The threat of water risk in the US municipal bond market

The subprime mortgage meltdown demonstrated the need for a more comprehensive understanding of possible risks to long-term investments. The growing discipline of “sustainability” – the consideration of social and environmental factors traditionally considered external to business practice – offers us a broadened platform for evaluating current and future risks, and moving to mitigate them. An important start would be to ask ourselves logical questions about the future reliability of the natural resources underpinning economic activity. Our economy is funded in part by long-term credit, which in part depends on the long-term stability of natural resources, such as water and energy that are critical to any business plan. Municipal bonds are a classic long-term investment vehicle: unlike stocks, most investors hold them for long durations and assume they will be safe investments over the life of the bond. The bonds themselves are issued to fund major infrastructure projects, such as water storage, sewage treatment and electric power production, which support economic activity. Any hidden risks in municipal bonds are a threat both to their direct investors, but also the broader U.S. economy. In a new report, The Ripple Effect: Water Risk in the Municipal Bond Market, Ceres, a coalition of institutional investors and sustainability organizations, partnered with stakeholders including Water Asset Management and Deutsche Bank’s Climate Change Investment Research Group, to create a framework for evaluating resource risk – specifically, water scarcity risks in municipal bonds. The report examined investment-grade water and electric utility bonds issued by major cities – including Los Angeles, Phoenix, Atlanta, Dallas, and Ft. Worth – that are experiencing simultaneous population growth and water availability constraints.The report shows that these utilities face moderate to severe water shortfalls in the coming years due to growing water scarcity, legal conflicts and other supply risks. Yet, these water risks do not appear to be reflected in the bonds and bond ratings that public utilities rely on to finance their infrastructure projects. These issues extend far beyond the eight U.S. cities analyzed in the report. Many other public water supplies around the country – more than 80 percent of Americans get their water from 50,000 public water utilities – are also facing water constraints due to surging water demand, pollution and more frequent drought. Electric utilities that use vast amounts of water for hydropower and cooling turbines face similar challenges.
These challenges are compounded by the water and electric power sectors’ increasing need to issue billions of dollars of new debt – primarily to upgrade aging infrastructure, but also to develop new water supplies from ever-remote locations. For example, Las Vegas, hard pressed to make up for shortfalls from dwindling Lake Mead, wants to build a $3.5 billion, 300-mile long pipeline to deliver water from rural northeastern Nevada. A $13 billion water diversion project is also being considered in California to satisfy secure the state’s imperiled water system. The report includes a model, developed by PricewaterhouseCoopers, to help investors quantify water risks to bond issuers. The model was applied to eight public utilities – six water and two electric power utilities – and generated water risk ratings under several different “stress tests” or water risk scenarios. The Los Angeles and Atlanta water utility system bonds received the highest scores, followed by the Phoenix and Glendale, AZ utilities. Despite these widely differing risks, all of the bonds that were evaluated
received generally favorable, often stable ratings from Fitch, Moody’s and Standard & Poor’s. A key report conclusion is that credit ratings agencies could improve their methods of factoring in water scarcity risks. The report offers a detailed set of recommendations for utilities, rating agencies and underwriters and investors to better manage this challenge. Better disclosure, stress testing, and a stronger focus on strategies that incentivize water conservation are just a few of the recommendations. The report has begun an important conversation among bond underwriters, utilities, rating agencies and investors about how to address this issue. Many raters and issuers took issue with our analysis and offered examples of where they were taking water risks into consideration. We offered an initial framework for this type of analysis, and we hope this conversation will result in the development of an accepted methodology for examining water risk in municipal utility bonds – one that any interested party can clearly understand and rely on. More broadly, hidden risk is not just confined to the municipal bond market, and sustainability risks are notlimited to water availability. Deutsche and Ceres both want to emphasize the growing importance of assessing these and other long-term sustainability trends and risks across all investment platforms – whether they are stocks or fixed income assets.
Our global economy is changing and it will require its participants to be more open and rigorous about understanding the connections between long-term economic prosperity and pressing sustainability threats such as climate change, population growth and resource scarcity. Considering the enormous challenges ahead, from restoring our credit markets to rebuilding failing public infrastructure, to addressing increasing tensions between our economy and the health of the natural world that supports it, we can’t afford to ignore them any longer.

This article was authored by Bruce Kahn, director and senior investment analyst at Deutsche Bank Climate Change Advisors and Mindy Lubber, president of Ceres. Link to report