The California Pollution Control Financing Authority plans to price $158 million in revenue bonds next week to pay for modifications to the seawater intake system for a San Diego County desalination plant.

The Claude “Bud” Lewis Carlsbad Desalination Plant was built by private operator Poseidon as a partnership that supplies water to the San Diego County Water Authority.

The plant, developed by Poseidon and operated by IDE Technologies, has produced more than 100 billion gallons of desalinated seawater since it opened in December 2015, providing San Diego County with 10% of its water supply each year, according to the preliminary limited offering memorandum.

“It’s 10% water supply that enables us to not have to talk about cutbacks,” said Lisa Marie Harris, the San Diego County Water Authority’s finance director and treasurer. “It’s a nice, resilient source of water that the region can rely on.”

The value of the stable supply of desalinated water has been underscored in the recent years of drought in California.

The Pollution Control Finance Authority, a conduit issuer operating out of the State Treasurer’s Office, will issue the private activity bonds for Poseidon Resources (Channelside) LP, a special purpose limited partnership that was created to finance, construct, own and operate the plant and construct the pipeline with which it delivers water.

Interest on the bonds, slated to price Feb. 16, will be tax-exempt, but subject to an alternative minimum tax.

Morgan Stanley is book runner. BofA Securities, RBC Capital Markets and JPMorgan Securities are co-managers. Orrick, Herrington & Sutcliffe is bond counsel.

Harris expects the triple-B level bonds, which are limited to qualified institutional buyers, to see strong demand.

“I believe there is currently strong demand for high-yield bonds as evidenced by positive fund flows into high-yield recently,” Harris said. “And, there should be high demand for public private partnerships, particularly in the water sector.”

There has always been strong demand for the water utility sector in general, especially on the West Coast, Harris said.

“The water authority is a strongly-rated entity and we are the sole off-taker, and we have always had strong demand for the paper we put on the street,” Harris said. “Even though these bonds are issued through the CPCFA, and they are private activity bonds.”

Poseidon declined to comment on the bond sale or project, after requesting that questions be sent via email.

The proceeds will finance a portion of the cost of permanent intake system modifications and a wetlands restoration project. A team led by a joint venture of Kiewit Infrastructure West Co. and J.F. Shea Construction is building the intake system. Odin Construction Solutions will build the wetlands project that is being designed by Anchor QEA.

The plant is on a six-acre parcel adjacent to the former Encina Power Station in Carlsbad and immediately south of the Agua Hedionda Lagoon on the Pacific Ocean. The plant site is leased from Cabrillo Power I, the owner and former operator of the power station.

The plant consists of pre-treatment facilities, a reverse osmosis system, post-treatment facilities, product water pumps, and connections to Cabrillo’s existing seawater intake and outfall facilities, a portion of which will be replaced with the permanent intake modification system.

The plant pulls seawater from the lagoon and uses reverse osmosis technology to produce 54 million gallons of desalinated water per day, according to the bond documents.

In addition to the bonds, Poseidon will enter into a $166.8 million Water Infrastructure Finance and Innovation Act loan agreement with the Environmental Protection Agency to finance part of the cost of the intake system modifications and part of the wetlands restoration project costs.

Updates to the seawater intake and discharge facilities were anticipated in the 2012 water purchase agreement with Poseidon that launched construction of the plant, but the current Ocean Plan Amendment was not in place at the time, said Jeremy Crutchfield, SDCWA’s water resources manager.

The Ocean Plan Amendment came as a result of changes made to the state’s environmental regulations in 2015, just as the plant was coming online, Crutchfield said.

The water authority and its private partners spent three years negotiating with state regulators to craft an agreement that would keep the Carlsbad plant operating and meet the more stringent environmental regulations.

“Three main components affected our facility,” Crutchfield said.

