Tuesday, February 3, 2015

Treasurer's Report on Delta Tunnels' "Affordability and Financing Considerations"

This report was released in November, but I only managed to take a second look yesterday.  I still don't find it convincing, and it doesn't appear to have done much to quell growing financial doubts about the $25 billion BDCP twin tunnels plan.

The report attempts to estimate whether the twin tunnels' are financially feasible.  In other words, do the water agencies that would pay for the tunnels have the financial capacity to successfully issue and repay its construction bonds?

I have no doubt in the capacity of the urban water agencies to pay their share.  These agencies have tremendous ability to recover their costs through rates and property taxes - even for a bad multi-billion dollar project like the tunnels.  However, these urban agencies are the minority players in the tunnels' financing, the majority of the water and the costs are allocated to agricultural contractors, and most questions about financial capacity have been targeted at these farmers.

The majority of the agricultural water contractors are part of the Federal Central Valley Project (CVP), not the State Water Project.  The executive summary of the Treasurer's report summarizes its findings on the CVP contractors as follows (page 8).
Even if the CVP contractors develop a new credit with a take-or-pay obligation and similar credit features of DWR bonds, it is not clear at this point whether $10.25 billion of bonds (assuming a 50/50 split) in the Base Case could reasonably be issued without a large rate stabilization fund or other credit enhancement or subsidy from the federal government, state government, or SWP contractors.
Not very reassuring.  The first part of the sentence assumes CVP contractors will agree to unfavorable changes from their current contracts, and the second part concludes that subsidies are still likely to be needed even if they do.

Specifically, it assumes CVP contractors will change to a take-or-pay system where they would be obligated to pay debt service for capital costs even in dry years when they receive little water.  It seems unlikely that these farmers would be willing to give up one of the most favorable terms in their current CVP contracts.  It also assumes additional unfavorable provisions to CVP farmers to secure repayment such as "step-up" provisions to pay their neighbors' costs if they default, and the ability to levy property taxes or assessments to guarantee payments.  Finally, it assumes that the CVP contractors will be able to establish a new credit sufficient for a mammoth $10 billion bond issue with a AA rating, even though half of these agencies have no history of issuing muni bonds and thus no credit rating, and even the larger AA rated agencies have relatively small bonds.

And even if CVP contractors agree to all these changes, the Report still casts doubts on the ability of the CVP farmers' to issue the bonds without a large rate stabilization fund (who would pay for this? the financial analysis in the report does not include costs for a rate stabilization fund) or subsidies from federal and state taxpayers or urban ratepayers; even though BDCP proponents have repeatedly denied that any such subsidies would be necessary or acceptable.

In contrast to the caveat-riddled report conclusions, tunnel proponents have been quoting this sentence in the news release  that puts a rosier spin on the results than any sentence I could find in the report itself.
The Treasurer’s report illustrates that the cost of the Delta conveyance facility is within the range of urban and agricultural users’ capacity to pay.
Specifically, the report estimates the cost of water with the tunnels is $213 to $278 per acre foot for Kern and $253 to $301 per af for Westlands, and that the "capacity to pay" of Kern farmers is $277 af and Westlands' farmers capacity to pay is $291 af.  The estimated "capacity to pay" is within the range of costs, so BDCP proponents state that the tunnels are "affordable."  I don't think falling within this range is going to be very reassuring to potential bond investors.  I reviewed the calculations in the report and see a few significant problems:

1. The analysis uses average values.  It does not account for variation in hydrology or markets.
2. Capacity to pay is overestimated. The return to owner/management is implausibly low.
3. Costs are likely underestimated, relying on optimistic assumptions about ratings and bond covenants.

With respect to the first issue, using average values, financing the tunnels requires these farmers to make payments in every year - they can't skip dry years or years when markets are unfavorable.  In a dry year like the current one, the cost per af of water shoots up under take-or-pay contracts, and net revenues drop if you are fallowing land or paying high prices for supplemental water.  The Report correctly notes this risk, and even proposes a solution - a large rate stabilization fund.  But it does not include the costs of establishing such a fund - which would most likely come from increasing the initial amount borrowed - and include the cost of this insurance into the cost of water.

