5
Structural, Pricing, and Regulatory Issues

INFRASTRUCTURE AND CAPITAL INTENSITY

Water and wastewater services require a vast but largely “invisible” infrastructure network that belies its capital intensity. Capital costs are concentrated in source-of-supply and water treatment facilities, transmission and distribution systems, and pumping equipment. Utilities in the energy and telecommunications sectors devote a greater proportion of the revenue dollar to operating expenses than does the water industry (Table 5-1). Even more significant is the ratio of net utility plant to revenues. For investor-owned water utilities (using 1998 data), this ratio is about 3.5:1, which is more than double the ratio found in the other sectors. The capital intensity of the water industry may actually be on the rise (Beecher, 1996). The water sector’s capital intensity means that fixed costs are a key characteristic of the industry’s cost structure. “Fixed costs” are infrastructure costs associated with water supply, treatment, and distribution. It is thus difficult to reduce capital costs, and even substantial savings in operating costs can help offset capital costs only to a limited extent.

Economies of Scale and Scope

Larger water systems can produce, treat, and deliver water at lower unit costs (dollars per gallon) than smaller systems because of economies in the use of labor and scale economies in raw water supply, water treat-



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Privatization of Water Services in the United States: An Assessment of Issues and Experience 5 Structural, Pricing, and Regulatory Issues INFRASTRUCTURE AND CAPITAL INTENSITY Water and wastewater services require a vast but largely “invisible” infrastructure network that belies its capital intensity. Capital costs are concentrated in source-of-supply and water treatment facilities, transmission and distribution systems, and pumping equipment. Utilities in the energy and telecommunications sectors devote a greater proportion of the revenue dollar to operating expenses than does the water industry (Table 5-1). Even more significant is the ratio of net utility plant to revenues. For investor-owned water utilities (using 1998 data), this ratio is about 3.5:1, which is more than double the ratio found in the other sectors. The capital intensity of the water industry may actually be on the rise (Beecher, 1996). The water sector’s capital intensity means that fixed costs are a key characteristic of the industry’s cost structure. “Fixed costs” are infrastructure costs associated with water supply, treatment, and distribution. It is thus difficult to reduce capital costs, and even substantial savings in operating costs can help offset capital costs only to a limited extent. Economies of Scale and Scope Larger water systems can produce, treat, and deliver water at lower unit costs (dollars per gallon) than smaller systems because of economies in the use of labor and scale economies in raw water supply, water treat-

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Privatization of Water Services in the United States: An Assessment of Issues and Experience TABLE 5-1 Capital Intensity for Major Utilities   Amount (in billions $)   Electric Utilities (1998) Natural Gas Utilities (1996) Local Exchange Carriers (1999)a Water Utilities (1998) Operating Revenues 217.8 62.6 113.2 2.8 Operating Expenses 186.1 59.4 93.1 2.2 Net utility Plant 328.2 77.7 165.8 10.1 Ratio of Operating Expenses to Operating Revenues 0.85 0.95 0.82 0.76 Ratio of Utility Plant to Revenue 1.51 1.24 1.46 3.52 aTelecommunications companies SOURCES: DOE (1998); FCC (1999); NAWC (1998); U.S. Department of Commerce (1999). ment, and financial and operating services. An example of a large water system is presented in Box 5-1. A larger system has a broader customer base in terms of the level and patterns of demand, which enhances opportunities for optimizing system operations and cost sharing. But water systems exhibit diseconomies of scale in the transmission and distribution of water because water is heavy and incompressible. As water is moved farther from the source and treatment facilities, additional pumping facilities are required. Long-distance transmission of water becomes more economical under some circumstances, with water availability and water quality being key considerations. The net economic benefit of regional solutions is highly circumstantial, owing to the trade-offs between transporting water and developing new sources of supply and treatment facilities. Economies of scale across the water industry have not been fully realized because of the industry’s fragmented structure (e.g., the many small companies that serve small populations). Public ownership can also be a constraint if systems cannot expand beyond geopolitical boundaries to capture potential regional-scale economies. However, public water systems often do expand beyond public boundaries. For example, the Los Angeles area Metropolitan Water District covers many cities, counties, and regions. In the San Francisco Bay area, the East Bay Municipal Utility District covers several cities and jurisdictions. And the New York City water system takes water from multiple watersheds in multiple states. Economies of scale in the water industry exist within both the investor-owned and public sectors and are identified by measures such as rev-

