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.

4. Downsizing Government. The privatization movement also has a purely philosophical aspect. Ideologues want less government, populists want a better society, both view privatization as a means to that end. A central philosophical issue for government policymakers is whether or not the provision of water services is a “core” government function. Ideas about government’s core functions are value-based and very personal. Most people agree courts and police are core local government functions. Regulation (including the economic, environmental, and social varieties) also is usually considered core. But opinions differ about road repairs, refuse collection, and schools. And of water service – is it “public works” or a utility business? A related issue is whether publicly owned water systems are accountable to taxpayers or ratepayers (defined as water consumers.) The utility’s perception of its clientele will shape its attitudes toward pricing and privatization.

5. The Profit Motive. Even more important is the profit motive among the various businesses engaged in privatization. Investor owned utilities, contractors, their consultants, lawyers, and investment bankers (who stand to make big fees helping private companies finance water utility acquisitions), and members of the trade press have played a very active part in promoting privatization, often to the exclusion of competing perspectives. Privatization is good for business, and is often the major source of revenue growth. So the commercial interest in privatization should come as no surprise. But what is good for business is also good for the public interest, at least with an appropriate system of regulation. Regulators must weigh the interests of consumers against the need for private firms to earn a competitive profit rate.

While there are many valid reasons for privatization, it may be worth calling attention to a few invalid ones. These reasons may explain why privatization often is viewed as a threat. First, privatization should be not implemented out of fear, intimidation, corruption, or a false sense of urgency (“now or never”). Second, cities should not avoid cashing in for a one-time monetary windfall without vision or purpose about the long-term interest of the community. Finally, privatization should be viewed as a means to achieving other goals, not as an end unto itself. In other words, pure rhetoric or ideology is not per se a valid reason for the privatization decision.

Thankfully, most privatizations are motivated by a desire for efficiency and cost control. Pragmatism has been far more important driver than ideology.

The Superiority of Privatization: A Statistical Analysis

Anecdotally, almost every water privatization initiative claims to have cut costs. However, differences in tax treatment and accounting methodologies, scale of operation, and local operating conditions (e.g., source water, topography, and system age) make apples to apples comparisons difficult. In one of the few such efforts, an analysis of more than 100 water and wastewater utilities during the 1990s by EMA Services, Inc., a major utility management consulting firm, identified an average “competitiveness gap” of 24 percent greater costs for the public sector in comparison to private sector industry leaders. (Paul Seidenstat et al., America’s Water and Wastewater Industries: Competition and Privatization, Public Utilities Reports, Inc., 1999.)

Along similar lines, a 1996 study sponsored by the Reason Foundation concluded that California investor‑owned water utilities provided “ comparable services to consumers at the same price as government‑ owned water companies even though they pay taxes and do not receive extra nonoperating income."

The Reason Foundation study quantified the operating efficiency gap as follows:

Investor Publicly

Owned Owned

Total Operating Expenses per Connection $272 $330

Employees per 1,000 Connections 1.62 1.49

Salaries as % of Operating Revenues 13.40% 37.13%

Maintenance as % of operating revenue 5.29% 9.13%

Staffing levels per connection are more than twice as hogh at public water companies. As a result, salaries consume more than one-third (37.1%) of operating revenues – or nearly three times the share spent by private water companies. This is especially troubling given the generally lower salaries paid by the government sector.

More evidence that public water utilities are not run like businesses is found in 1 1999 report entitled “Privatization of U.S. Water Utilities: Is There Anuthing More to Talk About?” by Kenneth Rubin. CEO of Hagler Bailly Serbvices, Inc. Rubin cites the following management comparisons:

Public Best

Average Practice

Average Annual Sick Leave 9 days 3 days

Overtime 12% 4%

Time to procure $10,000 item 3 months 1 day

Core services are fom 25 percent to 35 percent more expensive in public utilities. According to the Hagler Bailly analysis. This gap is attributed to inefficient work practices, bureaucracy, and a lack of automation. By adopting more competitive strategies public utilities couls cut chemical and energy costs by 15 percent. Supervisory labor costs can be slashed by as much as 30 percent, operating labor costs by 15 percent, and maintenance labor by 18 percent.

The efficiency gap in support services, a category that includes planning, engineering, construction, human resources, accounting, and finance, is even greater. Between 24 percent and 51 percent of the gap between inefficient public utilities and the best private operators is caused by poorly provided support services, according to the Hagler Bailly report.

Private ownership is not the only path to efficiency. Government owned water systems that contract out services to private operators are demonstrably more efficient than those that do not. Using an industry-wide database obtained from the American Water Works Association, we find that the average cost per 1000 gallons of water is $3.41 for utilities that do everything in-house, versus $2.62 per 1000 gallons for those that contract out more than 50% of their operations. The in-house only group needed 18.2 full employees per each 1 billion gallons of water produced, versus only 14.2 employees per 1 billion gallons for the utilities that contracted-out.

A review of the recent privatizations confirms the cost advantage of privately owned water systems. Among recent STOP

Can We Afford Water? Equity versus Efficiency

If local utilities had to finance the entire infrastructure gap by themselves and pass the costs along to users, water rates would more than double on average. Using the EPA’s benchmark that families paying more than 2% of income for water bills constitutes a “hardship,” even at today’s water rates some 18% of all U.S. households are paying water fees that exceed hardship levels. By 2009, if the water and wastewater funding gap was shouldered locally, at least 22 percent of U.S. households would be classified as hardship cases under the EPA’s criteria.

