasons for low participation levels.

■ Private insurers are still exposed to flood through coverage provided above federalpolicy limits, crop insurance, and ambiguity following catastrophic events aroundwhether wind or water caused damages.

■ The role of the private sector may increase in the future given proposed legislation,recent advances in catastrophe modeling and capital markets, and the currentindebtedness of the NFIP.

Overview

The Public Option

Congress created the NFIP, a division ofThe Federal Emergency ManagementAgency (FEMA), in 1968 to providesubsidized, federally backed floodinsurance for commercial and personalproperty in the U.S. In exchange,property owners pledge to promote

floodplain management and work toreduce flood-related costs using pre-ventative measures such as elevatinghomes and building with flood-damage resistant materials. At year-end 2010, the NFIP had more than 5.6million policies in force for a total ofmore than $1.2 trillion of total insured

property. In return, the federal govern-ment received more than $3.3 billionin premiums from homeowners andcommercial property owners in 2010.Although the coverage is not compul-sory on a nationwide basis, coverage ismandatory for property ownerslocated in Special Flood Hazard Areas(SFHA). FEMA defines SFHAs asareas that will be inundated by a floodevent having a 1% chance of beingequaled or exceeded in any given year,also referred to as the 100-year flood.

Since inception, the program haspaid more than $38 billion in losseson more than 1.3 million claims. Thisnumber skyrocketed in 2005 afterHurricane Katrina, which alone costthe NFIP $16.2 billion dollars onmore than 167,000 claims. The poli-cies tend to be concentrated in areasalong the coast and major rivers. Themost policies are in Florida (2.1 mil-lion), Texas (677,000), and Louisiana(485,000).

The Struggle For Private Insurers

So, why don’t insurance companieswant a bigger piece of the pie? Privateinsurers in the U.S. have cited floodmodeling as one source of difficulty.Landscapes are constantly changingdue to development, and protective



Growth in Premium Total Number of number of collected coverage Number of Total losses

policies policies (%) (mil. $) (bil. $) losses (mil. $)

1978 1,446,354 N/A 111.3 50.5 29,122 147.7

1979 1,843,441 27.5 141.5 74.4 70,613 483.3

1980 2,103,851 14.1 159.0 99.3 41,918 230.4

1981 1,915,065 (9.0) 256.8 102.1 23,261 127.1

1982 1,900,544 (0.8) 354.8 107.3 32,831 198.3

1983 1,981,122 4.2 384.2 117.8 51,584 439.5

1984 1,926,388 (2.8) 420.5 124.4 27,688 254.6

1985 2,016,785 4.7 452.5 139.9 38,676 368.2

1986 2,119,039 5.1 518.2 155.7 13,789 126.4

1987 2,115,183 (0.2) 566.4 165.1 13,400 105.4

1988 2,149,153 1.6 589.5 175.8 7,758 51.0

1989 2,292,947 6.7 632.2 265.2 36,245 661.7

1990 2,477,861 8.1 672.8 213.6 14,766 167.9

1991 2,532,713 2.2 737.1 223.1 28,549 353.7

1992 2,623,406 3.6 801.0 236.8 44,650 710.2

1993 2,828,558 7.8 890.4 267.9 36,044 659.1

1994 3,040,198 7.5 1,003.9 295.9 21,583 411.1

1995 3,476,829 14.4 1,140.8 349.1 62,441 1,295.6

1996 3,693,076 6.2 1,275.2 400.7 52,677 828.0

1997 4,102,416 11.1 1,509.8 462.6 30,338 519.5

1998 4,235,138 3.2 1,668.2 497.6 57,349 886.3

1999 4,329,985 2.2 1,719.7 534.1 47,247 755.0

2000 4,369,087 0.9 1,723.8 567.6 16,362 251.7

2001 4,458,470 2.0 1,740.3 611.9 43,589 1,277.0

2002 4,519,799 1.4 1,802.3 653.8 25,312 433.6

2003 4,565,491 1.0 1,897.7 691.8 36,838 780.5

2004 4,667,446 2.2 2,040.8 765.2 55,826 2,232.1

2005 4,962,011 6.3 2,241.3 876.7 212,897 17,714.8

2006 5,514,895 11.1 2,604.8 1,054.1 24,595 640.7

2007 5,655,919 2.6 2,843.4 1,141.2 23,132 612.4

2008 5,684,275 0.5 3,066.7 1,197.7 74,300 3,452.3

2009 5,700,235 0.3 3,187.1 1,232.4 30,839 773.1

2010 5,646,735 (0.9) 3,353.8 1,245.5 27,923 727.9

N/A—Not applicable. Source: Federal Emergency Management Agency.

