Fitch Ratings affirms the following rating on bonds issued by the Semitropic Improvement District of the Semitropic Water Storage District, California:
–$86.7 million water banking revenue bonds series 2012A and 2012B.
The Rating Outlook is Stable.
The bonds are secured by a gross pledge on water banking contract revenues received from five water banking customers of Semitropic. Semitropic has also pledged any available reserves and revenues for payment of the bonds if banking revenues are insufficient. Bondholders have a lien on the proceeds from the sale of a water banking partners’ stored water in the event that the banking contractor terminates its contract with Semitropic.
KEY RATING DRIVERS
VALUABLE WATER BANKING CONTRACTS: Semitropic provides valuable water banking services to five State Water Project (SWP) customers that provide water to the majority of California’s population. Water banking provides customers flexibility in managing the variability and cost of supplies in California’s tightly constrained water market, particularly in periods of drought.
STRONG CREDIT QUALITY OF CONTRACTORS: The collective credit quality of the five pledged water banking contracts is strong and at the high end of the ‘AA’ rating category. The contracts terminate at bond maturity in 2035 but are cancellable with one-year’s notice.
VARIABLE BANKING REVENUE COVERAGE: Pledged water banking contract revenues are quite variable. Pledged revenue coverage equals 1.2x or more with Metropolitan Water District of Southern California (Metropolitan, rated ‘AA+’ with a Stable Outlook by Fitch) usage at historical averages, but can fall below 1.0x in periods with minimal Metropolitan usage. Coverage was 0.95x in 2012 and 1.43x in 2013.
BACK-UP SEMITROPIC PLEDGE: The back-up pledge of any available district revenues provides cash flow support during years of lower banking revenues. Semitropic’s minimum cash reserve policy is to maintain at least $15 million in its emergency and contingency reserve. Unrestricted cash and investment equaled $18.8 million, or 173 days cash, at the end of 2013, providing adequate protection against short-term shortfalls in banking revenues.
CONTRACT TERMINATION RISK: Water contractors have the ability to terminate their water banking agreements with one year’s notice. Contract termination is a risk to bondholders since remaining revenues could be insufficient to repay bonds. However, the water banking program is a key water resource in the long-term water supply plan of each of the contractors, and the risk is viewed by Fitch as minimal.
METROPOLITAN USAGE CHANGE: The water banking program is an integral part of Metropolitan’s water supply management program. However, multiple years of no usage by Metropolitan could prompt a rapid rating decline.
ADEQUATE RESERVES: Maintenance of cash reserves at Semitropic is viewed as key for the rating given the inherent risk to bondholders of a change in usage of the program.
CONTRACT TERMINATION: Contract termination by one or more of the water banking contractors would likely cause a downgrade.
CONTRACTOR CREDIT QUALITY DECLINE: Material change in credit quality of the water contractors could result in a rating change to the water banking revenue bonds.
Semitropic Water District is located in central California, about 20 miles northwest of Bakersfield. The district provides supplemental surface water to farmers in order to reduce the impact of pumping on the region’s groundwater basin, and it provides water banking services to other water agencies. Semitropic’s surface water supplies are provided by the State Water Project (SWP) via the California Aqueduct that traverses the state from north to south.
The pledged water banking contract revenues are paid by Metropolitan, Santa Clara Valley Water District, Alameda County Water District (ACWD), Zone 7 Water Agency; and San Diego County Water Authority (rated ‘AA+’ by Fitch).
LOCATION WELL SUITED FOR GROUNDWATER BANKING
Semitropic benefits from a large, porous groundwater basin and a location on the California Aqueduct south of the Sacramento-San Joaquin River Delta. Its location south of the Delta allows Semitropic to serve SWP customers that are vulnerable to supply disruptions in the Delta and periodic droughts. Semitropic began selling capacity in its local groundwater aquifer to urban SWP customers in 1994. The combination of SWP imports and banking water deposits have allowed the district to stabilize ground water levels, increasing supply reliability and reducing costs for its agricultural users.
Banking customers bank (or store) water with Semitropic in high water years and withdraw it during low SWP allocation years, providing water supply stability to those customers in droughts. Banking customers are able to recall 90% of their banked water in future years, subject to the physical transport limitations of Semitropic’s system to pump groundwater storage back to the California Aqueduct.
WATER CONTRACTS PROVIDE FIXED O&M FEES AND USAGE FEES
Semitropic’s revenues include fixed assessments collected on local property tax bills, contract water sales revenues (sales of SWP water to irrigators), noncontract water sales (sales of banking water deposits and other water acquired by the district to farmers) and the pledged water banking revenues. Semitropic’s irrigation customers are contractually obligated to purchase available banking and SWP water. The price of contract and non-contract water is typically priced close to the cost of pumping water from the ground, making use of district water cost-neutral for irrigators.
Banking revenues include a minimum operations and maintenance (O&M) fee from users other than Metropolitan (when Metropolitan’s 10-year average use is above 35,000 AF) and volumetric deposit and withdrawal fees from all users. Non-Metropolitan O&M fees are adjusted annually by inflation and include a commensurate amount of deposits and withdrawals, making Metropolitan the primary payer of volumetric rates. The contracts do not include a take-or-pay provision, and the O&M fee is not reset each year to guarantee collection of Semitropic’s costs.
