The Future is Here

(Chapter 4 of 6) Municipal bond risk and a shrinking river.

Greg Danielian

Greg DanielianResearch Analyst, Franklin Templeton Fixed Income

Climate change is often discussed as something occurring in a distant future—an event we have time to prepare for and perhaps even prevent if we course correct. The future is already here in western North America. Over the last two decades, climate change and a megadrought have wrought havoc on the region’s most vital water supply, the Colorado River. As municipal bond (“muni bond”) investors in utilities, we are watching these events unfold while we continue to monitor municipal bond opportunities in the region. We believe muni bond investors play an important role in providing capital to these utilities in funding their capital needs to promote a reliable water supply in the face of mounting water supply stress.

Often referred to as the “World’s Hardest Working River”—each drop of water is used 17 times in its journey from the headwaters to the terminus—the Colorado River in the United States provides municipal water to over 40 million people, irrigates over 5.5 million acres of agricultural land, and generates over US$1.4 trillion in annual GDP and 16 million jobs.27 The total economic impact of the river is higher, but not as well documented, when you include México’s 1.5 million acre feet (MAF)28 allocation irrigating over US$2.9 billion of crops in the Mexicali Valley and supporting the Mexicali region’s globally linked US$2.4 billion manufacturing economy.29

Since the megadrought began in the late 1990s, available water supply in the river has declined over 15%, and due to climate change the river is projected to experience between 20%–30% less flow by 2050 and 35%–55% less by 2100.30 Based on 2014 dollars and economic activity, those reductions would cut economic production and labor income in the region by over US$576 billion and US$1.1 trillion respectively, as seen in Exhibit 11. Just over half of the economic loss will occur in California, the fifth largest economy in the world.

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EVERY DROP COUNTSExhibit 11: Extrapolated estimates of total economic impacts of different amounts of Colorado River water loss for the entire basin region

Source: James, et al., The Economic Importance of the Colorado River to the Basin Region. Tempe: Arizona State University, December 18, 2014. There is no assurance that any estimate, forecast or projection will be realized.

The Lower Colorado River Basin, which is made up of US states Arizona, California and Nevada, along with the country of México, is experiencing the full brunt of shrinking water supplies. The region is the lab for dealing with the impacts of climate change in real time—so much so that the Lower Basin has a doomsday clock, of sorts. However, the “clock” does not measure time, but rather the level of Lake Mead, the largest storage reservoir in the Lower Basin. And, instead of striking midnight, the magical number is 1,075 feet. This spot marks the water level of Lake Mead at which there will be an automatic shortage declaration. You’re probably wondering, what is a shortage declaration and who is impacted? How close could it be? And, what are the chances of it occurring? Finally, you may be wondering what this all has to do with muni bonds and what are we doing as muni bond investors to understand the implications. We’ll quickly explain them one by one.

First, it is important that we point out that we don’t expect the Colorado River water supply to impact major water utilities in the near to medium term. However, near-term investing can’t ignore long-term impact and, as discussed in the introduction to this piece, we have a fiduciary responsibility to our clients’ assets to understand these risks and how they will grow over time. As active managers, holistically understanding the risks allows us to both take advantage of gaps in information by more appropriately pricing risk and to move out of positions that are deteriorating in credit quality either from a supply risk standpoint or a financial standpoint.

When the clock strikes 1,075 feet As seen in Exhibit 12, which indicates the level of the lake on December 31, 2019, the water level was at 1,090 feet. That is pretty good compared to recent history. As recently as 2018, the lake hovered within inches of 1,075 feet. In 2015, the lake dipped below the level for several months— hitting a historical low of 1,071 feet—but creeped back over the line when the final measurement of the water year was recorded.31

THE COLORADO RIVER’S DOOMSDAY CLOCK Exhibit 12: Mean end-of-December elevation of Lake Mead and August 2020 CRSS. As of August 2020

