| By Audra Dickinson
U.S. water utilities are entering a calmer environment in 2024 as the rate of inflation continues to level off, so much so that Fitch Ratings has moved its sector outlook to neutral from deteriorating.
Much of the improved picture is driven by rates of revenues growth that are keeping pace with the rate of expense increases–a reversal of the prior two years where at many utilities rate adjustments were not fully recovering increased labor, chemical and other operating costs. After peaking at 6.5% in 2022, Fitch forecasts inflation of 3.3% in 2023 and 2.6% in 2024.
GDP growth rose to 1.3% in 3Q, the fastest rate since late-2021 and much higher than the 0.4% increase expected in Fitch’s prior global economic outlook. While growth will slow sharply in 2024, Fitch economists no longer forecast a recession for 2024. That said, interest rates will hover at or near their highest levels in over a decade, which will raise financing costs and increase revenue requirements over time for the capital-intensive water and sewer sector. As a result, water utilities have now worked higher operating and capitals costs into their budgets with 2024 budgets reflecting more standard rates of increase around chemicals, labor, supplies and power.
With the operating environment now on more stable footing, water and sewer systems seem to have greater certainty around budgeting. That said, cost decreases are not likely, resulting in a new norm for water utilities.
Regulatory Updates to Crystalize in 2024
The U.S. Environmental Protection Agency’s (EPA) upcoming rule finalization related to PFAS (per- and polyfluoroalkyl substances) is expected to drive decision-making at many utilities in the short-term as they update capital plans to comply with the finalized rule. While the costs of more stringent PFAS treatment requirements could be significant, the full scope of effects on cost structures and capital investing remain undetermined and will largely hinge upon a utility’s existing treatment capabilities and water supply sources. Compliance strategies are likely to affect capital spending initially but would also be expected to increase operating budgets to maintain the new facilities over the longer term.
Separately, the EPA has stated its intention to promulgate the final Lead and Copper Rule Improvements (LCRI) by October 2024. In the interim, utilities are working toward the same October 2024 compliance deadline for identifying and publicly disclosing all lead service lines. As such, strategies for compliance with the finalized LCRI should also emerge in 2024; in addition to any PFAS treatment costs that utilities face, the capital costs of LCRI compliance will also begin to factor into upcoming capital programs.
Sizeable Gaps Despite Ample Federal Funding
The American Rescue Plan Act (ARPA) and the Bipartisan Infrastructure Law (BIL) provide important funding support to water and sewer utilities to address needed infrastructure improvements and maintenance. Despite the significant infusion of funds, Fitch estimates a funding gap in excess of $85 billion over the next five years that will need to be covered by pay-go or additional debt.
Sustained above average inflation has had a dampening effect on how far federal and infrastructure funding will stretch. Any funding awarded is expected to cover fewer and a smaller scope of projects as contractor bids increased and drove capital improvement plans higher. A resurgence in inflationary pressures and/or labor availability could shift the sector outlook to deteriorating.
The funding gap between infrastructure needs as assessed by the U.S. EPA and annual state revolving fund allocations, ARPA and BIL funding is likely to widen after ARPA and BIL programs expire. Water utilities may need to tap the debt markets with more frequency or defer discretionary capital projects as remedies. Federal and state financing options may also be available, but most will be in the form of loans instead of grants.
Extreme Weather and Cyber Risk Remain Key Sector Issues
The increased frequency and worsening severity of extreme weather events will continue to be a threat to the sector as utilities work to expand and improve resiliency of water supply and contend with unforeseen expenses that can arise in the aftermath of severe weather events. To date, rating action at water and sewer utilities in the immediate aftermath of a natural disaster has been very limited given the sector’s robust liquidity position. Further, costs are often substantially recovered via FEMA reimbursements creating more of a timing mismatch rather than a permanent drawdown of liquidity. On the cyber front, many water and sewer utilities continue to work toward adhering to certain cybersecurity best practices absent any formal regulation. Shorter-term spending would likely focus on conducting cybersecurity assessments, but any identified vulnerabilities or successful breaches at a utility could result in unforeseen capex.
Although headwinds related to general inflationary pressures have eased, water utilities are entering a “new normal” operating environment in 2024. Positively, the rates of increase related to chemical, labor and power costs have normalized and are now generally in line with expected revenue rates of increase. While the threat of inflation has subsided, 2024 is likely to hold significant developments on the regulatory policy front that will likely increase capital programs over the short-term and eventually result in higher operating expenses over the longer-term.
Audra Dickinson is a senior director at Fitch Ratings and sector head for its Water & Sewer Group. She is based in Austin, Texas, and previously served as a senior utility financial analyst for Austin Water where she focused on debt-related matters specific to Austin Water, and related water revenue bond issuances.