June 10, 2002

To: President Ammiano

From: Budget Analyst

Subject: Review of Best Practices for Financing Large Capital Improvement Projects at Municipal Utilities in the State of California

Pursuant to Board of Supervisors Motion M02-47, the Budget Analyst, in conjunction with the Office of the Legislative Analyst (LAO), the Mayor"s Director of Public Finance (MOPF) and the Public Utilities Commission (PUC) have reviewed the best practices for financing large Capital Improvement Projects at municipal utilities in the State of California.

Specifically, the Board of Supervisors directed that the following tasks be performed:

1. In conjunction with the Office of the Legislative Analyst, review the best practices for financing large capital improvement projects at municipal utilities in the State of California;

2. In consultation with the Mayor"s Office of Public Finance, interview analysts at bond rating agencies to determine the outlook for the San Francisco Public Utilities Commission ("PUC") bond ratings for the Water and Clean Water enterprises and to determine recommended steps to improve bond ratings for the water and sewer enterprises;

3. Calculate potential savings in debt service payments for the PUC"s proposed Capital Improvement Program if bond ratings for the Water and Clean Water enterprises increase to their former levels.

This report presents a summary of the findings resulting from this review.

Background

Proposition H, approved by the voters on June 2, 1998, freezes retail Water Rates and Sewer Service Charges at their current levels until July 1, 2006, subject to the following exceptions:

As noted above, Proposition H permitted a total 18 percent increase in Water Rates to provide funding for debt service related to Proposition A and B Water Revenue Bonds. In November of 1997, San Francisco voters approved $304,000,000 in Water Revenue Bonds. Of that amount, $140,000,000 in Water Revenue Bonds were sold during FY 2001-2002, necessitating an 8.65 percent average rate increase for retail customers. The remaining $164,000,000 in Water Revenue Bonds is anticipated to be sold during FY 2002-2003.

The effective date of Proposition H followed two years of rate freezes that were self imposed by the PUC. Therefore, Proposition H froze rates at their 1996 levels through June 30, 2006, with the exception of the 18 percent increase allowed for debt service related to Proposition A and B Water Revenue Bonds.

After many years of preparation, the PUC has completed a long term Capital Improvement Program (CIP) for both its Water and Clean Water Enterprises. The total estimated cost of the CIP would require the issuance of total Water and Clean Water Revenue Bonds in excess of $4.6 billion. Because some of this cost will be funded by the City"s Suburban Resale Customers, the CIP costs that will be allocated to the City"s retail water customers is approximately $2.6 billion, $1.6 billion for Water Enterprise related capital improvement projects and, in the future, $1.0 billion for Clean Water capital improvement projects.

The previous approval of Proposition H and the resulting water and sewer service rate freeze has effected the financial condition of the City"s Water Enterprise and Clean Water Enterprise differently. Financial projections for the Water Enterprise indicate that its financial viability will largely be maintained through fiscal year 2007 and that the City will be able to meet debt service coverage¹ requirements contained in the Water Revenue Bond covenants. These projections include the 18% increase in rates permitted under Proposition H to fund authorized debt, but do not include the funding of the Water Enterprise Capital Improvement Program.

However, financial projections for the Clean Water Enterprise indicate that under existing rates, which have not been increased since 1996, prior to voter approval of Proposition H in 1998, total annual revenue will not be sufficient to pay both the operating and maintenance costs, as well as the revenue funded capital projects and debt service. For the three years (FY 2002-2003 and FY 2004-2005), unappropriated surplus funds will be available to fund operating expenditures and debt service on outstanding debt. However, without a rate increase or other financial intervention, the Clean Water Enterprise will exhaust its fund balance by FY 2005-2006. Moreover, financial projections show that the Clean Water Enterprise will not meet its debt service coverage requirements, and therefore will place its revenue bond debt in technical default of its bond covenants, in Fiscal Year 2005-2006.

Survey of California Municipal Utilities

Attachment 1 to this report presents the results of a survey of debt management practices of major Water and Sewer public utilities in the State of California, including the San Francisco Public Utilities Commission Water Enterprise and Clean Water Enterprise. The survey was prepared by the Board of Supervisors Legislative Analyst"s Office, with the assistance of the PUC.

