What does Westlands SEC penalty mean for the delta tunnels plan(aka WaterFix)?

Last week, the SEC found Westlands Water District was misleading bond investors, making Westlands only the second municipal bond issuer to ever pay a penalty to the SEC.  Bond rating agencies immediately placed Westlands' bonds a negative outlook.

The announcement puts a spotlight on an issue that I have been talking about since 2012: the agricultural water districts can not and will not pay for their proportional share of the $16 billion delta tunnels. In 2013, I said the financial hole in the delta tunnels plan was comparable to the hole in the high speed rail business plan:

In both cases, the "hole" in the capital financing for the project is an unrealistic projection of funds provided from a key source.  In the case of high-speed rail, the hole comes from federal government appropriations that are unlikely to materialize.  In the case of the tunnels, the hole comes from the unrealistic expectation that farms will pay the majority of the costs since the majority of the water is for irrigation.

I am hardly the only one to come to this conclusion.  Even WaterFix supporters openly acknowledge that the agricultural contractors might not be able to pay, even as they keep telling urban households that the tunnels will cost them $5 per month, a calculation that depends on the assumption that farmers pay the majority of the tunnels' cost.  If the farmers drop out of the plan, these household costs are likely to triple. 

While I have been continuously skeptical of agricultural districts ability to pay, I was surprised by the SEC fine.  It shows the situation was even worse than I thought.  Even for a relatively small amount of bond debt, Westlands had to resort to "Enron accounting" to boost their revenue in a drought.

So what now?  It should be clear now that a proportional cost allocation isn't going to work.  The Central Valley Project (mostly farmers) may even have to drop out completely, leaving the State Water Project (mostly urban agencies) to attempt financing the tunnels themselves. 

The Metropolitan Water District has discussed a "subscribed capacity" model as a potential solution to the cost allocation problem.  In this approach, individual water agencies would choose how much of the tunnels' capacity they want to pay for - allowing some districts to opt out entirely and others to pay a larger share in return for a larger share of the tunnels' benefits.  Although the details are unclear, I foresee a lot of problems with this approach, starting with the critical issue of defining the tunnels' capacity in a way that has enough capacity to pay the $16 billion tab and does not harm the water users who opt out.  I will leave that analysis for a future post.

For now, the Westlands/SEC situation shows why the WaterFix plan must stop dragging their feet and put forward a detailed financial plan and cost allocation now.  It is critically important for that plan to demonstrate how the bond requirements will be satisfied in periods of drought when water agencies experience their greatest financial challenges, and that financing the tunnels will not jeopardize other investments in the California Water Action Plan.  Paying the tunnel bonds' in a drought when water sales revenue is low will be a challenging even for wealthy urban agencies like Metropolitan and Santa Clara and it will be even more difficult if these urban districts have to stand behind the agricultural contractors who would be likely to miss payments in a drought.  Environmental approvals for the WaterFix depend on the project maintaining its promise not to export more water in a drought, and various regulatory entities must require the WaterFix to demonstrate that its proposed operations are financially feasible during a drought.