According to a recently released report, municipal bonds, which finance a large portion of the nation’s water utilities and infrastructure, may not carry ratings that reflect the growing pool of risk surrounding the nation’s water supply. Jointly produced by Ceres and Water Asset Management, the report is one of the first to examine the significance of mounting national water crises for the municipal bond market.
Municipal bonds are bought and sold based on their credit ratings, which are assigned by rating agencies and theoretically reflect the likelihood that the bond issuer will be unable to pay investors the interest they are owed. The Ceres/WAM study points to increasingly frequent water shortages and legal disputes over allocation of dwindling resources as indicators of the growing risk associated with municipal bonds, risk that the report says are not being adequately or accurately considered in the ratings assigned to these bonds. As a result of dubious ratings, the report claims, “investors are blindly placing bets on which utilities are positioned to manage these growing risks”. The likely result of this situation is that as shortages and water rights disputes continue, utilities will find it increasingly difficult to pay back investors and that consequently, investors will see their bonds drop in value.
The report comes at a critical time: in addition to a national economy that might not be able to withstand another investment fiasco, the water crisis in many parts of the country is becoming increasingly apparent. Last Sunday, Lake Mead, the reservoir fed by the Colorado River and responsible for supplying water to Los Angeles and towns throughout the Southwest, dropped to its lowest level since it was created in the 1930s. Lake Lanier, the main reservoir for the city of Atlanta, also dropped precipitously low during a drought in 2007.
These occurrences highlight just how drastically the water security of regions across the country has changed in recent years. Even if ratings agencies have considered issues of water scarcity in the past, such considerations have likely been under ‘business-as-usual’ scenarios and do not take into account the unstable and unpredictable risks of the future. According to the report, “today, ratings take little account of utilities’ vulnerability to increased water competition, nor do they account for climate change, which is rendering utility assets obsolete”.
Perhaps not surprisingly, the utilities examined in the report refuted its findings, claiming that ignorance regarding the influence of supply and demand on municipal utilities’ business operations produced skewed results. One possible response to this criticism, however, is that if utility companies feel that experts in assessing water scarcity are ignorant of municipal market functions, couldn’t the reverse also be true? Couldn’t municipal utilities perhaps be ignorant of ecological forecasting?
While cities from Los Angeles to Atlanta issued defensive statements in response to the report’s assertions that these places faced serious risk of shortages and/or limited access in coming years, one of the most surprising responses was that of the city of Phoenix. In a public statement issued shortly after the report was released, the city said that concerns over Phoenix’s importation of water were “unjustified and unjustifiable”. It seems only logical, however, to assert that over 1.5 million people relying on water imported hundreds of miles across the desert is neither economically secure nor environmentally sustainable.
What is perhaps most confusing about this response is the apparent animosity: the report is not accusatory; it is not a competitor of the utilities it studies – it is simply an attempt to prevent economic catastrophe caused by climate change. In the specific case of Phoenix, the lead author of the study said their purpose was merely to note that importing water is both extremely expensive and energy intensive. While the defensive responses of cities and utilities seem close-minded and short-sighted, they are also explicable: if municipal bond ratings fall due to more acutely perceived risks, cities could face a sudden decline in investors. What is truly baffling is the response of the rating agencies themselves.
Like the cities mentioned above, the major rating agencies included in the report (namely, Moody’s, Standard & Poor’s, and Fitch Ratings) disputed the study’s conclusion that they were not giving enough weight to water scarcity when assigning credit ratings to municipal bonds. All of the agencies insisted that the cost of, availability of, and access to water supplies were already important factors in their analysis of municipal bonds.
A spokeswoman for S&P’s said that their rating analysis “explicitly addresses how water sufficiency and quality issues are likely to affect business and financial risk”; similarly, a statement by a Fitch rep declared that “water supply risk has consistently and transparently factored into Fitch’s ratings and analysis of municipal bonds”. None of these statements, however, imply that the agencies are doing any research about how water sufficiency may change in the near future. It seems that when so much is at stake, extra precaution in the current economic climate would be supported by agencies that are still facing the consequences of past oversights, which some claim directly caused the collapse of the housing market in 2008.
In fact, the defensive statements of ratings agencies (who, it should be noted, don’t stand to incur any obvious financial loss by issuing lower municipal bond ratings) echo those they made following the 2008 collapse. Regarding that catastrophe, a representative from Moody’s said this September that the company “considers a range of information from various market participants about factors that could affect the credit quality of the transactions we rate.” Sounds familiar, right? It should: major contributing factors to the 2008 flop are very similar to concerns raised in this month’s report regarding municipal bonds. The ratings that agencies assigned to subprime mortgages from 2006 – 2008 reflected historical patterns but failed to take into account new changes in the mortgage market; similarly, current water bond ratings seem predicated upon a past when water was abundant as opposed to a future in which freshwater supplies are uncertain at best and severely limited at worst.
The collapse of the housing market demonstrated that the models used by ratings agencies are far from perfect. It also demonstrated the dire consequences of assuming constancy in any investment market. Even if the report is too conservative in its risk analysis, even if the methodology is flawed, there seems to be little downside to engaging in this kind of cautionary thinking. It also seems sagacious to acknowledge that if leading water experts are unsure of future water supplies, it is probably true that whatever manner in which water scarcity has been factored into ratings analysis in the past is probably not fully accurate. The truth is that no one, not investors, bond issuers, rating agencies, or scientists, know how to price the risk of water scarcity. To engage in a discussion, therefore, despite the uncertainty, seems practical while refuting the possibility of miscalculation, merely foolish.