Overview

California school districts entered fiscal 2025 in a position of financial strength, partly as a result of record per pupil funding and unprecedented one-time state and federal stimulus through the years following the peak of the pandemic. These extraordinary fiscal supports have thus far helped mitigate the challenges of broad school-age population declines and rising fixed costs. However, in S&P Global Ratings' view, key challenges could lead to credit pressure over the near term, including the risk that state aid will fail to keep up with rising fixed costs and increased expenditures. We also expect California school districts' reserve positions will weaken over the next year as districts focus on aligning continuously growing expenditures with revenue in the absence of Elementary and Secondary School Emergency Relief (ESSER) funding.

S&P Global Ratings evaluates the ratings on 687 school districts across California, including school facilities improvement districts. In the period from Aug. 24, 2023, to Aug. 12, 2024, we raised ratings on 16 school districts (2% of the total) and lowered nine (1%). Furthermore, we revised the rating outlook on 15 districts (2%), putting six (1%) on positive and nine (1%) on negative. The rating outlooks on the remaining 672 districts (98%) remained stable during this period. Following the release of our "Methodology for Rating U.S. Governments," published Sept. 9, 2024, on RatingsDirect, we placed 63 California school district ratings under criteria observation (UCO), signaling that we could affirm the ratings or change them as a result of the application of new criteria. For more information on the UCO designation and our plan for reviewing ratings under the new criteria, see the UCO list and "FAQ: A Closer Look At The New Methodology For Rating U.S. Governments," published Sept. 9, 2024.

What We're Watching In 2024 And Beyond

A slowing economy could affect long-term kindergarten-through-12th-grade state funding

California closed a $46.8 billion budget deficit by cutting, delaying, and shifting expenditures to other funds while protecting kindergarten-through-12th-grade state funding. The fiscal 2025 enacted California budget provides higher per-student funding, primarily as a result of withdrawing from the state's rainy-day fund. In particular, the state budget includes $3.6 billion in deferrals and a 1.07% cost-of-living adjustment, which is significantly less than that of the last three years. We believe that the state's trend of unprecedented revenue growth over the last two years has come to an end as a result of its slowing economy, which could affect the growth rate of kindergarten-to-12th-grade funding. S&P Global Ratings' economists are forecasting steady U.S. real GDP growth of 2.7% in 2024, and are still expecting the economy to transition to below-trend growth of 1.8% in 2025. S&P Global Market Intelligence (data compiled as of September 2024) forecasts that the state's economic growth will be slightly lower than the national level in 2024 but slightly exceed the national level at 1.9% in 2025. State unemployment continues to outpace the national average and job growth has also trailed that of the nation, with declines in industries such as information, manufacturing, and construction. The state's core revenue is highly sensitive to high-income earners' earnings, which tend to fluctuate with capital markets, often leading to a boom-and-bust cycle affecting funding formula revenue. Because personal income tax revenue sources account for nearly 55% of general fund budgeted revenue, kindergarten-to-12th-grade funding would likely be a target for expenditure reductions. However, after a decline in late fiscal 2022 and early 2023, personal income tax cash receipts have been trending up, and according to the state's department of finance, were up by 6.6% this fiscal year through September 2024 relative to forecast.

Proactive approach is necessary to maintain credit quality as enrollment declines are expected to continue to exceed expectations

For most districts, average daily attendance (ADA), adjusted for specific student demographic criteria, remains the most important factor influencing operating revenue under the state funding framework. Fiscal 2024 marked the seventh straight year of statewide student population declines, and managing the revenue effects of demographic change is a common topic in our management discussions. For fiscal 2025, we expect declining enrollment will begin to materially affect district finances as recent ADA declines begin to be reflected in the calculations affecting funding.

We are seeing the largest enrollment declines in large metropolitan areas such as Los Angeles and the San Francisco Bay Area, as well as in higher-cost-of-living areas, as many households seek more affordable housing. Because we expect ADA to continue to decline for the foreseeable future for many districts, we believe that budget adjustments will be required in some cases as districts grapple with declining enrollment, uncertainties regarding the state's long-term revenue outlook, and the expiration of one-time state and federal stimulus funds. We are monitoring the progress of school districts in aligning their budgets for structural balance.

