City of Los Angeles, CA Wastewater System Subordinate Revenue Bonds,

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1 U.S. Public Finance Local Revenue Bond Rating Report Wastewater System Subordinate Revenue Bonds, Series 2017-A (Green Bonds) Refunding Series 2017-B (Green Bonds), and Refunding Series 2017-C (Taxable) (Green Bonds) Analytical Contacts: Alice Cheng, Associate Director (646) Andrew Clarke, Senior Director (646) April 28, 2017

2 Table of Contents Executive Summary... 3 Security... 3 Use of Proceeds... 3 Rating Summary... 4 Outlook: Stable... 5 Key Rating Determinants... 6 Rating Determinant 1: Management... 6 Rate Setting Authority & History... 6 Capital Plan Management... 6 Labor, Pension and OPEB... 6 The California Drought... 7 Rating Determinant 2: Legal Mechanics and Security Provisions... 8 Flow of Funds... 8 Collection Agent... 9 Bankruptcy Assessment Rating Determinant 3: Service Area and Economy Population and Service Area Socioeconomic Indices Unemployment Historical Rates & Affordability Wastewater Service Contract & Other Customers Rating Determinant 4: System Characteristics Customer Base System Charges End Wastewater Contracts Water Supply Rating Determinant 5: Financial Metrics Debt Service Coverage System Liquidity Rating Determinant 6: Debt Structure and Capital Plan Requirements Leverage Capital Improvement Plan Conclusion Page 2 April 28, 2017

3 Executive Summary Kroll Bond Rating Agency (KBRA) has assigned a long-term rating of AA with a Stable outlook to the City of Los Angeles ( the City ) Wastewater System Subordinate Revenue Bonds, Series 2017-A, Refunding Series 2017-B and Refunding Series 2017-C (Taxable). All three series of bonds are designated Green Bond reflecting the environmental benefits of the capital facilities being financed. KBRA has also affirmed the long-term rating of AA+ and stable outlook to the City s Wastewater System Revenue Senior Lien Bonds and the long-term rating of AA and stable outlook to the City s Wastewater System Revenue Subordinate Lien Bonds. After the issuance of the 2017 bonds, the City expects to have approximately $1.08 billion of senior lien and $1.69 billion of subordinate lien outstanding. This rating is based on KBRA s U.S Municipal Water and Sewer Revenue Bond Rating Methodology. Security The senior and subordinate lien bonds are limited obligations of the City of Los Angeles, payable solely from wastewater system revenues on deposit in the senior and subordinate debt service funds. The City will transfer pledged revenues to the debt service funds on or before the 25th day of each month. Senior lien bonds are payable before subordinate lien bonds. Rates and charges will be set at levels sufficient to cover senior lien debt service by 1.25x and combined senior and subordinate lien debt service by 1.10x. Additional senior lien bonds can be issued if net revenues received before and after bond issuance are able to cover maximum annual debt service (MADS) on new and existing debt by at least 1.25x. The test for subordinate lien bonds is weaker at only 1.10x aggregate senior lien and subordinate lien MADS. The senior bonds have a debt service reserve fund (DSRF) requirement set at MADS but there is no DSRF requirement for subordinate bonds. Use of Proceeds Proceeds from the Series 2017-A Subordinate Bonds will finance construction and improvement of the Wastewater System ( the System ). Proceeds from the Refunding Series 2017-B Subordinate Bonds will advance refund certain portions of the Refunding Series 2009-A Senior Lien Bonds and Refunding Series 2010-A Subordinate Lien Bonds. Proceeds of the Refunding Series 2017-C Subordinate Bonds (Taxable) will advance refund certain portions of the Refunding Series 2009-A Senior Lien Bonds on a taxable basis. Refunding senior lien bonds with subordinate lien bonds will release $5.7 million held in the Series 2009-A DSRF. The City will use the available cash to reduce the amount of Series 2009-A principal outstanding, which enhances the net present value savings achieved by the refunding. Key Rating Strengths Experienced management team with a strong track record of setting rates and charges at levels required to fully fund operations and maintenance Very strong legal provisions that set forth a 1.25x senior and 1.10x combined senior/subordinate debt service coverage requirement, restrictive additional bonds tests, and a senior lien debt service reserve fund requirement Strong service area economy that is well diversified and includes most of Los Angeles and several affluent suburban systems Primarily residential customer base with limited commercial and industrial ratepayer concentration and adequate system treatment capacity Historically sufficient liquidity and strong debt service coverage Page 3 April 28, 2017

