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Investors Need to Account for Resource Scarcity

The 2008 financial crisis stemmed from the false assumption that housing prices would always go up. It took a simple look at the underlying shoddy mortgages to realize how delusional that assumption was. But only a handful of investors saw the scope of the problem before it got too big to fix.

In hindsight, the problem is clear to all – and we've tried to put regulatory and political band-aids in place to make sure it doesn't happen again. But history tells us we'll make the same mistakes somewhere else.

Will the next bust caused by faulty assumptions be in the municipal bond market? Some experts believe it's possible.

When cities want to build new roads, bridges, power plants and water treatment facilities, they issue municipal bonds – long-term loans that provide them capital to expand infrastructure. This $3 trillion market helps fuel the growth of cities around the country.

Over the past two years there's been a growing crisis in the market as analysts and investors question whether financially-struggling municipalities will default on their loans en masse.

However, the long-term risk associated with resource scarcity could be even greater. Unfortunately, few people in the investment community are addressing the problem.

According to a report released last October by Ceres – an organization that consults the corporate world on sustainability strategies – investors and rating agencies are not properly accounting for resource risk when investing in municipal bonds. The report, written in partnership with Water Asset Mangement, focuses on water shortages specifically, which already pose serious risk in the Southwest and Southeast of the U.S.

“Investors are blindly placing bets,” writes author Sharlene Luerig, who acts as Ceres' senior manager of insurance programs.

Without factoring in the availability of water in these regions, the credit risk of utilities can't be truly discovered, she says.

Consider this selection of problems, which are just a few of many outlined in the report:

In Nevada, Lake Mead – the reservoir that provides energy and water to Las Vegas and other urban centers in the Southwest – is drying up at an astonishing rate. If water levels continue to drop at their current rates, the Hoover Dam could stop generating electricity by 2013.

In Atlanta, water supplies may be cut by up to 40 percent in the next year because of a legal battle between Georgia, Alabama and Florida around the city's withdrawal of water from Lake Lanier.

And throughout the Southeast, power companies have had to reduce electricity production when there isn't enough water to cool facilities. In one recent case, the Tennessee Valley Authority lost $10 million over a two-week period of time.

All over the country, water and power companies are making tough choices due to resource constraints.

Water utilities make up about 10 percent of the municipal bond market. More than half of debt in the sector will be outstanding for another 20 years. Without an accurate assessment of the compounding risks these suppliers face in the next couple of decades, the municipal bond market could be in for another big shake up.

In this week's podcast, we'll hear from Sharlene Luerig about the looming problem and how it may impact the value of municipal bonds. The interview was excerpted from the Ceres Sustainability Podcast.

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