National Flood Insurance Program Historical DataTable 1

(As of year-end 2010)

(Mil. $) Direct premiums written

Fidelity National* 371.0

State Farm 317.6

Allstate 311.0

Hartford 298.5

Travelers 205.6

Selective 191.0

Assurant 184.2

Zurich 123.7

Nationwide 118.0

Harleysville 107.5

*Fidelity National has since sold its NFIP operation toWRM America. NFIP—National Flood Insurance Program.WYO—Write your own.

Top 10 NFIP WYO

Program Participants

Table 2

levees are susceptible to human error.The NFIP has also illustrated the dif-ficulty in producing current and accu-rate modeling for flood exposure.FEMA began a multiyear mappingmodernization program in 2003when, according to a March 2011Congressional Research Servicereport, 70% of maps used in the U.S.were more than 10 years old. Some ofthe delay could also be attributable tofunding constraints, however.Whereas catastrophe modeling agen-cies have sophisticated flood modelsfor many European countries, modelsfor the U.S. are generally still devel-oping. Funding could have a role hereas well. Insurance companies use hur-ricane and earthquake models tounderwrite, price, and manage theiraggregate risk exposure and properlyallocate capital. Catastrophe mod-eling agencies have little incentive todevelop similar models for floodswithout such a customer base.

Some are concerned that the costli-ness of charging actuarial rates woulddissuade buyers from purchasing cov-erage. According to a June 8, 2011,Congressional Budget Office report,FEMA estimates one-fifth of the poli-cyholders are paying 40% to 45% ofactuarial rates. More than one millionpolicyholders would fit into this cate-gory. Amid high unemployment andthe general economic downturn in theU.S., insuring for a 100-year floodmay not be the highest priority forpolicyholders—especially if premiumsmore than double to their true actu-arial rate. Additional private insurerprice increases could come from theneed to cover the cost of capital andgenerate a profit for shareholders—atask with which the federal govern-ment is not charged.

Private insurers may be unable togenerate sufficient premiums due toadverse selection (see table 1). Thetable shows that when significantlosses occur, policy purchases increase;however, the growth tapers off andsometimes even turns negative as timepasses. For example, in the aftermathof Katrina the policy count increased

6.3% in 2005 and 11.1% in 2006. Thefollowing four years had an averageincrease of 0.6%, with growth in 2010even turning negative with a decreaseof 0.9%. Perhaps the most drasticexample is in the wake of TropicalStorm Claudette, Hurricane Frederic,and flooding in numerous states in1979. After an uptick in policies of27.5% in 1979 and 14.1% in 1980,1981 saw a decrease of 9% followedby another decrease of 0.8% in 1982.This type of behavior could make itharder for insurance companies toprice adequately for flood coverage.

Private Insurers Still

Share Some Of The Burden

Private insurers play some role in mit-igating the risk of flood losses in theU.S. NFIP policies are administeredmostly through the Write Your OwnProgram whereby 87 private insur-ance companies act as selling agentsfor the NFIP in return for an expenseallowance by the federal governmentto make up for the costs incurred inthe process (see table 2).

Because the insurance companies donot take on the flood risk, they offerthis coverage as a supplement to theirstandard homeowner and commercialproperty policies. Although the insur-ance companies write the policies ontheir own paper, the premiums and alllosses incurred are passed through(ceded) to the federal government,while insurance companies take in feeincome for their services. Therefore,from a credit rating perspective, nocapital is at risk.