4 Key Rating Concerns Ongoing uncertainty related to water conservation and drought conditions Increase in labor costs may put additional pressure on the System's financials High system leverage ratios that are likely to remain elevated as the system finances its sizable capital improvement plan primarily with debt Rating Summary The City of Los Angeles is responsible for operating and maintaining one of the world s largest wastewater collection and treatment systems. The System has a service area of approximately 600 square miles with a population of over 4 million. It operates over 6,700 miles of sewers, over 100,000 maintenance holes, 44 wastewater pumping stations, and four water-reclamation plants. The System has a maximum treatment capacity of 580 million gallons per day (mdg), which provides sufficient treatment capacity given the maximum daily flow of 329 mdg in FY 2016 and average daily flow of approximately 60% of capacity. In addition to the City, the System serves 29 suburban entities within Los Angeles County that fall within the System s service area due to geographic topography. The Los Angeles Department of Water and Power (LADWP) provides water to the service area. The City of Los Angeles owns and operates the System. The mayor and the city council form the governing body responsible for setting rates and charges. The System is managed by the Department of Public Works (DPW) and operated by the Bureau of Sanitation (LASAN or the Bureau ). The governing body has demonstrated its commitment to setting rates and charges to fund operational and capital needs, which KBRA views positively. In 2011, the mayor and city council approved a series of four 4.5% increases and seven 6.5% rate increases that are automatically implemented each year through Fiscal Year The City is currently planning for an additional series of rate adjustments that will become effective after KBRA views the legal mechanics and security provisions as providing strong levels of bondholder protection. The senior lien general resolution requires the City to set rates and charges at an amount that will at least equal to annual operating expenses and 1.25x total annual debt service. The subordinate lien rate covenant is set at 1.10x combined annual senior and subordinate lien debt service. The senior lien bond indenture provides for a DSRF that is to be maintained at all times the senior lien bonds are outstanding. The DSRF requirement is MADS for senior bonds. The subordinate lien resolution does not include a provision for a debt service reserve fund. The current sewer service charge (SSC) rate is at $4.51 per hundred cubic feet (hcf) of flow. The average monthly residential wastewater bill is $32.40, based on discharge less than 10 hcf, which KBRA views as affordable when compared to other large utility systems. Rate adjustments have been frequent and sufficient to cover operating expenses and capital expenditures. The System s sizable customer base is diverse and largely comprised of residential users. The top 10 customers generated about 6% of the SSC revenues in FY On a cash basis, revenues from operations were $607.4 million in Of this amount, about 91% was generated from the SSC. On a cash basis, annual operating and maintenance expenses were $270.2 million, or 5% lower than in FY Net revenue available for debt service in FY 2016 on a cash basis was $346.0 million, resulting in a strong senior debt service coverage ratio of 3.25x and a combined debt service ratio of 1.73x. In general, the System has strong financial operating results in which operating revenues have exceeded operating expenses by at least 1.86x every year for the past five years. Historical debt service coverage on outstanding senior lien bonds has been very strong, at 2.52x or higher on an accrual basis (2.16x cash basis) over the last five years. Page 4 April 28, 2017

5 The System has demonstrated a history of strong liquidity. In FY 2016, the total cash balances in the Sewer Construction and Maintenance Fund, Sewer Operation and Maintenance Fund, Operation and Maintenance Reserve, Insurance and Liability Claims Fund, and Emergency Fund totaled $153.7 million, which equates to a System liquidity position of 207 days cash on hand. The System has high leverage ratios as indicated by its debt to plant ratios of approximately 70% in FY KBRA views high leverage ratios as a concern that may constrain future rate setting flexibility, but notes that the City has a good history of implementing rate increases and that rates remain affordable compared to other large utility systems. It is also KBRA s view that the current rate levels allow for adequate additional flexibility. The City estimates that the total costs for its current wastewater system capital improvement plan (CIP) will be approximately $1.9 billion during the five-year period from FY 2017 through FY The CIP will largely be financed with additional debt. Based on review of the six KBRA Rating Determinants included in the KBRA Methodology for rating Water and Sewer Revenue debt, KBRA has assigned rating determinant ratings as follows: Management: AA+ Legal Mechanics and Security Provisions: Senior Lien AAA, Subordinate Lien AA Service Area and Economy: AA+ (revised from AA) System Characteristics: AA+ Financial Metrics: AA+ Debt Structure and Capital Plan Requirements: AA Outlook: Stable The stable outlook is based on KBRA s view that debt service coverage will continue to exceed requirements while the System works through its sizable capital improvement program. It also reflects KBRA s view that the System will continue to manage the challenges related to water conservation efforts and drought conditions and that annual rate increases, which have already been approved through FY 2021, will enable the System to adequately manage the additional capital expenses. In KBRA s view, the following factors may contribute to a rating upgrade: A sustained alleviation of the drought conditions and water supply issues resulting in a continued and more favorable long-term water supply. A sustained reduction in system leverage. In KBRA s view, the following factors may contribute to a rating downgrade: A reduction in System revenues causing a sustained decline in debt-service coverage or liquidity. A sustained deterioration in the service area demographics profile leading to reduced rate-setting flexibility. Significant deterioration in the credit quality of one of the larger service contract customers that contracts with the City for wholesale wastewater-treatment services. Page 5 April 28, 2017

