S&P Global Ratings maintains long-term ratings on more than 1,600 municipal water and wastewater utilities in the U.S. Our ratings in the sector include utilities that use a combined pledge (consisting of both water and sewer revenues), as well as those that issue separately secured utility debt (for example, water-only or sewer-only revenue bonds). Our data set excludes debt issued by either wholesalers or state agencies to fund water and wastewater projects. We base our median ratios on statistical information from our municipal retail water and sewer utility public ratings. These medians are not requirements for any particular rating but rather reflect the sector's general credit trends at the specified levels. As economic conditions and the number of rated utilities change so will the reported medians. Most key financial median ratios including available liquidity median metrics improved although at a slower rate than the previous period, reflecting the rated municipal water and sewer utility sector's stability despite mounting cost pressures. This is evident in median liquidity levels rising to 546 days' cash on hand (DCOH) in fiscal 2022, despite utilities' average operating expenses increasing by 8% year-over-year.

Our median financial metrics for rated municipal water and sewer utilities remain healthy, reflecting stable financial profiles and the favorable funding environment provided by federal relief and infrastructure support funding. We consider municipal utilities' access to capital to be still relatively strong. However, funding costs are rising, operational bottlenecks (such as labor availability, and raw-material sourcing) could slow the delivery of additional investments, and large related capital funding needs could tighten rating headroom for utilities that have not prepared their balance sheets to absorb them.

We expect there will likely be continued pressure on rate affordability because the cost of water and wastewater treatment is expected to rise faster than inflation as utilities replace aging infrastructure, invest in new or alternative sources of supply, and respond to more-stringent federal and state regulations. Utilities will need to strike a good balance between capital investments and affordability in the long term to preserve credit quality. We expect credit quality for water and sewer utilities will remain sound for the remainder of 2023, building on the strong performance in recent years. Median debt service coverage (DSC) and cash remained at all-time high levels, supported by an infusion of federal grants. Most utilities have the financial capacity to support additional debt requirements and rising costs that might be necessary to pay for infrastructure or alternative supplies to improve resiliency. However, we view smaller utilities as having greater exposure to credit pressures given, on average, staff limitations, infrastructure deficiencies, and smaller rate bases across which to spread fixed costs.

Stable Rating Activity, But Potential Risks Ahead

About 46% of the water and sewer utilities are in the 'AA' category, 42% are in the 'A' category, 7% are in the 'AAA' category, and fewer than 5% are in the 'BBB' category or lower (see chart 1). The ratings distribution reflects the retail utilities' generally very strong enterprise and financial risk profiles supported by strong demographic and financial characteristics. The majority of ratings nationally remain at 'A+' and 'AA-'. The 'A+' and 'AA-' rating levels, collectively, account for nearly 40% of the total, reflecting the sector's very low risk and monopolistic provision of essential services. Reflective of our stable view for the sector, 96% of ratings had a stable outlook as of Aug. 31, 2023, with 3% carrying a negative outlook and about 1% have a positive outlook (see chart 2).

Chart 1

Chart 2

Compared with previous years, the ratings distribution generally reflects minimal changes. During 2022, upgrades outpaced downgrades by a two-to-one margin, reflecting overall stable rating activity last year. However, we observed a more balanced trend in the first half of 2023 (upgrades and downgrades were about even), with negative rating actions primarily fueled by deterioration in financial metrics, pressured by escalating operating expenses and sizable capital needs. In addition, few downgrades were also attributed to weak operational management, characterized by regulatory violations and vulnerable asset adequacy.

Outlook trends have generally remained consistent with previous years. Negative outlooks mostly reflect weakening financial metrics due to weak long-term risk-mitigation strategies, while positive outlooks reflect service area economic diversification, and improving financial and risk-mitigation strategies.

National Medians Exceed Pre-Pandemic Balance-Sheet Ratios, But Challenges Can Vary By Region

Looking at the pre-pandemic trend line (fiscal 2019), we observed healthy gains in net revenues (operating revenues less expenses and depreciation) for debt service across rating categories: for example, national medians for all-in DSC improved to 2.1x in fiscal 2022 from 1.8x in fiscal 2019. More notably, liquidity reserves have improved and were maintained in fiscal 2022 relative to fiscal 2019, even at the lower-rated utilities: 'BBB' category utilities have increased DCOH to nearly 200, up from 138 in fiscal 2019, while national median liquidity improved to 546 days in fiscal 2022 from 460 days in fiscal 2019.

