When the 'soft-path' gets hard: demand management and financial instability for water utilities

Abstract:

In the past, cost benefit analysis (CBA) has been viewed as an effective means of evaluating water utility strategies, particularly those that were dependent on the construction of new supply infrastructure. As water utilities have begun to embrace ‘soft-path’ approaches as a way to reduce the need for supply-centric development, CBA fails to recognize some important financial incentives affected by reduced water consumption. Demand management, both as a short-term response to drought and in longer-term actions to accommodate demand growth, can introduce revenue risks that adversely affect a utility’s ability to repay debt, re-invest in aging infrastructure, or maintain reserve funds for use in a short-term emergency. A utility that does not generate sufficient revenue to support these functions may be subject to credit rating downgrades, which in turn affect the interest rate it pays on its debt. Interest rates are a critical consideration for utility managers in the capital-intensive water sector, where debt payments for infrastructure often account for a large portion of a utility’s overall costs. Even a small increase in interest rates can add millions of dollars to the cost of new infrastructure. Recent studies have demonstrated that demand management techniques can lead to significant revenue variability, and credit rating agencies have begun to take notice of drought response plans when evaluating water utility credit ratings, providing utilities with a disincentive to fully embrace soft-path approaches. This analysis examines the impact of demand management schemes on key credit rating metrics for a water utility in Raleigh, North Carolina. The utility’s consumer base is currently experiencing rapid population growth, and demand management has the potential to reduce the dependence on costly new supply infrastructure but could lead to financial instability that will significantly increase the costs of financing future projects. This work analyzes how ‘soft-path’ approaches might be more efficiently integrated with investment in supply-side infrastructure and suggests how financial hedging tools could be used to improve long-term utility planning objectives.