The affordability issue is often cited as justification for increased federal funding and continuation of the tax exempt financing for government owned water works. There is another side to the story, however.

Water is already heavily subsidized and is, therefore, very under priced in the United States. A recent study by Raftelis Environmental Consulting (Charlottesville, NC) shows that average U.S. utility prices for drinking water range from a low of 0.007 cents/gallon to 0.042 cents/gallon, with an average of 0.017 cents/gallon. While the EPA states that water costs should be 2% of average household income, it currently ranges between 0.5% to 1.0% - effectively a subsidy of well over 100%. [“U.S. Water Industry Crosses the Threshold,” by Dan W. Noble, December 1999. Waterinvestments.com]

If there is one thing on which economists agree it is on the elimination of subsidies that reduce economic efficiency and harm the environment. Water subsidies are a textbook example. The current price of water does not reflect the overall cost to society of producing this valuable commodity. As a result: we consume too much water; we invest too much capital to build water infrastructure; we utilize too much of our lakes and rivers as reservoirs.

Efficiency demands that the price of water reflect the cost of gathering, purifying, and distributing safe drinking water to consumers. A price increase is justified on efficiency grounds. Higher water bills will invariably reduce the demand for water. Full cost pricing would induce changes in water use practices and promote innovative water saving technologies, especially for high volume users. Higher prices, by insuring efficient use of existing capacity, can help water systems defer, delay, or downsize costly additions to supply-side capacity.

But what about equity? Water is a commodity so basic that no family should have to devote more than 2% of its household income to it, according to EPA guidelines. Many local politicians resist privatizing municipal water works because such a move will often result in higher – unsubsidized – water bills. But subsidizing water for all customers – rich and poor alike, - is hardly the way to go. An income transfer program, modeled on the Low-Income Home Energy Assistance Program, could help low income water customers cover the costs of higher rates without distorting the market for water. Such income transfers are much less damaging to the economy and the environment than subsidized water rates.

Unfortunately, investor owned utilities face powerful incentives to not curb water demand via higher prices. All utilities depend on water revenues to cover costs. Private utilities must also earn a return on capital. For privately owned utilities, the disincentive to raise prices has been institutionalized through the state public utility commissions responsible for regulating rates and returns. Public utility regulators traditionally allow price hikes to maintain the rate of return on new investment, but not to cover higher operating costs or to promote conservation. A different regulatory philosophy – recognizing the benefits of full cost pricing and conservation - can correct the bias toward wasteful overinvestment in the water industry.

Privatization Models

As the U.S. water industry becomes more competitive, different strategies for privatization and restructuring are being tried. The following broad categories encompass the major approaches for injecting private sector strengths and competition into this municipally dominated sector. We list them in decreasing order of “privateness.”

Private Ownership This is the purest form of privatization. Under this model the ownership and operations of a municipal water system are sold to a private company, converting a government enterprise into a regulated, investor‑owned utility. Typically the purchasing company not only pays the local government, but is also subject to additional terms and conditions – e.g., limiting rate increases for some period, and/or establishing performance goals – that go beyond standard regulatory requirements.

Contract Operations and Maintenance (O&M) Under this approach, the public sector retains ownership of its system, but contracts out operations to a private firm. In full‑service contracting (also referred to as a "concession"), all functions are operated by the private vendor. Most such contracts restrict layoffs to attrition only. This is the most common form of public-private partnership in the U.S. water industry,

Managed Competition In a managed competition, bids are solicited from potential contract operators and compared to a proposal for restructured operation submitted by the public sector's managers and employees. While non-economic factors may play a role in such competitions, this award is typically made primarily on the basis of cost.

Outsourcing In this variation, non‑core operations and maintenance activities are outsourced via competitive bids. As with outsourcing in the private sector, this strategy is generally intended to help an organization focus on its core business functions (e.g., treatment plant operation, or pipeline maintenance) by using a specialized firm to manage a function in which the utility is not as expert or proficient, and/or cannot maximize efficiency and economies of scale (e.g., building and grounds maintenance, billing and collections, meter reading, laboratory services).

Two Paradigms

Despite this apparent variety there are really only two sharply contrasting models for privatization: The “Ownership” model and the “Contract” model.

Private Ownership

The ownership model is the “purest” form of privatization. It consists of investor ownership, use of private capital for major projects, and competition among private water companies. Almost all investor-owned water utilities are subject to regulation by state public utility commissions, which approve territories and terms of service, investments, expenditures, prices, and rates of return (profits). Private water companies generally charge higher rates than government run ones. This differential does not reflect costs, which are usually lower in private hands. Instead it reflects taxes (all levels), financing (including availability of tax exempt financing for city owned utilities), subsidies (often hidden), profits (return on equity), and the historic underpricing of water by many cities.

Government run water companies have considerably higher operating expenses than investor owned companies. They spend $330 per connection as compared to $272 per connection, according to a 1996 study by the Reason Foundation. Since there are no obvious differences in water quality or dependability, the 18 percent difference reflects the loss in operating efficiency under government ownership.

The major reason for the discrepancy: employment levels. Investor owned firms hire 1.62 workers per every one thousand connections while government owned firms employ over twice that amount at 3.48 employees per one thousand connections, according to the Reason study. The actual differential is probably higher, since public companies hire more contractors and consultants. Political patronage jobs in government run utilities is undoubtedly part of the explanation. Superior technology in private water works is another.