The existing ocean intake system that was part of the Encina power plant had screens with one-inch slots that had to be reduced to less than .5 millimeters, about the depth of a credit card, he said. The suction also had to be reduced to the point it would barely leave a ripple so that tiny fish and other sea creatures wouldn’t get caught on the screens, he said.

The desal plant’s intakes were originally configured to draw seawater from the Encina Power Station’s once-through-cooling system.

The power station shut down in December 2018. Its closure led to temporary intake-discharge operations at the desalination plant until new fish-friendly dilution pumps came online in 2020.

The new bonds and WIFIA loan will help cover the $274 million costs of the final phase of discharge modifications.

“The solid performance of operating the active screens during the pilot phase provides comfort that Poseidon can manage ramp-up risks as it transitions to the permanent intake system solution,” Moody’s Investors Service said in assigning a stable outlook.

Moody’s rated the new bonds Baa3, affirmed that rating on the outstanding debt, and revised the outlook to stable from positive on Friday.

“The outlook change to stable was prompted by the higher costs of and delay in constructing and transitioning to the new standalone seawater intake system as well as the higher costs of the wetland restoration project,” Moody’s analysts wrote. “It also takes into account the increased operating challenges of the plant in the fourth quarter of 2022.”

The plant experienced a power surge resulting in a transformer failure in October and corrosion of certain bolts and the subsequent replacement of all of the bolts in the 3-inch couplings connecting the reverse osmosis trains in November and December, according to Moody’s.

Compared to its previous expectations, Moody’s analysts wrote, the costs for the final phase of the modified intake system have increased materially to around $222 million from $100-125 million and project completion is not expected before September 2024.

The original projections were based on a concept that had been permitted in 2019, Crutchfield said. “As is the case with all infrastructure projects, we have seen a lot of inflation whether it’s related to supply chain issues or utility pricing increases. There are just a lot of drivers that have increased the costs from the original estimates,” he said.

“We also had to modify the design itself. The new design has a higher capital cost, but a lower operating cost,” Crutchfield said.

“Costs for the modified intake system can be passed through to the San Diego County Water Authority under the water purchase agreement, which is credit positive,” Moody’s analysts wrote.

As a result of the higher cost of the standalone intake system, the cost of desalinated water for the SDCWA will rise, but the increase “is still consistent with the range of future water rates the SDCWA has provided to its member entities,” Moody’s wrote.

The current cost that the water authority pays for the desalinated water is about $2,900 per acre foot, and over the course of three and a half years that price will increase by about $900 per acre foot by 2026 because of these modifications, according to a slide that Crutchfield had presented to the water authority’s board.

Harris confirmed that the water authority has headroom at its existing rate schedule, and won’t have to further increase rates to pay for the project.

“We have anticipated the costs of this project and have incorporated it into our most recent financial forecast projections,” Harris said.

The stable outlook reflects Moody’s expectation that Poseidon can successfully complete the transition to the standalone intake system by the end of 2024 and will generate an average debt service coverage ratio of at least 1.4 times going forward with minimal shortfall payments, according to the ratings agency.

Fitch, which upgraded the Poseidon bonds to BBB from BBB-minus in 2019, affirmed the rating and assigned it to the new bonds and WIFIA loan. It also maintained its stable outlook.

The water authority holds ratings of AAA, Aa2 and AA-plus from S&P Global Ratings, Moody’s and Fitch.

The CPCFA first issued bonds for the plant and a related pipeline in 2012. The $734 million deal won The Bond Buyer’s Far West Deal of the Year award in 2013.

Both the series 2023 plant bonds and the WIFIA loan will have equal footing with the existing 2012 plant bonds and 2019 pipeline bonds, according to the Fitch report. Poseidon expects to repay the outstanding balance on a $45 million privately placed Bank of America Merrill Lynch bank loan from 2019 with the new bond proceeds.

The water authority has a 30-year contract with Poseidon to purchase the water produced by the desalination plant that expires on Dec. 23, 2045, but is extendable for up to three years.

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