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Privatization of Water Services in the United States: An Assessment of Issues and Experience BOX 5-1 A Regional Municipal Water System: Cincinnati Water Works Cincinnati’s Department of Water Works is one of the largest in the country in terms of pumpage, number of customers served, square miles of service area, and miles of pipe in the water system. This department serves about 90 percent of the people in Hamilton County, Ohio, and sections of Butler and Warren Counties. On October 8, 1992, a state-of-the-art granular activated carbon water treatment facility designed to provide the public with the finest-quality water was dedicated. This plant was the first of its kind in the United States and is one of the largest in the world. SOURCE: City of Cincinnati: Available online at http://www.rcc.org/cww/source.html#. enues per gallon sold and assets per gallon sold. The capital intensity of the industry and its substantial economies of scale have a direct bearing on capital facility planning since it is more cost-effective to add larger increments of capacity. In all utilities, the line between “surplus capacity” for foreseeable needs and “excess capacity” (which could not be justified as part of the rate base under state regulation) can be a fine one. A certain amount of surplus capacity is needed by water utilities in order to provide a margin of safety, including the “safe yield” from supply resources.

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Privatization of Water Services in the United States: An Assessment of Issues and Experience Larger, regional water systems could help water utilities achieve lower costs through more effective use of the physical plant and opportunities to reduce total demand variability. Specifically, regional facilities could be sized to meet an efficient, properly priced level of demand while also being large enough to capture economies of scale and provide effective watershed management. Regionalization, or the merging of multiple water utilities into a single administrative unit, can be achieved under public or private ownership and with or without actual physical interconnection. Economies of scale in the drinking water industry are associated primarily with water source withdrawals and treatment, but these economies can be offset by the costs of transporting treated water long distances. Clark and Stevie (1981) indicated that at distances of only a few miles, diseconomies of transmission and distribution outweighed economies of extraction and treatment. However, more recent studies suggest that treated water can be transported as much as 100 miles under favorable physical conditions (including terrain and gravity effects). The cost effectiveness of long-distance water transmission also depends upon the size of the service markets involved. As water utilities face higher source-development and treatment costs (the latter associated with standards compliance), the desirability of achieving economies of scale is becoming more pronounced. Technological improvements and lower energy costs have the potential to reduce transmission and distribution costs. The result is that larger, regional water systems are becoming more cost-effective. Even if water can be transported long distances at a reasonable cost, extracting water resources from one region to meet another region’s needs can have detrimental environmental and social consequences (Howe, 2000). Importantly, water utilities also can achieve significant planning, management, operational, and financing economies without physical interconnection. The larger investor-owned and “multisystem” utilities have demonstrated the benefits of common management. “Satellite management” often is recommended as a regionalization strategy for systems that need professional management but cannot easily be interconnected. There is less fragmentation of wastewater collection and treatment systems (approximately 16,000 in the United States) than in drinking water supply systems (approximately 54,000 systems in the United States), which suggests (but does not verify) a greater degree of regionalization and consolidaton in the wastewater collection and treatment sector. Many rural areas depend on septic tanks for wastewater treatment. Increasingly, however, these systems pose a threat to water quality in streams and aquifers. Because of the requirements mandated by the total maximum daily load (TMDL) program of the U.S. Environmental Protection