Large private companies, by consolidating many plants and operations under one corporate umbrella, enjoy returns to scale unavailable to government water utilities or local contractors. These efficiencies effect administrative activities such as personnel, billing and collection, as well as the purchase of treatment chemicals and executive management. Large companies also have easier access to the capital markets and can often borrow at preferential interest rates because of the large size of their capital funding. (This may not fully offset the tax exempt interest rate advantage of public utilities described below.) By buying neighboring utilities, private companies can eliminate waste and excess capacity.

The economic advantages of size have spurred a strong consolidation movement in the U.S. water industry. Private water companies are scrambling to acquire government run utilities – and each other. In November 1998 California Water Services (San Jose, CA) announced a bid for Dominguez Water (Long Beach, CA). In March 1999, American States Water (San Dimas, CA) made an unsolicited bid for Dominguez Water that was countered and won by California Water Services. U.S. companies are even searching outside of the country, with Azunix (a spin-off of Enron Corp) purchasing Wessex Water in 1998.

The entry of Enron Corp., the largest natural gas company in the United States, into the water industry is symbolic of a larger trend: convergence of the water, electric, and natural gas industries. In any geographic location, electric, gas, and water utilities are likely serving the same customers. By diversifying into the water industry, electric and gas utilities can expand their rate base and reduce unit costs.

Regulation

Privately owned utilities are regulated because they have monopoly power over captive customers. We can find no major water operation anywhere in the world which has been “privatized” without some type of government control or regulation. Water is simply “too important” to be left to unfettered market forces..

There are three general types of government regulation of the water industry: rate of return regulation, purchase price regulation, and rate cap regulation. These are generally identified with the United State, France and Great Britain, respectively. There is overlap. Not every single type of government regulation is necessarily identified with one particular country. And, water utilities who wish to be privatized in other parts of the world have this smorgasbord from which to pick. But, these are the general models from which to pick.

We discuss rate of return regulation in the following section. The French and British regulatory models are discussed on pages TK through TK.

Rate of Return Regulation

Rate of Return Regulation (RRR) is the most familiar to regulatory agencies in the U. S., not just for water but also for most utilities. The concept is simple. If a utility is a “natural monopoly”, then it’s “rate of return” must be limited directly by regulators to avoid “price gouging”. In the simplest mathematical terms:

P=C x (1+r)

Where, P is the price of a unit of water, C is the cost of producing that unit of water, and r is the allowable rate of return (e.g. 6%, expressed in this case as 0.06).

This simple equation illustrates the tensions in this type of regulation.

It is easy to see how perverse and possibly conflicting incentives can arise under rate of return regulation. Utilities have an incentive to maximize total net return (C x r). They are, after all, private for profit entities. If they are not “efficient” (i. e. if “C” is higher than necessary), the utility may actually benefit. So long as the utility’s rate of return, “r”, exceeds the utility’s cost of capital, then some incentive exists to not necessarily be as efficient as possible.

Regulators face a different set of incentives. In determining allowable charges, regulators proceed on the premise that the return to capital invested in private water utilities (ROI) should be in line with that earned in other industries. If ROIs are too high/low, there will be too much/little capital investment. Although the rule seems clear cut, it requires sound judgement as to which costs are necessary and “allowable.”

It is foolish to think that regulators are immune to political pressure when setting rates – those in states in which commissioners are elected being the most susceptible, those (primarily the large states such as New York and California) in which they are appointed for long terms being the least prone to respond to the political pressures of the moment. Whether elected or appointed, they want happy customers (also known as voters). One way to achieve this goal is to keep the price of water, “P”, as low as possible and not rapidly rising. This can lead to the regulators micromanaging a utility’s operations and dissallowing vital capital outlays. (A large addition of capital plant, however needed and justified, coming into the rate base “all at once” is apt to produce politically unpalatable “rate shock” among ratepayers).

Rate of return regulation works best when there are no personal or institutional ties between the regulators and the regulated utilities. This is not always the case, however. A condition known as “capture” occurs when management knows that regulators will permit any costs to be covered by higher rates. When capture occurs, private utilities that over invest in capital, pad payrolls, and otherwise inflate costs are rewarded with higher water rates. (In the equation above, higher C leads to higher P.) Such utilities can actually increase profits by raising costs.

The inefficiencies of such regulation may be exaggerated, however. Because of the time regulatory commissions take to rule on rate cases, utilities can often retain for their shareholders sums earned in excess of allowable returns for several years. And because regulatory lag works in the other direction – it takes a while for regulators to allow rate increases when costs rise – utilities have a further incentive to keep costs under control. In any event, these perverse incentives are checked by competitive forces currently at work in the water industry, especially the proliferation of private companies looking to acquire mismanaged – and therefore under-priced – assets.

Traditional rate of return regulation can create barriers to privatization. Most state regulatory commissions value utility assets at book value rather than acquisition costs. As a result the rate base is too small to allow an acquiring utility to earn a reasonable return on its new investment. Water systems in such states will not be attractive to potential buyers. But for the regulator to allow the purchase price, or market value, to become the rate base on which the allowed return is to be computed, would be to engage in a circular process, since the market value is itself a function of the rates the regulator will allow. To use reproduction costs as the rate base is to launch on a process involving “endless controversy over the proper valuation of sunk capital, in direct contradiction of the economic principle that sunk investment costs are prominent among the 'bygones' that ought to be ignored in price making.” (Alfred E. Kahn, The Economics of Regulation: Principals and Institutions, New York, John Wiley & Sons, 1970, Vol. I, pp. 53-54.)

Profit sharing agreements, under which the efficiency benefits arising from privatization are shared between the acquiring utility and its customers, can be a pro-privatization alternative to traditional rate of return regulation.

