Archive for October, 2021

Why Ratepayers Protections are Needed in the U. S. Water Utility Privatization Push

Posted on: October 21st, 2021 by eric

By Peggy Gallos, Executive Director

Governments continue to provide water and sewer services in most of the United States. Eighty-four percent of drinking water systems are government-owned, as are 98 percent of wastewater systems (AWWC, 2020). However, heightened interest in water sector investing is a significant factor driving privatization. Sale and lease/concession agreements often advantage shareholders and investors at the expense of the people who use the system, and, unfortunately, laws and regulations favorable to privatizing have been put in place with insufficient safeguards to protect ratepayers.

Years ago, investor-owned utilities (sewer services as well) recognized that the backlog of capital upgrades and repairs in aging water and sewer systems presented an opportunity for growth and began lobbying to make conditions for privatization more favorable. Wall Street saw opportunity, too (Hanson et al. , 2018). Economic and political developments have played into that agenda, including in the context of the COVID-19 pandemic. Local governments and government utilities are experiencing revenue losses (Doyleet al. , 2020), and municipal decision-makers are lured into privatization deals by promises of high upfront infusions of cash (Maykuth, 2018).

In New Jersey, corporations provide drinking water service to about 40 percent of state residents and businesses (CWC, 2010) and a smaller but growing percentage of sewer customers. Ratepayers in New Jersey may not always understand that they will pay what might be called a “privatization premium” when their community changes from government-provided to corporate/private equity-provided service (Israel, 2021). The premium is well-documented, most recently in research on data from the 500 largest water systems in the United States (Zhang et al. , 2021). The researchers noted that regulations favorable to privatization correlate with higher prices. The study found this after controlling for factors including water system characteristics, water supply source, and water demand. The average annual bill for privately owned water systems is $186 higher than those of publicly owned systems ($501 versus $315). Low-income households spent 1. 55% more of their income on water if served by the private sector. The annual bill in New Jersey is $433. 7, and in Pennsylvania, $501. 2, compared to the national average of $336. 54.

The National Association of Water Companies (NAWC) and other pro-privatization groups continue to lobby for measures and pursue deals in ways that reduce public input, limit transparency, accelerate the pace of transactions, and maximize the value to be extracted from water and sewer systems. The NAWC has characterized these efforts as overcoming “regulatory hurdles”(NAWC, 2017). The policy wish list includes changing the way systems are valued, advocating regulations that limit utilities’ discretion in how to approach replacing infrastructure (Rules that require replacement based on the age of a pipe limit a utility’s ability to conduct more targeted, and often less expensive, repair and replacement), permitting the burden of capital and acquisition costs to be spread across all customers (even those who do not receive a direct benefit), accelerating the pace at which transactions are completed, and recovering capital costs more quickly by bypassing traditional ratemaking.

Fourteen states have passed laws permitting “fair market value” (FMV) in the sale of water systems (Miranda, 2021). Fair Market Value as permitted by the FMV laws is defined as the cash or cash-equivalent price agreed to by a willing buyer and a willing seller (Beecher, 2019). FMV laws modify the traditional and long-used method of valuing a system—“book value”— which is defined as original cost less depreciation and amortization. FMV laws allow the utility to be valued by outside appraisers who may use cost, income, and/or market methodologies to assign a value. Investor-owned utility rates are typically set by state utility commissions, and traditional ratemaking sets the permitted rate of return based on the size of the rate base (Mastracchio et al, 2020). Under FMV laws, the selling price is added to the rate base, which increases the burdens on ratepayers (Brand, 2014). Critics of FMV note that under this approach, neither the buyer nor the seller has incentive to keep the price as low as possible. The higher the price of the system, the higher the amount that ratepayers must subsequently cover. Aqua Pennsylvania Wastewater, Inc. acquired a sewer system serving 5, 343 people in Limerick, Pennsylvania (Clark, 2018) for $75. 1M, 63 percent above the net book value of the system (Place, 2017).

Pennsylvania’s FMV law is known as Act 12 (Pennsylvania, 2016). New Jersey’s FMV law is the Water Infrastructure Protection Act or WIPA (WIPA, 2015). Under WIPA, if certain broad conditions are met, the FMV approach must be used and the public referendum, long a prerequisite to selling a water or sewer system in New Jersey, is bypassed. Thus, under WIPA, a New Jersey system can be sold in a matter of months, under the radar of most of the community. The Division of the Rate Counsel, an independent New Jersey state agency that acts as a consumer advocate for utility ratepayers, testified that WIPA would make transactions less transparent, limit the public’s role, inflate selling prices, and burden ratepayers. The first transaction under WIPA took place in 2021 when New Jersey American Water (NJAW), a subsidiary of American Water Works Company, Inc. (American Water), bought Egg Harbor City, New Jersey’s water and sewer systems, which serves about 3,000 people, for $21.8 million. The transaction awaits approval from the New Jersey Board of Public Utilities (NJBPU) (NJAW, 2021).