Source: US Bureau of Reclamation, as of August 2020. There is no assurance that any estimate, forecast or projection will be realized. Note: The colored region, or cloud, for each alternative hydrology scenario represents the 10th to 90th percentile range of the projected reservoir elevations. Solid lines represent historical elevations (black), and median projected elevations for each alternative hydrology scenario (teal, yellow). Dashed gray lines represent important elevations for operations, and vertical lines mark the adoption of the 2007 Interim Guidelines and 2019 Drought Contingency Plans that lay out cuts in water deliveries to Arizona, California, and Nevada when elevations are reached. The method used togenerate future inflows in the current projections includes resampling the historical natural flow record (1906-2018) using the Index Sequential Method (ISM), referred to here as “Full” hydrology. One alternative to the Full hydrology scenario applies ISM to a shortened period of the natural flow record, 1988-2018, and is referred to as “Stress Test” hydrology. The Stress Test hydrology scenario removes the earlier portion of the natural flow record and focuses on the recent (approximately 30 years) hydrology, which has a 11% drier average flow than the Full hydrology. Use of the Stress Test scenario is supported by multiple research studies that identified a shifting temperature trend in the Colorado River Basin in the late 1980s that affected runoff efficiency and resulted in lower average flows for the same amount of precipitation (McCabe et al. 2017, Udall and Overpeck 2017, Woodhouse et al. 2016).

Also shown in Exhibit 12 is a modeling scenario, called the Colorado River Simulation System (CRSS), which projects the likelihood of cuts in the near future. Under both the full hydrology, based on the river flows from 1906–2018, and stress test hydrology, based on the last 30 years and considered more accurate based on the recent climate, there is over a 50% chance of the lake dropping below 1,075 feet by 2026. The stress test hydrology predicts it happening a couple years sooner, likely in 2023, and the overall chance by 2025 at 77%.

Once the lake drops below 1,075 feet, a shortage declaration triggers cuts to delivery of Colorado River water to Arizona, Nevada, and México—Arizona will lose just over 18% of its 2.8 million acre-feet (MAF) allocation. Starting at 1,050 feet, the cuts increase every five feet the lake drops. And, at 1,045 feet, they start triggering cuts in California, as seen in Exhibit 13. At 1,025 feet, the cuts are drastic—with each state and México cutting from nearly 10% to over 25% of their allocation. Also at 1,025 feet, the agreement must be renegotiated because at 1,015 feet, the hydropower station at Lake Mead (known as Hoover Dam) ceases to produce the 4.5 billion kilowatt-hours of electricity it supplies to over 8 million people in the region. Under the August 2020 CRSS, there is a 23% chance of the lake hitting 1,025 feet by 2026. The risk increases substantially after 2030—due to climate change projections and projected population growth—even with a conservative model, it is a matter of “when” not “if,” barring major changes to how the river is allocated and managed.

Understanding material and liquid risk

As you can imagine, a 50% chance of the region experiencing drastic cuts in water availability from a critical source poses long-term material financial risk, including to the municipal bond sector that supports water and energy utilities’ debt and capital projects. This risk is heightened in areas like the Lower Colorado River Basin, an already arid region with limited water supplies. By providing metropolitan areas in the region (e.g., Los Angeles, Phoenix, Las Vegas, etc.) water that is not available in their local watersheds and aquifers through massive infrastructure projects, in many ways the Colorado River is the Basin’s, and investors’ in the region, insurance policy—and it’s an expensive policy to boot.32

ALLOCATION CUT TRIGGER POINTS Exhibit 13: Planned lower basin reductions at each Lake Mead elevation

Source: US Bureau of Reclamation, Lower Colorado River Basin Drought Contingency Plan, 2019. Note: Full allocations are as follows: Arizona 2.8 MAF, California 4.4 MAF, Nevada 0.3 MAF, México 1.5 MAF

Though municipalities and their water providers—both municipal and private—are among the highest priority users in the system and will not see reductions until the lake hits 1,025 feet, the uncertainty created by cuts to lower priority users (read: agriculture and some industrial users) will place further strain on the entire system. For example, agriculture producers in Arizona dependent on Colorado River water delivered through the Central Arizona Project (CAP) will see their entire allocation cut when the lake hits 1,075 feet. This will result in irrigators turning to groundwater pumping to maintain crops. The same groundwater farmers will turn to is also considered the long-term back-up plan for many municipalities dependent on Colorado River water. For example, Pinal County (a mostly rural agricultural area just two decades ago) is now home to some of the fastest growing suburbs and exurbs of the Phoenix and Tucson metro areas. Over the next century, ground-water levels in Pinal County are predicted to drop from today’s level of 200 feet below surface to approximately 1,300 feet below surface.33

Just looking at the utilities sector in the Phoenix metropolitan area, 45% of the water supply to the Arizona Municipal Water Users Association (AMWUA)—representing 10 municipalities and 3.5 million people—is supplied by the Colorado River via the CAP aqueduct.34 Phoenix’s growth over the last five decades was largely fueled by Colorado River water and would not have been possible at the current scale without this critical water source.