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Privatization of Water Services in the United States: An Assessment of Issues and Experience Agency, more rural areas are shifting to centralized management. Regionalization can be achieved with or without physical interconnection, and it can be achieved under public or private ownership. Simple regional cooperation among water utilities also can be beneficial. Some larger municipalities have built or are promoting regional water systems. Most larger investor-owned utilities are regional by nature and have the added benefit of state regulatory oversight. Water utilities also demonstrate potential economies of scope in terms of joint management of water supply, wastewater treatment, and other services, such as maintenance services for well owners, service line and plumbing services, and even bottled water. Global competitors in the water business, including French firms such Vivendi and Lyonnaise des Eaux, provide a wide range of municipal services. Regional water or wastewater utilities are better positioned to capture both scale economies and economies of scope. RISING COSTS AND THEIR EFFECTS ON U.S. WATER SERVICES Costs are rising for the water industry. The need to replace and upgrade the delivery infrastructure will continue to be a driving force over coming decades. The nation’s aging distribution systems pose a threat to the quality of drinking water and are also the cause of losses of treated water from distribution systems. Urban systems typically lose 10 to 15 percent of their produced water, although some systems in geologically-unstable areas have reported losses near 50 percent of their produced water (these figures usually represent a combination of actual losses because of leaks and accounting losses because of inaccurate metering). The problem of water system losses grows as systems age. Water losses translate into higher costs and foregone revenues, and also jeopardize the safety and reliability of water service. Replacement costs far exceed original installation costs even when stated in comparable dollars. As cited earlier, one estimate of the investment necessary to maintain the nation’s infrastructure over the next 30 years is $250 billion (AWWA, 2001). A report by the Water Infrastructure Network (WIN) estimated the 20-year need for the water and wastewater industries combined at about $1 trillion (WIN, 2000). The lion’s share (56 percent) of these costs is for transmission and distribution, followed by treatment (26 percent), storage (9 percent), source-water development (8 percent), and other needs (1 percent). Another relevant issue is the cost of future raw water supply. In most regions, the low-cost sources of water have already been developed. The marginal cost of new sources of supply has risen sharply, while environmental values and constraints have made new supplies difficult to develop. In many areas, the costs of additional conventional water supplies

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Privatization of Water Services in the United States: An Assessment of Issues and Experience exceed those of conservation, reuse, and even desalination. In calculating the costs of supplying water, poor municipal asset accounting procedures may lead to an understatement of costs and inappropriate pricing of water. Many towns do not follow appropriate depreciation procedures for infrastructure, thus understating costs. Western towns that own water rights for their supplies often fail to carry these increasingly valuable rights as assets and then fail to count the opportunity cost of the water as a cost. An important development in the asset management area is Rule 34 of the Governmental Accounting Standards Board (GASB).1 GASB 34 is intended to help ensure that local governments are good stewards of the public’s assets. According to the rule, “Infrastructure assets that are part of a network or subsystem of a network are not required to be depreciated as long as the government manages those assets using an asset management system that has certain characteristics and the government can document that the assets are being preserved approximately at (or above) a condition level established and disclosed by the government” (GASB, 1999). This statement implies that infrastructure can be maintained in nearly original condition, which is very unlikely for water infrastructure. To the extent it is true, maintenance costs replace depreciation as a cost of operation. It is important to note that GASB 34 deals only with asset accounting and does not address whether the appropriate asset costs are included in setting the pricing structure. Some analysts believe that GASB 34 will stimulate privatization activity in the water sector because it will expose municipal inefficiencies and provide clear incentives for improving asset management through private sector expertise. Water Pricing Economists generally agree that water and wastewater services are frequently underpriced. But overcoming historic underpricing can trigger consumer outcry. It is becoming increasingly hard for water utilities to avoid or postpone the cost of maintaining a reliable and compliant drinking water system. Limited public funding and the achievement of economic efficiency mean that the cost of infrastructure improvements must be supported through rates. 1   The Governmental Accounting Standards Board is an independent, not-for-profit organization founded in 1984. It establishes and seeks to improve financial accounting and reporting standards for state and local governments. Available online at http://www.gasb.org.

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Privatization of Water Services in the United States: An Assessment of Issues and Experience Water price increases are outpacing the overall rate of inflation (Beecher, 1995). Water rate design is also becoming more complex as many communities try to recover the true cost of water service and incorporate marginal-cost pricing principles in their rate structures. Many communities use the rate structure as a means of encouraging conservation and have thus moved away from older decreasing block rates and toward uniform, seasonal, or increasing block rate structures believed to better reflect variations in the cost of service while motivating conservation (Raftelis Financial Consulting, 2000). Some studies show that the public is willing to pay for reliability and for high water quality (Howe and Smith, 1993, 1994). Yet water managers and city councils often lack the political will to practice cost-based ratemaking. They may want to protect residential customers (who are also voters) from higher rates and use water pricing and availability policies to promote economic development even though there is scant evidence to support the usefulness of this strategy. Politicians are more likely to be hesitant to raise rates because of political consequences rather than economic development concerns. Political motives aside, rising prices raise legitimate concerns about the affordability of a highly essential service by poorer segments of the population. Such water pricing issues are germane to all forms of ownership and management of water utility systems. It is believed by some that private utilities will be more effective than public utilities in terms of operational efficiency, innovation, and other performance indicators and that this should help lower the cost of service. The profit motive and state economic regulation (see below) provide incentives to keep costs low. But the profit motive may also provide incentives to cut corners on long-term investments, reduce efforts to monitor water quality, and avoid conservation and efficiency measures since profits depend upon volumes of water sold. When water services are provided by a privately owned water utility, rates charged may be higher than those provided by a publicly owned utility. Reasons for the rate disparity are listed in Box 5-2. Economic efficiency is promoted if water rates more accurately reflect the true cost of providing water services. Rate structures can improve economic efficiency by reflecting marginal costs, including the opportunity costs of the water associated with alternative supply options. The prospect of higher rates, however, may discourage asset privatization and has contributed to some instances of “reverse privatization” or “municipalization.” Private contract providers have incentives to increase operational efficiency. State regulation requires cost-based pricing to assure that cost savings from privatization will be passed along to ratepayers. However, there is no assurance that public utilities will pass along such savings,