Chart 3

Comparing expenses across rating levels, we see above-average growth in expenses--likely attributable to inflationary pressures. Our data suggest that utilities have experienced an uptick in operating costs post-pandemic, as evidenced by increases in expenses and operating budgets across all states. Nationwide, operating expenses (8% average increase) as of fiscal year-end 2022 almost doubled from the previous year. However, this increase has not yet had a negative effect on credit quality as rate adjustments and federal support (in the form of grants and infrastructure funding) have also increased across the board. On average, many of our rated utilities lowered their debt service costs from 2020-2022 due to refinancing activities, which, when coupled with increased revenue and higher costs, led to stable financial performance across ratings and all the largest states.

The Path To Asset Resilience Could Look Different For Every Region

By state, the modal, or most common, rating doesn't differ significantly, although some states (such as Alaska and Minnesota) have only a handful of ratings combined. For states with more than 25 ratings, the modal rating is usually in the 'A' category, except for eight states: California, Colorado, Florida, North Carolina, South Carolina, Texas, Utah, and Washington. The modal rating for these eight states is in the 'AA' category. Generally, statewide economic conditions, coupled with strong financial and operational management, skew ratings higher in these states. In addition, we note the strong management acumen offsets some of the above-average climate exposure within these states.

Due to aging infrastructure and more-stringent regulations, we anticipate forecast capital spending will primarily focus on infrastructure replacements in most regions and potential growth initiatives in faster-growing areas in the Mountain states and the South. In our latest Sustainability Insights research report, "Lost Water: Challenges And Opportunities," published Sept. 6, 2023, on RatingsDirect, we look at water-infrastructure challenges through the lens of nonrevenue water (NRW) or lost water opportunity. Greater focus on climate-resilience and adaptation projects could increase investment in water infrastructure, including reducing NRW. However, this would likely require more attention from public and private investors. We expect the cost of building resiliency into operations and infrastructure to address these rising risks to be borne by ratepayers, which could heighten affordability risks in the long term.

We rate utility revenue-backed bonds in almost every U.S. state, although the number of ratings depends on many factors, including access to state bond banks, bond issuance restrictions, and population. For analytical purposes, we divide the country into 10 regions consistent with the Environmental Protection Agency's categories. These regions share some characteristics such as climate, hydrology, consumption, agriculture, sources of water supply, state and regional environmental regulations, and economic attributes.

High inflation creates some volatility in credit metrics, with lower net revenues for debt service from higher-than-expected operating costs (assuming nominal growth in revenues). We observe that several utilities east of the Mississippi tend to have all-in DSC metrics that are below the national median combined with higher leverage (debt-to-capitalization ratio). This could imply that these utilities might have lesser financial capacity in a rising cost-of-service environment. Utilities west of the Mississippi tend to have stronger all-in DSC metrics compared with the national median and lower leverage (debt-to-capitalization ratio), which should somewhat buffer the effects of inflationary pressures backed by better financial capacity to support additional debt needs that are necessary to pay for asset resiliency.

Operational challenges can also vary across regions. Utilities east of the Mississippi tend to have ample water supply but deal more with aging infrastructure issues, particularly in older urban New England, Mid-Atlantic, and New York areas. Utilities west of the Mississippi tend to have a greater focus on water scarcity and supply reliability and diversification. Furthermore, many utilities in the Mountain and South regions face the challenges of a growing population, and a limited and vulnerable water supply, which necessitates higher investments in diverse supplies and storage. Even as the path to asset resilience can look different for each utility, adopting robust asset-management and emergency preparedness policies in addition to rate-making and budgetary flexibility would improve their ability to react to system challenges, which, in our view, would preserve consistent financial performance.

Medians By Rating

We generally see that many of the enterprise and financial risk profile medians tend to improve with credit quality (see chart 4). Not surprisingly, higher-rated utilities will have enterprise and financial risk profile scores at the lower (more favorable) end of the scale. Many higher-rated utilities tend to be in major metropolitan areas and therefore can spread fixed costs across a larger customer base; others are newer systems with fewer capital needs associated with maintaining aging infrastructure. Lower-rated utilities have higher (less favorable) enterprise and financial risk profile scores, and the common credit weaknesses include limited economies, low incomes, slim coverage, and lower liquidity levels especially on an absolute basis. They also tend to have below-average operational and financial management assessment scores, stemming from reactive policies and a lack of best practices. Charts 5 and 6 provide more detailed information regarding the specific criteria areas that comprise the broader enterprise and financial risk profiles. (Note that '1' is the most favorable assessment score on a six-point scale.)