It is important to note the distinction between cuts and water availability to a customer base. Allocation cuts do not necessarily translate 1:1 into cuts to water utilized to satisfy current demand. Thanks to investments in diversified water supplies through secondary sources and sharing agreements, AMWUA members and other major utilities in the Lower Basin would not be under immediate threat of the water “shutting off” if they were to have their Colorado River allocation reduced or completely cut. As active managers, it is our job to properly price the risk and understand the potential impact on investments if such cutbacks were to occur.

To understand the impacts, we must fully understand the supply risk to municipal water systems; what federal, state, and local governments are doing, and not doing, to curtail the risk; and what steps municipal water providers are taking, or not taking, to strengthen and diversify their water portfolios. Poor disclosure by issuers has historically been a major challenge in understanding these factors in the municipal bond sector. Issuers may provide sufficient detail on deal structure and security package, financials, outstanding debt and high-level characteristics of the utility system in their Official Statements (OS); however, as highlighted in a key assessment of water risk in the municipal bond market by Ceres, there is a general need to improve disclosure of material water stresses and their potential impacts on supply.35

Essentially, our analysts must be water experts with the experience to see through generic statements, gaps in data and missing information.

For example, many OS’s make general statements about water supply, such as: “[we] have adequate supply” or “[we’re] taking steps to diversify our supply.” Some asset managers may choose to take these statements as face value, but, as an active manager, we see such statements as a trigger to dig deeper and engage our research team to find out if these statements are backed by data and future plans. This framework and methodology were put to the test when our municipal bond team assessed the most severe impacts on California water utilities at the height of the recent drought by going through every issuer in our strategy, as well as other opportunities in the primary and secondary markets. Where we saw gaps in data and disclosure, we called issuers and asked for data and information to ensure that material risk was being covered under statemandated municipal usage cuts that ranged from just under 5% to over 35%, depending on the water agency.

Essentially, our analysts must be water experts with the experience to see through generic statements, gaps in data and missing information.

Digging deeper

First and foremost, we believe the majority of utilities have strong balance sheet resources and several levers to pull in the midst of multi-year droughts to maintain compliance with rate covenants and meet ongoing principal and interest payments while maintaining strong credit ratings. That said, when it comes to disclosure of water supply, there are municipalities that stand out as good examples. Some of the key items we are looking for in our analysis of water utilities include, but are not limited to:

  • Long-term planning: We’re looking for evidence of capital improvement projects to improve delivery and/or prevent loss, as well as long-term agreements to secure future sources and supply. And, in the case of AMWUA, they have already announced future rate structures for each tier of potential shortage.

  • Diversified supply: This can include mixes of groundwater and surface water—ideally coming from multiple reliable sources in the event a source has diminished or there is cessation of supply.

  • Evidence of multiple use: This can include potable reuse, desalination, use of grey water for irrigation, and even mixing groundwater with surface water.

  • Infrastructure investments: Investments in delivery infrastructure, storm water capture for treatment and recharge, increased water treatment capacity, and storage.

  • Advanced metering infrastructure: Allows utilities to leverage technology to promote conservation, identify potential leaks and improve water loss efficiency. Additionally, it provides a tool for the customer to manage household or business water use and utilize that data to better partner in conservation efforts with the utility in periods of drought.

  • Innovative agreements: This may include storage and delivery agreements, water wheeling, groundwater banking, and mutual-aid agreements.

On the other hand, we also must look for warning signs in disclosure, as there are cases in which multi-year droughts can lead to deteriorating credit quality. Additionally, lack of evidence of long-range planning, pre- and post-crisis, is concerning when evaluating investments. Below are some risk factors that raise concerns in terms of water supply reliability and disclosure.

  • Lack of understanding and/or inability to articulate the amount of water supply available is a major concern: This applies in normal operating years but accelerates in drought or shortage conditions.

  • Limited water supply diversification and/or single source supply: If a single source, we may have further concern if the source is imported and/or subject to third-party decision-making.