Although it would not significantlyaffect credit ratings, U.S. insurancecompanies still take on some floodexposure. Private insurers can insureboth residential and commercial proper-ties with values of more than the NFIPlimits of $250,000 and $500,000,respectively. In most cases, however, theNFIP policy is the first layer of protec-tion and bears the brunt of the damage.Typically a more valuable commercialproperty would have a higherdeductible, and the NFIP policy canactually serve as fill-in to pay that


amount. In its current format and aslong as flood insurance coverage is pro-vided within a well-diversified portfoliogeographically and by product, it isunlikely that one major flood wouldcause material ratings pressure.

Aside from coverage for flooddamage to commercial and residentialstructures, insurance companies alsoinsure farmland and crops. Here, thefederal government also has a hand inproviding coverage but in a co-partici-pation capacity. Whereas the govern-ment acts as the first layer of protectionfor structural flood coverage throughthe NFIP, private insurers typicallyretain most of the risk in crop insurancethrough “multi-peril crop insurance,”and the government takes on increas-ingly larger portions as the severityincreases. Here, instead of passing alongall premiums and losses to the govern-ment, private insurers retain most ofboth the premium and the risk.

As the name suggests, multi-perilcrop insurance covers many perils inaddition to flood, including drought,frost, and fire (see “Crop Insurance IsVolatile, But Profitable,” publishedDec. 15, 2011, on RatingsDirect on theGlobal Credit Portal). Direct premiumswritten for the crop insurance market in2010 were $7.7 billion, more thandouble the premiums for the NFIP.Writing crop insurance enables insur-ance companies to diversify their port-folios away from the coastal hurricane-prone exposures while still handingover the most severe catastrophic lossesto the federal government. Therefore,crop insurance performance remainedstrong in 2005 amid heavy losses forinsurance companies with exposures toHurricanes Katrina, Rita, and Wilma.

Flood Versus Wind: Murky

Waters For Insurers

Another diff iculty insurers faceregarding flood insurance is that pri-vate insurance companies could stillbe exposed to flood claims even whenthey have specifically excluded cov-erage for this peril in their policies.When major hurricanes hit the coast itis difficult to determine whether windor water caused the damage. This isimportant as wind is generally cov-ered by private insurer policieswhereas flood is covered by govern-ment policies. In the aftermath ofKatrina in 2005, various insurancecompanies were defendants in mul-tiple lawsuits alleging they failed topay covered wind damages they cate-gorized as flood, causing the govern-ment to pay the bill. Some allegedstorm surge was not included in theflood exclusion and therefore shouldbe covered. Although insurance com-

panies were mostly dismissed from theallegations, earnings or even capitalcould be at risk if rulings adverselyaffect insurance companies.

The Future Of Flood Insurance

More important for insurance compa-nies are the prospects of future partic-ipation by the federal government.With a current outstanding Treasuryloan of more than $17 billion to theNFIP, the program is currently underscrutiny. Many solutions have beenproposed, including revamping theNFIP, restructuring it so that the gov-ernment only acts as a reinsurer (orthe government purchases reinsur-ance), and securit izing the riskthrough the catastrophe bond marketto tap into capital markets. The NFIP

is currently on temporary extensionand set to expire May 31, 2012.

A recent bill, The Flood InsuranceReform Act of 2011 (HR 1309), waspassed by the House of Representativeson July 12, 2011, and a similar bill iscurrently pending in the Senate. OnFeb. 9, 2012, Senate Majority LeaderHarry Reid and Minority LeaderMitch McConnell were urged bySenators David Vitter and Jon Testerto expedite passage of the bill. Theletter to Reid and McConnell wassigned by a bipartisan group of 41 sen-ators. Among other reforms, HR 1309of the House extends the NFIP to2016, introduces a five-year phase-inof up to 20% annual increases to theactuarial rate, and establishes aTechnical Mapping Advisory Councilto enhance flood insurance rate map-ping. The bill also promotes privateinsurers’ participation in the programby requiring the study of privatizingthe program, the assessment of privatecompany requests for proposals toassume a portion of the risk, andauthorizing the purchase of reinsur-ance for the federal program.

