ORGANIZING
WATER & WASTEWATER INDUSTRIES TO MEET THE CHALLENGES OF THE 21ST
CENTURY
Paul Seidenstat
Department of Economics
Temple University
The capital intensive, monopolized,
and largely government owned and operated water and wastewater industries of
the U.S. are facing major challenges. In light of these financial and service
quality pressures, designing an optimal organizational structure has taken on
greater urgency. Local governments have
a variety of options. Some form of public private partnership may be the most
efficient organizational format. .
As the United States economy developed
and population increased and clustered in urban areas, the challenge of
providing a safe and reliable water supply had to be addressed. Both private
and public systems were built to access raw water sources, pipe water to
treatment plants, and deliver clean water to the final users.
A large and costly infrastructure
was built and was largely owned and operated by government organizations,
although a viable private sector coexisted. Amid rising costs of maintenance
and accessing raw water and a greater emphasis on achieving clean water, a
reexamination of the structure of water and wastewater systems is taking place.
Hybrid organizational arrangements that utilize private producers have emerged
amid a closer look at public structures that is being taken by many local
governments. Efforts are being made to make water supply and wastewater
treatment more efficient by restructuring and by attempting to inject
competition into the marketplace.
STRUCTURE
OF THE WATER AND WASTEWATER INDUSTRIES
Structuring water and wastewater
systems is fundamentally affected by the existence of an array of economic
elements that make monopoly inevitable. Thus, these industries are
characterized by a set of geographical monopolies existing side by side. Most
of these monopoly systems are owned and operated by government organizations.
Given major barriers to entry,
municipally owned water utilities with monopolistic service territories have
become the dominant national model for service delivery in water markets.
Similarly, the U.S. wastewater industry that evolved primarily as a
governmental response to the public health threat posed by uncontrolled water
pollution provides wastewater collection and treatment services that is
overwhelmingly provided by local governments (US EPA, 1998a).
Over most of the twentieth century, these models of public sector monopoly have
achieved a high degree of stability, if not always efficiency.
In its most recent national survey (US
EPA, 1997a), the EPA has estimated that there are more than 180,000 public
water systems in the United States. According to EPA and Safe Drinking Water
Act definitions, 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 of the year. Water that
does not come from a public water system, such as a well serving one or just a
few homes, is a private supply 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.
Table 1 shows that among these more
than 50,000 community systems, only 43 percent were publicly owned, 33 percent
were 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 one
percent served by ancillary systems.
According to this same EPA survey,
total U.S. water industry revenues were estimated to total $25.9 billion as of
1995, primarily from water sales. Of this amount, 86 percent was received by
publicly owned systems, mirroring the percentage of the total population served
by such systems.
Table 1
|
U.S.
Community Water Systems by Ownership Type, Population Served, and Annual
Revenue (1995) |
||||
|
Ownership |
Number |
% Of Total
Number |
% Of Total
Population Served |
Annual
Revenue $Billion) |
|
Public |
21,789 |
43% |
86% |
22.2 |
|
Private |
16,540 |
33% |
13% |
3.7 |
|
Ancillary |
11,960 |
24% |
1% |
N/A |
Source: U.S.
Environmental Protection Agency, 1997a.
In the wastewater market, according to
the EPA’s 1996 Clean Water Needs Survey report shown in Table 2,
publicly owned treatment works (POTWs) serve 190 million U.S. residents,
approximately 72 percent of the total U.S. population, and the EPA projects
this total to grow to 275 million (90 percent of the projected total
population) by 2016. Moreover, almost all of the private sector’s involvement
in wastewater service delivery has historically been limited to small
subdivisions, trailer parks, and individually owned septic systems. Large-scale
wastewater treatment facilities and collection systems continue to be almost
entirely publicly owned, and, while a handful of wastewater systems have been
acquired by investor-owned water utilities and environmental services companies
there are no publicly traded U.S. wastewater companies per se.
According to U.S. Bureau of the Census
data on government finances (U.S. Bureau of the Census, 1996), total
state and local government spending to provide sewerage services totaled nearly
$23.6 billion in 1995, with by far the largest share of this expense, over
$22.1 billion, supported by local governments. Of this total spending, nearly
$8.9 billion combined (and over $8 billion in local dollars) were for capital
improvements to treatment and collection systems.