  • Minimal, overlooked or undefined investments into water systems: This is further complicated if we see lack of investment into supply diversification, lack of meaningful renewal and replacement to promote system reliability and efficiency, and if annual investments are not aligning with long-range plans and/or long-range planning cycles are not being met.

  • Unmetered customer base: This presents challenges in messaging to encourage conservation in times of drought and hampers enforcement during severe drought or mandated cuts.

  • Lack of information: We have seen some issuers limit publicly available information, which creates challenges in truly identifying risks. This is especially concerning during a water scarcity crisis and can be a red flag if it occurs among weaker credits with weak financial fundamentals and/or risks associated with concentrated water supplies and/or reliance on imported water supplies.

  • Outdated information: We have seen issuers fail to meet state-mandated deadlines on updating water plans. For example, we have seen several issuers in California fail to commission their 2015 water plans when currently they should be issuing their 2020 plan. Therefore, their water plan is from 2010. As a result, this may leave investors with minimal insight into any recent challenges faced by the utility and how the utility plans to address those challenges moving forward to ensure a reliable water supply. It also leaves investors in the dark if long-range plans established in the plan were met and successful.

  • Lack of post-drought or crisis disclosure and evidence of lessons learned: This leaves investors unable to understand how the utility managed through drought or crisis both financially and from a water supply perspective. It is important for us to understand what worked or didn’t work. Were they successful in reducing demand? Were they able to lean on and/or identify alternative short-term water supply if necessary? Utilities that continue to forgo and/or have not accelerated long-range planning post-drought are of concern.

Finally, there are areas in disclosure where we see room for improvement. While some issuers do a great job in outlining risks associated with water supply, we note a couple key areas for which there can be improvement.

  • If an issuer is exposed to varying degrees of cuts to water allocations, we need to see a detailed look at the impacts of those cuts to the source water and overall water supply portfolio by drought severity level.

  • In the event an issuer has not been to market recently and agreements such as the Drought Contingency Plan have been agreed upon, we would like to see updated disclosure on changes to the issuer’s water supply availability and/or water risk in general to the issuer.

Spreading the risk

So, what is being done beyond the local level to curtail this risk? For one, the Basin states and México signed an agreement in 2019 called the Drought Contingency Plan (DCP). The agreement attempts to spread the risk among seven states and México, which includes Arizona, Nevada, and México taking voluntary cuts starting in 2020 in an effort to keep more water in Lake Mead. As mentioned earlier, this region is the test lab for dealing with climate change—the intra-state compact combined with a series of groundbreaking binational agreements between the United States and México have become a global model for binational cooperation. Without these agreements, the doomsday clock would have struck 1,075 feet several years ago and we’d be well on our way to 1,025 feet, as the lake is projected to drop 12 feet per year in a “do nothing” scenario due to “structural deficits”—meaning, about 1.2 MAF more are withdrawn from the lake than currently flow into it because of over-allocation.36

DCP’S POSITIVE IMPACT ON RISKExhibit 14: Risk of Lake Mead falling below 1,025' without DCP vs. with DCP under full hydrology and stress test hydrology projections based on April 2018 CRSS. As of June 2018

Source: US Bureau of Reclamation, Drought Contingency Plan planning documents. There is no assurance that any estimate, forecast or projection will be realized.

As seen in Exhibit 14, the DCP essentially cut the risk in half, under both the full and stress test hydrology and without this historical agreement, of reaching 1,025 feet. As managers of municipal bond portfolios, these collaborative efforts reduce some of the risk to our investments. And as mentioned previously, AMWUA has agreed to rate increases tied to shortage cuts as part of the DCP. This proactive approach to planning provides our analysts a long-term view of how potential future cuts to supply will be managed, as well as how the likely reductions in usage will be handled from a revenue standpoint.

Actively engaged at the confluence

In conclusion, when looking at the Colorado River Basin, we are tracking these issues from a long-term risk standpoint. We don’t believe major municipalities are at risk of losing water supply over the coming decades. However, we do believe it is important as stewards of our clients’ assets that we understand the complexities of the Colorado River Basin and how shrinking water supplies in the coming decades will create mounting pressures on issuers and investors. When we come across issuers that don’t provide adequate information, it is an immediate signal to engage further and dig deeper. As active managers, we view the confluence of gaps in data and information as a catalyst for mispricing.

 


 


WHAT ARE THE RISKS?

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