Although private insurers historicallyhave struggled to take on flood risk,there have been many advances in mod-eling, capital markets, and risk-transfer-ring products since 1968 when theNFIP began. Although private insurers’current exposure is only on the booksas a small operating profit and minimalcapital at risk, a more pronounced rolemay surface in the near future. Sinceinception, the NFIP has maintained agoal of more private-company partici-pation, and the current political andeconomic environment could be a cata-lyst for change. CW



More important for insurance companies arethe prospects of future participation by thefederal government.


Blake MockNew York (1) 212-438-7278

Taoufik GharibNew York (1) 212-438-7253

Damien MagarelliNew York (1) 212-438-6975


Water

The east of England is currently experiencing a drought, with

reservoir levels already 20% lower than normal. What’s more,

we believe the region is likely to face severe water shortages

over the longer term due to significant changes in rainfall patterns on

account of climate change and a steadily increasing population.

Among other detrimental effects, this could lead to water shortages,

increased energy prices, and flood risk. It could also lead to operating

and financial challenges for utilities and energy-intensive businesses

operating in the region.


How Water Shortages In EasternEngland Could Increase CostsFor U.K.-Based Utilities

Editor’s Note: Standard & Poor’s Ratings Services would like to acknowledge thecontributions to this article of Aled Jones and Candice Howarth of the Global SustainabilityInstitute at Anglia Ruskin University, as well as that of Liesel van Ast of Trucost PLC.

Credit FAQ

Standard & Poor’s Ratings Services,together with the Global SustainabilityInstitute at Anglia Ruskin Universityand environmental research organiza-tion Trucost PLC, have conductedjoint research into the drought in theeast of England. This research high-lights that without increased invest-ment into managing both demand andinfrastructure (in the form of increasedstorage capacity, new water sources,reduced leakage, or a higher penetra-tion of water meters), water andpower companies operating in the eastof England are likely to face both con-tinued water shortages and increasingoperating and capital costs. We believethese costs could harm the utilities’credit quality over the long term if notappropriately mitigated.

In this FAQ, we answer investors’questions about how the water shortagein the east of England could affect utili-ties’ credit quality.

Q. How severe is the current watershortage affecting the east of England?

A. In our view, it’s very severe. TheEnvironment Agency reports thatgroundwater levels in the east ofEngland are currently lower than in1976—the year commonly associatedwith the most severe drought in the U.K.

On Feb. 20, 2012, the U.K. governmenthosted a drought summit at which watercompanies and other interested parties metto formulate ways to avert a severe watercrisis in the most vulnerable regions ofEngland, including the east. Delegates atthe summit were told that a year-and-a-half of low levels of rainfall have left thesoil so dry and reservoirs and river levels solow that the water industry believes curbson water use are now likely (see chart 1).

Q. Are the current drought conditionsjust a short-term problem?

A. No. The east of England has been awater-stressed area for the past 30 years.Last year, Anglian Water PLC (see note1)—which provides water and waste-water services to the east of England andHartlepool—applied for two droughtpermits for reservoirs located in theNene catchment area following very lowrainfall of 453 millimeters (mm) overthe year. This is equivalent to 75% ofthe 1961 to 1990 U.K. average rainfallof 603 mm. (We use the 1961 to 1990U.K. average as our baseline referenceperiod for the comparisons that follow.)

Furthermore, we believe that climatechange could have a significant andadverse influence on rainfall in the eastof England in the short, medium, andlong term. According to the Departmentof Environment, Food, And RuralAffairs’ (Defra’s) U.K. Climate

Projections 2009 (UKCP09), theaverage summer rainfall will dropapproximately 7% by 2020 and 21%by 2080 under its medium greenhousegas (GHG) emissions scenario A1B (seenote 2). This is one of three scenariosoutlined under UKCP09, each of whichmakes different assumptions for factorsincluding GHGs and land use.

Q. How will climate change affect rain-fall in the future?

A. According to UKCP09, the totalaverage annual rainfall for the east ofEngland will remain approximately thesame until 2030. However, we under-stand that the spread of precipitationacross the year is likely to change dra-matically as a result of climate change.