Table 2
|
U.S.
Wastewater Publicly Owned Treatment and Collection Systems in 1996 |
|||
|
Treatment
Facilities |
% Of Total
Population Served |
Collection
Systems |
Annual
Expenditures, including capital* ($Billion) |
|
16,024 |
71.8 |
20,670 |
$23.6 |
Sources: U.S. Environmental Protection Agency, 1998c;
U.S. Bureau of the Census, 1996 (Note: because this financial data is drawn
from a different survey source in a different year from the other data in this
table, any correlation involving this fourth column should be considered
approximate).
In evaluating U.S. water and
wastewater industries, it should also be noted that there is significant
overlap between the two sectors. In many cases, both services are delivered by
the same public agency, sometimes even as part of a larger municipal utilities
authority or public works department. In addition, both industries are
typically served by many of the same major engineering firms, consultants, and
contract operators.
CHALLENGES FACING the
INDUSTRY in the 21st CENTURY
America’s water and wastewater
industries have met the challenges of adequate coverage and major health
concerns over the last century. At the beginning of the 21st
century, outbreaks of waterborne diseases are rare, even though water quality
and safety issues must continually be addressed. However, innovations in
treating water and purifying wastewater lag behind technical progress in many
fields. A growing concern about pollution has led to greater government
involvement in establishing standards both of drinking water and wastewater.
Despite the two centuries of progress
in improving the quality of the product in the water market, nearly nine out of
ten Americans have some concerns about the quality of their home drinking
water. Over half of the respondents to the survey have worries about health
contaminants in their water and object to the smell or taste. Over 40 percent
cite problems of sediment in their water or the presence of hard water
according to the Water Quality Association.
Systems across the country now face
quality and cost problems. The specific problems of American water and
wastewater systems that appear to require immediate attention include the decay
of the infrastructure, meeting rising standards for clean water, and developing
a reliable financing mechanism.
There are over 700,000 miles of water
and wastewater pipes, which is four times the mileage of the interstate highway
system, and many of these pipes are old, some over 100 years. Some of the pipes
installed in the 1920’s and after World War II, were made of materials whose
life expectancy is much shorter than the average of older piping. More than one-third
of the utilities had 20% or more of their pipelines nearing the end of their
useful life. Over 60% of the water and wastewater utilities, especially public
systems, had practiced insufficient infrastructure rehabilitation and
replacement (USGAO, 2002).
The consequences of aging pipes are
more frequent water main leaks. When pipes fail, pressure drops and dirt,
debris, and pathogens are sucked into the water system. The quality of sewer
systems is also of concern since sewer systems are very old and are corroding
and leaking. Combined storm water sewer systems with their attendant sewer
spillover are commonplace and impose health problems during heavy rain periods.
Some water and wastewater plants are
using older technology. Upgrading these plants is a technical and financial
task of considerable magnitude.
More stringent federal environmental
and public health regulatory standards, coupled with technological change,
present a challenge to water systems. New drinking water regulations phasing in
at the start of the twenty-first century as mandated under 1996 amendments to
the Safe Drinking Water Act, for example, are toughening standards for guarding
against bacteria and other microbial contaminants (the Interim Enhanced Surface
Water Treatment Rule), while simultaneously requiring that utilities reduce
potentially harmful by-products of the disinfection process (the Disinfectants
and Disinfection Byproducts Rule). To achieve these somewhat conflicting goals,
many utilities will need to significantly upgrade their treatment processes, in
some cases switching from chlorination to more complex and less familiar
technologies such as ozonation.
In total, the EPA estimates that
these two new rules alone will cost over $1 billion per year nationwide (USEPA,
1998b). Similarly, Clean Water Act requirements for wastewater systems are
increasing responsibilities and costs not only for plant operation, but also
for storm water control and the reduction of pollution overflowing from
collection systems. According to the most recent EPA Clean Water Needs Survey
of wastewater and storm water infrastructure needs, major upgrades are
projected to be required from 1996 through 2016 (USEPA, 2001).
