Overview

Arizona local government and water utility ratings demonstrated credit stability in 2022 and 2023 and, despite hydrological challenges and softening economic trends, continue to benefit from population gains, ample liquidity, and water supply diversity. Longer-term rating stability is also provided by the state's conservative and supportive water policies and planning guidelines that moderate development to protect supply sufficiency. Given the state's population growth and climate volatility, S&P Global Ratings believes alternative supply development is necessary for long-term rating stability. We also believe Arizona utilities have significant financial flexibility to raise rates to account for the development of higher-cost and drought-tolerant supply alternatives due to their substantial operating reserves and low water rates relative to their Western peers.

S&P Global Ratings maintains general creditworthiness ratings on two counties, 22 municipalities, and 18 utilities in Arizona. The majority of both local government general creditworthiness ratings (76%) and utility ratings (78%) are 'AA-' or higher. Only 22% of utility ratings are in the 'A' category, Which we consider indicative of the utility sector's credit quality, as the national median utility rating is 'A+'. About 96% of the municipality portfolio has a stable outlook, while one rating has a positive outlook. Overall municipal credit quality remained fairly stable from October 2022 through September 2023, with only one rating change in the last year: an upgrade due to improved economic and financial conditions. Meanwhile, the credit trajectory for the utility sector was generally stable during the past year, with one raised rating attributed to robust financial performance. During the same period, we revised the outlook on two ratings to stable from negative. We have not downgraded an Arizona utility rating since Jan. 1, 2022. In general, we expect Arizona local governments will maintain stable credit fundamentals in the near term due to improved underlying tax bases fueling the expansion of core revenue streams.

Both the utility and local governments sectors face headwinds from inflationary pressures, a challenging labor market, and the potential for an economic slowdown in 2023 and beyond, as forecast by S&P Global Ratings Economics. (For more information, see "Economic Outlook U.S. Q4 2023: Slowdown Delayed, Not Averted," published Sept. 25, 2023, on RatingsDirect.) However, we believe that strong growth trends during the past several years will enable most municipal issuers to withstand short-term revenue contractions, due to their robust reserve positions and strong market value to assessed value (AV) differentials, which support ongoing taxable value growth.

Managing Hydrological Volatility And Credit Risk

In some respects, Arizona is better positioned hydrologically than its Western and Southwestern peers, given the production of the Salt and Verde rivers and the availability of its significant groundwater basin. Conversely, aquifer depletion is a meaningful credit risk as Colorado River allocations dwindle. Managing hydrological volatility will be an ongoing rating pressure for Arizona issuers that will require them to develop additional supply and demand strategies to maintain a sufficient water supply, encourage residential conservation, and increase agricultural efficiencies.

Most of our rated entities do not rely on the Colorado River as a primary source for tap water, but several use the imported supply for artificial aquifer recharge. In western Arizona, we believe the groundwater basins are more at risk of overdraft because they are not managed and over pumping is depleting the water table. The primary water users in Arizona--and the Western region in general--are agricultural, which represents 72% of water use. While irrigation dwarfs other water uses, the agricultural sector has also used efficiencies to cut its consumption by over 30%, more than any other group. Arizona's agricultural policies support improved conservation by restricting additional agricultural production, limiting irrigation loss to 10%, and limiting allocations. Continued irrigation improvements and potentially reduced farming during droughts will likely play a large role in addressing future scarcity and could result in economic and labor shifts in areas where fallowing or shifts in output occur.

Last week, the U.S. Bureau of Reclamation (USBR) executed seven new conservation agreements with 18 Arizona entities to support Lake Mead operations. The agreements incentivize the voluntary conservation of nearly 350,000 acre-feet in 2023, and up to 984,429 acre-feet through 2026, when the current Colorado River operating guidelines expire. The USBR is working to finalize additional agreements. The Biden administration also announced a $63 million investment funded by the Inflation Reduction Act to finance voluntary system conservation, which was instrumental in the agreements' success. We expect federal support will be critical in achieving voluntary conservation goals.  

Based on forecasting by the Kyl Center for Water Policy, we believe most issuers would have sufficient water supply until a tier-three shortage declaration, which would trigger mandated cuts of 720,000 acre-feet. At that point, some issuers with greater reliance on the Colorado River for their supply would be challenged to meet their customers' needs. To combat fluctuations and increase capacity, issuers are investing in both alternative supplies and infrastructure to improve water delivery in shortage scenarios. This includes additional wells, exchanges and interconnects, and treatment/distribution enhancements. We believe ongoing investment in such infrastructure is critical to maintaining credit quality.

We believe Arizona issuers have the financial capacity to absorb the costs of these necessary infrastructure investments. From a local government perspective, a period of strong revenue trends allowed many issuers to build robust reserves, while the expanding underlying tax base supports debt and capital initiatives. Further, water costs and overall utility rates remain low on a relative basis, which gives issuers more leeway to pass along increased alternative supply and infrastructure costs to ratepayers. We consider this relative affordability as credit supportive.

What We Are Watching

Local government portfolio buoyed by robust reserves, positive operating performance

Arizona local governments have benefitted from strong tax base growth in recent years. Double-digit market value increases support the expectation of continued net limited AV (taxable value) growth for the foreseeable future, despite potential economic contractions. Income indicators throughout the state lag national medians across each rating category, which we believe highlights its relative affordability. We note that these indicators have increased gradually overall in recent years as demographics shifted and additional employment opportunities expanded.