From 1970 to 2000, the averageannual rainfall in the east of Englandwas 603 mm, with a relatively evenspread of 306 mm in winter and 297mm in summer. However, by 2030,UKCP09 forecasts 8% more rainfall inwinter and 8% less rainfall in summeracross its low, medium, and high GHGemissions scenarios. Winter rainfall isimportant for recharging reservoirs andaquifers (natural underground waterstorage locations). By 2050, accordingto UKCP09, there will be 15% lesssummer rainfall and 15% more winterrainfall on average.

At the extreme, by 2050, there is a10% probability of 37% less rainfall inthe summer and 30% more in winter(see chart 2). We note that the amountof rainfall is not necessarily an accuratepredictor of the deployable wateroutput, because this depends on variousfactors involved in capturing rain—including catchment area characteris-tics, previous rainfall patterns, andavailability of water treatment.

The potential change in water avail-ability throughout the year is exacer-bated by differing demands in eachseason. In a typical year in the east ofEngland, demand for water in thesummer is 6% higher than in the winter.In a dry year, summer demand isapproximately 9% higher, according toAnglian Water. This has significantimplications for the storage and trans-port of water throughout the region.

Q. How are the water utilitiesaddressing the effects of climate changein the east of England?

A. Anglian Water’s mitigation plans forthe east of England are set out in its 25-year Strategic Direction Statement(SDS), published in 2009.

The SDS identified populationgrowth and climate change as the twomost significant challenges facingAnglian Water. As a consequence, thecompany is targeting £13 billion ofinvestment before 2035, £1 billion ofwhich will address the effects of climatechange directly. The investment isdirected toward the:


features special report | Q&A

The Environment Agency reports thatgroundwater levels in the east of England arecurrently lower than in 1976…

■ Resilience and reliability of water andwastewater services;

■ Security and conservation of waterresources; and

■ Growth in demand across the east ofEngland.In January 2011, Anglian Water

expanded its SDS plans through itsClimate Change Adaptation Report. Itsubmitted this report to the U.K. gov-ernment as required by the ClimateChange Act 2008. This detailed thecompany’s climate change risk assess-ment methods and the actions to betaken to manage those risks, such asdemand management and infrastruc-ture investment.

Other water companies in the southeast of England, such as Thames WaterUtilities Ltd. and Southern WaterServices Ltd. (see note 1), have alsoincreased spending on drought meas-ures. Thames Water is spending £1 bil-lion per year between 2010 and 2015on capital works, of which one-quarterrelates to drought and water manage-ment measures.

Q. What other plans do the utilitieshave to conserve water in light of arising population?

A. The East of England RegionalEconomic Strategy 2009, published bythe East of England DevelopmentAgency (EEDA), shows the 2012 popu-lation for the east at 5,766,600, withprojected growth of between 0.5% and0.9% per year.

Although the EEDA’s East of EnglandImplementation Plan shows thataverage household water usage isreducing—largely due to a switch towater meters from ratable bills—thereis some way to go to reach the targetset by the water industry’s ownresource management plans. Thattarget is 122 liters per person per dayby 2030, representing an 18% reduc-tion on today’s level. However, basedon current usage trends, the industryexpects only a 4.5% reduction perperson. U.K. government targets aretoward the lower end of these projec-tions (see note 3).

Assuming a projected populationgrowth of 0.8% per year, together withthe current trajectory of householdwater usage per person of 150 liters perday, we estimate that demand forhousehold water in the east of Englandwill rise by about 10% by 2030.

Population growth will also increasenonhousehold water demand (i.e., pro-duction, manufacturing, and services),which will further increase demandoverall. However, water efficiencymeasures, such as installing less water-intensive industrial processes, maycounter some of this growth and there-fore it’s difficult to model nonhouseholddemand with any accuracy. For the pur-poses of our calculations, we thereforeassume that nonhousehold demand willremain roughly constant.

However, we note that the majorityof the population increase is likely to beconcentrated in areas of high density,which are already experiencing highwater stress. Consequently, the 10%increase in demand we project by 2030is likely to be an underestimate, unlesswater can be more easily transportedacross the region.


Source: Environment Agency.© Crown, and Standard & Poor’s 2012.

NorwichPeterborough

Bury St. Edmunds

IpswichCambridge

Milton Keynes

London

Chelmsford

U.K. drought areas

Areas Declared In Drought StatusChart 1

Q. What pressure will changes in waterresources place on local water companies?

A. Water shortages could lead watercompanies to pump more water fromrivers into the reservoirs. Pumping more

water could increase the energy andcarbon intensity of water provision.

