Privatization of Water Services in the United States: An Assessment of Issues and Experience (2002)

Below is the uncorrected machine-read text of this chapter, intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text of each book. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.

Executive Summary A lthough many U.S. water utilities are today publicly owned and operated, many U.S. water utilities were initially private ventures. But interest in the prospects for an increased role for private sector participation in water supply and wastewater services in the United States expanded during the 1990s as economic, fiscal, regulatory, and environ- mental factors led city officials across the United States to consider priva- tizing parts or all of their water supply and wastewater systems. The term “privatization” covers a wide spectrum of water utility op- erations, management, and ownership arrangements. The four major classes of privatization options can be characterized as (1) private provi- sion of various services and supplies such as laboratory work, meter read- ing, and supplying chemicals; (2) private contracting for water utility plant operation and maintenance (both 1 and 2 are often referred to as “outsourcing”); (3) negotiating a contract with a private firm for the de- sign, construction, and operation of new facilities (this option is referred to as design, build, and operate, or DBO); and (4) outright sale of water utility assets to a private company. In the United States, the contracting of management and operations to a private provider (outsourcing) has been more common than the sale of utility assets to private companies. No major U.S. city has sold its utility assets in recent decades, although some smaller water utilities have done so. Because of variations in political, demographic, economic, and physi- cal circumstances, no single model of public or private water services (drinking water and wastewater treatment) delivery best fits all situa- 1 

2 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES tions. Although there is no inherent reason why either the public or pri- vate sector should be the preferred sector for delivering water services, public and private sector operations often face different constraints and incentives. For example, on one hand, privately owned and operated wa- ter utilities may be less tied to local politics than publicly owned utilities and they may have greater flexibility to make staffing changes. On the other hand, public systems may be more responsive to public input and more amenable to conservation objectives. The issues are complicated and dynamic, and vary greatly across communities and regions. Public and private water utility management organizations are guided by different sets of incentives. Some of these differ between the public and private sector, while some incentives are common in both. Whatever the mix, public and private utilities operate best with clear lines of authority and responsibility, with technical competence, and with the ability to make long-term investments. Given appropriate incentives, au- thorities, and responsibilities, water utility privatization will represent a viable option to public ownership or operations. But according to indus- try financial consultant George Raftelis, “Privatization is not an all-en- compassing panacea for water and wastewater facility financing and con- struction. Rather, it is one of several approaches to solve the capital infrastructure problems facing local government utilities” (Raftelis, 1989). This report reviews key issues and experience with water services privatization in the United States and examines privatization’s economic, fiscal, regulatory, and other implications. It is intended to help the reader make informed judgments about which situations represent good candi- dates for privatization and which do not, and should therefore be of interest to water utility managers, urban government officials, and con- cerned citizen groups. STRUCTURE OF THE WATER AND WASTEWATER INDUSTRY Historically, water services were initially delivered by private pro- viders in many cities in the United States, such as Boston, New York, and Philadelphia. As these and other larger U.S. cities grew, water services became a core function of local government. This trend accelerated largely because of a legislative change after World War I, when Congress ex- empted interest payments on municipal bonds from federal income tax. This assured that municipalities could issue bonds at lower interest rates than those for taxable bonds. The U.S. water industry today is highly diversified. As of 1999, there were nearly 54,000 community water systems in the United States (the U.S. Environmental Protection Agency defines community water systems as systems serving more than 25 people, regardless of ownership). The 

