The Untapped Potential of Water Privatization

THE UNTAPPED POTENTIAL OF WATER PRIVATIZATION

A HUDSON INSTITUTE REPORT

FOR AMERICAN WATER WORKS, INC.

By Edwin S. Rubenstein

Executive Summary

Americans enjoy the best water service in the world. It’s so good we think little about it. Turn on the tap and water comes running.

Yet getting that water to the customer is a huge business. And the U. S. lags far behind much of the rest of the world in how we treat water utilities.

Privatization of water utilities is becoming commonplace in much of the world. In France, water utilities are private. Some are quite large and have worldwide operations: Vivendi and Suez Lyonnaise des Eaux are examples. Britain’s government water monopoly was broken into eight large private water utilities by Margaret Thatcher. Much of the developing world gives concession contracts to private water utilities to build and operate their expanding systems. Worldwide, just $300 million was spent on water privatization between 1984 and 1990. In the next seven years, more than $24 billion was spent. There is no question where the rest of the world is moving.

The U. S. lags this worldwide trend. Only about 15% of U. S. water customers are served by privately owned water utilities. The vast bulk – some 24,000 water utilities – are owned by a municipality, a water authority, or a federal entity. These publicly owned entities sell water at subsidized rates. They increasingly contract out at least some of their operations to private firms. It is truly ironic that the capitalist and entrepreneurial United States has far more government control of water than neo-socialist France.

Here are key findings regarding the U.S. water industry:

- WATER UTILITIES ARE THE MOST CAPITAL INTENSIVE OF PUBLIC UTILITIES. They require up to three times more capital to generate a dollar of revenue than electric utilities. A water utility may require up to $12 in capital plant investment for every $1 in revenue generated, compared to something more like $4 for electric utilities (thought of as also very capital intensive). This makes tax-free debt a major competitive advantage for government-owned water utilities.

- THE WATER INDUSTRY FACES ENORMOUS CAPITAL INVESTMENT REQUIREMENTS Much of the capital infrastructure of the water industry is at or beyond its useful service life. An infrastructure-funding gap of $11 billion per year is projected for the next twenty years. If such costs are passed through to consumers, 22% of American households would pay more than 4% of their income for water – a hardship level according to EPA benchmarks.

- GOVERNMENT WATER UTILITIES WILL FIND IT INCREASINGLY ATTRACTIVE TO PRIVATIZE. Looming capital investment requirements will present government water utility managers with a set of unattractive choices: raise rates substantially to pay for the new investment, allow water quality to deteriorate, and/or engage in costly legal battles with the EPA. There will be an increasing temptation to exit gracefully and hand the problem over to someone else. Serious regulatory issues must be resolved (see below) before sales of public water works to private companies becomes universally feasible.

- INVESTOR-OWNED WATER UTILITIES ARE ROUGHLY A THIRD MORE EFFICIENT THAN THEIR PUBLIC COUNTERPARTS. Whether measured by payroll per unit of water or rate of return on capital, investor-owned water utilities are, on average, more efficient than their public counterparts. The best practice government water utilities are only about as efficient as an average practice private utility. The best practice private utilities far outstrip the best practice government utilities.

- DESPITE THEIR EFFICIENCY, INVESTOR-OWNED WATER UTILITIES OFTEN CHARGE HIGHER RATES THAN PUBLIC UTILITIES. This seeming anomaly reflects the non-efficiency advantages of government owned utilities. Unlike private utilities they pay no taxes, are subsidized by local tax revenues, and have access to tax exempt debt (a subsidy from all federal taxpayers). And unlike regulated private utilities, public utilities can amass large amounts of cash for short-term investment income – in effect forcing past ratepayers to subsidize current ratepayers.

- WATER IS ‘UNDERPRICED’ IN THE U.S. As a result of the subsidies noted above, water bills do not reflect the true costs of producing water. This creates too much demand for water and unnecessary damage to the environment. Government subsidies also facilitate overstaffing, inefficient operations, and patronage in public utilities.