Population in the Anglian Waterregion has grown by some 20% since1989. However, the same amount ofwater is put into supply today as in

1989 (1.2 billion liters a day). This islargely due to the company’s watermanagement measures, such asmetering, leakage control, and waterefficiency. Nevertheless, the companyestimates that it will require capitalinvestment of almost £12 billion todeliver its long-term strategy to exploitnew abstraction points and reservoirsand implement its water efficiencymeasures between 2010 and 2035.

Using UKCP09, Anglian Water proj-ects a total additional requirement rela-tive to potential supply of 49.6 ml ofwater per day by 2036 to 2037. Thisshortfall would be concentrated in fourof its 11 water resource zones. The pre-diction is based on surface water yieldcalculations, river flows, and ground-water reservoir replenishment rates.

Positively, Anglian Water has identifiedabout 19 new water abstraction sourcesand reservoirs, as well as demand manage-ment solutions. The latter include waterefficiency measures for domestic customers,such as water audits and the installation ofwater-efficient domestic appliances in40,000 homes in the past two years. Thecompany estimates that these measures aresaving an average of 40 liters of water perhousehold per day. In addition, 87,000water meters have been fitted in the pasttwo years, out of a target of 183,000 by2015. The Anglian Water region has 67%meter penetration, the highest figureamong major U.K. water companies.

Q. What steps is Anglian Water takingto protect its credit quality in the face ofsuch large investments?

A. Anglian Water has little prospect ofgenerating positive net cash flows (aftercapital expenditures [capex]) before 2035,in our opinion. It therefore expects to relyon the debt markets to finance its capexprogram. Under the regulatory frameworkoperating in the water sector in Englandand Wales, Anglian Water would typicallyseek to have such capex approved in itsasset management plan and then added toits regulated asset base. This would subse-quently allow the company to increase itsregulated tariffs and pass on the cost ofasset depreciation to its customers, thereby



2050 Summer

2050 Winter

(40) (30) (20) (10) 0 10 20

10% probability level 90% probability level

30 40

(% change)

Source: U.K. Department of Environment, Food and Rural Affairs’ Climate Projections 2009 (UKCP09).© Standard & Poor’s 2012.

2030 Summer

2020 Summer

2020 Winter

2030 Winter

Chart 2 Potential Change In Precipitation InThe Anglian Water

Catchment Area 2020To 2050

© Standard & Poor’s 2012.

Boundary of the Anglian Water licensed regionSite of special scientific interestAreas affected by 0.4 meter rise in sea levelFlood zone 2 is land that has: (i) between a 1 in 100 and 1 in 1,000 annual chance of river flooding; (ii) between a 1 in 200 and 1 in 1,000 annual chance of sea floodingWastewater treatment works affected by 0.4 meter level riseWater treatment works affected by 0.4 meter sea level riseGrowth areas defined by U.K. governmentGrowth points defined by U.K. government

Sources: Anglian Water PLC’s Strategic Direction Statement published 2007; Environment Agency 2004; Communities of local government websites.

Lincoln

Grantham

Norwich

Thetford

Ipswich

Colchester

Peterborough

Huntingdon

Northampton

Bedford

Cambridge

■

▲

▲

Anglian Water’s Assets Vulnerable To 0.4 Meters Above Sea LevelChart 3

protecting its credit quality. However, weunderstand there remains some uncer-tainty over the timing and flexibility of thetariff increases, as well as over the assump-tions underlying the asset managementplans submitted to the regulator, Ofwat.

Ofwat plans to change the way it setsprice limits in the future to take accountof factors such as population growth,climate change, and the increasingscarcity of water resources. Abstractioncharges will adjust to reflect the relativescarcity and abundance of water, orcompeting water demands.

Although the environmental costs ofwater use and infrastructure will increas-ingly be included in water pricing in theU.K., we believe that power generatorsand energy-intensive firms could face moreimmediate financial risk from water usethrough business disruption and changesin abstraction licensing conditions.

