Despite better than anticipated snowpack throughout the western U.S. and ongoing efforts to mitigate the effects of drought and aridification, longer term prospects for the Colorado River remain dire. Actions taken to date have been insufficient to turn the tide, prompting the United States Bureau of Reclamation (USBR) to release the draft SEIS, which affects water systems and hydroelectric power production in the Lower Basin states (Arizona, California, and Nevada) that rely on the Colorado River system. We believe the intention of the SEIS is to spur the seven effected states to agree to a set of priorities specifically past 2026, when a current set of guidelines (established in 2007) expires. The 2007 Colorado River Interim Guidelines addressed the issue of water shortages in the basin and linked the operations of Lake Powell and Lake Mead, but key stakeholders agree that a more comprehensive set of cuts will be necessary to fully address operations within the Colorado River watershed in the future.

On April 20, the Bureau of Reclamation released its April 24-Month Study, which provides a mid-year review of the Colorado River Basin hydrology, projects water levels at the major Colorado River reservoirs for the proceeding two years, and provides an early look at January 2024 projections for river operations. Following this winter's storms, and with near-record snowpack in the basin and a 20-foot increase is projected in Lake Mead's elevation, which should provide greater flexibility in garnering a consensus on a short-term solution. Furthermore, intentionally created surpluses (ICS) from offtakers, such as the Metropolitan Water District of Southern California (MWD), may be larger than anticipated given favorable supply conditions.

Proposal Focuses On Lower Basin, Leaving Upper Basin Untouched

The SEIS proposal outlines three options. The first is a "no action" proposal, which could further stress the system's hydroelectric conditions and reservoir levels, increasing the risk of even more severe supply disruption, which we view as a longer-term credit risk.

The other two options (Action Alternative One and Action Alternative Two) would both significantly accelerate the curtailment for Lower Basin states from the current guidelines:

• One alternative lowers water releases based on the concept of priority, while the other applies an equal reduction across all Lower Basin water users, regardless of priority.
• Nevada's respective curtailments are relatively similar in both proposals.
• Upper Basin states are unaffected in both proposals.
• Water deliveries to Mexico are also unchanged in both proposals, maintaining the provisions of the 1944 Water Treaty.

The largest difference between the two remaining proposals is the level of water cuts placed on Arizona versus California (as illustrated below). We believe both scenarios will be difficult to implement given legal hurdles and the elevated level of curtailment suggested. Furthermore, a solution that addresses only the Lower Basin, rather than all stakeholders, could raise objections. Finally, the allocation of mandated water cuts within each state is uncertain, thus, there is a possibility that restrictions could fall more heavily on municipal users versus agricultural, or vice versa, both of which increase credit risk.

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Proposals Unlikely To Spark Significant Rating Changes

In "Western U.S. Drought: Declining Supply, Rising Challenges", published Aug. 16, 2022, S&P Global Ratings noted that water rights that were once viewed as certain are being questioned and may be superseded by state or federal efforts, leading to potential changes in rating fundamentals. We view actions to stabilize the basin as beneficial to long-term credit quality for the offtakers as they reduce the likelihood of either "dead pool" (when water in a reservoir drops so low that it can't flow downstream from the dam) or "minimum power pool elevation" (when a dam no longer has enough water to generate hydroelectricity). The approach, however, could have varied effects on credit quality, depending on a utility's water supply portfolio and financial flexibility. The 2026 renegotiations are expected to be more contentious and influential, albeit, outside the current outlook period.

Our ratings for U.S. not-for-profit water utilities assess whether utilities have sufficient financial capacity to meet their current obligations in the existing operating environment. As the situation evolves, S&P Global Ratings will assess whether the proposals or the pending 2026 renegotiation of the 2007 Interim Guidelines affects our assessment of asset adequacy under our criteria. Financial performance can be countercyclical to drought conditions for most utilities (i.e. wet years result in lower revenues and dry years higher revenues). In addition, we assess what future obligations may be required to provide reliable water to the customer base. This includes procuring additional supply, access to storage and stored water, and upgrading infrastructure. We then assess how future obligations will influence financial performance--including their sway on affordability and financial metrics.

Looking Beyond Conservation

Overall, we continue to believe the Colorado River offtakers are adequately positioned to navigate water supply challenges. While some credit characteristics may weaken over time, we anticipate few rating actions linked to either SEIS alternative, if adopted, due to the Lower Basin's:

Substantial storage.   Most offtakers have several years of immediate access to stored water (through surface or aquifer storage) or access to alternative supplies.

Conservation programs.  Many utilities have experience managing mandatory or voluntary conservation programs. They typically focus on outdoor irrigation and historically have achieved double-digit reductions in demand on a short-term basis. The potential problem is that most of the "low hanging fruit" has already been implemented in some states, and we believe incremental demand savings will be more difficult.