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Privatization of Water Services in the United States: An Assessment of Issues and Experience BOX 5-2 The Public-Private Rate Disparity The following factors may account for differences between public and private water prices: Profits. Private systems must recover a return on equity. Taxes. Private systems pay income and other taxes. Financing. Public systems may have access to tax-exempt bonds and to state revolving loans and other public funds. Subsidies. For cities, subsidies can flow to or from water and wastewater systems. Costing. Private systems charge a depreciation expense and may recover other costs. Rate practices. Public systems can charge higher rates to customers outside of boundaries. Charges. Public and private systems can charge system-development charges to pay for capacity. Investment deferral. Some systems, public and private, defer or avoid capital investment. Economic regulation. Regulated private systems must set rates based on costs. SOURCE: City of Cincinnati. Available online at http://www.rcc.org/cww/source.html#. although most public utilities are required to operate on a “no profit” basis, so that savings could be passed on if they are not spent. REGIONALIZATION AND CONSOLIDATION The water services industry’s fragmented nature and the existence of scale economies suggests there are opportunities for water system regionalization. Regionalization in government operations usually means that one or more communities turn over their assets (and, in their view, local control) to another public agency or regional authority. Similarly, regionalization in the water utility sector refers to the consolidation of facilities or activities among contiguous or nearby systems. Unfortunately, discussion of other ways to achieve the benefits of regionalization without communities turning over assets and local control is often lost in the debate. In contrast to regionalization, where multiple utilities merge into one larger organization, consolidation is the mutually agreed upon take-over of one system by another. A consolidation may consist of, for ex-

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Privatization of Water Services in the United States: An Assessment of Issues and Experience ample, two private water utilities merging to form one utility. Consolidation is generally viewed as a broader process and may encompass mergers among systems in different locales (i.e., at the corporate level). Given the similarities, the two terms are often used interchangeably. A recent survey of the literature on regionalization and consolidation (Beecher, 1996) suggests that consolidating water system operations and/ or management may represent a viable alternative from several perspectives (see Table 5-2). For example, from an economic perspective, consolidation can help lower capital and operating costs and prices. From a financial perspective, consolidation can help raise the capital needed to replace and improve an aging water delivery infrastructure. From an engineering perspective, consolidation can improve operational performance. From a natural resources perspective, consolidation can enhance environmental protection, resource conservation, and contingency planning for conditions of scarcity caused by natural disasters or other supply emergencies. The formation of regional systems around watersheds can be beneficial (see Chapter 6). The public policy and public administration literature also supports the idea of provision of many services (such as utilities and transportation) because public goals may be achieved more cost effectively. A more recent rationale for regionalization and consolidation comes from the 1996 Safe Drinking Water Act (SDWA), which increases the need to ensure and build the technical, financial, and managerial capacity of water systems. Several specific provisions in the act also require consideration of structural alternatives that involve fundamental changes to the organization, ownership, or management of a water system, including regionalization and consolidation. The capacity development provisions of the law (which refer to improvements in technical, financial, and management capabilities to comply with regulations), as well as certain variance and enforcement provisions, will slow the creation of new systems and encourage personnel with existing water systems and regula- TABLE 5-2 Perspectives on Consolidation Perspective Key Reasons Economic Economies of scale and scope (lower unit costs) Financing Access to capital and lower cost of capital Engineering Operational efficiency and technological improvement Natural resource Resource management and watershed protection Federal standards Compliance with standards at lower cost, greater capacity development, and greater affordability of water service   SOURCE: Beecher (1996).