In the end, privatization will involve a multiparty bargain between the private sector buyer, the municipality or other public sector seller, the regulator, and, perhaps, the EPA, the latter having a major say in the magnitude and timing of future capital investment. The difficulty of achieving such a bargain, along with the tax preference accorded public sector debt, explain the popularity of long-term contracting as opposed to the outright sale of public water utilities to private water companies.

Tax and Political Barriers to Private Ownership

Despite the obvious advantages of private ownership, sales of government owned water utilities to private companies have been fairly rare in the 1990s. Such sales typically involve the sale of smaller water systems to existing, neighboring investor‑owned water utilities that offer economies of scale and more sophisticated management. For example, in 1996 alone, United Water Resources acquired two small New Jersey systems to gain approximately 40,000 new customers, Consumers Water Company purchased three local systems, and the Philadelphia Suburban Corporation acquired eight systems to add over 17,000 new customers (Price Waterhouse, 1997). In the wastewater industry, the first sale of a federally subsidized municipal wastewater facility ‑ the Franklin Area Wastewater Plant in southwestern Ohio ‑ took place in 1995, and has not been widely replicated.

The major obstacle to the sale of municipal water assets in the second half of the twentieth century is the structure of the U.S. tax code. Municipal debt continues to be tax‑exempt, while privately issued debt remains taxable. As a consequence, public utilities enjoy lower capital costs than privately owned utilities. This is seen in the interest rate differential between tax exempt municipal bonds and corporate debt:

The Spread Between Taxable and Tax-Exempt Interest Rates

Year	Municipal Bond Interest Rate (High Grade)	Corporate Bond Interest rate (Baa)	Spread: Municipal Less Corporate Bond Interest Rate
1980	8.51%	13.67%	5.16%
1985	9.18	12.72	3.54
1990	7.25	10.36	3.11
1991	6.89	9.80	2.91
1992	6.41	8.98	2.57
1993	5.63	7.93	2.30
1994	6.19	8.62	2.43
1995	5.95	8.20	2.25
1996	5.75	8.05	2.30
1997	5.55	7.86	2.31
1998	5.12	7.22	2.10
1999	5.43	7.87	2.44

Source: Economic Report of the President, February 2000.

The spread results in significantly lower debt service costs. For example, cumulative interest payments on a $1 million thirty-year bond would be $497,000, or 53% more at the current corporate interest rate (7.87%) than they would at the municipal bond rate (5.43%). This is particularly important given the highly capital‑intensive nature of the water industry.

Federal subsidies also favor public ownership. For years following the passage of the Clean Air and Water Act, federal construction grants were made available to public utilities only. This made it difficult for any private utility to play a leadership role in addressing the environmental goals of that era. It also made subsequent ownership changes impractical. Until 1992, municipalities were required to repay all such federal grants they had received upon sale to a private operator. In 1992, however, President George Bush's Executive Order (EO) 12,803 on Infrastructure Privatization gave municipalities new flexibility to sell public infrastructure while only being required to repay any remaining "undepreciated" portion of the grant. Also, in response to EO 12,803, the EPA announced its intent to allow private operators to receive federal assistance. In conjunction with the decreasing availability and significance of such subsidies in the 1990s, this policy change has served to shift the playing field much closer to a level position.

Political concerns over water rates and the control of water systems may limit the sale of government water utilities to private firms. For local politicians, control is often the central issue in the water industry. He who controls water, controls the economic destiny of the city or town. In this respect, the water industry is more local in character than other utilities (electricity and gas). Even when a privatized water utility might lower water costs through economies of scale or increased operating efficiencies, local communities are often reluctant to surrender control over rates and finances to state regulatory bodies. Considerable evidence suggests that many long-term contracts are structured to avoid economic regulation by the states, to the liking of both the privatizers and the cities in which they operate.

For small communities near major investor-owned utilities, however, the economies of scale afforded by such larger systems may overwhelm such drawbacks. These communities may also be motivated by the one‑time influx of capital that such a major asset sale may bring. For example, after paying off its system debt, Franklin, Ohio's $6.8 million sale generated more than $1 million in proceeds for the county and municipal governments served by the plant. Similarly, in 1998, the Mayor of Birmingham, Alabama proposed the sale of that city's water and sewer system primarily to capitalize a school construction trust fund, following voter disapproval of a sales tax increase targeted for school improvements. Perhaps exemplifying the difficulty of such a major sale, however, Birmingham voters rejected this proposal in a November 1998 referendum.

Some regions of the country, such as Pennsylvania and New Jersey, have begun to see significant use of this strategy. Most areas of the nation do not yet have private water utilities large enough to pursue this approach. Absent dramatic government intervention to overhaul the tax code, modify environmental regulations, and generally restructure the market, asset sales face far greater obstacles than less pure forms of privatization.

Contract Operations and Maintenance

Long term contracting is by far the most widespread form of privatization. It has changed the economics and politics of the water industry in many fundamental ways. Perhaps reflecting the influx of French investors and parent companies into the U.S. water market, this model closely parallels the competitive system of France. Its popularity, however, is clearly the result of recent changes in the U.S. tax code.

Following substantial lobbying from the United States Conference of Mayors, the Department of the Treasury issued new tax regulations in 1997 enabling long-term private contracting for water operations and management. Under previous rules, if a publicly owned water facility was under contract operation for more than five years, it was deemed to be for “Private Use” and ineligible for tax-exempt capital financing. Under the 1997 modifications, however, contracts of up to 20 years are now permissible without affecting the tax-exempt status of a utility's debt. With longer term contracting now practicable, long-term capital investments can be incorporated into O&M agreements and amortized over a period that makes such agreements more cost-competitive.