- THE U.S. WATER INDUSTRY WILL ALWAYS POSSESS ATTRIBUTES OF ‘NATURAL MONOPOLY”; SOME REGULATION WILL ALWAYS NECESSARY. Water is bulky, heavy, and has a low per unit value. Transporting it for long distances is usually not economically possible. This along with the lack of anything approximating the national grids that exist in the electric, gas and telecom industries, make it highly unlikely that the water industry, whether publicly or privately owned, will ever be deregulated. Effective day-to-day competition for customers is simply not feasible.

Our findings suggest that a restructuring of the U.S. water industry, to take advantage of the benefits of market pressures, is in the interest of the general public. Since investor-owned water companies are more efficient than their government-owned counterparts, they can deliver comparable services at a lower cost. This means that despite paying taxes to local, state, and federal authorities, private water companies can supply water for the same price as government-owned companies. The tax money, in turn, instead of being lost to inefficient water services can be passed on to consumers via tax cuts, or used to fund other government activities. The equivalence between private and public water services despite the higher operating costs of the former is possible because of the stronger incentives for cost reduction in the privately owned companies. The profit motive provides a reward structure for managers that operate in the best interest of the general public.

Data presented below demonstrate that investor-owned water companies operate more efficiently than publicly owned ones. It remains unclear, however, whether this superiority extends to capital investment as well. In theory, private companies determine infrastructure spending based on need, subject to cost benefit analysis and the return on investment. In practice private companies are subject to rate of return regulation which links water rates to the amount invested – the rate base. If regulators set the allowable rate of return too high, too much capital will be invested. If the allowable ROI is set too low, too little capital will be forthcoming. Under this regulatory regime operating efficiencies may raise ROI above the permitted rate, forcing companies to cut water rates. Consumers alone will reap the benefits of better operations. Neither the shareholders nor the managers of private water companies benefit from enhanced efficiency.

Perhaps the best evidence of the failure of the current regulatory framework is the inability of private U.S. water companies to compete internationally. While U.S. computer and biotech companies dominate their foreign competitors, French and British companies dominate the market for new water and sewer systems. The absence of American water companies in the global arena reflects the predominance of government ownership plus a private water sector that is regulated on a rate of return basis and dominated by cost-plus thinking. This regulatory environment is not conducive to the creation of large efficient water companies capable of competing in international markets.

Recommendations

1. ELIMINATE THE FEDERAL TAX EXEMPTION FOR PUBLIC UTILITY DEBT. The exemption was intended as a subsidy for state and local government borrowing. It may make sense to help such governments defray the cost of police, fire, and other core services for which private sector alternatives are not readily available. But private water companies, operating without benefit of subsidies, have demonstrated their ability to provide water services at prices comparable to those charged by government owned water utilities. The exemption is a major obstacle to utility privatization. Taxpayers and water users alike will benefit from elimination of the wasteful subsidy for public utility debt.

Alternatively:

2. STATES SHOULD CREATE WATER UTILITY “BANKS” TO ENABLE PRIVATE WATER UTILITIES TO ACCESS THE TAX EXEMPT DEBT MARKET. The private utility would issue it own (otherwise taxable) debt to the Water Utilities Bank, and as a quasi-government entity the bank would in turn issue its own tax exempt debt. The utility would receive the proceeds for capital investment needs. This concept is hardly novel. States do it all the time with Industrial Revenue Bonds. Some states have set up higher education funding authorities whereby private colleges and universities issue their own (otherwise taxable) obligations to the authority which in turn issues it own tax exempt debt of their behalf.

These changes will “level the playing field” between private and government owned water utilities in the debt market.