Chart 4

Chart 5

Chart 6

Table 1

Large Utilities Are Better Equipped To Handle Rising Costs

Another factor we considered are medians by utility size (see table 2). Nearly 75% of utilities tracked by S&P Global Ratings fall into the small and very small categories (less than $5 million-$25 million in annual operating revenues).

Table 2

Because of their size, large utilities continue to benefit from economies of scale compared with their smaller counterparts. Operating expenses at small and very small utilities (with less than $25 million in operating revenues) have increased about 10% year over year, and even more significantly when compared with fiscal 2020. Large and very large utilities (more than $75 million in operating revenues) have also seen expenses rise; however, their total costs are up only about 5% since last year. Larger utilities benefit from a stronger cushion to absorb costs as seen by their strong median all-in DSC and liquidity metrics (above the national medians) compared with below-average financial metrics and approximately $5 million in absolute cash for smaller utilities. This divergence is also seen in the leverage median ratios, which are considerably higher at small utilities.

Chart 7

Finally, larger utilities have increased their overall revenue by more than 10% since 2020, while smaller utilities typically have less available financial capacity. Overall, large utilities seem to be better positioned to manage regulatory demands given healthier financial profiles, while smaller utilities could be vulnerable to changing regulations and are showing signs of weakening margins in a slowing economy with rising service costs.

Tax-Backed Utilities: Operating Risk Is Somewhat Mitigated By Taxing Flexibility

In our criteria, "U.S. Municipal Water, Sewer, And Solid Waste Utilities: Methodology And Assumptions," published April 14, 2022, we expanded our scope to cover all utilities with water and sewer operations, including tax-secured debt issuances that were previously rated under our "GO Debt" criteria, published Oct. 12, 2006. We believe it is impractical to attempt to separate tax revenues levied on behalf of tax-backed utilities from their operations. The effects of tax revenues or tax pledges are best evaluated holistically as part of our "Water and Sewer" criteria, and we view taxes as not otherwise insulated from the operating risk of the tax-backed utility.

Our criteria allow for a more-flexible approach to additional notching benefits to the operating stand-alone credit profile (SACP) based on the use of modifiers or adjustments to better capture relevant consideration of tax support for these utility providers. In general, higher tax-notching benefits (up to four notches) are applied to those utility districts with a large and growing tax base and where there exists a willingness and ability to increase tax levies for debt service or operations. We recognize that utility districts with taxing powers can lower pressure on utility rates by effectively balancing their taxing and rate-setting authority. For example, although water-rate revenue is directly related to water consumption, the tax component could act as a buffer to stabilize revenue in the event water consumption declines. Based on our review of tax-secured utilities, nearly 70% of these utilities are highly rated and fall under the 'AA' and 'AAA' rating categories.

Chart 8

Based on our assessment, we note that about 70% of tax-backed utilities did not receive any tax-notching benefit, which could imply that we view their tax pledge on parity with the operating net revenue pledge for bondholders. For the remainder, the majority (29%) of tax-backed utilities received a favorable one-notch benefit. In our observation of tax-backed utilities, we note that several of these utilities do not levy considerable taxes (despite having taxing powers) and they tend to rely more on rate revenue to manage their budgets. In some cases, state tax restrictions limit tax-raising flexibility that limits adding supplementary tax revenues to their operations. Given the capital-intensive nature of the utility sector, we anticipate tax-backed utilities to refine decisions around ratepayer funding of its operating and capital needs in the long term, thereby relying less on taxpayer support.

What We're Watching

Most water and wastewater utilities entered 2023 with strong financial flexibility and liquidity levels and, as of Aug. 31, 2023, we maintain a stable outlook on 96% of the utilities we rate. Unless we see significant budget pressure from regulations or water-supply challenges, we expect the credit quality of utilities will remain stable through the end of the year and into 2024. Our ratings increasingly reflect medium-to-large utilities scaling up their capital and maintenance programs while maintaining steady financial capacity and experiencing less credit volatility than small utilities. However, while we anticipate general stability across the sector, credit stress among small utilities could continue, as operating pressures mount due to rising costs and labor challenges, which could weaken financial performance. Weather and cyber events, management turnover, and poor governance and risk management, among other occurrences, can also constrain operating flexibility.