EXECUTIVE SUMMARY 3 vast majority of these systems serve small populations. In fact, 85 percent of U.S. community water systems serve only 10 percent of the population served by community water systems. Investor-owned water supply utilities (i.e., “private utilities”) ac- counted for about 14 percent of total water revenues and for about 11 percent of total water system assets in the United States in 1995. Investor ownership of wastewater utilities is more limited than investor owner- ship of water supply utilities, in part because of extensive federal funding of wastewater treatment plants that began after World War II. Investor- owned water supply and wastewater utilities are subject to state eco- nomic regulation that oversees rates charged, evaluates infrastructure in- vestments, and controls profits. In contrast, private contract arrangements under public ownership are not subject to this regulation. The private sector has favored public-private relationships that are not subject to state economic regulation. According to the National Association of Water Companies (NAWC), the proportion of water services in the United States provided by private water companies, whether measured by customers served or volume of water handled, has remained close to 15 percent since World War II (NAWC, 1999). FACTORS DRIVING WATER SERVICES PRIVATIZATION The magnitude of investments that will be required to continue to provide high-quality, reliable drinking water and wastewater treatment services to the nation is huge. A recent report from the American Water Works Association (AWWA) estimated the necessary investments in re- placement of the nation’s water infrastructure to be $250 billion over the next 30 years (AWWA, 2001a; this estimate is based on a water utility survey). Public officials with limited financial and technical resources are interested in alternatives that may help meet these needs. Customers increasingly demand high-quality, reliable drinking water and wastewater treatment service. Surveys have indicated that customers are often willing to pay more for high quality water and reliable service. Water bonds usually pass at elections, another indication of the public’s willingness to pay for high-quality services. The Safe Drinking Water Act of 1974 has been a major factor in initi- ating changes in utility management and operations. With standards becoming increasingly stringent (illustrated by EPA’s 2001 arsenic stan- dard), it has become more difficult, especially for small and medium- sized utilities, to comply with standards at acceptable cost levels. Small to medium-sized water utilities (those generally serving fewer than 50,000 people) face the greatest difficulties in meeting the full range of technical, business, and infrastructure needs and compliance with in- 

4 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES creasingly strict drinking water and wastewater effluent standards. Ap- proximately 95 percent of the public water systems in the United States serve fewer than 10,000 people. Private utilities and larger public utilities typically have adequate resources and more advanced technical capabili- ties than smaller public utilities. Owing to economies of scale, private entities are often able to apply centralized scientific, technical, and busi- ness expertise to serve smaller, widely spaced systems. Likewise, some larger public water utilities, like the city of Cincinnati, increasingly assist in the provision of management services, procurement, and the provi- sion of reliable, high-quality water supplies to smaller surrounding com- munities. For smaller communities, “regionalization”—consolidation of water utility management and operations across several communities—can achieve scale economies and performance improvements. Regionalization includes the combination of utility organizations, wholesale service ar- rangements, cooperative agreements, and satellite management of mul- tiple systems, and can be achieved through both private and public sector arrangements. The primary barriers to regionalization appear to be insti- tutional and political, as policymaking institutions (including laws, regu- lations, and decision makers) may not favor water system consolidation in the interests of maintaining some degree of local control over person- nel, management, and operations decisions. A major impact of increasing competition from the private sector has been to stimulate public water agencies to engage in self-improvement programs such as establishing performance benchmarks, modifying work practices, implementing staff education and certification improvement, and accelerating investments in new technologies. Flexible workforce practices are particularly important; many systems that convert to priva- tized operations reduce costs by reducing the size of their workforces through changes in work practices and by broadening their employees’ range of skills. These practices are also increasingly utilized by public utilities through pre-arranged attrition schedules that protect employee rights. “Benchmarking” performance against other public water utilities has become a common practice. In the long run, the resultant widespread improvements in public water utility performance may constitute the most significant result of the presence of a privatization alternative. KEY CONSIDERATIONS IN WATER SERVICES PRIVATIZATION Several factors are relevant to municipalities that are considering privatization options. These include loss of some degree of control over a vital public service, uncertain control during emergencies, loss of exper- tise (which would make reversal of operations difficult), requirements for 