3. REGULATORS SHOULD ALLOW PRIVATE WATER UTILITIES TO USE PURCHASE PRICE ACCOUNTING RATHER THAN DEPRECIATED BOOK VALUE OF ASSETS WHEN FIGURING THE RATE BASE OF AN ACQUIRED UTILITY. Presently, a private water utility acquiring another faces serious obstacles. Traditional rate of return regulation recognizes only the depreciated book value of capital assets. Much of the acquired infrastructure is apt to be very old and totally or largely depreciated. The purchase price will greatly exceed (as a “going concern”) this number. The acquiring utility will find it difficult or impossible to recover their investment.

4. REGULATORS SHOULD CONSIDER ALLOWING UNFINISHED CONSTRUCTION TO BE INCLUDED IN A WATER UTILITY’S RATE BASE. Presently, there is some reluctance to undertake major capital project because of “rate shock” when a project is completed and comes on stream (and into the rate base) all at once. Phasing new construction in gradually as the project is underway smoothes out the rate increase.

Introduction

Water is unique.

Four things are necessary for the most basic subsistence: air, water, food, and clothing and shelter in climates where occasional cold can be life threatening. Everything else is up the consumption chain.

Of the four, air is the most important to our short-term survival. Deprive the human brain of oxygen for five minutes, and we die. Air is not an economic good. It is a “free good”. We consume it from our first breath out of the womb until our last gasp on earth. But there are no meters on our chests with someone charging for every breath.

Food is also necessary for existence. But we can do without food for periods of weeks or even months, if necessary, and still remain alive.

Water is in a unique position. Humans can survive without it for a few days, at most. Water is the first item up the chain of human survival from air. It is more urgent than food, but less urgent than air. The occasional protester may stage a “food strike”. Have you ever heard of a “water strike”?

No commodity bought and sold in the economy is as essential as water.

Early settlements clustered around a source of fresh, drinkable water. There was little choice except perishing from thirst. It wasn’t until the Romans and their aqueducts that water could be transported long distances. Many Roman aqueducts are even today considered architectural and engineering marvels. They were the first somewhat modern “water works”.

Fresh, pure water must be stored, treated, transported to where it is needed and the wastewater disposed of. Doing these things is costly. Hence, water is not “free”, except perhaps to a backpacker sipping from a glacier-fed stream. Even then, the backpacker is likely to dump in a water purification tablet…just in case. Unlike air, water is an economic good carrying a price tag at the water meter.

Water covers two-thirds of the earth’s surface, but less than 10 percent of it is potable. Although the supply is finite, demand continues to grow exponentially. In areas where competition for water has been fierce, like the American West, a system of water rights has been set up to avoid the often bloody fights over ownership and use. In much of the world access to water is a matter of political power and its close relative, money. Yet waste and misuse are universal – clean water used to flush toilets or run factory equipment, for example – reflecting the misguided notion that water is limitless.

There is good news, however. As a nation, we have recently cut back on water use. Since peaking in 1980, annual water withdrawals are down by 472 gallons per capita, or 24%. The reduction mainly reflects new water saving technologies in hydroelectric power and in agriculture, which together account for about 80% of overall water usage. But private, non-commercial usage is at or near all time highs. And overall usage is still huge - about 1500 gallons of water per day. Since 1940 overall total per capita water usage is up by 46%; non-irrigation usage is up a whopping 98%. (See chart below.)

U.S. Water Withdrawals

Year	Total (Bil. Gallons)	Per Capita (Gallons)	Non-Irrigation Withdrawals (Bil. Gallons)	Per-Capita Non- Irrigation Withdrawals (Gallons)
1940	140	1,027	69	506
1950	180	1,185	91	599
1955	240	1,454	130	788
1960	270	1,500	160	889
1965	310	1,602	190	982
1970	370	1,815	240	1177
1975	420	1,972	280	1315
1980	440	1,953	290	1287
1985	399	1,650	262	1083
1990	408	1,620	271	1076
1995	402	1,500	268	1000

Source: Statistical Abstract of the United States, 1999.

