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California has entered its fourth year of drought, and mountain snowpack is at just 6% of the long-term average. That means less melting snow feeding reservoirs during the warming spring months. To mitigate the effects of the drought, California Governor Jerry Brown issued the state’s first ever executive order mandating a 25% reduction in water use. From a municipal credit perspective, the drought and reduced water consumption will have varying but broad implications for everything from Central Valley agricultural production to municipal hydropower generation to municipal water supply.
Central Valley credits supported by an agricultural economic base will continue to be pressured, as farm acreage lays fallow and economic activity falls. Across the nation, expect the price of tomatoes and avocados to spike because California accounts for over 95% of all U.S. production of these essential guacamole ingredients.
The impact to municipal hydropower credits is neutral or negative depending on the structure of the specific entities’ “take or pay” contracts. “Take or pay” contracts protect bondholders, insofar as the power purchaser must pay for the debt payments even if the power is not delivered. The key analysis to perform entails making sure the maturing debt matches the length of the “take or pay” contract. If the bonds mature before the contract’s terms end, the bondholder is well protected. A recent mitigating factor for the drought is that the California economy has grown less dependent on hydropower than it was just two years ago. As the EIA.Gov charts (below) show, non-hydro renewables and natural gas electricity generation have both surged since 2011. It’s encouraging to see a relatively quick rebalancing of energy production in the state, and it is also encouraging that the water suppliers and consumers have incentive to quickly change their behavior.
While water supply credits are not known for their adaptability, drought conditions do increase their pricing power. It may not be intuitive, but when water is scarce, water supply credits have more pricing power and therefore greater ability to manage their income statements and balance sheets. In wet years, the reverse happens: pricing power falls, operating margins narrow and balance sheets can deteriorate. In general, water credits are some of the most conservatively managed credits in muniland. Later this summer, when you’re picnicking with family and friends discussing how pricey the guacamole dip has become, you can console yourself with the knowledge that your municipal bond portfolio is well insulated from the drought conditions in the West.
Source: NPR, US Department of Agriculture, US. Energy Information Agency and SNWAM Research