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Audited Financial Transparency for Public Sector Utilities and Credit Rating Decisions

When looking at either the historic performance or the forecasted outlook by many of the credit rating agencies, public utilities including water & sewer have been stable and weathered the COVID-19 pandemic with relatively little impact to their financial standings.

A portion of the credit for this positive news goes to the early preparedness undertaken by the management teams on their rate setting initiatives that included building up liquidity for the future capital needs and/or building reserves for a rainy day. These initiatives are looked upon very favorably by the rating agencies, hence earning a stable outlook for this sector. Along the same lines, the need for timely completion and reporting of their audited financials adds to the comprehensive assessment picture.

In this article, we will take a look at the future of public utilities in the wake of natural disasters, aging infrastructure, cyber security, experienced workforce scarcity, and federal push to enhance the public utilities.

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Financial Reporting for Public Utilities

When we review the main reason for many public agencies to get a rating downgrade or negative outlook, it’s often one or a few structural challenges paired with either a delay or non-reporting of their required financial statements in a timely manner. Primarily, the public utilities in the United States are provided and managed by the City and its elected officials providing the oversight; however, the financials are typically kept and reported in a segregated manner from the General Fund reporting. The public utilities and their finances are often referred to as Enterprise Funds or business-like activities. So, in a broader manner, these business-like activities have their own set of revenues, generated through the utility rates set by the governing boards, and the expenditures are tracked in a separate manner related to running these utilities for the public good.

Now, when a rating agency is assessing the financial strength and viability of these public utilities, they are solely basing their assessment on the data reported through the City’s quarterly and annual financial reporting, as well as information requested through other channels like number of utility customers, population growth forecast, impact of natural disasters on the utility revenues generated, and the overall liquidity and capital market access to meet the future capital projects. In a recent publication by Standard and Poor Ratings, it states that, “During the past two years, S&P Global Ratings had 54 negative rating actions across the water and sewer sector. Of those negative rating actions, approximately 38% or 21 were driven by weak transparency, accountability, or risk management”, highlighting the dire needs of adequate and timely financial reporting for many U.S. public utilities.

The aforementioned financial disclosures and reporting requirement aren’t needed only for the credit rating assessments, but they are important for these agencies to access the capital markets to issue future debt obligations. Furthermore, the ratings agencies are on the lookout for any voluntary disclosures that are needed to be reported as part of the financial assessments related to the overall operations of these utilities.

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Climate Change and Natural Disasters for Public Utilities

It’s important to note that public utilities and their operations revolve around water, the supply of which is impacted by many natural disasters like drought in the Western regions or flooding in other areas. Furthermore, it’s also important to monitor the impact of climate change on the availability of water sources for local governments and their ability to provide these important services.

Climate exposure is emerging as a key metric for some rating agencies as they review the financial health and forecast of American utilities. Also, it’s not the impact of climate change on the future of revenues for these agencies, but how the management and governing authorities are strategizing around these issues. Another report published by Standard and Poor highlights this need by stating “comprehensive risk disclosure supports a better understanding of management’s assumptions, plans, and financial capacity to address any chronic or acute physical climate risks. In the utility sector, mitigation and management of physical climate risks and natural capital concerns can be a key factor in credit quality, as they influence the system’s ability to provide reliable essential services. Water scarcity (natural capital), for example, can affect financial performance, including revenue collection (conservation), customer growth (development), expenditures (cost of water), and infrastructure requirements (developing alternative supply).”

The Bottom Line

Although American public utilities are being viewed as a stable sector due to the financial preparedness measures taken by many agencies, it’s also important for public utilities to start incorporating the added threat like climate change and natural disasters in their mitigation tactics, especially when the leading credit rating agencies are incorporating these metrics into their assessments.

Investors should also carefully review and assess the timely reporting of audited financial statements by these public utilities before making investment decisions.

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Sep 07, 2022