We don’t see the big picture. Yes, we flush toilets, take showers, make coffee and wash dishes. Those things we understand. We also eat fresh vegetables grown with irrigation water. We eat meat, eggs and milk. These require enormous amounts of fresh water until the underlying plants and animals grow to maturity. We drive cars made from steel made in water-hungry steel mills and consume other products made by a million other industrial processes. These are water uses we don’t see. But they are still real.

It’s still approximately 1500 gallons per day. Fifteen hundred gallons is enough to fill the average backyard spa 4 times over. Fifteen hundred gallons is also enough to fill an average backyard swimming pool in seventeen days. In other words, if you are a new pool owner and don’t wish to consume any additional fresh water, you and your family must go into a coma for 17 days to fill your pool with fresh water you otherwise would have drank, flushed, or otherwise consumed.

Few of us would opt for that.

Instead, we argue in this study that:

1. The U. S. water industry is currently reliable. We turn on the tap of a faucet, and we expect the water to flow. However, this is unlikely to be so in the future unless a serious reorganization of the U. S. water supply takes place.

2. About 95% of the U. S. water industry is in government hands. It is operated and maintained either directly by a municipality or some sort of regional government water authority.

3. Water is “underpriced” in the United States. Thanks to subsidies – including the tax exempt bond interest allowed government utilities – the water bills of government run systems do not reflect the total cost of providing water to residents. As a result, Americans consume more water than is economically justified.

4. Private companies have shown they can provide clean water at a lower cost than publicly run systems. Technical expertise, economies of scale, and customer service are on the side of the private companies.

5. The trend around the world is not to “socialize” the water industry. It is sell public water assets to private companies or allow private firms to operate government-owned water utilities.

6. The U. S. is far behind other countries in this “demunicipalization” effort. Our economy and our environment will both benefit from more private sector involvement in the provision of water.

Competition and Privatization in the Water Industry

Market forces have been slow to come to the United States water industry. Many public water systems began as private, for-profit enterprises in the eighteenth and early 19^th centuries. Over time devastating cholera epidemics and major fires in the nation's cities led Americans to view water as a public responsibility rather than a private commodity. As towns and cities expanded, most private water companies found they could not cope with the added costs while still maintaining reasonable rates for full-paying customers. By the turn of the century, more than 200 communities had shifted from private to public ownership. Municipally owned water works, acting as public monopolies, became the dominant national model for service delivery.

During most of the twentieth century the public sector monopoly model was accepted uncritically.

Although the water industry continues to be monopolistic in character, competitive forces began to be felt in the 1990s. In the late 1980s, it was estimated that only 100 to 200 U.S. water and wastewater facilities were under contracted operation. By 1997, a survey found this total to have grown to more than 1,200 facilities in 44 states, including Puerto Rico, and some industry watchers were predicting further growth in operations and management contracting of 20 to 30 percent per year over the next five years. Similarly, while there were still only 17 publicly traded U.S. water companies as of 1998, many of these investor-owned utilities are gaining territory through the acquisition of smaller public and private systems. According to one survey of 10 such utilities, total growth in net income increased by 13.5 percent in 1996 alone.

Private water utilities compete among themselves in a number of venues, including: extending service to unserved or underserved areas; engaging in acquisitions, mergers and hostile takeovers; bidding for operations contracts; purchasing water on wholesale markets; trading water rights; maintaining a service and quality image (e.g., bottled water); promoting private ownership and public-private partnerships.

The expanding number of competitors in the water industry includes investor-owned water utilities, municipal water utilities, nonutility contract operations firms, energy holding companies, and foreign multinationals.