Q. How could water shortages affectpower companies and future elec-tricity tariffs?

A. Infrastructure that locks in highlevels of resource dependence and pollu-tants could face higher-than-forecastcosts, lowering future cash flows andreturns on investment. Water shortagesmay well increase both the cost ofpower and electricity tariffs.

For example, EDF Energy PLC(A/Negative/A-1) runs Sizewell B, anuclear pressurized water reactor, and thelargest power station on the east coast inSuffolk, with the capacity to generate1,191 megawatts (MW). The plant’swater use equates to less than 2% of thetotal water supplied by Essex and SuffolkWater per year. (Essex and Suffolk Wateris owned by Northumbrian Water Ltd.[BBB+/Stable/—].) Trucost, an environ-mental research company, calculates thatif mains water were priced to reflect localwater use as a percentage of annuallyrenewable freshwater resources (95%),the Sizewell plant could incur waterscarcity costs totaling an additional £1.7million per year, based on 2010 waterconsumption. (Water scarcity costs reflectthe financial impact that water extractionhas on freshwater replenishment,

ecosystem maintenance, and the return ofnutrients to the water cycle. Trucost esti-mates this by modeling standardized costdata relative to water scarcity.) As Sizewellwas shut down for several months in2010, costs are likely to be higher in yearswhen it is fully operational. Rising waterstress in the east could increase the plant’sscarcity costs to almost £2 million a yearby 2025, according to Trucost.

RWE Npower PLC (part of RWE AG;A-/Negative/A-2) owns the second-largestpower station in the region, Tilbury B inEssex. The plant has a capacity of 1,063MW and is located in a catchment areathat is very short of water. Water scarcitycosts for RWE Npower could total morethan £51 million annually. This is based onthe power station’s estimated water usagein 2010, and Trucost’s calculation of thehigher price per cubic meter, reflecting theadditional the cost of usage and assuming100% take-up of water availability.

Trucost has applied water scarcitycosts to the estimated water consump-tion of a further seven power plants inthe east of England in 2010, based onaverage water use for the differentprocesses used. Together with Sizewell Band Tilbury B, the power stationsaccount for 94% of electricity generatedin the east. According to Trucost, if allof the plants were to internalize waterscarcity costs and pass them through inhigher power prices, median industrialelectricity prices could increase by 5.7%from 2011 levels. These calculationsexclude the lower external environ-mental costs of cooling water, which isreturned to the water course untreated.

Tilbury B power station is due toswitch from coal to operate on 100%biomass fuel between 2012 and 2015,which could increase water use. Withthe switch in fuels at Tilbury B andhigher future water scarcity costs forSizewell B and RWE Npower’s GreatYarmouth power station in 2025,Trucost believes that water scarcitycosts for all nine power plants analyzedcould push up future power prices bymore than 6%. RWE Npower hasapplied to continue operating theTilbury biomass plant beyond 2015.However, on Feb. 27, 2012, two out of


three of Tilbury’s biomass storage unitssuffered fire damage. Should thisdamage lead RWE Npower to revert toan earlier plan to replace the biomassplant with a less water-intensive com-bined cycle gas turbine alongside asmall open cycle gas turbine, theaverage industrywide electricity pricerise driven by water scarcity costs couldbe limited to less than 6%. Such amove, however, could increase GHGemissions from the plant and lead tohigher carbon costs instead.

Q. Apart from shortages, what otherwater risks are facing the east ofEngland?

A. One of the main water risks facingthe east of England is flooding. Acrossthe U.K., the government expectsflood damage costs to reach up to £27billion per year by 2080 from £1 bil-lion per year today. From 2010 to2011, its budget for flood risk man-agement was £629 million.

Flooding from rivers is likely to belimited. However, by the 2030s, the eastof England is likely to see an increase inprecipitation on the rainiest day of theyear of 7.8% (averaged over the threeUKCP09 scenarios). When set againstthe backdrop of an overall increase inwinter precipitation, increased rainfallon the wettest day of the year will inour view increase the likelihood of sur-face water flooding.