EXECUTIVE SUMMARY 5 adequate contract supervision, and implications for water quality, envi- ronmental values, public health, and local job security. A frequently- voiced concern is the possible contradiction between short-term profit maximization and long-term needs to protect infrastructure and water source areas. Goals of public agencies and private contractors are different. Con- tracts should therefore be carefully designed and implemented to protect public interests such as protection of the local workforce, customer ser- vice, civic responsibility, and environmental stewardship. To help ensure that goals are met, the contract should specify arrangements for monitor- ing and enforcement. Regardless of the terms of ownership and contrac- tual arrangements for operation, the ultimate responsibility for providing safe drinking water and wastewater treatment, and for complying with standards, rests with a public agency. Privatization is not equivalent to competition—long-term contracts between the private sector and utility monopoly may not be subjected to ongoing competition. In contrast to contracts for operation only, privately owned utilities are accountable to state economic regulators (public util- ity commissions) that apply a public interest standard to the evaluation of utility investments, expenditures, rate structures, and profits. And al- though regulation has weaknesses and is an imperfect substitute for com- petition, oversight and monitoring are important to help stabilize rev- enues, to ensure cost recovery, and to help guarantee a reasonable return on investment. Although private operation and management of water services may provide savings in operating budgets and capital costs, because of the bias against private operations in the United States tax code, a private operator with the same real costs as a public operator would have to charge higher rates. Investor-owned utilities that both own and manage assets must allow for depreciation and profits, while public sector rates may not reflect actual costs because of subsidies and for political reasons. Inadequate municipal accounting practices frequently make it difficult to achieve cost-based pricing. For example, the opportunity cost of the raw water itself is rarely considered in water utility accounting practices, and to do so would change the national dynamic of water pricing. The pros- pect of higher private rates has been a deterrent to privatization through asset transfers. Private contractors also have concerns about competing for utility operation and management, including the uncertain profitability of the venture and longer-term potential for extension of the contract. Prepara- tion of bids is costly and competition among the qualifying bidders can be intense. In the past, the procurement process through which requests for proposals are publicized and responses are made has varied, with result- 

6 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES ant uncertainties for both municipalities and contractors. This procure- ment process is increasingly being standardized. Private contractors are concerned about advantages possessed by municipalities because of their ability to issue tax-free bonds, the lack of access to alternative sources of public funding, and complex regulations concerning private management of publicly funded facilities. Public wastewater facilities were funded through federal grants dur- ing the 1960s, 1970s, and 1980s. The grant program has been replaced by state revolving funds that were initially federally funded, but that are now available only to publicly owned water and wastewater utilities. A variety of financial assistance programs that would facilitate private sec- tor participation have been proposed, including federal matching funds combined with state appropriations and low-interest loans, but funding to date has been limited to cases of extreme community hardship. The State of California has provided some low-interest assistance to investor- owned utilities but insists that customer rates be lowered to reflect these subsidies. Expanding such loan programs would increase opportunities for private sector participation. Only recently have longer-term (up to 20 years) private operating contracts of plants financed by tax-exempt bonds been permitted. Although a water utility’s success can be partly measured in immedi- ate terms such as cost savings, its ultimate effectiveness should be evalu- ated over longer time horizons, and in the context of broader social and environmental considerations such as public health and environmental stewardship. Water services privatization arrangements ideally will en- hance, not detract from, compliance with environmental and public health standards. Environmental stewardship considerations include the watersheds that provide raw water supplies. Control of land use and possible devel- opment in watershed areas are growing concerns with privatization and with foreign ownership of private water companies. Preservation and appropriate use of watershed lands should be part of an integrated water resources management approach under either public or private owner- ship. In many parts of the United States, water has usually been considered a free resource, with accountable costs reflecting only the capture, trans- mission, treatment, and delivery functions. Nationwide recognition of the importance of environmental protection, along with rapid population growth in many regions, has increased competition between traditional and newly emerging environmental uses of water. These developments have emphasized the importance of being able to transfer raw water sup- plies from older and lower-value uses (primarily agriculture) to new emerging uses. Water markets that facilitate short-term loans and perma- 