Some of the newer entrants to the competition have a strong global presence and resources that far outweigh those of even the largest U.S. water utilities. Powerful French water companies and newly privatized British utilities are looking to buy American assets. In France, private companies have long competed for long-term management contracts and franchises, and have developed into multibillion dollar, highly sophisticated international conglomerates. For example, Vivendi (formerly known as Compagnie Générale des Eaux) took over the Houston‑based Professional Services Group in 1980. Through this subsidiary Vivendi manages approximately 200 wastewater and 170 water facilities in the U.S., including contracts in Newark, New Jersey, and Oklahoma City. Similarly, Suez‑Lyonnaise des Eaux, another major international company with origins in the French water industry, has partnered with United Water Resources, one of the three largest investor‑owned U.S. water companies, to operate more than 25 North American systems, including contracts for a number of large utilities, such as Milwaukee, Indianapolis, Houston, and Atlanta.

Along with the French, several of the major privatized British water companies are also now active in the United States and elsewhere around the globe. For example, Anglican Water P.L.C. is partnering with the largest U.S. investor‑owned water company, American Water Works, Inc., to compete for operations and management contracts as American Anglican Environment Technologies, and is under contract from 1997 until at least 2002 to manage the Buffalo, New York water system, among others.

The private water industry is more profitable – on a Return on Equity basis – than other regulated utilities. With sensible regulation, a well-run water company can earn a return on equity of between 8 and 14 percent. On average, private water companies use capital far more efficiently than do public water utilities: only 6% of public utilities – the best in their class – perform better than the average private utility, according to the Boston based BTI Consulting Group.

In the restructured electric and gas industries, direct competition among companies for the same customer base means lower prices and lower profit margins. By diversifying into water, electric and gas companies have the opportunity to raise their overall profitability. As a result, mergers between water companies and newly competitive energy and electric companies are likely. Combining metering, billing, customer service, and back office operations would result in clear-cut efficiencies across multiple utilities.

In what may prove to be the start of this trend, Enron Corporation, one of the largest U.S. energy companies and a major player in ongoing electric and natural gas deregulation, announced in July 1998 that it was purchasing Wessex Water P.L.C., a British water and sewerage company. Enron's chairman cited restrictions under the U.S. Public Utility Holding Company Act as constraining such acquisitions in the U.S. With several bills in Congress proposing to repeal this Act, however, the potential for future realignment is rising.

Although water is a natural monopoly, the influx of private companies looking for new acquisitions has forced local water companies to act as if they had competitors. Private water companies that overinvest in capital, pad payrolls, and otherwise let their costs go out of control, will suffer declining stock prices. That will make them vulnerable to hostile takeovers. The threat of new ownership is a powerful incentive for management to think and act as if they faced direct competition.

Another form of competition – a better term, suggested by water analyst Janice Beecher, might be “contestability” – has sprung up between public and private water companies. Local governments, when faced with a prospective rate hike, will either seek out private managers or try to sell their publicly run water utility to a private company. (See the Atlanta section below.) On the other hand, a city served by a private water company can invoke its rights of eminent domain in an attempt to bring water under municipal control. In truth, good and bad performers are found on both sides of the privatization fence. A mixed system of private and publicly run water utilities is clearly optimal. The playing field, currently tilted against private ownership, must be leveled, however.

How Big is the U.S. Water Industry?

In its most recent national survey (1997), the EPA found more than 180,000 public water systems in the United States. This total includes both “community” water systems serving at least 15 connections or 25 residents year‑round, and “non-community” water systems, such as an individual well serving a school or church, providing water to a nonresidential population at least 60 days out of the year. Water that does not come from a public water system, such as from a well serving one or just a few homes, is considered a private supply and is excluded from the federal government's statistics. While the nation's 50,289 community water systems in 1995 represented only 28 percent of all identified public water systems; they served an estimated 93 percent of the U.S. population.

COMMUNITY WATER SYSTEMS IN THE U.S. 1995

Ownership

Number

% of Total

Number

% of Total

Population Served

Annual Revenue

($ Billion)

Public

21,785

43%

86%

22.2

Private

16,540

33%

13%

3.7

Ancillary

11,960

24%

Source: EPA, 1997.