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Privatization of Water Services in the United States: An Assessment of Issues and Experience tors to consider changes in ownership, physical interconnection, and other structural alternatives. Regulatory policy is a key element in this process. The primary barriers to consolidation are not technical or economic, but institutional and political. Institutional factors such as laws, regulations, and decision makers do not necessarily favor water system consolidation. Another contributing factor is the somewhat parochial nature of water supply as a utility enterprise. Energy and telecommunications companies tend to serve large regional territories and continue to merge into even larger conglomerates, while water is local in character. Communities sometimes use water and wastewater utilities to try to control and manage economic development, albeit inefficiently. The identity of a water services system, in keeping with public ownership and the “public works” perspective, often is intrinsically tied to the local community. From the perspective of local communities, the chief concern about regionalization and consolidation is surrendering control, either to a regional authority or to state public utility regulators. The desire of communities to retain local control and use political processes to govern water utility decisions has tended to thwart regionalization efforts. These are legitimate public policy concerns that cannot be eschewed or dismissed. In fact, regionalization will be successful only when communities feel it is in their best interest and that they will have appropriate access to the utility and influence on its decision-making. A common method used to achieve regionalization of utilities is with interagency contracts. In many metropolitan areas of the United States, the large urban water or wastewater system has contracts with the adjoining water utilities of the smaller suburban communities. Through these contracts, the larger utility provides all services or a subset of services to the smaller community. The net result is that many of the economies of scale of large operations are made available to the smaller community, and the smaller community retains local control and local ownership of its assets. Some private operators try to achieve the same results by marketing their services to multiple communities in a region. Their operations plan is to secure contracts for many utilities in a geographic area and then drive down costs through economies of scale by centralizing services such as call center operations, laboratory services, technology maintenance, purchasing, and even plant operations. Private operators and public agencies can thus broaden their boundaries of operations beyond the communities that abut their existing system. In the 1980s, the cable television industry followed a similar strategy when cable television companies moved into a region to market their services and secure franchises from local communities. The rationale for regionalization is stronger in a setting of rising costs and prices. Although the industry cannot control many types of costs—

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Privatization of Water Services in the United States: An Assessment of Issues and Experience infrastructure replacement and treatment costs—it can help control costs through efficiency and innovation. Clearly, models of implementation are needed to involve communities in the process of regionalization, initially and on an ongoing basis. Regionalization is widely regarded as a beneficial option for restructuring the water industry and for overcoming the fragmentation of 50,000 community water systems across the United States. At issue is whether the public or private sectors are best able to advance regional solutions. Larger, private (investor-owned) utilities are regional by nature. They are unconstrained by local geopolitical boundaries, and perhaps less constrained by local political agendas related to water supply and development. Privatization contracts generally address only the needs of a single locality and may not present a vehicle for cost-effective regionalization. In theory, a contractor might help provide regional services but this would require approvals from various local governments. Other forms of water services privatization, such as build-own-operate, can be designed to address regional needs. REGULATION Regulation of water systems reflects the U.S. system of federalism or shared responsibility for governance. All community water systems are subject to regulation by state drinking water primacy agencies pursuant to the federal Safe Drinking Water Act (SDWA). Systems must, at a minimum, meet federal standards, but states can impose additional standards. States have primacy with respect to water quantity regulation, including regulation of withdrawals and diversions. Interstate, state, and regional authorities can also exert significant influence. Examples include the Delaware and Potomac River Basin commissions (formed under interstate compacts) and the Florida Water Management Districts (intrastate). The imposition of quantity and quality regulations should not depend on ownership.2 That is, enforcement and permitting processes should apply equally to all types of systems. Much of the criticism of the U.S. model of regulation, which emphasizes ratebase, rate-of-return, and rate design determinations, focuses on issues related to incentives. The system is not entirely without incentives, as underperforming utilities will not earn their authorized return. Under the traditional model, utility incentives for efficiency and innovation are constrained because gains achieved by cost savings are generally allo- 2   Some private owners assert that they are treated differently than public owners in terms of regulatory compliance.