Excise taxes (including sales taxes), the largest revenue stream for the majority of the municipal portfolio, continue to rise despite some revenue normalization after a period of extraordinary growth post-pandemic. We expect fixed costs will continue to increase in the coming years, as the cost of living and pension costs rise after weaker investment returns in fiscal 2022. We view the state's median pension carrying charges as moderate relative to municipalities' budgets. Overall, we observed positive operating performance by our rated municipality portfolio contribute to robust reserves that averaged more than 80% of operating expenditures, which we consider extraordinarily strong. We believe these factors provide issuers with a cushion to absorb any near-term cost increases.

Utilities' healthy financial performance supports infrastructure investments

Arizona water utilities have exhibited supportive economic fundamentals, strong operational management, and low water costs in recent years. Nearly 80% of the portfolio garnered the top two enterprise profile scores within our water and sewer criteria compared to only 49% of the nationwide portfolio. One of the unique attributes and strengths of the Arizona portfolio stems from its larger relative utility size. Approximately 60% of our rated utilities have a revenue base of more than $75 million, compared to only 14% of the national portfolio. We believe larger utilities provide greater access to economies of scale, which is a positive adjustment in our criteria. Smaller credits tend to exhibit greater volatility and exposure to event risk. Arizona has very few credits that we consider small or very small.

Financial performance for the state's utilities was healthy during the past three years: Liquidity was well over 600 days' operations, which we consider strong on a nominal basis, and median debt service coverage ranged from 1.8x to 2.1x, which we consider extremely strong. Liquidity compares favorably to national medians, which we consider important, given utilities' need to manage hydrological volatility and support growth.

Debt service coverage had historically been on par with national levels, but most recently the median declined more than 20 basis points due to rising operating costs. We consider this indicative of the costs associated with a heavier reliance on groundwater, given the state's low hydrology, extreme heat, and cutbacks in surface supply. The debt-to-capitalization ratio is slightly higher than the national level, and we expect it will continue to rise as utilities invest in their infrastructure to meet rising population demands and water supply needs.

Growth management and water supply are key credit considerations for Arizona issuers

Arizona has experienced significant growth during the past three decades, necessitating investment in both general infrastructure and additional capacity to both supply water and treat wastewater. A rising population generally results in additional taxing and rate capacity, which translates to corresponding increases in available revenue- and growth-related fees. However, this added revenue may be offset by the commensurately higher capital and operating costs associated with supporting a growing population and supplying water and wastewater services.

We view the state's recent decision to limit development in areas where the full allocation of available groundwater has been reached as a positive credit factor. This decision suggests that in the state's regulated basins, the 1980 Groundwater Management Act (which is modeled around a rolling 100-year supply) is being executed appropriately and accounts for the effects of climate variability and population gains to ensure that supply sufficiency is a factor in development decisions. We view this type of comprehensive water supply planning as supportive of credit quality.

Of the six existing active management areas (AMAs), the state's decision to limit development applies only to the Phoenix AMA and will not affect certificates of assured water supply already issued for the approximately 80,000 lots currently under development in the Phoenix metropolitan area. We expect the limitations to increase development costs in parts of the Phoenix suburban area, which may pressure housing affordability. However, we believe cities have several options to mitigate those pressures. In addition, most rated issuers are within the "designated assured supply" area, which means this limitation will not directly affect them.

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Developing additional supply options

How three high-growth Arizona cities are acquiring new water supplies and diversifying their water portfolios:

• Buckeye: Issued $80 million in excise tax debt to secure water rights for future development
• Queen Creek: $27 million purchase of Colorado River water from former farms in Cibola
• Mesa: $185 million agreement underway within the Gila River Indian Community to address additional supply, although the city is also located within a "designated assured supply" area

Spotlight On Environmental, Social, And Governance Factors

Arizona ranks as one of the fastest-growing states in the nation by population, which brings both opportunities and longer-term challenges. The state's geography spans forested mountains to arid desert, which pose a range of long-term physical risks such as wildfire and extreme heat, as well as natural capital risks stemming from prolonged drought and water-supply stress. These risks could negatively influence the credit fundamentals of local governments and utilities we rate as population, development, and tourism trends could wane over time, potentially impacting budgetary balance absent forward planning and mitigation strategies.

Arizona has elevated exposure to physical risks related to its significant hydrological volatility. Currently, 18% of the state is in severe or extreme drought, compared with 23% in 2022. The Salt and Verde rivers are near record highs. With respect to the Colorado River allocations, we expect the upcoming operating year will improve relative to 2023, given the wetter conditions. That said, future shortages are a certainty, and it is possible that the Colorado River allocations for all lower basin users will be reduced in the 2026 U.S. Bureau of Reclamations renegotiations. (For more information, please see "USBR Proposal Raises Water Supply Uncertainty For Lower Basin States; Impact May Trickle Down To Future Negotiations," published April 27, 2023, on RatingsDirect.) Given the effects of aridification and anticipated future hydrological volatility, we expect water stress will be a perennial credit risk facing Arizona issuers.

Strong risk management, culture, and oversight practices by Arizona municipalities and utilities mitigate some exposure to physical risk and underpin credit stability, in our view. The state has conservative policies in place to address supply sufficiency. Further, our operational management assessment scores for Arizona utilities--for capture assets as well as organizational and rate management--are stronger than the national average, which we believe demonstrates the commitment by the state, municipalities, and utilities to manage the potential effects of ongoing hydrological variability.

We view the state's population growth and demographic trends as a social opportunity when compared with areas of the country experiencing stagnant-to-declining populations, as growing employment opportunities and the relatively low cost of living continue to attract young, highly-skilled professionals and employers to the region. However, if this growth is not appropriately managed and home price appreciation pressures affordability, the state could experience an uptick in the unhoused population and rising service needs could pressure issuers' long-term budgets.

Arizona Utility And Municipality Data

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