Capital Requirements
There have been various projections
as to the cost of meeting the required rehabilitation, replacement, and repair
of drinking water distribution systems and wastewater collection systems in the
United States. Estimates range from $300 billion to $1 trillion over the next
twenty years to repair, replace, or upgrade water and wastewater systems; meet
rising demand; and accommodate the rising water quality standards (see
USEPA, 1998a; AWWA, 1999; Schearzwalder, 2002; Segal, 2002). A major
infusion of funds is immediately required to avoid major problems. One recent
study estimates that $12.1 billion for infrastructure needs to be invested
immediately by community water systems to protect against microbiological
contamination (Clark, et al, 2002).
Facing the large capital requirements
of a decaying infrastructure and the pressure to upgrade water quality, water
and wastewater systems have to face the task of generating sufficient revenue
to cover all the required operating and capital outlays. In most cases, rates
will have to be raised, possibly doubled. However, political pressure can be
intensive to moderate rate hikes, with the result that insufficient revenue may
threaten to undercut necessary expenditures.
The GAO finds that water and
wastewater utilities do not generate sufficient local revenue from customer
charges, taxes, or other local revenue sources to cover all the necessary costs
including operations and maintenance, debt service, and depreciation beyond debt
repayment. The federal agency argues that about 25% of water systems and 40% of
wastewater systems are not generating sufficient revenue. As a consequence, 29%
of the systems defer maintenance because of insufficient funds and most systems
do not collect enough to cover all capital costs. Almost one-half of the
utility managers do not believe that funding over the next decade will be
sufficient (USGAO, 2002).
Another challenge for water and sewer
systems is to control operating costs. Very often there are inefficiencies in
terms of excessive staffing or lost revenue due to substantial quantities of
unaccounted for water. With low productivity, costs per gallon of water or
wastewater service can be excessive; consequently, either rates charged to
users will be higher or losses will emerge that will make it more difficult to
finance the required refurbishing and upgrades.
To improve productivity and produce a
good quality product, water and sewer systems continually are challenged.
Developing and applying new technology in collecting, treating, and
transporting drinking water or wastewater requires expertise, a strong
incentive system, sufficient research and development funding, and adequate operating
funds. These requirements are often lacking in poorly funded public water
systems where governments have other important priorities.
The aforementioned issues are
particular acute for very small systems that face major disadvantages. Small
systems, especially in wastewater, face higher costs and difficulty in
providing the necessary management and engineering expertise.
Recent studies suggest that to
achieve a reasonable level of unit costs, a system should serve 3,000 persons
(or 1,000 connections). To be able to generate the revenue necessary to support
a full-time operator and professional manager, a system has to serve from 3,000
to 5,000 persons. The World Bank in its studies in Latin America finds that
water and wastewater systems encounter greater efficiency over a range of
10,000 to one million users. The Office of Water Services (OFWAT) in England
and Wales find economies of scale up to one million persons (Cadmus Group,
2002).
The larger problem, however, is the
capacity of small systems to comply with clean water standards. Often small
systems lack the operating and financial management skills and sufficient
revenues such that they under-invest in necessary repair, maintenance,
rehabilitation, and replacement of plant infrastructure and equipment. Small
systems have the highest rate of non-compliance with drinking water
regulations. They also appear not to make provision for long-term
infrastructure repair or replacement (Shanaghan, 1994).
STRUCTURING SYSTEMS TO
MEET THE CHALLENGES
Despite the monopoly structure, the
dominant U.S. model of public sector operation is undergoing change as systems
confront these challenges. Alternative models can be mobilized to provide and
produce water and wastewater services. Elected officials can choose among these
alternative models with the goal of a achieving reliable and quality services
at a minimum cost. There are two elements to the models, ownership and mode of
operations, as seen in Table 3.