Contract provisions vary significantly. For example, Buffalo adopted a five-year contract (with a five-year renewal option) in 1997 with American Anglican Environment Technologies for full-system operation. Buffalo's contract, which is projected to save $23 million, or 30% of pre-contract operating costs, over the first five years, guarantees no layoffs and continued civil service status for the municipal employees of the system. Indianapolis selected a contract team made up of a private treatment plant operator and its local public employee union, saving over 25 percent ($13 million over five years) on managing its wastewater system. Late in 1998, Atlanta gained widespread attention by reaching a 20‑year agreement to manage its water system; the largest yet operated under contract. (See below.) As evidence of intense private sector interest in such opportunities, Atlanta required interested parties to pay a nonrefundable $50,000 fee just to participate in the bidding. Five companies bid for the project.

The length of the contract is crucial. Short term O&M contracts usually do not offer large enough total dollar savings to cover capital investment needs. The kind of operating and capital changes required to generate 20 percent and greater operating cost savings take time to implement. Long-term contracts allow municipalities and private contractors to share and spread risks appropriately and efficiently, and implement a broader range of cost saving measures.

More than any other device, long-term contracts have brought large domestic and foreign companies into the water market. Such arrangements, by obviating the need for costly re-bids every few years, are much more attractive to the industry. Although experience with long-term contracting is limited, casual observation suggests that average annual cost savings from long-term contracts are greater than average savings from successive short-term ones. This seems to validate the industry’s contention that more efficiency can be realized over a longer period.

Long-term contracts have also reduced opposition to privatization by public employee unions. It is increasingly common for long-term O&M contracts to require that all employees be hired by the winning bidder (save those who cannot pass a drug test), and that contractors not lay off any of those employees for a set period (usually at least one year). Large water companies tend to operate with about one-third fewer workers than government does. The natural turnover rate of employees can bring the total number of employees down to the desired level (i.e. where the private firm can make a profit at the contract price they bid) in around 3-5 years. So, for short-term contracts, no-layoff provisions would mean no profits, and so were rarely seen. With long-term contracts they are becoming the norm.

Another labor issue is that of employee benefits. Recent years have seen many private firms offer wages that are converging on those employees earned from local government, but benefit packages lagged. Notably, private sector defined contribution pension plans were viewed as inferior to public-sector defined benefit pension plans. With the splendid performance of the stock market in recent times, defined contribution plans have begun to look more attractive. Also, private pension plans often have much shorter vesting periods, and many governments are converting to defined contribution pensions. These developments have to some extent closed the gap between private and government benefits packages.

Public officials are reluctant to relinquish control over water rates and availability. In many parts of the west, control over water is tantamount to control over economic growth and activity. Long-term contracts may exacerbate that concern. On the other hand, there is a growing realization that the higher user fees necessitated by capital improvements have very regressive effects on local residents. This realization is changing the politics of privatization. As Atlanta’s liberal mayor showed, conservatives do not own privatization policy. His core constituency, the urban poor, stood to loose the most from the expected 100 percent increase in rates if the public works department continued to operate the water system.

Long-term privatization also challenges the rationale for a growing policy practice—managed competitions. In managed competitions in-house employees bid against private firms for the contract. Since a significant advantage of long-term privatization comes from shifting risks to the private sector, it is very difficult for an in-house team to offer competitive bids. To date, no long-term contracts have been bid as managed competitions. This may turn out to be a non-problem, since much of the reason for managed competitions is to assuage public employee unions objections to privatization, and long-term contracts offer full-hire provisions in its place.

Disadvantages

Disadvantages start with the inevitable conflict of interest that exists whenever principals (governments) delegate responsibilities to agents (contractors). Which party is responsible for environmental compliance or the planning or implementation of needed infrastructure investments? Will the government blame the contractor? Will the contractor blame the government? This ambiguity is, of course, absent when water works are privately owned.

Contracts are growing longer in length and more lucrative financially, to the obvious benefit of the contracting community. Larger and longer contracts reduce risks and enhance profitability, but they also have negative implications. First, they narrow the field of viable competitors, resulting in an oligopolistic market. Second, they challenge the capacity of local governments to design and oversee contracts to protect their interests over the long haul. Experienced contractors generally have the advantage in the contracting process. Third, and perhaps most important, they suggest the possibility of monopoly power and potential for abuse over time.

Contracting is oligopolistic at the bidding stage because few firms qualify, but is monopolistic once the contract is awarded, with relatively weak competitive pressure over time. The problem of persistent monopoly power is perhaps the most important consideration for policymakers. As analyst Janice Beecher writes: “A twenty-five year cycle of bidding – however intense the bidding – hardly constitutes robust competition. The competition is intermittent at best. Moreover, the contracts model is designed rather transparently to circumvent the authority of the state to regulate monopolies and their profits. In other words, contracts effectively eliminate regulatory risk to the private firm.” [Janice A. Beecher, “Privatization, Monopoly, and Structured Competition in the Water Industry: Is There a Role For Regulation?”, 1999.]

Governments must be “smart buyers" when deciding how to share power with private contractors. Bidding often presumes maintenance of current prices with no assurance that savings or “profits” will be used for system improvements or to lower water bills. Good contracting requires crystal-clear performance incentives and meaningful enforcement mechanisms. There is no fool-proof mechanism for achieving this; “best practices” are not well established. In practice, contracting is rife with favoritism, waste, fraud, and corruption involving public and private partners. In Sharing Power author Donald F. Kettl writes that “Despite the enthusiasm for entrepreneurial government and privatization, the most egregious tales of waste, fraud, and abuse in government programs have often involved greedy, corrupt, and often criminal activity by the government’s private partners – and weak government management to detect and correct these problems.”