6 Key Rating Determinants Rating Determinant 1: Management The City of Los Angeles owns the Wastewater System. The Bureau of Sanitation is responsible for the operation and maintenance of all System facilities. The Bureau operates under the direction of the Department of Public Works. The Department of Public Works operates under the direction of the mayor and city council. The mayor and city council approve System operating and capital budgets and set System rates. The Bureau is managed by an executive staff who have considerable experience and long tenures at the City of Los Angeles. The Bureau is one of the largest City agencies with nearly 3,000 employees and an annual operating budget of over $1.1 billion across all departments. The Bureau annually reviews System rates as part of the budget process. The mayor and city council may enact rate increases during the budget process or at any time upon the recommendation of the Bureau and the city administrative officer (CAO). The Office of Accounting of the Board of Public Works provides accounting and financial services. It also bills and collects certain revenues, processes appropriation and budgetary documents, and initiates payments. Rate Setting Authority & History The Bureau conducts an annual review of current rates and charges during the budget process to help ensure that budgeted revenues will meet all rate covenant requirements and planned expenditures for operations and capital improvement. In fiscal year 2011, the City enacted a series of rate adjustments that automatically increase System rates with a series of four 4.5% increases and seven 6.5% through fiscal year The ongoing rate increases were adopted to fund operations and the capital improvement program. The City does not need to approve any additional rate increases at the current time but does have the ability to do so if necessary. Capital Plan Management The System has a very well-developed and comprehensive capital-improvement program that is monitored throughout the fiscal year and updated annually. Capital planning policies are guided by the Integrated Resources Plan and the One Water Los Angeles 2040 Plan. The Bureau s program review committee approves all capital projects based on their scope, budget, and schedule. The Bureau produces the wastewater system capital improvement program annually, which is an ongoing, ten-year capital expenditure program. The CIP s objectives are to meet federal and state regulatory requirements and the City s policy regarding water pollution control. The City monitors its revenues and billable wastewater volume and adjusts the capital program accordingly. Labor, Pension and OPEB A number of City departments and bureaus contribute labor and employee time to the operation of the System. The Bureau had an authorized headcount of approximately 1,282 employees in its wastewater program, 99% of which are unionized with most represented by bargaining units that are members of the Coalition of Los Angeles City Unions. KBRA understands that the City and the Los Angeles Coalition of City Unions have reached a memorandum of understanding on a new contract that runs through June 30, 2018 and includes 2.0% salary increases effective July The Bureau s employees belong to the Los Angeles City Employees Retirement System (LACERS). Under the new GASB Statement No. 67 Financial Reporting for Pension Plans, LACERS funded ratio on a market value basis was 70.5% as of fiscal-year-end 2016, down from 81% from KBRA notes that the most Page 6 April 28, 2017

7 recent LACERS funded ratio is lower than in 2008 due to a combination of factors including investment losses in and recent investment return fluctuations. The current underfunded actuarial accrued liability (UAAL) is $4.9 billion, and the total accrued actuarial liability is $16.9 billion. The Bureau has increased contributions to fund its portion of pension costs in recent years. While the increase in pension contributions have stabilized, the Bureau expects that healthcare related costs will increase over the next few years. The System does not anticipate the increase in pension costs will affect debt service coverage as the increases have already been incorporated in the System s financial projections. As of June 30, 2016, the System s share of the City s pension and OPEB costs was $32.3 million or 7.4% of the City s total pension and OPEB costs, which also represented 12% of the System s operating expenses on a cash basis. The System s share of pension and OPEB costs for FY 2017 is expected to be $34.1 million or 7.4% of the City s total pension and OPEB costs and 3.7% the System s budget. The City provides post-employment retirement healthcare benefits (OPEB) to retired employees who are eligible for pension benefits. The City began prefunding the costs of these benefits on an actuarial basis in FY The majority of municipal entities do not prefund their OPEB liability, therefore KBRA views the City s prefunding of its OPEB obligations on an actuarial basis as a very positive credit factor. As of June 30, 2016, the OPEB funded ratio was 80.5%. The City generally pays the full annual required contribution or annual defined contribution payment for both its pension contributions and OPEB obligations. The California Drought The City of Los Angeles addressed the statewide drought in a proactive manner. It was an early adopter of water conservation and began undertaking conservation efforts in 2009, well before Governor Jerry Brown implemented a mandatory urban water usage reduction in The City s water conservation efforts include an executive directive ordering City departments to cut nonessential water use by reducing the watering of landscapes, washing of motor vehicles, and operation of fountains. The City also asked residents to voluntarily reduce watering lawns and other landscapes to two days a week and to install low water landscaping and more water efficient plumbing fixtures. The drought and water conservation efforts reduced wastewater flows by a compound annual rate of 2.5% between 2007 and During this time, the System maintained strong financial performance and debt service coverage by controlling expenses, implementing rate increases, and delaying nonessential capital projects. Recent weather patterns have restored water supply levels and eased drought conditions across the state. The reprieve enabled Governor Brown to terminate the Executive Drought State of Emergency Order for all but four counties (Fresno, Kings, Tulare, and Tuolumne) effective April of The Governor has not fully rescinded statewide water-conservation efforts, and the Making Water Conservation A California Way of Life document, which sets forth permanent restrictions on wasteful water practices, is still in effect. The Making Water Conservation a Way of Life provisions include a prohibition on activities such as hosing off sidewalks and driveways, and using non-recirculated water in a fountains or other decorative water features. The City is not amending its position on water conservation and KBRA understands that the City will continue to move forward with its plans to become less reliant on outside water sources. The System has issued a recycled water plan in conjunction with the LADWP, the Department of Public Works, and the Bureau of Engineering. Some of the initiatives within that plan can be achieved in the short term, such as stormwater recapture, while others are longer-term, such as treating a contaminated groundwater basin in the San Fernando Valley. Page 7 April 28, 2017

