Most key financial median ratios diminished slightly compared with recent historical periods, reflecting the rated municipal water and sewer utility sector's increased pressure from rising costs. This is evident in median liquidity levels declining to a still robust 514 days' cash on hand in fiscal 2023 from 546 days in the previous fiscal year, due primarily to a growing expense base and limited strengthening of reserves, while median coverage declined 10 basis points year over year. Upcoming budgets for water and sewer utilities are already reflecting higher operating costs, and while larger utilities have benefited from economies of scale, smaller utilities faced challenges in a rising cost-of-service environment.

S&P Global Ratings continues to affirm most of its ratings, but a negative bias on rating actions remains in 2024. These actions are generally due to strained cash flow, with financial metrics that no longer provide adequate financial capacity. During the first three quarters through 2024, rating actions skewed more negatively as the utility sector experienced more downgrades than upgrades. We expect the utility sector credit quality will be tempered by emerging regulatory requirements, affordability pressures associated with accelerating capital spending, and the relatively high cost of operations. Consistent with our negative sector view, we anticipate potential weakening of financial performance in the near term, and increased risk for structural imbalance for any utility without a close alignment between demand and fixed-cost recovery.

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 wholesalers or state agencies to fund water and wastewater projects, and solid waste utilities. 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.

Utility Sector View Remains Negative

We maintained our negative sector view starting mid-2024 for the municipal water and sewer sector, given our unfavorable trend of rating and outlook actions, and limited improvement or uneven performance trends for many utilities. However, management actions on rate adjustments, easing of inflationary pressures, and recent federal policy rate cuts that could lower borrowing costs could provide some stability to utilities in the medium term. Conversely, labor costs are expected to continue to rise given the persistent above-average vacancy rates and regulatory uncertainty remains which could further pressure margins. Our view of the retail water and sewer utility rating trends, which influence our sector view, along with consideration to revise our sector view, could be informed by:

• Underlying financial performance trends, including expense and revenue drivers as well as key assumptions in forecasts;
• The magnitude of capital spending needs and funding sources, supported by adequate financial and debt capacity; and
• Outlook revision trends and the pace and resolution of ratings that already carry a negative outlook.

There will likely continue to be a negative bias on our rating actions this year, given negative rating actions exceeded positive ones in the third quarter of 2024.

Rating Distribution Is Stable, But Rating Activity Has Been Net Negative

The number of ratings at the higher end of the spectrum fell slightly

Although the number of rating changes or the addition of new issuers can change the rating distribution from year to year, significant movement between rating categories is unusual, and our rating distribution remains fairly similar to that of previous years (see chart 1). However, the number of ratings in the 'AAA' and 'AA' categories fell 2%, while the 'A' category was net neutral (as those gains were offset by a similar shift to the 'BBB' category). As a result, the number of ratings in the 'BBB' category or lower rose nearly 2% in 2024, indicating a weakening in overall credit quality at the higher end of our rated universe with a modest shift toward the lower end of the spectrum. Our most common rating nationally remains 'A+', which is consistent with previous years.

Chart 1

Downgrades continue to outpace upgrades

During the first three quarters of 2024, the ratio of downgrades to upgrades increased to 1.7-to-1.0, mostly due to weakening credit quality (see chart 2). Medians across rating categories have not been immune from sector difficulties and have exhibited a slight weakening in financial metrics. Amid this backdrop, we expect the credit quality of smaller utility providers could remain volatile, while that of larger utilities will likely be more stable as they leverage their greater financial cushion to improve cash flow and reinvest in asset hardening. 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.

Chart 2

Outlook revisions have a negative bias, but most ratings carry a stable outlook

The ratio of unfavorable to favorable outlook revisions was 1.2-to-1.0 through the first three quarters of 2024. Although negative outlook revisions increased in 2024 compared with the relative stability of previous years, the negative bias had a modest effect on our percentage of negative outlooks for the sector, which was nearly 4% as of Sept. 30, 2024, compared with 3% at the end of 2023. Nearly 95% of utility ratings had a stable outlook (see chart 3). Negative outlooks mostly reflect weakening financial metrics due to weak long-term risk-mitigation strategies.