Second, the capacity to pay is overestimated.  To estimate capacity to pay, the Report uses average per acre revenue for 5 years, 2008-12, and subtracts an estimate of per acre costs from UC Cost/Return studies excluding cost for water and a return to owner/management (i.e. profit).  The Report then allows for a miniscule return of $90 to $94 per acre (Figure 20-21, page 37-38), and defines the remaining net revenue as the "capacity to pay for water."  The low value for a return is because the report used 10% of net revenue as an allowance for profit, rather than the more commonly used approach of a percentage of gross.

I don't think there are any farmers out there that would consider $90 per acre a reasonable return, especially when more than half the land is in vegetables or permanent crops.  According to USDA, the rental rate of irrigated cropland in California in 2012 was $340 per acre. My relatives in Michigan and Ohio have rented farmland for almost $200 an acre in the frosty and unirrigated Midwest.  Rental rates are reasonable to use for a return on bare land, but they do not include a return on investment in permanent crops (like the nearly $10,000 acre investment in establishing an orchard) or a return to management effort.  So what is reasonable value?

According to the BEA farm income data, the average net return to farming in Fresno County since 1969 is 25% of gross revenue with a range from 9% to 37%.  Profits have been strong in recent years, with margins over 30% of gross revenue since 2011 and over 20% in every year since 2002.  In light of this, I would argue that 10% of gross revenues would represent the minimum return to ownership/management to use for payment capacity.

Another approach could be a return on investment necessary to attract capital to a business with the risk profile of farming.  An example of this kind of allowance would be the 11-11.5% return on investment the Public Utilities Commission uses in determining allowable rates for investor owned utilities.  A 10% ROI to estimate a fair profit for farmland would be even more than 10% of gross revenue - but I will use the 10% of gross revenues to be conservative.

Using 10% of gross revenue, the return to management in the Report for Kern would increase from $94 acre to $439 acre and increase from $90 acre to $363 acre for Westlands which reduces the net revenue available to pay for water.  $400 per acre is not a lot of profit for running a farm, but it is a little bit higher than the rental rate of land and seems a reasonable estimate of the minimum necessary to keep the land in ag. production which I think is the spirit of the payment capacity calculation.

If you make this adjustment to a minimal profit margin, the calculated payment capacity for Kern drops to $164 af of water, and for Westlands it drops to $192 af.  Both of these values are well below the estimated cost range, and thus one should conclude that farmers do not have the capacity to pay for the tunnels and make a minimal profit.  

Finally, on the cost side, the Report's estimate of costs do not appear to account for any coverage ratio that is common in bond covenants.  Typically, bond covenants would require the debt issuer to ensure that net revenues after operating expenses are at least 1.25x annual debt service payments.  The new credit entity for CVP farmers will not only need revenue in excess of its debt service payments, it will undoubtedly need its own general manager, lawyers, lobbyist, office, etc.  Farmers will have to pay those costs, the costs of establishing and maintaining a rate mitigation account, and keep their annual net revenues at least at 1.25 times the debt service if they have any hope of the credit ratings and borrowing costs assumed in this report.  I haven't made an estimate of all this, but I think it would boost the cost range of water by at least $50 af, maybe closer to $100 af.

The bottom line is that I think a more reasonable estimate of maximum payment capacity for farmers is about $175 af, and their average cost of water will be at least $300 af with the tunnels.  Even for permanent crops, the adjusted maximum payment capacity is about $325 af and the water supply is not nearly reliable enough to shift to 100% permanent crops.

As frustrating as current conditions are to south-of-Delta farmers, they are still very profitable today. If they are paying for the tunnels, they have little chance of being profitable.

Like Hydrowonk Rodney Smith, the Treasurer's Report has left me more convinced than ever that the tunnels are not a doable deal.

P.S.  It should also be emphasized that the Treasurers' report only looks at financial feasibility, it is not a benefit-cost analysis or policy analysis.  The first page of the Report states this clearly,
The report does not address the merits of the BDCP per se or the question of whether the state and other parties involved in the project should proceed with this project.
That hasn't stopped tunnel boosters like the Metropolitan Water District from misrepresenting the report.  Clearly Jeff Kightlinger didn't read the first page of the report when he issued a statement that said "this independent review finds that BDCP is a prudent investment."

This post is too long already, so I recommend this post from the Hydrowonk for a good explanation of why the average cost analysis in this Report does not show that the tunnels are a prudent investment.