8 KBRA will continue to monitor the financial and capital funding impacts related to the drought and water conservation efforts. It is KBRA s view that the System has successfully managed the challenges related to reduce water flow. KBRA also positively views the System s adherence to plans assuming future water supply will be constrained. Based on the foregoing, KBRA views the System s management structure and financial-management policies as being consistent with a AA+ rating determinant rating. This rating level reflects the System s flexibility to increase rates, proactivity in approving rate increases through 2021, and strong response to ongoing drought problems. Rating Determinant 2: Legal Mechanics and Security Provisions KBRA views the legal mechanics and security provisions as providing a strong level of bondholder protection. These provisions are a key rating factor given the System s challenges related to drought conditions, water conservation and supply. The System employs a traditional net-revenue pledge and has a very strong ratepayer collection system. Bonds are issued at both the senior and subordinate levels and both lien structures are open. KBRA assigns separate rating determinant ratings to the senior-lien and subordinate-lien bonds to reflect the order of payment priority and slightly weaker provisions at the subordinate level. The Wastewater Revenue Bonds Series 2017-A and Refunding Bonds Series 2017-B and 2017-C will be issued under the subordinate general resolution. The Series 2017 Bonds are secured by a pledge of and lien on the 2017 Subordinate Debt Service Fund established by the Twenty-First Supplemental Resolution. The legal provisions governing both liens are summarized in the following table. City of Los Angeles, Senior and Subordinate General Resolution Revenue Pledge Rate Covenant Additional Bonds Test Debt Service Reserve Requirement Flow of Funds Senior Lien Net Revenue Pledge 1.25x Annual Senior Lien Debt Service Net Revenues > 1.25x Maximum Annual Debt Service Due on Senior Lien Debt Debt Service Reserve Fund > Maximum Annual Debt Service for Senior Lien Debt The Flow of Funds is Closed Subordinate Lien Net Revenue Pledge 1.10x Annual Senior & Subordinate Lien Debt Service Net Revenues > 1.10x Maximum Annual Debt Service Due on Senior & Subordinate Lien Debt No Debt Service Reserve Fund The Flow of Funds is Closed Source: City of Los Angeles Wastewater System Senior & Subordinated Revenue Bond Resolutions Flow of Funds After Sewer System Charges are received from LADWP and deposited into the Sewer Construction and Maintenance (SCM) Fund, they become available to be applied for all costs related to operating and maintaining the wastewater system. The general resolution sets forth a clearly defined flow of funds that establishes a net revenue pledge on SCM Fund monies placed within the debt service funds, as illustrated in the diagram on the next page. The flow of funds is closed. Surplus funds may be used to pay system capital expenses or for any other lawful purpose related to the system, provided that an amount equal to operating and maintenance expenses during the next 45 days remains within the SCM Fund. It is KBRA s view that the flow of funds provides a strong level of bondholder protection. Page 8 April 28, 2017

9 Collection Agent The City s Wastewater System, unlike most systems, does not directly collect sewer service charges and fees from wastewater system users. Instead, like other utility service providers within the City of Los Angeles, wastewater bills are collected by the LADWP. SSC and fees appear on a single bill along with water, electricity and other utility charges. Residents do not have the ability to selectively pay line items or portions of their LADWP bill. Payment delinquencies of over $150 are subject to potential disconnection and could ultimately result in a lien being attached to the delinquent property. KBRA views the bundling of wastewater, water, power, solid waste and other utility charges, and the potential threat of disconnection for all utilities in the event of non-payment, as providing a very strong payment incentive. The SSC appears on bimonthly utility bills (monthly for commercial customers) delivered by the LADWP. On a weekly basis, LADWP transfers an amount equal to that week s projected Wastewater revenue to the Bureau of Sanitation. Adjustments are made each month to reflect the actual revenue collected for the previous quarter. The LADWP applies an administrative charge (about $3.0 million per annum), and adjusts transfers to reflect refunds of incorrectly billed charges, bank returned checks, and various other adjustments. The administrative collection charge amount has not increased in several years. It is the System s view that sufficient notification would be given to incorporate any administrate charge amount increases into future budget cycles. In 2013, LADWP implemented a new billing and collection system. The system malfunctioned due to technical problems and caused revenue delays for the System. The problems were corrected and revenue collections are back to normal. FY 2016 wastewater fees collections equaled 101.7% of budgeted amounts, reflecting the impact of prior year overdue. Page 9 April 28, 2017

10 Based on the foregoing, KBRA views the legal mechanism and security provisions of the senior lien and subordinate lien bonds as being consistent with a AAA and a AA rating determinant rating, respectively. These rating determinant ratings reflect the strong levels of bondholder protections, and the lower payment priority, absence of a debt-service reserve fund, and other security provisions in the subordinate-lien resolution that are generally weaker than the senior-lien resolution. Bankruptcy Assessment It is KBRA s understanding that according to bankruptcy provisions in the State of California, local governments, counties, cities, districts, public authorities, public agencies and other municipal entities, are allowed to file for relief under Chapter 9. While local governments within the State are granted broad authority to file Chapter 9, California Government Code sections require cities, counties, and certain other special districts, to first attempt to resolve their fiscal problems with creditors, employee groups and other interested parties through a mediation process or to declare a fiscal emergency before they may file a petition for relief under Chapter 9. Given the strength of the City s management and its strong financial condition, KBRA views the risk that the City will access the process to file for bankruptcy as remote. It is KBRA s understanding that the pledge securing the Bonds constitutes a pledge of special revenues, as defined under the U.S. Bankruptcy Code and, thus, would qualify for special protections afforded to holders of the Bonds secured by special revenues in the event of a municipal bankruptcy filing by the City of Los Angeles. It is KBRA s understanding that because the Revenues securing the Bonds would likely qualify as special revenues under the Bankruptcy Code, the City s pledge of the Revenues to pay the Bonds would not terminate upon a municipal bankruptcy filing under Chapter 9. Any pledged funds received by the City following a chapter 9 bankruptcy petition would remain subject to the pledge contained in the underlying bond documents. Thus, the application of the Revenues to regularly scheduled payments of principal and interest on the Bonds likely would continue under 11 U.S.C. 922(d) throughout any bankruptcy proceeding, albeit subject to the payment of the necessary operating expenses of the wastewater system as specified by 11 U.S.C. 928(b). Additionally, it is KBRA s understanding that the California Revenue Bond Law of 1941 contains language which may automatically establish a lien in favor of bondholders on the revenues securing the bonds without requiring the City of Los Angeles to take any action. KBRA understands that such a lien should not be terminated by the filing of a bankruptcy petition and should survive the bankruptcy filing, requiring that the funds collected to pay the principal and interest on the bonds may only be used by the City of Los Angeles for that intended purpose. Further, under Chapter 9, it is KBRA s understanding that the preference provisions contained in the U.S. Bankruptcy Code do not apply to payments made on bonded indebtedness by a municipality, meaning that a debtor municipality may not claw back payments made to bondholders pursuant to the terms of the bonds that were made within the 90 days preceding the filing of the bankruptcy petition. KBRA notes that there is no certainty regarding how a bankruptcy court examining the bond issuance would ultimately rule on the issues set forth above. Additionally, KBRA understands from discussions with outside legal counsel that no controlling judicial precedent exists analyzing the issues set forth in this Bankruptcy Assessment. KBRA, in consultation with outside counsel, has reviewed relevant secondary sources and persuasive case law to predict how a court reviewing a properly presented case would analyze the Bonds. There can be no guarantee, however, how a bankruptcy court, with its considerable equitable powers, would ultimately rule. Page 10 April 28, 2017