Table
3: Structural Models
Ownership Mode
of Operations
Public Public
Executive
Department
Department
– Enterprise Accounting
Agency
– Reports to Legislative Branch
Independent
Agency
Stock
Company
Municipal
Water District
Multi-Jurisdictional
Agency
Public
Private Partnership
Outsourcing
Operations
and Maintenance Contract
Build,
Design, Operate (or variants)
Franchise
Leasing
Concession
Private Private Subject to
Public Regulation
Private –
Not Regulated
Government Ownership and Operation Model
In light of the monopolistic market structure with its
potential performance imperfections - as compared to a competitive market - of
restricted output, high prices, elevated costs, above normal profits, and poor
quality service, controlling the behavior of the monopolist has been treated as
a critical policy issue by elected government officials. One policy option is
to have public ownership.
In many cases, water or wastewater
utilities were not government-initiated. Private companies frequently started
piped water systems; eventually they were taken over by government. In the U.S.
while many public water systems began as private, profit-motivated companies in
the nineteenth and early twentieth centuries, outbreaks of typhoid and cholera
and major fires in the young urban centers led to dissatisfaction and eventual
government takeover. Regulators enforcing profit restrictions on private
utilities, federal and state government subsidies of publicly owned systems,
and the taxation of private investments contributed to the dominance of
government owned water utilities. By the end of the twentieth century, more
than 200 communities had shifted from private to public ownership (Westerhoff,
1998) and municipally owned water utilities with monopolistic service
territories had become the dominant model for service delivery.
The same process toward government
ownership also was present in the case of sewer systems. Benito mentions that
private systems were more common in smaller and medium-sized cities but by the
beginning of the twentieth century, almost all cities of more than 30,000 had
publicly owned systems (Beito, 1991).
There are several options available
in a government ownership model. Possibilities include:
1.
government executive department
2.
government executive department subject to "enterprise accounting"
3.
government agency reporting to legislative branch
4.
independent agency
5.
government stock company
6.
municipal water district
7.
multi-jurisdictional agency
One option is to treat the water
utility as a regular government department that not only is subject to common
operating rules such as personnel and procurement but also is treated as a
municipal department for budgeting purposes. Water and wastewater may be
combined with other infrastructure operations into a broader "public
works" department. All revenues and
expenditures go into the general fund and the water department must compete
annually for operating and capital funding. The department is subject to the
same political and budget pressures as the police, parks, and other typical
municipal departments. It is a part of the executive branch and reports to an
elected chief executive.
The ordinary departmental budget
treatment, however, can lead to budget decisions that obscure the
"business nature" of a utility that directly collects revenue for its
services. Many governments expect "user fee" services to be
completely self-financing. Consequently many municipal governments, especially
larger ones, in the U.S. establish an "enterprise accounting" system
that allocates all relevant revenues and costs to the utility’s operations. If
properly configured, the accounting device can reveal whether the utility is
fiscally viable or has to be subsidized by tax revenues. Also, budget requests,
especially for capital funds, more easily can be judged on the basis of their
economic feasibility.
In a study for the Los Angeles
Department of Water and Power, the Rand Corporation examined five alternative
governance models in addition to the typical government department models (Baer,
2001). In a number of smaller cities, the municipal utility reports to the
City Council (or legislative branch) directly. The City Council sets policy but
the execution is left to the executive director (or chief executive officer) of
the utility. The idea is to remove the utility from local politics as much as
possible and to give it budget and personnel autonomy. For small utilities this
system may work well.
A variant of the City Council model
is to establish an independent city agency that reports to an independent
governing board appointed by the mayor and approved by the City Council. The
board members serve for fixed and staggered terms to remove them from
day-to-day politics. Jacksonville, Florida and Knoxville, Tennessee have this
arrangement. Again, the board appoints the chief executive officer who is
afforded considerable freedom in running the utility. In this case, the board
also sets rates. However, capital outlays typically have to be approved by the
city government.
Another option is to have a government-owned stock company with
much more freedom to operate. This model is more commonly found in Western
Europe, especially in The Netherlands (Schwartz and Blaakland, 2002).
Generally, this business structure is independent from direct government
controls and can operate more like a private enterprise.
The North American version of
"corporatization," primarily used for electric utilities as in
Toronto and a few smaller U.S. cities, is where the city establishes a
municipal corporation and appoints the board members. As in the Dutch case,
significant power is placed into the hands of the appointed executive but the
agency generally is confined to one political jurisdiction.