Industry giants American Water and Aqua America, Inc. (Aqua) subsidiaries have sought another type of shareholder-friendly regulatory modification, meant to cover the cost of infrastructure. Indiana and Michigan Water President Deborah Dewey, whose company is an American Water subsidiary, referred to it in a 2018 webinar for the National Governors Association (Dewey, 2018). Dewey identified implementation of “infrastructure mechanisms” as part of a policy wish list. Calling it an infrastructure cost mechanism might be more descriptive.

Pennsylvania was an early adaptor. Nick DeBenedictis, then chairman and CEO of Aqua (which started as Philadelphia Suburban Water and later was acquired by Essential Utilities, Inc.), lobbied the Pennsylvania legislature to pass a law permitting the Distribution System Improvement Charge (DSIC). His proposal became known as “Nick’s Bill.” Wendell F. Holland, former chair of the Pennsylvania Public Utility Commission, called the DSIC that was the result of DeBenedictis’ successful lobbing “a huge regulatory tool, a game-changer.” (Maykuth, 2015)

The NJBPU approved a DSIC about a decade later. The New Jersey wastewater version is the Wastewater (Collection) System Improvement Charge (WSIC). Although the New Jersey DSIC and the WSIC were approved more than a decade apart, the arguments for and against them were similar. The mechanisms allow investor-owned utilities to impose rate increases relating to certain capital improvements without prior approval of the NJBPU. When the DSIC was proposed, NJAW argued it was a “solution” to the aging infrastructure crisis and that they needed an additional incentive to do capital work. They argued that the “regulatory lag” between when dollars were spent on capital improvements and when they were recovered in rates was problematic. (Henkes, 2009). One expert, who testified against the proposal, disputed the characterization that there was a “crisis” and argued that the company knew the locations of its oldest pipes and had the wherewithal to predict where breaks would most likely occur. He pointed out that the DSIC would “distort the otherwise neutral capital planning process in favor of the types of projects eligible for DSIC.” (Woods, 2010). Moreover,  “if the company has a mechanism to immediately recover the capital cost of projects that renew or replace water mains, valves, services, and meters, they will be more likely to invest their finite capital dollars in these projects as opposed to projects that might increase energy efficiency or result in improved water quality.” (Woods, 2010).

New Jersey’s Rate Counsel, an independent state agency that represents the interests of utility ratepayers, criticized the DSIC and WSIC as well as WIPA. Rate Counsel argued that the DSIC bypasses “traditional ratemaking,” a process put in place to protect ratepayers. (Henkes, 2009).

A 2021 order of the Kentucky Public Service Commission (KPSC) may be relevant as an example of the kind of distortion of the neutral capital planning the New Jersey expert predicted in 2010 (Woods, 2010). The KPSC order dealt with how Kentucky American Water (KAW), an American Water subsidiary, had applied the state’s infrastructure cost mechanism, which Kentucky calls the “Qualified Infrastructure Program” (QIP). The QIP permits “systemic replacement of aging mains.” The KPSC found that KAW had included projects in a QIP filing that did not qualify. In what may be an example of “better to ask forgiveness that to ask permission,” the KPSC said it would approve the unqualified QIP projects but that “any future deviations” would be met with “extreme disfavor.” (CKPSC, 2021).

In 2021 in New Jersey, a bill (S3637) titled the “New Jersey Retirement Infrastructure Collateralized Holdings Fund Act” was introduced. It would establish a trust fund for the benefit of several State pension funds, and it would permit municipalities, counties, the State itself, and private concerns to voluntarily turn over assets such as water or sewer systems, roads, and parks to the trust fund. The trust fund would own the asset. The bill would permit the trust fund to use FMV. Another provision could effectively coerce local governments to dedicate a water or sewer system to the trust fund. After holding the asset for a period of time, the trust fund could “flip” a water system (that is, sell it), most likely to an investor-owned utility. Thus, the bill acts as a Trojan Horse to facilitate privatization. One commentator has argued that the bill creates a stealth tax to fund the pensions (Bauer, 2021). The bill is drawing interest outside of the state and, if successful, could become a model for similar legislation in other states. As this policy note is being written, the New Jersey bill remains in legislative committee.

Privatization approaches as embodied in this type of legislation are often sold as the only possible solution. New Jersey’s WIPA bill (Greenwald, 2014), that was passed by the Democrat-controlled legislature and signed by Republican Gov. Chris Christie (Johnson, 2015), stated outright that systems could be so far gone as to be “beyond governmental capacity to restore.” Unfortunately, local elected leaders may not be aware of the downside of privatization under FMV terms. The system was already owned by the community, and by privatizing, they then have to pay investors back through their rates (Beecher, 2019).

Leasing contracts and concession agreements are other forms of privatization that also can put investor interests ahead of those of ratepayers. In 2012, Suez Water (then United Water), the private equity firm Kohlberg, Kravis & Roberts (KKR), and the City of Bayonne, New Jersey, signed a concession agreement. KKR provided 90 percent of a $150 million upfront payment to Bayonne. Suez Water put up the other 10 percent and agreed to run Bayonne’s water and sewer systems for 40 years. The partners in the agreement publicly said that rates would remain flat for several years. However, that did not happen because provisions in the complex concession agreement required rate hikes to make up shortfalls in specific revenue targets. The deal uses a “revenue path” model meant to protect investors and guarantee an 11-percent rate of return for 40 years (Hughes et al. , 2016). Since 2012, Bayonne rates have risen more than 50 percent (Israel, 2021).