Chart 3

Balance-sheet ratios remain sound, but capital spending is increasing and could influence leverage ratios

In our view, despite financial performance weakening from the peak of 2022, utility sector balance sheets are still a principal credit strength (see chart 4). In addition, despite the rising operating cost environment in recent years, median financial metrics slightly weakened compared with recent historical levels: For example, national medians for all-in debt service coverage (DSC) dropped to 2.0x in fiscal 2023 from 2.1x in fiscal 2022. Utilities are starting to make progress on deferred and strategic projects, and capital spending is expected to increase based on recent Environmental Protection Agency (EPA) surveys, which reflect costly regulatory mandates and aging infrastructure needs. With this, utility debt activity saw a rise in revenue bond issuance in the third quarter of 2024, and we expect it will continue for many utilities into 2025. Given median leverage ratio (debt-to-capitalization) of 35%, there's likely some debt capacity, but depending on cash flow trends, increases to debt service could pressure all-in DSC.

Chart 4

Operational Challenges And Financial Performance Can Vary By Region

The U.S. Census Bureau defines four statistical regions: Northeast, Midwest, South, and West, and is the most commonly used classification system for utilities in the U.S. based on commonalities like climate, hydrology, consumption, agriculture, sources of water supply, regional environmental regulations, and economic attributes. By regions, the modal, or most common rating only differs slightly and is within a three-notch range of 'A' to 'AA-' (see chart 5 for regional ratings distribution). The Northeast's common rating is 'A+', while the Midwest is concentrated at the 'A' rating. The West and South have modal ratings at 'AA-', and generally, favorable economic conditions, coupled with strong financial and operational management, skew ratings higher in the West and South. In addition, we note the strong management acumen offsets some of the above-average climate exposure within these regions.

Operational challenges and financial performance can also vary across regions (see heat map for regional ratios). We observe that many utilities east of the Mississippi River tend to have all-in DSC metrics that are below the national median combined with higher leverage (debt-to-capitalization ratio). Utilities east of the Mississippi tend to have ample water supply but deal more with aging infrastructure issues including lead and copper service line replacement, particularly in older urban New England, Midwest, Mid-Atlantic, and New York areas. One of the major sources of costs for sewer utilities in recent decades has been the EPA consent decrees for sanitary sewer and combined sewer overflows in many of the major Midwest and Northeast cities. Due to aging pipeline infrastructure and more stringent quality standards, we anticipate capital spending will primarily focus on infrastructure replacements in the Northeast and Midwest.

Utilities west of the Mississippi tend to have stronger financial metrics compared with the national median and lower leverage ratios, which should somewhat buffer the effects of higher cost-of-service backed by better financial capacity to support additional debt needs that are necessary to pay for asset resiliency and growth. Utilities west of the Mississippi also tend to have a greater focus on drought, water scarcity, and supply reliability and diversification. Furthermore, many of these utilities face the challenges of a growing population, and a limited and vulnerable water supply, which necessitates higher investments in diverse supplies and storage. Economic growth and improvement in income metrics are factors that are helpful to long-term credit quality, while conversely, they can also create growth-fueled infrastructure requirements. While few utilities can realistically change the macroeconomic and operating conditions under which they function, we believe that strong management of long-term operational and capital requirements will likely be a key factor supporting rating stability.

Chart 5

Key Credit Drivers And Regional Sector Trends

Increasing climate issues and tightening regulations stress infrastructure resiliency

Most utilities continue to deal with aging infrastructure needs but are also grappling with stringent regulatory requirements and the need to prepare for climate resiliency, while maintaining affordable rate structures. In our view, an increasing exposure to physical climate risks for water and sewer utilities will likely require additional capital plan expenditure associated with asset hardening and resiliency. The National Oceanic and Atmospheric Administration estimated 24 confirmed weather and climate disaster events in 2024 (year-to-date), with losses exceeding $1 billion each. 2023 was a historic year, with 28 weather and climate disasters with a price tag of at least $93 billion that surpassed the previous record of 22 in 2020. Disaster costs over the past 10 years (2014-2023) exceeded a record $1.2 trillion for any 10-year period, reflecting the increased exposure and vulnerability to extreme weather and climate events. Greater focus on climate-resilience and adaptation projects would increase investment in flood control and drought-tolerant sources of supplies and water storage. Likewise, the EPA's latest drinking-water and clean-water infrastructure surveys point to growing infrastructure needs (approximately $1 trillion over the next 20 years) that far exceed the influx of funding. We anticipate that regulatory mandates and enforcement actions will probably continue at an increased pace. The EPA has continued to raise awareness on its final Lead and Copper Rule Improvements (LCRI), and nutrient pollution entering watersheds at excess levels. The LCRI will mandate lead service line replacement within a 10-year timeframe, and we continue to track the development and costs associated with proposed drinking- and clean-water regulations for contaminants such as per-and polyfluoroalkyl substances (PFAS). Although the risks vary by region, our rating analyses incorporate a utility's mitigation plans through review of long-term financial and capital-planning documents as well as any specific resiliency plans. We expect the cost of building resiliency into operations and infrastructure to address these rising risks will be borne by ratepayers, which could heighten affordability risks in the long term.