11 Rating Determinant 3: Service Area and Economy The system provides wastewater collection, treatment, and disposal services for a service area that is approximately 600 square miles and includes most of the City of Los Angeles. Due to the economics of gravity flow, wastewater services in parts of the City are served by other agencies and the System provides services for 29 entities outside the City boundaries. Areas within the City that are not served by the System are served by the Los Angeles County sanitation districts. KBRA has primarily focused on analyzing the economic base of the City of Los Angeles as the City comprises approximately 85% of System flow. In this rating determinant, KBRA also factors in the demographic characteristics of the total area served by the System, as the 29 additional entities are generally more affluent suburbs of the City, such as Santa Monica and Beverly Hills. Population and Service Area Socioeconomic Indices KBRA views the economic base of the City of Los Angeles as strong and well diversified. Recent improvements in the global economy generated positive momentum for growth in employment and full market value. The City of Los Angeles is the second largest city in the nation by population and is the principal city in southern California. The City is the county seat of Los Angeles County and home to nearly 40% of the county s 10.2 million residents. An established center for the media and entertainment industry, the greater Los Angeles area is supported by the presence of diverse companies and serves as headquarters to 13 Fortune 500 firms. Additionally, in 2015, the City was ranked sixth on the Global Cities Index based on business activity, human capital, and information exchange. The City is home to Los Angeles International Airport, which was the world s seventh-busiest airport by total passengers in The County remains one of the larger manufacturing centers in the nation and is home to the ports of Los Angeles and Long Beach, which combine to form the ninth-busiest international container port. City of Los Angeles Los Angeles County California United States 2015 Chg from Chg from 2010 City of Los Angeles as % of Los Angeles County 2015 Chg from 2010 City of Los Angeles as % of California 2015 Population 3,971, % 10,170, % 39.1% 39,144, % 321,418, % Chg from 2010 City of Los Angeles as % of United States Age Dependency Ratio % % % 57.7% % 60.8% % Population with B.A. Degree or higher % % % 32.3% % 30.6% % Poverty Level % % % 15.3% % 13.4% % Income per capita $30, % $29, % 102.5% $32, % 92.5% $29, % 100.5% Source: U.S. Census Bureau is used as the source in order to provide a consistent comparison among different units of government. 1 Age dependency ratio is the sum of the population under 18 yrs and over 65 yrs divided by persons age 18 to 64 yrs. 2 Year over year change shown as nominal change in percentage points. The City s resource base metrics showed overall improvement in Growth in population has exceeded that of the state and of the nation. The City has above average education attainment levels, which have kept pace with the nation. At the same time, the age dependency ratio has come down slightly and continues to be lower than the national rate. This suggests a more highly educated workforce that could potentially provide positive momentum to the City s economy. The poverty level in the City has been higher than the state and national averages and was a high 20.5% in 2015, although it has trended down slightly compared to KBRA notes that a high poverty level is typical for large cities like Los Angeles. In 2015, income per capita in the City was $30,136, which represented a 9.1% increase since The City s income per capita is higher than the state level and on par with the national level. Taxpayer concentration continues to be low, with the City s ten largest taxpayers representing a modest 1.91% of total valuation in Page 11 April 28, 2017