The regionalization of small local water companies is impossible if they are managed under private contact. Spatial and temporal boundaries will prevent optimal long-term solutions. A patchwork of private contracts, in other words, will not help the water industry achieve much needed economies of scale through the formation of publicly or privately owned regional systems.

Another negative is the tendency for governments to focus on short-term contractual benefits while ignoring long-term disadvantages. Some long-term contracts include large concession fees, paid by the contractor to the local government, that represent some portion of future cost savings. (Another way to describe them is as the present-discounted value of future user fee increases.). However stated, the practice means that future rate-payers will pay higher rates than they might otherwise would have as a result of current Mayor’s desire for a pot of unencumbered dollars to spend as he wishes. Even if that money is used in an actuarially wise fashion, such as on infrastructure, there may be considerable resource misallocation.

Contracting proponents maintain that private contractors will provide the best service at the lowest price in order to renew their government contracts as they expire. In many cases, however, the problems are due to insufficient or out of date infrastructure rather than inefficient operations. Contractors manage the operations side, not the capital and infrastructure side of water utilities. If a municipality feels there is no way, even with the help of an private O&M contractor, that it can raise the funds needed to revitalize its infrastructure, then the outright sale of water assets to a private company is clearly the best alternative.

Given the economic and political advantages of private ownership, there is little doubt that many local governments choosing long-term O&M contracts would have chosen to sell the water utility outright were it not for our perverse tax code. The interest rate advantage for public ownership makes contracting the more attractive option even if operational and administrative efficiencies favor a sale or lease. Therefore a good argument can be made for leveling the playing field by either eliminating the tax exemption for public borrowing, or making it available to all utilities – public and private alike.

Other Regulatory Models:

The French Experience

France has a long history of private water utilities. In 1782 a private company was given a franchise to distribute water to Paris. From the early 1850’s, other cities (Cannes, Le Havre, Calais) were giving their water franchises to private firms. Private water companies including such international giants as Vivendi currently serve nearly 75% of the French water market,.

French water utility regulation relies principally on market forces. A franchise to provide water in a given area is put up for bids. The franchise is good for a specified number of years. Government involvement is limited to drafting a bid document and monitoring compliance by the successful bidder over the life of the franchise. Typically the franchise agreement will specify prices which may be charged (which may increase by specified amounts over the life of the franchise depending on the terms of the successful bid) and certain measures of quality of product and service.

These bid documents are fairly easy to draft. The technology of the water utility business is widely known and changes relatively slowly. Measures of water quality and levels of service are also widely known. Barrriers to entry are thus limited, ensuring a healthy number of bids.

France uses two main types of regulation. One is the concession under which private water utilities are invited to bid on a long-term franchise to build and/or modernize the capital plant. The utility agrees to provide the funds for the capital outlay and to operate the facility. Concession arrangements are popular where the municipality either lacks the funds for, or doesn’t wish to assume the risk of financing the capital facility itself.

The second is the affermage system. In the affermage system, there is still a bidding process on price and quality for operation of the facility, but the municipality itself advances the funds to underwrite the capital outlay. The governmental unit still owns the facility. In many cases, the bid document will specify a bond to be forfeited if the facility is not turned over to its governmental owner in a specified condition at the end of the contract. This is not unlike putting down a security deposit when leasing an apartment.

Both forms of regulation have “self-enforcing” safeguards. First, private bidders have an incentive to bid as low as they reasonably can on the present and future price(s) of water they agree to provide. Otherwise a competitor may steal the contract. Second, the successful bidder retains an incentive to wring efficiencies from the operation. After all, the price(s) of water at a given point in time are fixed by the agreement. Ratepayers are protected from and undue “cutting of corners” by the quality of service and product provisions of the agreement.

Franchise bidding obviously tends to work better with larger water systems. If the operation is small, it may be “not worth the effort” to attract more than one or a handful of bidders. In this case, the competitive bidding market to provide a specified level of quality at the lowest price tends to break down due to lack of competition.

Nonetheless, franchise bidding has often worked well in France and elsewhere when the circumstances are right.

Great Britain: A Good Regulatory Idea on Paper…But…

Great Britain was rather late in coming to the idea of privatizing water utilities.

A variety of new regulatory regimes are available to regulators who fear that traditional rate-base, rate-of-return regulation offers too little incentive to efficiency. These include the regulation of prices rather than profits, so that cost savings are shared between customers and shareholders, and the use of intercompany cost comparisons, or benchmarking. A radical new approach, much used in the U.K., regulates firms by use of a price cap. One formula is that regulated prices should rise at “inflation minus X.” Under this approach water prices go up at the annual inflation rate less an annual efficiency improvement (“X”). The advantage of this approach is that it mimics a competitive market. Firms do not control prices – they become “price takers” – and any cost reduction flows directly into profits. Difficulties arise over the appropriate value for X. If X is set too high, the water system will suffer chronic losses; if X is too small, companies will earn large monopoly profits.

Can Water Be Deregulated?

A natural monopoly exists when only one producer can operate profitably in a given market. This alone is not enough. There must also be substantial barriers to entry for potential competitors so that the natural monopoly company has little or no fear of future competitors.