Financial capacity.  Most western region utilities have the financial capacity to support the additional debt and operating costs that may be necessary to pay for infrastructure or alternative supplies to improve resiliency. Coverage and cash are at peak levels and federal funding provides an additional infusion. Furthermore, while a customer base that is large and growing presents challenges, it also improves scale--which provides greater financial capacity to support any necessary additional infrastructure.

Affordable rates despite rising water costs.   Utilities need to develop supplemental supplies to offset reductions in Colorado River allocations but the challenge is potential new options could be significantly more expensive. However, the average water bill for the three Lower Basin states, using the major wholesaler rates and retail rates of rated issuers as a proxy, is well below 1% of median household income, which provides managers with significant rate-setting flexibility. Those with regulatory pressures and redundancy needs may face greater challenges but given the essentiality of service, we believe elasticity of demand is favorable. It's a question of utilities communicating the essentiality of creating greater redundancies in the system to customers.

While we don't anticipate significant rating changes, continued supply scarcity and increased federal intervention creates uncertainty in the operating environment, which will pressure utilities' long-term planning and management. Water rights uncertainty or unanticipated reductions in supply may hinder planning efforts, threaten interagency agreements, and stress storage.

While storage is ample, some is not accessible without infrastructure investment and construction, which takes time and funding to achieve. Further, some storage may not be accessible to areas that require supplemental supply. Economic impacts, especially to agriculture, could influence population, employment, income and gross county and state economic output.

Utilities' financial performance could weaken due to reduced revenues from greater conservation or increased operating expenses from water purchases or additional treatment, especially for utilities with rate structures that don't have mechanisms to stabilize revenues such as drought surcharges and resiliency components. Leverage may be exacerbated by the need to develop supplemental supplies or infrastructure to access stored supplies.

Improved Supplies Ease Some Pressure On Lower Basin

The draft SEIS is intended to improve operating integrity for hydropower assets and support basin recovery overtime. Given the improved hydrological outlook and challenges related to implementation of the USBR alternatives, we believe the greater likelihood is that the draft SEIS leads to a seven-state compromise for the interim period before the 2026 renegotiations. The proposals include Lower Basin states reducing deliveries beyond what was agreed upon in the Drought Contingency Plan, as outlined below.

Table 1

Any consensus decision we view as a short-term fix. The pending 2026 renegotiation of the 2007 Interim Guidelines (also known as the Colorado River Interim Guidelines for Lower Basin Shortages and Coordinated Operations for Lake Powell and Lake Mead) likely will be contentious given the utilities' conflicting interests, which include balancing urban and agricultural use, priority rights, tribal interests, environmental considerations, and affordability.

Fortunately, the surface and groundwater supplies in Arizona and California (in addition to the Colorado River watershed) have improved with this year's above average snow and rain, augmenting alternative supply options this year, such as from the Salt (230% of average) and Verde (450% of average) rivers in Arizona as well as the State Water Project (100% allocation) and Los Angeles Aqueduct (296% of average) in California. Utilities with diverse alternative resources should be better positioned to navigate the potential additional curtailments. Nevada, while significantly more dependent on Colorado River, continues to have best-in-class demand management, which we expect will help it manage through the current challenges. All three Lower Basin states (Arizona, California, and Nevada) have substantial storage, which supports our view of credit quality.

Proposals Will Bring Parties To The Table But All Eyes Are On The 2026 Renegotiations

We expect the draft SEIS will encourage all parties to come to the table to find a bridge solution to address supply vulnerabilities. However, timeliness in execution is an important consideration to avoid acute supply stress. We believe any solution not based on legally established water rights is more vulnerable to litigation and thus more difficult to implement. Although USBR can address extraordinary circumstances, under Section 7(D) of the 2007 Interim Guidelines, the ability to override legally established water rights is unclear. We will monitor negotiations and the role the federal government takes. We will also monitor whether the prospect of longer-term scarcity triggers a discussion to establish a minimum delivery level for health and safety for municipal and industrial users.

We will also monitor the political landscape with respect to rate setting. The cost of water in Arizona and Nevada is extremely low compared with California. This is partly the result of California investing in alternative supplies, which are higher in cost. The cost of water in California can serve as a lens to the potential future water costs in Arizona and Nevada. The ability to pass through higher water costs to customers in Arizona and Nevada will be critical to utilities' credit quality. The highest-rated issuers will manage both supply and demand.

A final decision from the USBR is expected in August, following the public comment period, and will affect utility operations in 2024 and potentially in 2025. We also note that the decision made in the next two years may also influence the 2026 renegotiations, which will determine Lower Basin state's water strategies for years to come.

Editor: Michelle Jew.