Of the 12 major public utilities surveyed, including San Francisco"s Water Enterprise and Clean Water Enterprise, only the San Francisco utilities are subject to a rate freeze. A second significant difference between San Francisco"s utilities and those surveyed is that eight of the public utilities are able to issue bonds with the approval of their governing body without voter approval. In contrast, San Francisco"s Water and Clean Water Enterprises are required to obtain voter approval of revenue bonds for capital improvement projects. Charter Section 9.107 authorizes the issuance of revenue bonds for any purpose to create, repair, improve or expand the water, sewer or power systems provided that such bonds are approved by a simple majority vote of the electorate.

There are exceptions to the voter approval requirement of Charter Section 9.107 however. Charter Section 9.107 authorizes the issuance of revenue bonds for the water, sewer or power systems with a three quarters approval of the Board of Supervisors under certain limited instances as follows:

The City Attorney is reviewing whether Charter Section 9.107(b) was intended to extend to the sewer system. However, because Charter Section 9.107(b) only states that such revenue bonds can be issued with just the approval of the Board of Supervisors and without voter approval only for "reconstruction or replacement of existing water and electric power facilities", the Charter does not appear to provide for major Capital Improvement Projects for system "redundancy", such as multiple pipelines that permit continued transport of water should a major pipeline fail, or expansion or creation of a new system or auxiliary system. Therefore, it appears that virtually all projects included in the PUC"s CIP will require voter approval for authorization of revenue bond funding.

Two other public utilities surveyed, namely the Contra Costa Water District and the San Diego County Water Authority, require voter approval for authorization to issue revenue bonds.

Although the Contra Costa Water District (CCWD) requires voter approval for new revenue bond issues, CCWD is able to issue refunding bonds with just approval of their Board of Directors. However, as noted in Attachment 1, CCWD"s debt issuance practice is to initially fund capital improvement projects through the issuance of commercial paper, a short term debt instrument. The issuance of such commercial paper to fund capital improvement projects does not require voter approval. Therefore, in order to convert to long term funding, CCWD refunds its commercial paper debt with refunding revenue bonds authorized by its Board of Directors. By using this practice, CCWD eventually funds its capital improvements with revenue bonds without obtaining voter approval.

The San Diego County Water Authority (SDCWA) is also required to obtain voter approval for authorization to issue revenue bonds. However, SDCWA also uses a debt alternative to traditional revenue bonds. SDCWA issues Certificates of Participation (COPs) to fund capital improvement projects, which do not require voter approval.

The Proposition H rate freeze has had a negative impact on the credit ratings of the City"s Water and Clean Water Enterprises. Prior to the rate freeze, Moody"s rated the Water Enterprise Aa and Standard & Poor"s (S&P) rated the Water Enterprise AA with a stable outlook. After the rate freeze was imposed, Moody"s downgraded the Water Enterprise to A1 and S&P downgraded the Water Enterprise to AA-, with a stable outlook. Subsequently, in July of 2001, S&P downgraded the Water Enterprise again to A+ with a stable outlook. The Clean Water enterprise was downgraded by Moody"s after the rate freeze from A1 to A2, with a negative outlook. Similarly, S&P downgraded the Clean Water Enterprise from A+ to A, with a negative outlook, subsequent to the rate freeze.

Attachment 2 provides a glossary of Moody"s and S&P ratings definitions.

The table on the following page shows that the PUC"s Clean Water Enterprise has the lowest credit ratings (A2 with a negative outlook) of the twelve utilities surveyed ², and the PUC Water Enterprise has the lowest Moody"s rating (A1, with the same rating as one other water utility) and the third lowest S&P rating (A) of all water utilities surveyed.

Discussions with Rating Agencies

Motion MO2-47 also directed the Budget Analyst to interview analysts at bond rating agencies to determine the outlook for the San Francisco Public Utilities Commission ("PUC") bond ratings for the Water and Clean Water enterprises and to determine recommended steps to improve bond ratings for the water and sewer enterprises, in conjunction with the City"s Director of Public Finance, Ms. Monique Moyer.

The Budget Analyst and the Director of Public Finance conducted lengthy telephone interviews with both the Moody"s and S&P public utility analyst teams. The viewpoints expressed by analysts from both ratings agencies were very similar and will be summarized herein.