Is water a natural monopoly? Free market advocates say no, pointing to deregulation occurring in other U.S. utilities, particularly electric and gas utilities in the late 1990s. Among energy utilities, previously integrated services of production, distribution, and marketing have been "unbundled" to create new areas for competition. While distribution must generally remain a regulated monopoly, new deregulation policy is enabling electric companies to compete as either producers and/or retail marketers. Electric power can be transmitted over long distances at a cheap price (called “wheeling of power”). Electric utilities are being given much more ability to merge and engage in power wheeling by state regulatory commissions.

But neither the technology nor the economics of water permit such competition. Drinking water quality can degrade over time and distance, and water from different sources may not react well upon mixing. Water is bulky. Transporting it for long distances via pumping stations and expensive pipeline infrastructures costs a great deal of money relative to the price of the water being moved.

Water requires much more infrastructure to produce and distribute than other basic services. Water utilities require as much as $12 in capital investment for every $1 in revenue. Comparable numbers for electric utilities are roughly $4 for every revenue dollar generated, $3 for basic telephone companies, and $2 for railroads. This has two implications: (a) capital requirements make competitive entry difficult and contribute to the “natural monopoly" nature of the water business, and; (b) cost of capital is crucial in determining the profitability and viability of a water utility, whether public or private.

Unlike electricity or natural gas, water is a “local” commodity. There will always be a monopoly element, requiring economic regulation by either local governments or state public service commissions.

A possible exception can be found in the water starved Southwestern U.S. Infrastructure is in place connecting the Colorado River to Phoenix and Tucson via the Central Arizona Project, and to Los Angeles and San Diego via the Colorado River Aqueduct. The State Water Project in California transports water from the Bay Area to Southern California. This massive infrastructure coupled with rapid growth and a severe water shortage may support the development of a water market comparable to those seen in electricity and natural gas.

The "unbundled" energy utility model may have other applicability. In some metropolitan areas both conservation successes and demographic shifts from city to suburb have left larger systems with excess capacity that can provide more cost‑effective "production" than building or upgrading nearby smaller plants. Under a different regulatory structure, such economies of scale might be better captured through selling water to a neighboring utility.

Case Study: Atlanta – A Liberal Mayor Embraces Privatization

Atlanta provides water and wastewater service to more than 1.5 million people. The city owns and operates two water treatment plants, with a capacity of 201.4-mgd; three major pumping stations; 90.5 million gallons of storage; and 2,400 miles of water mains. In addition there are three wastewater treatment plants and a 2,200 mile sewer system.

Like many metropolitan areas of the United States, Atlanta’s water and sewer systems are deteriorating and in need of massive capital improvements. The city’s 1997 Capital Improvement Plan called for spending $850 million over the next five years to replace and upgrade antiquated facilities, provide for future capacity, and meet environmental requirements. Faced with the need to finance immediate capital improvements, Atlanta was faced with two choices: raise water rates again to meet operations and debt service requirements, or cut operating expenses to offset higher debt service costs.

The city decided in June 1997 to assess ways of cutting costs. In July 1997 the city retained a group of consultants to evaluate possible alternatives for cost savings and technical improvements. The consultants outlined several different methods for obtaining cost savings: internal re-engineering, outsourcing, managed competition under which public employees could compete with private contractors, contract operations of facilities, and private system management. The consultant team estimated the savings that could be derived from each of the options, and assembled them into savings packages or alternatives. The range of annual savings predicted by the consultant’s model went from $14.9 million per year for light re-engineering/outsourcing to $39.6 million for the most dramatic alternative: placing the entire water and wastewater systems under private management.

In December 1997 Bill Campbell, the populist Democrat mayor of Atlanta, decided on private management of the city’s water utility and the largest wastewater treatment plant. “I am not a fan of privatization,” the Mayor wrote. "But my personal philosophy is that we serve the public’s best interest by not closing our eyes to the reality that if we fail to privatize, we will be forced to severely raise rates.” The mayor’s political calculus was actually quite simple. The city water system was significantly out of compliance with environmental standards, leading the federal government to fine the city on a daily basis. The water utility’s own estimate of the cost to upgrade the system and achieve compliance called for a more than 100 percent increase in water rates, which caused an uproar among residents, especially the poorer neighborhoods which are the mayor’s power base.

Atlanta set an ambitious schedule for the procurement process, looking to close on a contract less than one year from the issuance of its RFP. One reason for the tight scheduling was that the savings anticipated through privatizing the water system had to be “bankable” when the city sold its next issue of tax exempt water bonds. Otherwise the rating agencies would have downgrade the securities and interest costs would have risen. Because the main goal of this privatization was to offset rate increases and pay for new capital spending, the city needed to have a contractor identified with a guaranteed level of savings when it went into the bond market in late 1998 or early 1999.

Many problems were noted in the city’s plan. Among them: the hurried schedule for the bidding process; a lack of specific details regarding oversight for both bidding procedures and operation of the system; and ambiguity surrounding plans for about half the capital improvements. National experts on privatization expressed concern with the speed of the process of selecting a contractor. The proposals were due from bidders on July 2; the City picked a vendor on August 12^th. Conflict of interest questions dogged the selection of an Atlanta law firm with ties to Mayor Campbell to represent the city in the privatization process.