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Privatization of Water Services in the United States: An Assessment of Issues and Experience cated to ratepayers with subsequent rate adjustments. The United Kingdom has tried to address this issue by implementing a price-cap model, which effectively allows regulated utilities to retain efficiency gains as long as price limits are not exceeded. However, the system also involves a number of potential adjustments and performance requirements. The United Kingdom model has received mixed reviews, but is still a relatively new approach. Many state commissions in the United States are moving toward performance-based regulation for the energy sector, having already done so for telecommunications. With time, interest in performance-based regulation of water utilities will likely grow (for further discussion of U.S. public utility regulation, see Phillips, 1993). Economic Regulation Economic regulation involves the control of prices and profits of investor-owned utilities. Economic regulation by states is regarded as a substitute for competitive markets and public ownership, which presumably ensures accountability by other means (see Table 5-3). That private monopolies need to be regulated, but public monopolies do not, is a subject of debate. Water utilities are by nature highly monopolistic; that is, competition between them is limited by the physical and economic properties of service. For publicly owned monopolies, accountability is assured through electoral and other public channels (namely, municipal governance). For privately owned monopolies, accountability is assured through economic regulation by state commissions. Economic regulation applies to virtually all private water utilities (although not private contract companies), and some publicly owned systems in some states opt to provide this level of oversight. State public utility commissions in the United States apply a ratebase/ rate-of-return method of economic regulation, whereby they contemplate the value of assets on which a return can be earned (the ratebase), the authorized (but not guaranteed) rate of return to recover capital costs, and the allowable operating expenses for the utility. Once the utility’s total revenue requirements are established, regulators also approve the prices that can be charged to various classes of utility customers (the tariff). Various well-established standards of prudence and reasonableness are applied in the regulatory review process. Regulated companies must operate within the parameters approved during its most recent rate case. During periods of rising costs, rate cases often are conducted on an annual basis. In between rate cases, the utility must operate in a manner that preserves its ability to recover costs and its authorized return. To help

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Privatization of Water Services in the United States: An Assessment of Issues and Experience TABLE 5-3 Regulatory Jurisdiction for Water Utilities   Regulatory Jurisdiction Area for Regulation Federal Interstate State Substate Local Water Quality Congress, EPA River basin commissions Drinking water primacy agencies (SDWA) None Health departments Water Quantity None River basin commissions Water resource agencies Water management districts (varies) None Water Prices None None Public utility commissions (mostly investor-owned systems) None Public ownership, other local controls

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Privatization of Water Services in the United States: An Assessment of Issues and Experience control prices and profits of investor-owned water utilities, they are regulated by state public utility commissions. Commission jurisdiction over different kinds of systems, and the scope of commission authority over different kinds of activities, both vary substantially from state to state. Some analysts view economic regulation of utility revenues and rates as a deterrent to privatization because regulation constrains profitability and does not provide the performance incentives of competitive markets (Haarmeyer, 1993; Raftelis, 1989). Some analysts also believe that regulation provides disincentives (or inadequate incentives) to investor-owned utilities for furthering consolidation through mergers and acquisitions. In fact, the private sector is looking for a clear, transparent, and predictable set of rules (which constitutes good regulation). In 1995, 46 state commissions regulated approximately 8,750 water utilities, while 28 state commissions regulated approximately 2,150 wastewater utilities. Commission jurisdiction is summarized in Figure 5-1 and Table 5-4. The commissions do not exercise uniform authority over all of the systems under their jurisdiction. Investor-owned utilities are the most comprehensively regulated. In 21 states, jurisdiction extends to certain types of publicly owned or nonprofit water utilities. FIGURE 5-1 Regulatory jurisdiction for water utilities. SOURCE: Beecher (2000).