California has also been at the
forefront of using the idea of a municipal utility district. Under the law,
voters can establish a separate public agency to operate a public utility.
Board members would come from the various geographical parts of the political
jurisdiction. Similar to the other structures, the district is managed by an
appointed management group with much autonomy. However, this structure allows
the utility to float its own bonds for capital improvements.
California
law also allows the establishment of a multi-jurisdictional agency where two or
more cities, counties, or public agencies can operate the utility. Initially
set up for the electricity market, such a concept could be extended easily to
water or wastewater operations.
Government operations, however,
often may not produce water or wastewater services efficiently. The potential
inefficiency of government operated systems flows from the absence of competition[1],
the difficulty of providing meaningful incentives for managers to minimize
costs and provide a high level of service, and the complexity of rewarding
employees for maximizing productivity. Lacking a profit-based measure of
performance, rewarding managers on the basis of cost, quality of product, or
responsiveness of service is problematic.
Often, little discretion is given to the
manager in making personnel decisions including hiring and firing. Also,
offering incentives to employees for outstanding performance is constrained in
a civil service, typically unionized, environment. Often payrolls may be
expanded for patronage or macroeconomic reasons. For example, in the experience
of Great Britain within a year of privatization the Thames Water's staff was 20
percent below its peak level (Economist, 1990).
The existence of organizational
slack that results in above minimal costs of operations is commonplace in
public systems. A study by the Association of Metropolitan Sewerage Agencies
and the Metropolitan Water Agencies (1998) indicates that operating costs in
many public systems can be cut by at least 10%. By applying currently available
methods four public systems were able to cut costs by 20-25%.[2]
As a government department,
additional constraints on managerial decision-making may be imposed on the
water or wastewater utility. Budget requests are subject to a political
budgeting process. The water department must compete with other government
departments for operating or capital funds. Overall, owing to the reoccurring
financial problems of many local governments in the 1970’s, the early 1980’s,
and from 2000 to the present there has been a strong effort to strengthen
balance sheets and credit ratings by careful management of budgets and debt.
The competition for borrowed funds can be especially intense since
municipalities face statutory or constitutional limits on the level of
outstanding debt and strive to maintain good credit ratings by limiting debt.
Thus, under funding presents a major obstacle to improving service or product
quality. Consequently, maintenance may be shortchanged or plant upgrading or
expansion plans may be cut back.
The enterprise or stock corporation
variants may mitigate some of these disadvantages. As an enterprise fund, the
water utility can be given some autonomy and could be expected to live within
its revenue means with less political interference. However, in practice in
many local governments in the U.S., it is still subject to the personnel rules
and the budget, especially the capital budget, allocation process.
Additionally, the borrowings of the corporation may still be counted again any
debt limitations that the local government faces.
The corporate stock model, wherein
stock is issued and owned by the government, offers even a greater degree of
independence. It may be free of government personnel and budgeting rules. It
may also be able to reward managers and high productivity employees based on
profit and cost considerations and may not be subject to government budget
rules. Public managers will tend to be influenced by political pressures,
although this will depend on the degree of corporatization. Corporatization
strengthens the political autonomy of a publicly owned enterprise by making it
increasingly self-sufficient financially and introducing rules which protect
directors and senior managers from being removed on political whim. However,
there are constraints on the level of profits and, thus, it may evolve as a
cost-plus monopoly subject to rate of return constraints. With government
ownership of the stock, the operation still may be subject to political
interference.
Another potential limitation of the
government operations model is that water and wastewater operations are local
government functions. In the U.S., municipalities typically have jurisdiction
over water and wastewater operations. If there are economies of scale (and
scope) in major distribution systems, raw water supply, wastewater treatment,
and customer service operations, localized operations may be on too small a
scale to achieve these lower costs.
Overall, organizational mechanisms
such as regional compacts or inter-government contracts may be used to overcome
the scale limitations. However, there are often political obstacles to this
form of cooperation.