12 The City s housing market has improved after undergoing a period of decline in the time periods. The City has benefited from increases in assessed valuation of property over the past few years. The City s property values stabilized in 2012 and AV growth resumed in Assessed value net of the homeowner exemption grew by 2.5% in 2013 and 5.1% in In 2015, AV increased by another 6.0% to $464.4 billion, which equates to a full market valuation per capita level of $133,974, a level which KBRA considers high. KBRA views the increase in the City s tax base as a positive credit factor. Total employment has grown at an annual rate of 1.8% since 2010 or an overall employment growth rate of almost 13%. The average year-to-date 2016 employment level is 7% higher than the pre-recession peak. The largest employment sector is trade, transportation, and utilities. The second largest employment sector is education and healthcare due to the presence of many public and private higher-education institutions located within the City, followed by professional and business services, supporting the large number of corporations that operate in the City. Leisure and hospitality is another important economic driver. In 2015, the City achieved a record 45.5 million visitors, which was 2.8% more than in The City has a goal of reaching 50 million visitors by The City s employment base shows an above average concentration in the information technology industry, reflecting recent technology sector growth. A number of large high-tech companies have set up offices in the City, including Google, YouTube, Yahoo Inc., Belkin, Facebook, and Microsoft. Tech industry growth is also driven by a diverse mix of small start-ups that have established offices in Los Angeles due to the relatively lower real-estate costs compared to the San Francisco Bay area. Unemployment The City lost over 140,000 jobs between November 2007 and December 2009, culminating in a peak unemployment rate of 13.8% in This was higher than the rates for the county, state, and nation. The City has experienced modest employment gains in each of the years since then and, as of December 2015, the City recovered 104% of the jobs lost, which is similar to the state s record, but better than recovery within the county and the nation. In 2015, the annual unemployment rate of the City was 7.1%, still higher than the county (6.7%), state (6.2%), and the U.S. rates (5.3%). However, in 2016, the City s unemployment rate trended more positively than that of the state. The preliminary City unemployment rate in February 2017 was 5.1%, which is the same as the state s but higher than the U.S. average. Historical Rates & Affordability The City has adjusted SSC rates on an annual basis since 2005, from $2.49 per hundred cubic feet (hcf) to the current $4.51 per hcf. Despite the approved 6.5% annual increases, the City expects rates to remain affordable as compared to other large systems. In general, the overall residential SSC is based on customers billable wastewater volume. For residential customers (single family and small multi-family) the SSC is calculated using the minimum daily water usage during winter months. For commercial and large multi-family customers, the wastewater bill is based on 93% of their total metered water usage. Wastewater Historic Sewer Service Charge Rate Effective Date SSC Rate % Incr. from ($/hcf) Prior Year % % % % % % % % % Current % Source: City of Los Angeles, Bureau of Sanitation charges for industrial users are based on wastewater strength which will be discussed in in details in rating determinant 4. Page 12 April 28, 2017

13 Wastewater Service Contract & Other Customers Of the 29 entities that contract with the System, 20 receive wastewater conveyance, treatment, and disposal services on a wholesale basis under universal term contracts that are in effect through The System expects that wastewater service provided to these entities will be extended beyond 2029 pursuant to renegotiated contracts. The nine entities operating under older sewage disposal contracts, which vary as to terms and conditions, although each requires payment of operation and maintenance expenses and capital costs for those components of the sewer system used by the entity. Entities Population** 2015 Per Capita Income** 2015 Unemployment Rate as of April 2016*** Glendale 201,020 29, % Santa Monica 93,220 59, % Beverly Hills 34,869 84, % LA County Sanitation District #4 N/A N/A N/A Culver City 39,717 46, % San Fernando 24,931 18,092 N/A El Segundo 17,037 45,644 N/A Crescentia Valley Water District N/A N/A N/A Marina Del Rey N/A N/A N/A Universal City N/A N/A N/A All Others N/A N/A N/A Total City of Los Angeles 3,971,883 30, % *** Source: U.S. Bureau of Labor Statistics Major Subscribing Entities * Source: City of Los Angeles, Bureau of Sanitation ** Source: U.S. Census Overall, these 29 entities contributed roughly 14% of the System flow in FY The five largest outside entities are Beverly Hills, Culver City, Glendale, Los Angeles County Sanitation District #4, and Santa Monica. These entities generated roughly 11% of the System flow in FY As shown in the table above, some of the demographic characteristics of the wastewater service contract participants are more affluent than the City, which KBRA views positively. Based on the forgoing, KBRA has revised the rating determinant rating on the service area and economy rating determinant to AA+ from AA. The rating determination revision incorporated KBRA s view on the City s continued improvement in its resource base as discussed in the City of Los Angeles General Obligation Refunding Bonds Series 2016A (Taxable) Bonds rating report, published on November 30, In addition, this rating determinant rating also factors in the broader service area economy base linked to the 29 outside entities that the System serves under wastewater service contracts, hence a one notch rating determinant rating differentiation from the City s municipal resource base. Page 13 April 28, 2017

14 Rating Determinant 4: System Characteristics The System serves an extensive area and has a total wastewater treatment processing capacity of 580 million gallons per day. Service areas are determined by natural drainage patterns that do not follow political boundaries. Wastewater is collected via 6,700 miles of mainline sewers, over 100,000 maintenance holes, 44 wastewater pumping plants, and other facilities before it reaches treatment plants. The 44 pumping plants are part of the conveyance system, which is designed to have extra standby pumps and power supplies. In case of system failure, certain plants have additional storage retention basins and emergency bypass lines. All the treatment plants provide wastewater conveyance, treatment, and disposal services to 29 sanitation districts, cities, governmental entities and private businesses in addition to the City of Los Angeles. KBRA views the System as having adequate levels of treatment capacity. The System consists of four treatment plants in two service areas (Hyperion and Terminal Island). The Hyperion System serves the central, western, and northern areas of the City. Operating under the Hyperion System are three plants - the Hyperion Treatment Plant, the Donald Tillman, and the Los Angeles-Glendale Water Reclamation Plants (DCTWRP). The Terminal Island System is located at the City s southern harbor and provides services to this area. The Terminal Island system is served the Terminal Island Water Reclamation Plant (TIWRP). Average flow for the total System as of FY 2017 was 329 mgd or 56.7% of the System s overall maximum capacity. Treatment Facility First Year of Operation Current Design Capacity (million gallon / day) Average Flow (mgd) FY 2016 HYPERION SYSTEM Hyperion Los Angeles-Glendale Tillman Total Hyperion System TERMINAL ISLAND SYSTEM Terminal Island TOTAL BOTH SYSTEMS Source: City of Los Angeles, Bureau of Sanitation The largest plant is the Hyperion Treatment Plant (HTP) with maximum capacity of 450 mgd. Current average flow of HTP is 252 mgd. The smallest plant is the Los Angeles-Glendale plant with maximum capacity of 20 mgd and current average flow of 17 mgd. The Tillman plant started service in 1984 and is the most recent addition to the System. Page 14 April 28, 2017