In addition, a rise in the sea levelcould intensify flood risk. Much of theeast of England lies below sea level andon a floodplain. One-fifth of the regionis low-lying, while Norfolk and Suffolkhave some of the fastest-eroding coast-line in Europe. Norfolk is most exposedto flooding, with 25% of properties atrisk. Properties are also at risk fromfloods in Essex and Cambridgeshire.These risks are set to increase, with thecoast of east England likely to see a risein the sea level of at least 44.7 centime-ters (cm) by the 2080s, in the govern-ment’s base-case scenario (which doesnot include ice melt projections).

Anglian Water has two water treat-ment works and 58 wastewater treat-

ment works located in coastal flood-plains less than 40 cm above sea leveland is therefore at risk of coastalflooding by 2080 (see chart 3). Theprojected asset value at risk forAnglian Water is up to £2.4 million by2020 and £7.5 million by 2080, basedon the UKCP09 medium greenhousegas emissions scenario and its mod-erate flood risk. We believe that Essexand Suffolk Water (under the aegis ofNorthumbrian Water) is likely to havesimilar assets at risk. Water companiesare not currently required to pay forflood defenses, although they doinvest in sewers that alleviate surfacewater flooding, which leads to extracapex requirements.

Anglian Water is investing in 20 flooddefense schemes at key water treatmentsites as part of its five-year, £1 billionprogram to address the effects of cli-mate change.

Power plants using tidal/seawaterfor cooling are also exposed to floodrisk, such as storm surges and a rise inthe sea level. For instance, followingthe 2011 earthquake in Japan andsubsequent water contamination atFukushima Dai-chi Nuclear PowerPlant, a stress test was conducted atthe Sizewell B nuclear power stationto assess risks from drought andflooding. Drought was not considereda hazard because EDF Energy receiveswater from Essex and Suffolk Water,but the generator is nevertheless cur-rently considering several enhance-ments to the plant, including improve-ments in flood protection.

Q. Are there any potential remediesthat could help alleviate water short-ages in the east of England over thelonger term?

A. Measures that we consider couldpotentially alleviate the stress on waterconsumption include central and localgovernment taking a coordinatedapproach to water management, and theinclusion of adaptation measures, suchas flood protection, in water tariffs.

Anglian Water has integrated climatechange adaptation into its business plan-

ning process for the current 2010 to 2015asset management period. Ofwat hasapproved flood protection schemes, watersupply resilience schemes, and water effi-ciency initiatives for implementation. Thecompany is considering other long-termoptions to secure water, such as majorwinter storage schemes, water re-use, andgroundwater recharge schemes. The U.K.government’s Water White Paper, pub-lished in December 2011, supportedAnglian Water’s approach to waterresilience, suggesting to us that fundingfor water efficiency measures may beeasier to secure in the future.

Nevertheless, we believe furtherresearch is needed to understand thevalue of water restrictions, togetherwith clear national guidance—particu-larly in terms of planning and design ofwater transfer schemes. Withoutincreased national and local focus onthe management of water demand,infrastructure investment alone may notbe sufficient to resolve predicted long-term water shortages. CW

Notes(1) Anglian Water is financed by Anglian

Water Services Financing PLC, whose class A debt we rate ‘A-’ and its class Bdebt ‘BBB’.Thames Water Utilities Ltd. is financedthrough Thames Water Utilities CaymanFinance Ltd., whose class A bonds we rate‘A-’ and its class B bonds ‘BBB’.Southern Water Services Ltd. is financedthrough Southern Water Services (Finance)Ltd., whose class A bonds we rate ‘A-’ andits class B bonds ‘BBB’.

(2) Scenario A1B is one of three emissionsscenarios used in the preparation of theUKCP09 projections. For more details, seethe Defra Web site http://ukclimateprojec-tions.defra.gov.uk/content/view/868/531/

(3) “Future Water—The Government’s WaterStrategy for England” (Defra), 2008.




Michael WilkinsLondon (44) 20-7176-3528

Karin ErlanderLondon (44) 20-7176-3584

Daniel Climent-SolerMadrid (34) 91-389-6940


Water

CreditWeek - CFA Institute · By Aneesh Prabhu, CFA, FRM, New York For centuries, man has known that water is key not only to life but also to economic development. As populations

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