Note: Community Water Systems serve at least 15 connections or 25 residents year-round, according to EPA and Safe Drinking Water Act definitions.

Only 43 percent of the nation’s community water systems are publicly owned, 33 percent are privately owned utilities, and 24 percent were classified as "ancillary systems" (i.e., very small systems, typically privately owned, that provide water as an ancillary service to some other enterprise such as a mobile home park). However, because most private systems are relatively small, an estimated 86 percent of the U.S. population received its water from publicly owned community systems, with only 13 percent relying on private utilities and 1 percent served by ancillary systems.

Total U.S. water industry revenues were $25.9 billion in 1995, primarily from water sales, according to this same EPA survey. Of this amount, 86 percent was received by publicly owned systems, mirroring the percentage of the total population served by such systems.

Factors Driving Water Privatization

All public services – not just water – are moving towards the use of market forces. Privatization, deregulation, and competition have not only become public sector buzzwords, but they have also become a reality in services ranging from transportation to corrections, energy, and education.

The dynamics pushing the water industry in this direction include:

1. Cost Control. The prospect of cost savings and of cash up front are major drivers. In the water industry, private operators are more efficient and less bureaucratic than government run utilities. Large private water companies engage in R&D and hire the best personnel. They are demonstrably ahead of government owned utilities in terms of technology and state-of-the-art practices. Further, corporations are not answerable to the electorate. Therefore they do not avoid the politically distasteful, but often necessary, rate hikes needed to pay for vital infrastructure. Unconstrained by public bidding and debt issuance requirements, privately owned utilities often can finance construction projects at less cost than government.

It would be wrong, however, to assume that public water companies cannot change their practices. Many government owned systems are evaluating their current operations against industry best practice and are improving plant efficiency as a result. Some reportedly have cut costs by nearly one-third and workforce by as much as 36% - to the point where “Privatizers don’t even visit us anymore” according to Hagler Bailly’s 1999 report to the National Research Council.

2. Federal Mandates. More stringent federal environmental and public health regulatory standards, coupled with technological change, are also contributing to increasing privatization. New drinking water regulations phasing in at the start of the twenty‑first century as mandated under 1996 amendments to the SDWA, for example, are toughening standards for guarding against bacteria and other microbial contaminants. In May 2000 EPA proposed new rules to reduce arsenic in tap water which are expected to cost $375 million per year. Earlier rules affecting chlorination and disinifectants will cost over $1 billion per year nationwide (U.S. EPA, 1996 Clean Water Needs Survey Report to Congress, 1998).

3. Infrastructure. America’s water systems face an infrastructure-funding gap of $11 billion per year over the next 20 years, according to a report published by the Water Infrastructure Network in April 2000. Water systems that currently invest $13 billion a year to meet all capital needs would have to spend $24 billion. “This level of investment," the study notes “would be unprecedented and would face considerable competition within local budgets from operating and maintenance costs that are escalating by 6 percent a year above the rate of inflation. Current federal contributions cannot help because they have declined about 75 percent in real terms since 1980 and today represent only about 10 percent of total capital outlays for water and wastewater infrastructure and less than 5 percent of total water and wastewater outlays.” An earlier estimate by the EPA’s Drinking Water Infrastructure Needs Survey projected that $138.4 billion would be required for drinking water infrastructure nationwide from 1995 through 2015, and many industry officials believe the real cost will be significantly higher. Just for the replacement of water mains and other aging distribution system infrastructure, for example, the largest drinking water industry association, the American Water Works Association (AWWA) estimates 20-year costs of $325 billion – more than four times the EPA’s estimate of $77.2 billion.

Executive Summary................................................................................................... 1

Private Ownership....................................................................................... 18

Rate of Return Regulation................................................................ 19

Contract Operations and Maintenance......................................................... 22

Disadvantages................................................................................. 24

Can Water be Deregulated?..................................................................................... 26