15 The TIWRP is designed to treat an average of 30 mgd of wastewater and current average flow is 14 mgd. The TIWRP has advanced wastewater purification technologies that utilize microfiltration and reverse osmosis to recycle up to 5 mgd of wastewater, which is then sold to the LADWP and to its customers. Customer Base About 90% of the System s operating revenue is from the basic SSC. Residential wastewater requires a less stringent treatment process than commercial and industrial wastewater. For this reason, an industrial waste surcharge is added to non-residential customers with higher than domestic strength wastewater. The surcharge and industrial waste enforcement fees accounted for about 3% of System operating revenues in A universal service contract governs 20 of the 29 contract customers. The contract requires agencies to pay the proportionate share of any revenue shortfalls that result from non-payment on behalf of other contracting agencies. The remaining 9 entities work with the System through an older sewage disposal contract. The outside customers generated roughly 3% of the System operating revenues. There are over 685,000 user accounts and the SSC is imposed on each of these users. In 2016, total usage of the System by Los Angeles customers was 133,787 hcf of billable volume. The number of System customers has been flat for the past decade. Billable volume, however, has declined by 20% since 2005 due to water conservation efforts and drought conditions. The majority of the land within the service area is developed and the System anticipates its customer base to continue to remain stable for the next five years. The chart below shows the System s customer base in FY Residential customers comprised 92% of the System customers. Of this amount 75% are single family homes, 11% are small multifamily homes, and 6% are large multifamily residential buildings. Commercial and industrial users make up approximately 8% of the System s customer base. Customers by Class FY 2016 Customers by Billable Volume FY 2016 (hundred cubic feet) All Others 0% Commercial/ Industrial Large 8% Multifamily 6% All Others 4% Single Family 34% Small Multifamily 11% Commercial/ Industrial 24% Single Family 75% Large Multifamily 29% Small Multifamily 9% Source: City of Los Angeles Wastewater System The chart on the right above shows the System s billable volume by customer class. Single-family homes, large multifamily buildings, and commercial/ industrial users are the top users whose billable wastewater as a percentage of FY 2016 total volume were 34%, 29%, and 24%, respectively. Page 15 April 28, 2017

16 Number of Customers Billable Volume (thousands of (hundred cubic feet) System Charges End The majority of the System customers are in the City of Los Angeles. These customers, residential, commercial and industrial, generated about 86% of the System s overall flow in FY The current SSC rate is $4.51/hcf and will have annual increase of 6.5% through FY Qualified low income residential users are eligible for a 31% discount on the first 1,800 cubic feet of bimonthly wastewater volume. The discounts are offset by a 0.84% surcharge to the base SCC on other non-low income residential customers and the City General Fund. About 8% of the System users are commercial or industrial based. The System imposes a quality surcharge fee (QSF) to these users whose wastewater discharge exceeds that of the domestic standards to meet additional treatment requirement needs. The QSF is used to cover treatment costs for treating high strength wastewater. Wastewater strength is measured by the amount of suspended solid (SS) and biochemical oxygen demand (BOD) levels. It is KBRA s view that the System has good residential and commercial and industrial customer base mix. Commercial and industrial customers with high strength wastewater have charges that are higher than the residential customers based on the treatment requirements and other resources that go into maintaining environmental standards. A one-time sewerage facilities charge (SFC) is imposed on all initial connections to the System. Based on the SFC formula, initial connection charges for a typical single-family residence with three bedrooms would cost approximately $950 and a residence with four bedrooms would cost $1,136. Wastewater Contracts The System serves 29 entities outside of the City limits, within the Los Angeles County on a wholesale wastewater disposal service basis. These customers account for about 3% of the System operating revenue or 14% of the System s overall flow. All wastewater service contracts are in place for through Most of the System s charges and fees are billed based on usage volume and treatment requirements of wastewater discharges. Only a very small portion of the System operating revenue is generated from fixed charges and fees. 800, , , , , , , ,000 0 Historic Number of Customers by Class vs. Billable Wastewater Volume Single Family Small Multifamily Large Multifamily Commercial/ Industrial All Others Total Billable Wastewater Volume 180, , , , ,000 80,000 60,000 40,000 20,000 0 Source: City of Los Angeles Wastewater System As shown in the chart above, the System s customer base has been fairly stable over the past decade. As mentioned earlier, the lower number of customers is due to consolidation of accounts after the implementation of the new LADWP billing system. The System estimates that its customer base is expected to remain stable. Page 16 April 28, 2017