STRONG, BUT VOLATILE REVENUE STREAM
The pledged water banking revenues provide a strong but variable source of repayment for the rated bonds. Pledged revenues have averaged $9.7 million a year over the past five years, equal to 1.2x coverage of maximum annual debt service (MADS) on the rated bonds and parity swap obligations. MADS occurs in 2035 and equals $8.3 million.
Coverage varies with usage of the banking program, particularly by Metropolitan. A 2003 contract amendment allows Metropolitan not to pay the O&M fees as long as its ten-year rolling average of storage and withdrawal amounts of water from the bank is 35,000 acre feet (AF) or above. Metropolitan reached this ten-year average beginning in 2010, reducing the district’s O&M fee revenue.
The change somewhat reduces Semitropic’s water banking fees in the long-term, and it significantly changed the timing of payments from Metropolitan while increasing revenue volatility. Changes in Metropolitan’s fee structure agreed to in 2012 further exacerbate near-term pledged revenue volatility and timing mismatches by reducing storage deposit fees in exchange for increases in future withdrawal fees. Fitch believes the change increases the risk that pledged revenue coverage will fall below 1.0x for some periods over the next few years even though the change will provide greater overall revenue stability over time by moving excess revenues from typically very strong wet years to dry years.
No further amendments to the contracts are permitted by the bond indenture without a certification to the trustee that it would not adversely affect payment of debt service. O&M fees from the four non-Metropolitan pledged banking customers equaled $3.7 million in 2013 compared to debt service of $6.5 million.
Metropolitan makes significant use of the banking program in wet years (depositing excess water supplies) and in dry years (withdrawing water), but it uses the program very little in balanced water years when its SWP and Colorado River deliveries roughly equal its needs. For instance, Metropolitan made minimal use of the program in 2012, reducing Semitropic’s pledged banking revenues to $4.4 million and debt service coverage to just 0.95x. Pledged revenues recovered to a more typical $9.3 million in 2013, providing a solid 1.43x coverage.
Typical California water supply conditions (wet years alternating with periods of drought) are likely to keep Metropolitan’s water banking revenues at a level that provide solid coverage on average over time with occasional shortfalls covered by pledged reserves.
Metropolitan’s combined storage and withdrawals averaged 78,255 AF annually over the 10 years ended 2013. At that level, coverage would range from 1.2x to 1.8x with no volumetric fees from other users. However, a sustained drop in Metropolitan’s usage to the 35,000 AF level required to avoid O&M fees would create financial stress for the agency and could put downward pressure on the rating. Multiple years with no Metropolitan usage would likely result in a downgrade of more than one notch.
Semitropic has experienced two years without Metropolitan usage since 1994, but it has never experienced two consecutive years.
The back-up pledge of Semitropic’s other revenues and reserves is key to protecting bondholders during periods of limited use by Metropolitan, and Semitropic’s overall financial performance has been adequate. All-in debt service coverage averaged 1.6x over the past three years. Liquidity averages a solid 186 days of operating expenses. While overall financial performance is judged to be adequate to offset the risk of short-term shortfalls in pledged banking revenue coverage, available resources are only sufficient to withstand relatively short period of no more than one to three years at the current rating level.
BANKING PARTNER DEPARTURE UNLIKELY
Fitch views the potential for water banking contract termination by one of the five pledged contractors unlikely given the stability in SWP water supply and costs offered by the water banking arrangement. Increasing water supply scarcity in California and the high cost of procuring equivalent supply security through desalination, dam construction and/or water reuse add to the incentives to participate in the banking program. Banking customers would also forfeit banked water in the event of a termination, and current banking balances total more than 700,000 AF of water (worth more than five times the par amount on the outstanding bonds at the low end of recent market rates).
HIGH DEBT BURDEN
Semitropic’s debt levels are above average with debt to net plant assets of 72%. Amortization is typical with 36% maturing in 10 years and 81% in 20 years. The district’s debt profile includes an unusual off-the-market, forward-starting swap with payments beginning in September 2014 and payments on parity with the water banking revenue bonds. The swap had a negative mark-to-market value of $15.8 million as of July 29, 2014. Management says it will consider terminating the swap when mark-to-market values reach $6 million or lower, which is not expected in the near term. In the meantime, the district has increased property assessments to cover the expected payments. This provides a reliable source of repayment, but does not boost legally pledged revenues. Fitch expects the district to adjust rates as necessary to provide adequate overall financial performance, but expects fairly narrow water banking revenue bond coverage until the swap is terminated. The district currently has no plan to issue additional debt on parity with the water banking revenue bonds.
In addition to the sources of information identified in the Revenue-Supported Rating Criteria, this action was informed by information from CreditScope and IHS Global Insights.
Applicable Criteria and Related Research:
–‘Revenue-Supported Rating Criteria’ (June 3, 2013);
–‘U.S. Water and Sewer Revenue Bond Rating Criteria’ (July 31, 2013);
–‘2014 Water and Sewer Medians’ (Dec. 12, 2013);
–‘2014 Outlook: Water and Sewer Sector’ (Dec. 12, 2013).
Applicable Criteria and Related Research:
Revenue-Supported Rating Criteria
U.S. Water and Sewer Revenue Bond Rating Criteria
2014 Water and Sewer Medians
2014 Outlook: Water and Sewer Sector