EXECUTIVE SUMMARY 7 nent transfers of water rights, while long existing in the western United States, are playing an increasing role in effecting these transfers. Communities are also often concerned about the implications of privatization for employment and other community values, such as aes- thetics and water’s cultural values. The community and the water ser- vices provider will both be better served to the extent that such issues are openly discussed when considering appropriate roles for the private sec- tor in water services provision. KEY FINDINGS AND CONCLUSIONS The Committee on Privatization of Water Services in the United States reviewed a range of issues associated with public and private ownership and operations of water utilities in the United States, and lists its key findings and conclusions below: Water services privatization takes many forms, and no one form or structure fits all situations. Alternatives range from contracting for vari- ous services to the sale of system assets. Privatization arrangements will usually be most effective when they consider the context of local values. Pressure from large national and global water companies has moti- vated improved performance by public water utilities. Performance standards have improved because of the existence of private alternatives. “Benchmarking” against the performance of similar water utilities is a widely used approach. Leadership training programs, offered by both private and public agencies, have expanded. Privatization is not the same as competition. The municipality must retain the ability to monitor performance and assume operations in case private operations fail. In the case of private ownership of utility assets, states impose regulation by a commission, but the commissions frequently do not have the resources to adequately monitor and enforce regulations. Misuse of monopoly power is a possibility, but regulatory action should be able to minimize this threat. Not all privatization efforts are successful. Well-run and poorly-run organizations exist in both the public and the private sectors. In several cases, operating contracts have not been renewed; in some instances, longer-term contracts have been repossessed by the city before the expira- tion date. Some cases have resulted in litigation, while others have been resolved through negotiation. Small to medium-sized utilities face the greatest challenges and problems and are prime candidates for availing themselves of services from either private or public organizations. These smaller utilities often lack the resources and expertise to meet today’s drinking water and waste- 

8 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES water treatment standards. Regionalization and consolidation of small to medium-sized utilities hold great promise for improved performance. Both are being provided by the public and the private sectors. Customers appear to value potable water reliability and quality quite highly, and surveys have shown their willingness to pay for bet- ter services. This finding must be tempered with the observation that expressed willingness to pay may not always motivate officials to pro- pose higher utility rates or propose the need for borrowing. Public offi- cials are often unwilling to charge appropriate prices because of a history of underpricing and a fear of criticism. The water services industry faces a great need for maintenance and replacement. Most of this need can be attributed to the low priority as- signed to water systems in past municipal budgets. Some of these needs are also because of U.S. demographics, as increasing urban populations in some areas require additional water infrastructure. The design-build-operate contractual arrangement and its variants have been successful in some large water service systems in the United States. An example is provided by the recent expansion of Seattle’s water utility. Such arrangements encourage creative applications of advanced technology and project efficiencies. Liberalization of federal tax laws has helped encourage private par- ticipation in the operation of publicly owned plants that were funded by public bonds or grants. Urban utilities can now enter into contracts of up to 20 years for the operation of such systems. These advantages do not extend to privately owned systems. The Safe Drinking Water Act of 1974 has been a major factor in causing change in utility management and operations. In particular, this has pressured small to medium-sized utilities to improve their op- erations and/or seek private assistance. Development on watershed lands and the protection of environ- mental quality around reservoirs could be relevant issues in water ser- vices privatization. Especially in the case of asset sales, there is concern about land that may be subject to development. Preservation of water- shed lands that do not generate revenue may be a loss to shareholders but are often a boon to local residents and customers. Workforce issues are important considerations in water services privatization, both as a possible source of cost savings and a focal point for public concern. Labor costs are a major component of utility costs, but there are always local concerns about maintaining traditional patterns of employment. Continued public ownership and operation is the most likely fu- ture for the majority of water utilities. Many public water utilities are 

EXECUTIVE SUMMARY 9 likely to respond to the pressures of possible privatization by improving their performance, rather than privatizing part or all of their operations and ownership. Organizations are often reluctant to proactively initiate substantive changes, particularly if there is no overriding water services issue of great local concern.