In the view of the ratings agencies, the San Francisco PUC Water and Clean Water Enterprises have strong credit factors which include its large customer base within an economically viable region and relatively low rates for its retail and wholesale customers. The Proposition H rate freeze however has created concerns among the rating analysts because of its negative impact on the financial profiles of the Water and Clean Water Enterprises and the implications of the long term effect on the PUC"s ability to fund essential capital improvements for the water and clean water systems, the primary assets of the two enterprises. The analysts noted that the structural integrity of the system is placed at risk due to the uncertainty of the PUC"s ability to fund and implement the long term CIP.

Other factors contribute to the rating agencies viewpoints besides the rate freeze. The voter approval requirement causes some uncertainty with respect to the PUC"s ability to obtain authorization to issue revenue bonds. The ratings analysts also noted that the PUC"s bond covenants are weaker than those of its counterparts in California. The PUC"s debt service coverage ratio (which must be equal to 1.25 times or greater according to the bond indentures) is able to use prior unappropriated surplus revenues as a funding source in addition to just using annual operating revenues alone. Other public utilities calculate such coverage ratios using only annual operating revenues and not prior year unappropriated surplus revenues. In the past, this has not been seen as a serious problem by the rating agencies, but the combination of the weaker covenants and the depletion of reserves for both the Water and Clean Water Enterprises due to the rate freeze increases the concerns of the rating agencies.

The rating agencies were asked what steps the City could take to improve its credit ratings for the Water and Clean Water Enterprises. Both rating agencies responded that such actions as lifting the rate freeze and attaining authority to issue revenue bonds would be viewed favorably. However, such actions in and of themselves would not be sufficient to cause either rating agency to upgrade the Water and Clean Water Enterprise credit ratings.

Both Moody"s and S&P stated that ratings upgrades would not occur unless and until the financial profiles, as measured by such factors as the Water and Clean Water Enterprise debt service coverage ratios, improved dramatically, coupled with assurances that the CIP would be carried out and supported with a credible and sustainable financial plan for the future. If all of these pieces were in place, the rating agencies indicated that they would be inclined to return the credit ratings of Water and Clean Water Enterprises to their former levels.

In the view of the rating agencies, the financial improvements in the Water and Clean Water Enterprises can only occur by increasing the water and sewer service rates and by maintaining the rate making authority to further increase water and sewer service rates in the future in order to assure financial stability, flexibility over the capital improvement program and the authorization to fund it.

Potential Savings in Debt Service Payments for the Water and Clean Water Enterprises if Credit Ratings Return to their Former Levels

Generally, bond investors consider municipal bonds to be more secure if their credit ratings are high. The higher credit rating is an indicator of less risk and therefore investors are willing to receive lower bond interest rates. Bonds with lower credit ratings are viewed as possessing relatively more risk of default, and therefore investors expect higher bond interest payments.

The City"s Director of Public Finance, Monique Moyer, estimates that the lowered credit ratings of the Water Enterprise since the Proposition H rate freeze would result in a 0.2 percent increase in interest rates if the PUC were to issue new revenue bonds today. Ms Moyer concludes that the cost of a 0.2 percent increase in interest for the $1.6 billion in revenue bonds, to fund the Water Enterprise share of the CIP which would be paid by San Francisco ratepayers, would result in increased debt service of $3.2 million annually and approximately $32.0 million over the first 10 years of debt service payments.

Ms Moyer also estimates that the expected lowered credit ratings of the Clean Water Enterprise as a result of the Proposition H rate freeze would result in a 0.4 percent increase in interest rates today and approximately $4.0 million annually in increased debt service costs due to higher interest payments, and a total cost over the first ten years of debt service payments of approximately $40.0 million, for the $1.0 billion CIP that must be supported by the City"s Clean Water Enterprise ratepayers.

In the estimation of the Budget Analyst, water rates would have to increase by 4.5 percent above current levels simply to provide funding for the Water Enterprise"s additional interest payments due to the lowered credit ratings.

Similarly, sewer service charge rates would have to increase by 2.8 percent simply to provide funding for the Clean Water Enterprise"s additional interest payments due to the lowered credit ratings.

Such incremental rate increases could be avoided, to the benefit of the City"s ratepayers, by improving the Water and Clean Water Enterprise credit ratings to levels which were in effect prior to the approval of the Proposition H rate freeze.

