Agency rates Nacimiento Water Project revenue bonds at ‘A+’
– Fitch Ratings, a bond rating firm, has assigned an ‘A+’ rating to the $112.1 million Nacimiento Water Pipeline Project revenue refunding bonds series 2015A and 2015B, issued by San Luis Obispo County Financing Authority.
Bond proceeds will refund selected maturities of the authority’s 2007A and 2007B bonds and cost of issuance, according to the company. They found that the rating outlooks are stable.
The Nacimiento Water Project bonds are backed by water delivery entitlement contracts with five San Luis Obispo County water providers: the city of San Luis Obispo, Paso Robles, Atascadero Mutual Water Company, the Templeton Community Services District and San Luis Obispo County Service Area 10A. Contract payments are senior obligations payable from participants’ gross water revenues.
Fitch’s analysis centers on the three primary participants — Atascadero, SLO and Paso Robles — which pay 96-percent of debt service and whose contributions could not be fully recouped through step-up provisions. The ‘A+’ rating reflects the credit quality of Paso Robles, whose rating is the lowest of the primary participants.
The ‘A+’ rating for Paso Robles reflects the water utility’s modest debt service coverage, strong liquidity, elevated debt burden, history of rate controversy, and healthy service area. However, given a fully volumetric rate structure and large conservation mandate, financial performance is likely to be weaker in at least the short-term.
Fitch rates the city of San Luis Obispo’s water revenue bonds ‘AA’ with a Stable Outlook. Atascadero’s financial performance is solid with healthy liquidity and adequate, consistent debt service coverage.
Financial performance of most participants has been solid through 2015, but state mandated drought conservation measures will force deep cuts in sales volumes in 2016, reducing revenues and debt service coverage. Each of the primary participants has significant reserves that will allow them to absorb near-term revenue misses with limited impact on overall credit quality. The participants all have high debt burdens due to the project, which is quite large relative to the utilities’ customer bases.
The Nacimiento Water Project is of vital economic importance to California’s Central Coast region. The project provides increased water supply reliability and allows for future demand growth, improving the economic prospects of the region.
Debt service is supported by water delivery entitlement contracts that provide strong bondholder protection despite variable water supply and demand conditions.
The rating is sensitive to changes in financial performance of underlying obligors. The rating could come under downward pressure if Paso Robles fails to set rates that improve financial performance over the next few years. Rating pressure could also develop if the extreme drought worsens and forces multi-year water rationing that reduces financial performance of the primary participants on a sustained basis.
The participating water agencies are located on California’s central coast about halfway between Los Angeles and San Francisco. The project consists of a 45-mile pipeline that connects the agencies to Lake Nacimiento, a reservoir in the sparsely developed region near the border between San Luis Obispo and Monterey counties. The connection provides the region an additional 15,750 acre feet of water annually.
The Paso Robles water enterprise’s financial performance has been improving very slowly over the past several fiscal years as it navigated weak water sales, decreasing connection fee revenues, and rate controversy to build in the cost of the Nacimiento project into rates.
The California State Water Resources Control Board in May 2015 mandated that the city reduce water usage by 28-percent from 2013 levels. Thus far the city has achieved 31-percent conservation. The city has a water ordinance in place and has enacted an amendment to the ordinance effective Aug. 1, 2015 imposing fines upon customers that use above an allotted amount. The city has not provided a projection regarding the impact of the additional conservation or penalties on revenues.
The current drought measures are likely to set back efforts to improve financial performance. Paso Robles is currently conducting a rate study and projections do not yet incorporate its state-mandated 28-percent reduction in water usage in 2016. The city’s fully volumetric rate structure suggests a significant decline in revenues is likely.
The utility has ample cash reserves to withstand near-term revenue misses. It had $17.9 million of unrestricted cash and investments, or 832 days cash, on hand at the end of fiscal 2014. Fiscal 2014 cash levels equaled more than four years of annual debt service.
The utility has been required to make deposits to a coverage fund due to its failure to meet its 1.25x debt service coverage target. It had anticipated no longer needing this deposit of about $1.5 million after fiscal 2015; however, given potential revenue impacts related to the drought, the deposit may still be necessary.
While these deposits have been a sign of stress, they do benefit bondholders more than some other uses of the funds and help support the rating. Fitch believes the utility’s cash position will remain healthy but vulnerable to further shocks and unlikely to support a higher rating in the near term.
Strong reserves give the utility some room to adjust rates gradually, but the rating would likely come under downward pressure if the system experiences significant revenue pressure without offsetting actions that could include additional rate increases and/or changes to the rate structure. Management says the city may consider the reintroduction of a fixed component to the rate structure during the current rate study, which could improve performance and reduce revenue volatility after fiscal 2016.
Paso Robles faced significant opposition, including protests under California’s Proposition 218 and legal challenges, to fixed capital charges it tried to impose to support project costs. The rate controversy delayed by about four years the city’s plan to gradually raise rates to fully cover debt service costs. After scrapping its initial rate plan, the city imposed a five-year, 2012 – 16 rate package that appeared likely to provide adequate debt service coverage when fully phased-in, but the rate package’s replacement of fixed capital charges with volumetric rates exposes it to greater revenue losses in periods such as the current drought.
Atascadero’s financial performance has been on an upward trend in recent years. Fitch expects coverage to dip meaningfully in 2016 due to state drought conservation regulations, which require a 28-percent cut in water usage. Fitch also expects the utility to continue to adjust rates as needed to restore financial performance, but if performance falls to the forecast level, it could put downward pressure on the rating. The utility has ample liquidity with 507 days cash on hand at the end of fiscal 2014, providing a solid margin of safety against any near-term revenue misses.
The Atascadero utility has significant rate flexibility because it is not regulated by the California Public Utilities Commission or subject to the tax and fee limitations that apply to rate-setting at governmental water agencies.
The pipeline was shut for repairs in June 2014 after a leak was detected in the pipeline under the Nacimiento River. Project participants did not receive deliveries during peak summer watering months of 2014, exacerbating the impact of the current drought on local supplies. Management believes the pipeline leak is the result of a construction defect. The county repaired the pipeline using about $1.5 million of unspent bond proceeds and is seeking reimbursement from the project contractor. The county restored pipeline capacity to the level necessary to provide contracted deliveries in April 2015. It plans an additional repair to restore full pipeline capacity (beyond currently contracted deliveries) at a later date.
Additional information is available at www.fitchratings.com.
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