Preliminary fiscal 2025 budgets for many kindergarten-to-12th-grade school districts across the state included elimination of staff positions to achieve or maintain structural balance. However, layoffs across 94 districts throughout the state were subsequently rescinded and the enacted state fiscal 2025 budget suspended the Aug. 15 layoff deadline for certified and classified staff. We view the layoff suspension as a short-term remedy and, absent sustainable improvements to kindergarten to 12th-grade school district revenue structure, we expect that some districts may find reduction in staffing necessary over the near to medium term.

Some districts have begun to make adjustments to their budgets, including updating multiyear projections, adjusting class sizes, implementing programs and initiatives to boost classroom engagement and attendance, factoring in attrition to reduce head count to match enrollment, and managing personnel expenses. Some school districts have also begun to consider merging or closing schools as a result of declining enrollment, but school closure decisions are politically challenging and may take time to translate into financial relief.

A 10% reserve cap of expenditures wasn't triggered in fiscal 2025, but we expect districts' reserves to weaken as a result of primarily spending down one-time state stimulus funds

The reserve cap, which limits local reserves to 10% of general fund expenditures, was enacted in 2014 and became law after voters approved Proposition 2, the state's rainy-day fund for kindergarten-to-12th-grade schools and community colleges. The 10% reserve cap was not triggered for fiscal 2025, and according to the state's fiscal 2025 enacted budget, it is not projected to be triggered in fiscal 2026. However, we expect school district reserves to continue to decline over the next year as districts spend down one-time state grant funding. We also expect school districts, which continue to prioritize learning loss, to fund some expenditures that federal stimulus funding once covered. To the extent that these draws stem from unaddressed structural budget deficits, this could lead to rating pressure.

California Child Victims Act

The California Child Victims Act (Assembly, or AB, 218) was signed into law in 2019, significantly reforming the statute of limitations for child sexual abuse cases, extending the time in which victims can come forward and seek justice. We believe this law may negatively affect school districts, given that insurance rarely covers such claims. Districts may face substantial financial liabilities for child sexual abuse cases if current or former employees are found liable for these sorts of crimes, and a declining reserve position and/or rise in debt burden could occur if judgment obligations are issued. While the scope of this liability risk remains unknown, we believe the passage of AB 218 increases the uncertainty over this potentially devastating impact on individual districts' finances. Should a district be found liable for a substantial sum that results in either a material drawdown in reserves or the issuance of a material amount of judgment obligation bonds, then we could lower the ratings by one or more notches.

Spotlight On Environmental, Social, Governance Factors

School districts are exposed to various acute physical risks stemming from wildfires and droughts as well as chronic issues resulting from extreme heat, flooding, and sea-level rise. Although the risks vary by region, our rating analyses incorporate an obligor's preparedness through review of long-term financial and capital planning documents as well as any specific resiliency or emergency plans. Furthermore, the state experiences natural disasters from earthquakes, but has robust building codes to bolster resiliency, which we view positively. We will continue to take into account how pervasive drought conditions and other environmental risks might affect population and economic growth for each district.

California's shortage of affordable housing and high social service costs as a result of income disparity are significant. The state addresses this issue for school districts through concentration grants that provide additional aid under the state funding formula. Exacerbating the enrollment trends are declining birth rates and recent declines in population, the latter of which is partly attributed to residents moving to states with lower costs of living. While the latest data shows the state population rebounding as of 2024, should weaker demographic trends continue, this could significantly affect school districts that depend on the per pupil funding formula, especially as the state's pension managers project that contribution requirements are likely to rise through the middle of the decade, potentially encroaching on other spending priorities. (See "No Quick Fix For The U.S. Affordable Housing Shortage," published Aug. 21, 2024.)

Finally, state oversight of school districts' financial health and disclosure requirements helps underscore credit fundamentals, and the state has an institutionalized practice of providing liquidity and assuming financial controls during periods of financial distress by appointing a state administrator to replace the district's superintendent and school board. We find this system generally effective in stabilizing districts' finances and operations, though the recovery can be prolonged, which leads to our overall neutral view of governance for the portfolio.

Kindergarten-to-12th-grade school districts have also experienced sharp increases in cyber attacks in recent years, including several significant attacks on California school districts. However, we have observed no long-term operational or material financial effects on credit quality, especially as cyber risk mitigation strategies have become more sophisticated. (See "Cyber Risk Insights: U.S. K-12 Schools Are A Playground For Cyber Criminals," published Oct. 24, 2023.)

California School District Local Governments Data

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