Conclusions

Of the 12 major public utilities surveyed, including San Francisco"s Water Enterprise and Clean Water Enterprise, only the San Francisco utilities are subject to a rate freeze. A second significant difference between San Francisco"s utilities and those surveyed is that eight of the public utilities are able to issue bonds with the approval of their governing body, without obtaining separate voter approval. Both of the two public utilities besides San Francisco"s Water and Clean Water Enterprises that require voter approval for the authorization to issue revenue bonds, namely the Contra Cost Water District and the San Diego County Water Authority, employ alternative long term financing methods in order to fund capital improvement programs without the necessity of obtaining separate voter approval.

The Proposition H rate freeze has had a negative impact on the credit ratings of the City"s Water and Clean Water Enterprises. Prior to the rate freeze, Moody"s rated the Water Enterprise Aa and Standard & Poor"s (S&P) rated the Water Enterprise AA with a stable outlook. After the rate freeze was imposed, Moody"s downgraded the Water Enterprise to A1 and S&P downgraded the Water Enterprise to AA-, with a stable outlook. Subsequently, in July of 2001, S&P downgraded the Water Enterprise again to A+, with a stable outlook. The Clean Water enterprise was downgraded by Moody"s after the rate freeze from A1 to A2, with a negative outlook. Similarly, S&P downgraded the Clean Water Enterprise from A+ to A, with a negative outlook, subsequent to the rate freeze.

The PUC"s Clean Water Enterprise has the lowest credit ratings (A2, with a negative outlook) of all the utilities surveyed, and the PUC Water Enterprise has the second lowest Moody"s rating (A1, with the same rating as one other water utility) and the lowest S&P rating for a water system (A).

Further, the PUC Clean Water Enterprise is the only utility with a negative outlook, indicating that ratings are likely to decline to lower levels.

Moody"s and S&P, in response to our questions, stated that such actions as lifting the rate freeze and attaining authority to issue revenue bonds would be viewed favorably. However, such actions in and of themselves would not be sufficient to cause either rating agency to immediately upgrade the Water and Clean Water Enterprise credit ratings.

Both Moody"s and S&P stated that ratings upgrades would not occur unless and until the financial profiles, as measured by such factors as the Water and Clean Water Enterprise debt service coverage ratios, improved dramatically, coupled with assurances that the CIP would be implemented and supported with a credible and sustainable financial plan for the future. If all of these pieces were in place, the rating agencies indicated that they would be inclined to return the credit ratings of Water and Clean Water Enterprises to their former levels.

In the view of the rating agencies, the financial improvements in the Water and Clean Water Enterprises can only occur by increasing the water and sewer service rates and maintaining rate making authority to further increase water and sewer service rates in the future in order to assure financial stability, flexibility over implementation of the CIP and the authorization to fund it.

In the estimation of the Budget Analyst, water rates would have to increase by 4.5 percent above current levels simply to provide funding for the Water Enterprise"s additional interest payments of $3.2 million annually (approximately $32 million over the first ten years of debt service payment) due to the differential between the Water Enterprise"s current, lowered, credit ratings and its 1996 credit ratings prior to the rate freeze.

Similarly, the increases to sewer service charge rates would have to increase by 2.8 percent above current levels simply to provide funding for the Clean Water Enterprise"s additional interest payments of $4.0 million annually (approximately $40 million over the first ten years of debt service payment) due to the differential between the Clean Water Enterprise"s anticipated, lowered, credit ratings and its credit ratings prior to the rate freeze.

Such incremental rate increases could be avoided, to the benefit of the City"s ratepayers, by improving the Water and Clean Water Enterprise credit ratings to levels which were in effect prior to the approval of the Proposition H rate freeze.

c: Supervisor Daly
Supervisor Gonzalez
Supervisor Hall
Supervisor Leno
Supervisor Maxwell
Supervisor McGoldrick
Supervisor Newsom
Supervisor Peskin
Supervisor Sandoval
Supervisor Yee
Clerk of the Board
Mayor Brown
Pat Martel, General Manager, Public Utilities Commission}
Controller
Susan Leal, Treasurer
Monique Moyer
Ben Rosenfield
Ted Lakey
Jesse Smith

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Attachment 1
Attachment 2
Attachment 3

 

¹ Debt Service Coverage requirements in the revenue bond indentures require that net revenues in each Fiscal Year must be equal to at least 1.25 times more than the revenue bond annual debt service due in that fiscal year.

² The East Bay Municipal Utilities District is comprised of two enterprise funds, water and wastewater. Both enterprises have the same credit rating and are therefore combined in the table on the next page.