17 Billable Volume (thousands of (hcf)) Revenues from Operations ($ 000) Water Supply Wastewater operations are directly related to the availability of water supplied to the System. The LADWP is responsible for supplying water to the System s service area. Existing water sources of the City are water delivered by the Los Angeles Aqueducts from Mono Lake, local groundwater, and water purchased from the Metropolitan Water District of Southern California (MWD). Although drought conditions exist, it is KBRA s view that water supplied to the City has been adequate and reliable for maintaining system operations and debt service coverage levels. Sustained drought condition has been affecting California for many years. The MWD had scaled back on water supplies to its member agencies, including the City, by 10% from July 2009 to April Water supply was back to normal after that period. In response to the sustained drought in , MWD reduced water allocation by 15% beginning July 1, A penalty surcharge was imposed on member agencies who failed to meet the 15% reduction target. Prior to the water allocation reduction by MWD, Mayor Garcetti had asked the City residents to voluntarily reduce water usage by 25%. In addition, the City has developed a Water Supply Plan that addresses its water needs through The ultimate goal of the plan is to ensure a sustainable water supply to the City. The plan outlines sustainable water supply deliveries through the MWD and LADWP and includes guidelines for water conservation and water recycling. It is KBRA s view that the City and System management team has been proactive in finding ways to conserve water consumption. The System does not anticipate a dramatic decline in wastewater flow in the short to medium term because the water reduction will mostly affect water use for irrigation and landscaping purposes. As shown in the graph below, billable volume declined by approximately 20% (from 162hcf to 134hcf) from FY 2008 to FY The System made rate adjustments such that rate increases offset the decline in billable volume resulting in an increase in operating revenues through Prolonged statewide water conservation mandate could pressure the System s revenue strength. However, water conservation ended in FY 2016 after being in effect for three years. At this time, the System anticipates billable wastewater volume will have minor growth from FY 2017 to FY 2021 due to both stabilized flow and small growth in customer base. 180 Revenues from Operation vs. Billable Volume 800, , , , , , , , * 2018* 2019* - Billable Volume Source: City of Los Angeles Wastewater System * Out year projections Revenues from Operation Page 17 April 28, 2017

18 The System is built and designed to handle a maximum capacity of 580 mgd. As a result of water conservation, wastewater flow has declined to approximately 60% of the System s maximum capacity in recent years. It is KBRA s view that the System has the capacity to handle potential growth in wastewater flow due both to increase in water supply and customer base expansion. Based on the forgoing, KBRA views the System Characteristics as being consistent with a AA+ rating determinant rating. This rating is based on the System s very diverse customer base, well-maintained sewer system, and abundant treatment capacity with stable usage trend. KBRA also considered that a prolonged drought might pressure the System s flow volume and the associated revenue due to more restrictive water conservation measures. Rating Determinant 5: Financial Metrics On a cash basis, the System s operating revenue is largely generated from the SSC, which made up 91% of revenues in FY As the table on the below, other operating revenue sources are comprised of service contracts (2.4%), industrial waste surcharge (3.0%), sewerage facility charges (3.1%), and other revenues (0.5%). Revenues from the SSC had 7% increases in FY 2016 to $550 million, which can be attributed to the combination of SSC rate increases and recovery of prior year receivables. Operating revenue in FY 2016 was $607 million, or a 6% increase compared to FY The System s operation and maintenance expenses fluctuated over the last five-year period. In FY 2016, annual operating and maintenance expenses was $270.2 million (cash basis), or a 5% decrease compared to FY Operating and maintenance expenses between FY 2013 and FY 2014 were higher than the normal levels due to payments of certain litigation settlements by the System. Net revenue available for debt service in FY 2016 on a cash basis was $346.0 million resulting a strong senior debt service coverage ratio of 3.25x and a combined debt service ratio of 1.73x in FY In general, the System has strong financial operating results in which operating revenues exceed expenses by at least 1.86x each year for the past five years. City of Los Angeles Sewer Construction and Maintenance Fund Statement of Revenues, Expenses and Changes in Net Position Cash Basis FY 2012 to FY 2016 ($000) Operating Revenues Total operating revenues 607, , , , ,118 y-o-y % change in revenues 6% 5% -4% 14% -5% Operating Expenses Total operating expenses 270, , , , ,850 y-o-y % change in expenses -5% -1% 8% -1% 5% Operating Income 337, , , , ,268 Nonoperating revenues 8,764 14,373 8,789 12,548 14,163 Revenues available for DS 345, , , , ,431 y-o-y % change in revenues 14% 14% -16% 30% -12% Debt Service Coverage Ratios Debt Service Requirements - Senior 106, ,423 97, , ,551 Senior DSCR 3.25x 2.99x 2.72x 2.67x 2.16x Commercial Paper Notes Variable and Fixed Rate Subordinate Bonds 93,170 87,033 79,074 76,754 70,664 Subordinate DSCR 1.73x 1.61x 1.50x 1.62x 1.33x State Revolving Fund Loan 13,605 13,605 13,605 13,605 13,605 Net Revenues After Debt Service 132, ,543 75, ,960 46,611 Nonoperating revenues Grant Reimbursement 10,949 2,468 8,383 2,231 1,340 Wastewater Service Contracts ,703 12,153 8,196 9,541 FEMA Reimbursement 24, , Total Non-operating Revenues 35,317 20,251 21,760 10,454 10,881 Nonoperating expenses Deposits to Escrow Accounts ,524 0 Balance Available 168, ,794 97, ,890 57,492 Source: City of Los Angeles, Bureau of Sanitation Page 18 April 28, 2017