From hydrology to conservation, water could have significant effects on West region utilities

West region utilities face the paradox of utility-led conservation partially due to water scarcity and hydrological volatility. In addition, the Colorado River's ongoing supply imbalance suggests that ongoing negotiations between users will result in meaningful curtailments after Dec. 31, 2026, when key operating guidelines for lower-basin shortages established in 2007 expire. Add to that the evolution of demand-side management, such as voluntary and mandatory water-conservation measures; and improved water efficiency. The result is that often the utility's fixed costs are spread over static or even declining sales. This creates the paradoxical business model and political challenge of raising rates to cover not only increasing costs but declining sales. In our view, strong long-term financial and operational planning at the local and regional level can foster operational certainty and can lead to credit stability. Many utilities in the West have active long-term water supply planning and drought-management, conservation, and risk-management plans. In our view, successful conservation programs have allowed utilities to avoid, or at least defer, large capital costs. Lower water sales from conservation don't necessarily have to reduce a utility's net pledged revenues. The largest operating costs for most utilities are usually electricity (for treatment and pumping) and chemicals (for treatment), and even with lower water sales, a utility could find some corresponding relief in its operating budget. That, in turn, can factor directly into a utility's financial risk profile stability, with an alignment between demand and fixed-cost recovery via rates. Therefore, rate-making and financial flexibility could improve a utility's ability to react to these challenges, which, in our view, would preserve consistent financial performance.

Weather can significantly affect financial risk profiles

In our experience, weather-related effects are the main reasons for a utility to miss its budgeted DSC ratio. Although on average, the climate in the U.S. continues to warm, leading to more intense and prolonged heatwaves, which typically influences demand and revenues favorably, the trend is nonlinear, such that in any typical year, many utilities also may face a cooler, wetter spring relative to historical trends, which can have an offsetting effect to demand that drives sales revenues. Therefore, weather and its influence on revenues are interrelated and remain important to credit quality. Across regions there could be a compounding effect of revenue softness due to recent weather shifts and a new baseline in operating environment based on recent increases in commodity and energy prices. A rate structure that promotes alignment closely with a utility's changing revenue and cost profile along with a credible history of adjusting rates proactively is a factor that will continue to support rating stability.

Medians By Rating

We generally see that many of the enterprise and financial risk profile medians tend to improve with credit quality (see chart 6). 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 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 their 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 7 and 8 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 6

Chart 7

Chart 8

What We're Watching

Management challenges: funding of long-term needs will pose the biggest test for utilities.   Utility managers face pressure as they navigate the increased scrutiny of the current regulatory environment, aging systems, and migrating populations trends. Utilities will likely have a challenging year addressing these issues due to funding constraints given the sector's well-documented needs and limited federal or state capital dollars among competing high-priority projects. In addition, the operating environment appears to be stabilizing, and water and sewer utility officials seem to have greater certainty around budgeting. That said, meaningful cost decreases are not likely, resulting in a "new normal" environment for the water and sewer utility sector.

Continued credit variation between small and large utilities.  We expect smaller utilities will continue to face greater operating challenges, while larger utilities with robust financial resources and economies of scale will maintain their positions. Overall, large utilities seem to be better positioned to manage regulatory demands given healthier financial profiles and more sophisticated management teams, while smaller utilities could be vulnerable to changing regulations and are showing signs of weakening margins in a rising cost-of-service environment.

Increased capital spending and debt issuance are likely.  Debt issuances in 2023 slowed as many utilities defended their balance sheet or delayed the commencement of larger capital projects amid operating pressure and significantly increased borrowing costs. However, utilities can't continue to delay capital-intensive strategic or maintenance projects indefinitely and could begin to accelerate capital spending. We observed increased utility revenue debt activity in the latter half of 2024 that will likely continue into 2025.

Event risks place ongoing pressure on utilities for both financial and management resources.  Cyber events, along with weather and other physical risks, require planning and investment to minimize financial and operating disruption. The unexpected nature of these events, which appear to be increasing, requires ongoing attention at a time when management resources are already stretched. Although these increasingly recurring events are often considered one-time in nature within fiscal year performance, they can constrain operating flexibility.