After an extremely hard-fought competition among private firms, the city chose a joint venture of United Water Services and its parent Lyonnaise des Eaux to operate and maintain the system for 20 years (The other competitors for the contract were Vivendi’s Compagnie Général des Eaux, U.S. Filter Corp., and a joint venture of the U.S. firm OMI and Thames Water). The agreement cuts the cost of upgrading and operating the utility by 44 percent, and means water rates need increase less than 30 percent to pay for the upgrades. The city’s annual cost was $49.5 million, and United Water’s bid only $21.4 million a year. However, the city will also pay roughly $6.1 million a year to cover the costs of electricity, natural gas, and insurance for the facilities, as well as contract monitoring costs.

United Water hired all 535 existing water department employees. The firm will operate the city’s two water treatment plants, and all meter reading, billing, and customer service responsibilities. Atlanta still owns the system, and will continue to set rates, finance capital improvements, assume all market risk for delivery of raw water to the treatment plants, and ensure contract compliance.

United Water agreed to a no-layoff (without cause) policy for the 535 employees of the city water department for the full duration of the contract, which exceeds the city’s request for a three-year period. The firm will use early retirement incentives, drug and alcohol screening, cross-training and transfers of skilled operators and managers within its regional operations, planning to reach optimum employment levels in two years.

The politics of the contract process were not pretty. The RFP was modified 18 times after it was issued, and a final 80-page version was issued only two days before final prices were due. Nonetheless, an independent reviewer hired to watchdog the process judged the process to be fair, if not the best he’d ever seen.

Observers, and bidders, were surprised when the city decided to provide first-round prices to local newspapers and technical bid summaries to each of the bidders. They then asked the bidders to improve all aspects of their proposals for best-and-final offers three weeks later. But the city may have been crazy like a fox—United Water’s winning bid was 21 percent lower than its original!

And the firm not only cut the price, it also upped its efforts in other measures. The city set a quota of 30 percent minority participation—United Water came back with a plan have 35 percent ownership of its local operating company owned by local minority businesses, and 60 percent of the system management be minorities. Not only that, but the firm agreed to move some corporate offices and invest 5 percent of its pretax profit in job training and economic development in the city’s economically distressed neighborhoods. This gave the Mayor great leverage in selling the privatization to his constituents, and took the contract to new heights in contract terms unrelated to the service being contracted.

Conclusion

The single most defining event in water privatization over the past decade has been the advent of long-term contracts. Atlanta’s 20-year agreement to manage its water system is the largest such contract signed in the United States. What lessons about future privatizations does the Atlanta contract teach us? Here are the broad trends implied by the contact:

1. Privatization of infrastructure is now on the table in the nation’s big cities. Other big cities like Seattle, Chicago, and Houston have dabbled in partial privatization already. The environmental and fiscal pressures on them are beginning to outweigh the traditional political powers of public-employee unions and the belief that privatization is too risky.

2. Many contracts will entail hiring all existing employees. This trend has been emerging ever stronger in the last few years. Employees like it, for obvious reasons, and if they fail to stop a privatization from occurring in the first place, this is often their first demand. Interestingly, most of the private firms do not oppose the idea. They see it as helping reduce ill-will associated with privatization, and in fact have always on average hired over half of existing employees for their intimate knowledge of the local system.

3. Most contracts will be long-term. It takes 10 years or more of significant operating efficiencies to pay for the upgrades most systems need, especially if the private firm is putting up some of the capital. Moreover, political pressure makes firing existing employees difficult. Thus while a private firm typically uses two-thirds the personnel to operate a given system, it usually takes years after privatization for natural employee turnover to bring manning levels down that far. United Water Services has lost money on the Atlanta contract, and will not earn a profit on it for several more years – when manning levels are diminished.

4. Large cities are at an advantage when it comes to privatization. Water companies crave the exposure and publicity that comes from operating in a large metropolitan area. They will sacrifice profit margins, and submit bids at or even below cost in order to come in with the winning bid. Expect other large city contracts to be laden with unrelated “community benefit” requirements. Minority participation requirements are old hat, but the Atlanta contract in particular opened the door to all manner of stratagems from corporate office locations to school programs. Such provisions appeal to big city politicians but greatly reduce the economic advantages of privatization.

5. A troubling development arising from long-term contracts like Atlanta’s concerns inter-generation equity. The contract included large concession fees, paid by the contractor to the local government, that represent some portion of the present-discounted value of future operating cost savings. Another way to describe them is as the present-discounted value of future user fee increases (or lack of decrease made possible by future operating efficiencies). However stated the practice means that future rate-payers will pay higher rates than they might otherwise have to as a result of current policy-maker’s desire for a pot of unencumbered dollars to spend as they will. Even if that money is used in an actuarially wise fashion, such as on infrastructure, there may be considerable dead-weight loss during the transfer.

6. The politics of privatization will not always follow conventional thought. Atlanta’s liberal mayor showed conservatives do not own privatization as a policy. As liberals begin to realize that the cost of improving infrastructure, even with tax-exempt funding, is much more of a burden on the poor than the middle-class or wealthy, they will embrace the efficiency gains that accompany competition

7. Expect to see employees of privatized utilities strive to keep their public-sector defined-benefit pensions. There is a move in the public sector to convert to defined contribution pension systems. To the extent that occurs, public pensions will have no particular advantage over private ones, which are mostly defined contribution.

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

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

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

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

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

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

THE UNTAPPED POTENTIAL OF WATER PRIVATIZATION

U.S. Water Withdrawals

Year

Withdrawals

Irrigation Withdrawals

Ownership

Number

Number

Private Ownership

Rate of Return Regulation

Contract Operations and Maintenance

Disadvantages

The French Experience

Great Britain: A Good Regulatory Idea on Paper…But…

Case Study: Atlanta – A Liberal Mayor Embraces Privatization

Conclusion