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Privatization of Water Services in the United States: An Assessment of Issues and Experience TABLE 5-4 Commission-Regulated Water and Wastewater Utilities   Water Utilities Wastewater Utilities Utility Ownership Number of Commissions Number of Utilities Number of Commissions Number of Utilities Investor-Owned or Private 46 4,092 28 1,233 Municipally Owned 11 1,547 6 649 Districts 7 1,300 4 205 Cooperatives 4 1,436 2 50 Homeowners’ Associations 6 85 1 0 Nonprofits 1 73 1 15 Other 1 1 0 0 Total 76 8,534 42 2,152   SOURCE: Beecher (1995). In general, regulation is viewed as a deterrent to asset transfers and as unnecessary or undesirable when extended to contract operations. In terms of investor ownership, however, regulation can be beneficial in terms of stabilizing revenues, ensuring cost recovery, and providing a guarantee of a reasonable return on investment. Regulation requires utilities to accept a degree of regulatory risk, but it shields them from other forms of risk, including risks associated with municipal politics at the local level and, to some degree, global competition. Economic regulation by the states offers certain advantages over alternative methods for overseeing utility monopolies, setting rates for service, and resolving conflicts. Most smaller cities do not have comparable expertise and resources. State commissions demonstrate economies of scale and scope in regulation when compared to decentralized oversight by local governments. Although their traditional policies are based upon rate-based/rate-of-return methods, the commissions also have responded to the economic and technological changes affecting the utility industries, including emerging competition. Privatization through local “outsourcing” requires significant safeguards, or local contracting and oversight can be prone to corrupt influences. State commissions can make politically unpopular decisions and can be more flexible and less arbitrary than regulation imposed through legislative or judicial means. New roles for regulatory agencies, such as dispute resolution for contractual agreements, might also prove beneficial. In general, state regulation can be used to further various state policy goals, such as efficiency pricing, integrated resource planning, and universal service. Regulation is an imperfect substitute for competition—as is government ownership. The rate-based/rate-of-return method can pro-

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Privatization of Water Services in the United States: An Assessment of Issues and Experience vide too much incentive for overinvestment and too little incentive for cost control and innovation. The method also tends to be historically focused and reactive. Regulation may also have social and environmental implications. The regulatory process can be time-consuming, costly, and bureaucratic. Finally, regulation can be unresponsive to broader market forces. Some weaknesses in the regulatory model can be addressed through deregulation and some through regulatory reform. In recent years, as technological and market advances have introduced competition, deregulation has become an option for some segments of the telecommunications and energy industries. Deregulation of investor-owned water utilities, where monopoly power is persistent and competition is limited, is not well supported. However, another form of deregulation occurs when local governments assume the oversight function. Many advocates of privatization believe that local control is preferable to state regulation. Regulation and Privatization It can be argued that privatization and economic regulation share the common goal of establishing managerially sound and financially viable water and wastewater systems. Strategic use of acquisition and other regulatory incentives already has had a considerable influence on the restructuring of the water industry. Modern public utility regulation ideally encourages utilities to meet least-cost and efficiency goals, and it uses market-like methods in the process (for example, competitive bidding). It may be easier to reward investor-owned utilities than unregulated utilities for implementing efficiency and other desirable measures. Regulation can be an agent of privatization by providing positive incentives for the expansion of investor-owned systems. Moreover, regulation can provide a level playing field for emerging markets (or “structured competition”). Economic regulation may account for at least some of the performance differences between publicly and privately owned utilities. Utilities that underperform routinely find it difficult to achieve their authorized rate of return. Tables 5-5 and 5-6 summarize potential regulatory roles for changes in ownership and service contracts. The role of regulation tends to be more obvious in cases involving transfers of assets to and from private utilities. However, regulators may also look at the prudence and terms of service contracts in which regulated utilities are engaged as either providers or recipients. Regulators have several means for encouraging privatization through investor ownership, all of which involve making it easier for regulated systems to acquire other systems. Regulatory methods that encourage the private sector role include acquisition adjustments and other acquisition

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Privatization of Water Services in the United States: An Assessment of Issues and Experience TABLE 5-5 Potential Regulatory Roles in Privatization—Ownership Transfers Current Ownership Ownership After Transfer Public Private From public ownership Generally not regulated. In some cases, providing utility service outside of municipal boundaries may be regulated by the state commissions. A certificate of public convenience and necessity may be required, particularly if the acquisition is made by a newly formed private utility. The transfer of assets and financial arrangements probably requires approval as well. Acquisition adjustments require a determination of ratemaking treatment. From private ownership The transfer of assets and ownership probably requires regulatory approval. Regulators also may want assurances that the transfer is in the public interest. In most cases regulation will not prove to be a significant barrier to the transfer. Regulatory approval may be required for both utilities in the transaction. The transfer of assets and ownership probably requires regulatory approval. It may be necessary to modify the acquiring utility’s certificate of public convenience and necessity. Acquisition adjustments require a determination of ratemaking treatment.   SOURCE: Beecher et al. (1995). incentives; modified ratemaking, including consideration of future costs and cost adjustment mechanisms; single-tariff (or uniform) rates across a regional territory; profit-related incentives, including rate-of-return incentives and profit sharing; and consideration of changing risk profiles in ratemaking (Beecher et al., 1995). In effect, these techniques can enhance the financial viability of acquisitions. Regulators also may encourage privatization by streamlining regulatory procedures and narrowing the scope of regulation. Regulatory jurisdiction for privatizatized operating contracts is more limited. Only a few states have adopted specific authority in this area, in many instances limiting regulatory authority for contractual arrangements:

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Privatization of Water Services in the United States: An Assessment of Issues and Experience TABLE 5-6 Potential Regulatory Roles in Privatization—Service Contracts Service Provider Service Recipient Publicly Owned Utility Privately Owned Utility Publicly owned utility Generally not regulated. In some jurisdictions, utility service outside municipal boundaries may be commission-regulated. The contract may be reviewed for prudence and financial terms. Privately owned utility Subsidiary activities may be regulated to shield captive customers from risks associated with diversification. Prudence of contracts may be reviewed. Regulatory approval may be required for both utilities in the transaction. The contract may be reviewed for prudence and financial terms. Subsidiary activities may be regulated to shield captive customers from risks associated with diversification. Service vendor Generally not regulated, particularly if contractual procedures and local government authority provide sufficient protection. In some cases, the vendor can appear to behave as a public utility entity, which could trigger regulatory intervention. The contract may be reviewed for prudence and financial terms. Regulators may want to review contractual terms in relation to the obligation to serve, service reliability, and service quality.   SOURCE: Beecher et al. (1995). The New Jersey legislature endorsed the concept of privatization and streamlined regulatory review of contract agreements by the Board of Public Utilities in the Water Supply Public-Private Contracting Act (effective May 11, 1995). Legislation enacted in Florida in 1996 (Statutes at 153.9) exempts from commission jurisdiction any wastewater facility operated by private firms under contract with a county, municipality, or district. The statute is comprehensive, except for the obvious fact that it does not address privatization agreements for water service. In California, wastewater privatizers must “apply to the commission for a determination that the proposed privatization project is not a public utility … and is therefore exempt from commission regulation” (California Statute 10013). Californians also amended their state’s Constitution with passage of Proposition 218 (effective January 1, 1997) to require voter approval for local taxes and user fees under specified circumstances (also see Sherman, 1997).

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Privatization of Water Services in the United States: An Assessment of Issues and Experience The state of Indiana enacted privatization legislation in 1995 (amending Title 36 of the Indiana code) to provide new options for designing, constructing, and operating municipal facilities under privatization agreements. However, the statute does not address a role for the state regulatory commission with respect to private operations of water or wastewater systems. In practice, there has been little state-level regulatory review of privatization agreements. To many privatization advocates, economic regulation is not necessary because local governments can “regulate” through the contract vehicle and associated review processes. Others have suggested, however, that a regulatory role might be justified under some circumstances to prevent abuses of monopoly power by profit-seeking contractors, to ensure that cost reductions are reflected in the rates charged for service, and to protect communities and water customers in the context of constrained local regulatory capacity. Emerging regulatory approaches tend to focus on performance issues and the limitations of the traditional regulatory approach in providing performance incentives. Performance-based ratemaking, or benchmarking, and price caps may change the regulatory environment for privatization and create better opportunities for utilities to profit from efficiency and innovation. An emerging issue in the context of regulation is the diversification of traditional water utilities. Many of the larger investor-owned water utilities have created holding companies in order to provide both regulated and unregulated services. For regulators, these structures (which have been widely used in other sectors) can raise concerns about cost allocation and related transactions. More important is the issue of risk allocation. Regulators want to ensure that captive ratepayers of the utility monopoly do not bear burdens and risks associated with the utility’s unregulated ventures. Finally, the movement to deregulate network industries is presenting new challenges to water utilities (Beecher and Rubin, 2000). Although the industry may be mildly contestable, and some forms of structured competition can be implemented, there is little evidence to support the deregulation of private water utilities.