In 2017, KKR sold interests in Bayonne and a system in Middletown, PA, to Argo Infrastructure Partners for a gross internal rate of return of 36 percent and 2. 8 times gross money on $75 million invested capital (Vitelli, 2018). KKR continues to have a role in Bayonne as a lender. One municipal official recently noted that the City is contractually obligated to borrow funds for capital work from KKR (Israel, 2021). A June 12, 2021, New York Times article on the private equity sector said that at least 50 percent of all private equity business now consists of lending (Drucker et al. , 2021).

Critics of privatization suggest that local officials at a disadvantage when they are seated across a negotiating table (Snyder, ND; Beecher, 2019). Middletown, PA, sued Suez North America (as part of Middletown Water Joint Venture, a partnership with KKR, the same partner it had in Bayonne, NJ) several years after it sold its sewer system, trying to stop a rate hike and arguing that the representatives who entered into the deal did not understand the contract terms. However, a judge said the contract with Suez was sound and dismissed the case (Miller, 2019). Critics of privatization note that deals often lack transparency. The editorial board of a North Carolina newspaper criticized the private equity firm Bernhard Capital Partners when it asked local officials to sign non-disclosure agreements (Baez, 2021).

Local officials eager to erase municipal debt or address pension liabilities see selling or long-term leasing as sources of quick cash. Higher bids mean higher upfront amounts. Terms like “economies of scale” are used, implying that ratepayers of the system being acquired will gain an economic benefit when their system is consolidated into the corporate holdings. In the short term, the new corporate owner may improve the infrastructure. That’s a benefit. But the ratepayers receive the benefit at a considerably higher cost than they would have if their municipality had retained ownership and implemented the improvements itself. Privatization adds costs. Corporate water companies pay more for capital, they pay taxes, and their holding companies get a cut of the revenue (Beecher, 2019 and Beecher, 2021). If there are operational savings, they will likely benefit the shareholder, not the ratepayer. Efficiencies are more likely found in operations when contiguous systems are regionalized, rather than corporate consolidation (Beecher, 2019; Klien and Michaud, 2019).

Municipal leaders, especially those whose constituents have lower incomes, have other options, including regionalization or service contracts with other public systems (“public-public” partnerships). They can hire qualified water sector professionals who know how to manage infrastructure-related debt to stabilize rates and limit rate shocks and who understand how to leverage the low-cost borrowing through State Revolving Funds. Public solutions do not mean that rates will not rise, but they remove the cost of profits for shareholders from the equation.

The problem with FMV laws like those passed in New Jersey, Pennsylvania, and other states is that they price public systems out of the market and severely limit public solutions. In the Limerick, PA transaction mentioned above, Aqua’s bid was 43 percent higher than the bid of the next highest bidder, a government-run system, the Bucks County Water and Sewer Authority (Clark, 2018).

Pennsylvania’s FMV law, enacted in 2016, is making rates less affordable and will continue to do so (McCloskey, 2021). There is no reason to think FMV laws will do otherwise elsewhere. Turning public goods into vehicles for private profit is bad public policy. Civic engagement and democracy need to be supported, not undermined. We should be doing our utmost to protect affordable water and sewer service. The role of regulators should be protected, too. There are ways to do that.

First, in the event that a governing body is considering selling or leasing a system, it should be required to do so with appropriate public input, including public hearings, public comment periods, and putting the question on the ballot. Laws limiting public input should be resisted, and those already in place should be repealed. Likewise, FMV laws inflating the valuation of systems should be reversed. These laws limit a community’s options and heavily favor deep-pocketed corporation giants like American Water and Essential Utilities and their state subsidiaries.

Second, public utility commissions should not yield their traditional ratemaking powers by adopting “infrastructure mechanisms” and should roll back the rules already adopted. In order to avoid the appearance of favoring the very corporations they regulate, public utility commissioners should not actively advocate for privatization (Sol Warren, 2019). One of the reasons for traditional ratemaking processes is to provide reasonable notice and predictability regarding periodic rate increases.

Finally, water “Bill of Rights” (McGarry, ND) rules and legislation should be strengthened and more widely adopted to increase ratepayer protections and protect transparency and democratic rights (ITPI, 2019). Such measures could protect people from paying for acquisition costs that do not directly benefit them. Tucson, Arizona’s city charter states that ratepayers have “the right to pay only reasonable, necessary, and directly related fees” (emphasis added). Water bills of rights could address service shut-offs, assistance for low-income customers, and worker protections. Strengthened measures could include requirements for disclosures about the full rate impact of transactions and how each ratepayer dollar is spent. They could require strong provisions to hold private companies accountable after signed deals. They could also ensure that, with rare exceptions, dollars collected from ratepayers to support infrastructure are used solely for that purpose.

In a world where water supply and quality are becoming more problematic than ever and investors are seeing increased opportunities to reap financial rewards, all ratepayers, but especially the poorest among them, need protection from excess.



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