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October 28, 2010
Water Scarcity Is a Growing Risk for Public Utilities and for Investors in Municipal Bonds
    by Robert Kropp

A report from Ceres and Water Asset Management finds inadequate disclosure of risks by public water and electric utilities, and that rating agencies may foster wasteful consumption by ignoring risks.

Water scarcity is the issue through which climate change is most likely to be felt, according to CDP Water Disclosure. Quoting a finding by the Organization for Economic Cooperation and Development (OECD) that "47% of world population will be living in areas of high water stress by 2030 unless new policies are introduced," CDP Water Disclosure states, "Corporations that measure their water usage are better able to manage it."

A report entitled
The Ripple Effect: Water Risk in the Municipal Bond Market, published this week by Ceres and Water Asset Management, focuses on municipal bonds, which, the report states, is "the debt instrument of choice for public utilities," which include both public water and electric power utilities.

Citing increases in extreme droughts, water demand, and water pollution, the report states, "These trends present real risks for investors who supply the vast amount of capital needed to build and maintain the nation’s water and power infrastructure."

In a
press conference announcing the report's publication, Matthew Diserio, President of Water Asset Management, said, "Municipal and public agency bonds from water-stressed regions in the US are often issued with much less information about water supply availability and the associated risk disclosure requirements than the information supplied by investor-owned utilities, which are regulated by each state's public utility commission along with the Securities and Exchange Commission (SEC), if they are publicly traded."

The report applies a quantitative model developed by
PricewaterhouseCoopers (PwC) to six water bonds
and two electric power bonds. Among the six water utility bonds, those issued by the Los Angeles Department of Water & Power and Atlanta’s Water and Sewer System received the highest risk scores. The two electric utility bonds, Alabama’s PowerSouth Energy Cooperative and the Los Angeles electric power system, also received high risk scores.

Regarding these findings, Mindy Lubber, President of Ceres, said, "Our report makes clear that this risk scenario is a distinct possibility for utilities in water-stressed regions and bond investors should be aware of it." At the press conference, she added, "Despite the risks, all eight bonds have received generally favorable ratings. Investors should treat water availability as a growing credit risk in utility bonds."

The major credit rating agencies— Moody’s Investors Service, Standard & Poors, and Fitch—already buffeted by charges of effectively enabling the financial crisis by providing inflated ratings that misled investors into believing that securities consisting of subprime mortgage loans were credit-worthy, came into their share of criticism in the report as well. According to the report, the methodologies of the rating agencies "largely ignore water risk and may even unintentionally foster wasteful water consumption."

"Many credit ratings reward pricing and infrastructure plans that encourage increased water use and revenue growth with disregard for even near-term supply constraints and likely disruptions," the report continued.

At the press conference, Lubber said, "Credit rating agencies should be giving more attention to water scarcity in their utility bond ratings."

The report makes clear the risk to investors when utilities "fail to factor water stress into water or power pricing, debt reserves and capital expenditures," and rating agencies do not "reward water utilities for having water pricing that reflects scarcity and encourages conservation or for selecting supply alternatives that boost local resources in favor of risky water imports." In such a scenario, investors are left "with insufficient information for managing their potential exposure in holding such bonds," the report states.

However, as Diserio of Water Asset Management said at the press conference, "The solutions are readily available to address water supply and quality challenges." The report provides recommendations for utilities, credit rating agencies, and investors.

For utilities, the report recommends improved disclosure of water stresses, the implementation of strategies to manage demand and reduce leakage, and infrastructure investments to reduce risk. As the report found, "More than 18 billion gallons per day of water are lost to leakage, poor accounting and other unbilled consumption. These losses are estimated at an annual cost of $2.6 billion."

Rating agencies are advised to conduct water risk stress tests, consider water intensity when rating electric utilities, and reward utilities that manage water demand with higher ratings.

"The historical assumption that water will always be there may no longer be the case," Diserio said. "A greater degree of disclosure and analysis is a first step toward addressing those challenges."

The report recommends that investors engage with utilities to encourage better disclosure of water risks, encourage their asset managers to assess and engage utilities on water risks, and request that the Municipal Securities Rulemaking Board and the SEC "provide guidance to issuers and underwriters regarding disclosure of material water and climate risks."

At the press conference, Bruce M. Kahn, Director and Senior Investment Analyst at
Deutsche Bank Climate Change Advisors (DBCCA), said, "This report is a first step in how we as asset managers can look at the issue of water scarcity and how it affects municipal bonds."


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