Public Private
Partnerships
As
concern grew in many countries about meeting efficiently the demand for safe
and clean drinking water, publicly owned and operated systems began to look at
enlisting the help of the private sector in improving the efficiency of their
operations. There is a long history of private enterprises supplying various
services and designing and building
projects, and in some countries such as France, supplying full contracted
operation. Now, private vendors are offering a much more extensive range of
services in a much larger number of countries.
1. Outsourcing
Today government water utilities
frequently enlist the assistance of the private sector for some routine
operations. It is believed that a limited private partnership for one or more
specific functions can be cost effective as the private firms compete for the
right to provide the service and the terms (e.g., regarding quality and
performance) of the service are regulated by an enforceable contract. Commonly included in these functions are
installing and reading water meters, billing and collection, infrastructure
maintenance and repairs, and laboratory services. Firms performing these
services, especially on a regional or national basis, can take advantage of
economies of scale and better utilize the latest technology.
2. Operations and Maintenance Contract (O&M)
In this arrangement, private firms are
contracted to manage the utility. Since managers work for a private company
that can increase profits if costs can be constrained, given a fixed monetary
contract, they can be rewarded for effective performance. The vendor may assume
the risk of ensuring that minimum water quality levels are reached. Moreover, a
company experienced in managing water or wastewater systems can derive the managerial and technological benefits that
come from operating a number plants and systems. The private company may not be
bound by the government's procurement rules that can raise the costs of
supplies and services purchased by the utility.
To be successful, the public
authority has to assure fair bidding and design a clear and comprehensive
contract. If the contractor is required to follow the government requirements
as to personnel policies and procurement, many of the benefits of private
operations may be lost. Rather than focusing on input issues, the contracting
government can concentrate on specifying output targets. In this fashion, the
contractor is free to utilize the most cost-effective technology and resource
utilization to meet the terms of the contract.
3. Design, Build, and Operate (and Variants)
When government water utilities decide
to expand their facilities, they typically turn to private contractors to
design and to build the infrastructure. Usually a separate contractor is used
at each stage of the process. In retrospect, this separation of designing and
building usually increases the time to complete the project and can lead to
less efficient and more costly projects. Since the design engineers do not have
to operate the facility their interests are not aligned with the
operators. Consequently, the design of
the project may not have achievement of operational efficiency in mind. Without the experience or knowledge of
operations, builders often overlook aspects of the structure that can simply
operations and reduce operating costs.
While the conventional
design-bid-build-operate approach to public works contracting is well
understood and most appropriate for many applications, it has shortcomings.
These include excessive design costs due to “undesirable risk allocation and
mixed incentives, failure of designer and builder to collaborate in ways that
would lead to reductions in construction costs,” problems of low bidding and resultant
costly change orders, a greater risk of failure owing to the difficulty in
establishing liability among the designer, contractor, and the municipal
operator, and several other weaknesses.
Public utilities including water
utilities have begun to recognize the inefficiencies of using separate
contractors. A new organizational model for expanding facilities is now in
place that combines all three functions of design, build, and operate.
There are several variants of this
model. One is a straight design, build, operate model (DBO) in which the
winning contractor performs all functions except financing the project. The
project is owned by the government utility but the responsibility for
operations is contracted out to the private sector. Another is where the private entity designs,
builds, arranges the financing and operates the project. At some specified
future, the project is transferred to
the government. This method is referred to as design, build, finance
operate, transfer (DBFO, DBOT or, sometimes, BOT or BOO). The experience in the
US has proven to be positive as illustrated by the Seattle experience. However, some state laws still preclude this
option for many utilities.
4. Franchise[3]
4A. Leasing
This model is similar to the
management contract arrangement except that the lessee takes on additional
functions. The local government owns the assets but the private partner manages
the facilities, provides working capital, and bills and collects from the
customer. The lessee is responsible for maintenance and upgrading of
facilities. Water rates are determined initially as a part of the bidding
process but the operator usually remits part of the revenue collected to the
government as a lease payment.
4B. Concession
When a publicly owned system requires
both private management expertise and private capital, a concession contract
can be arranged. Private firms typically bid for the contract, with the bids
representing the level and structure of
rates. Besides advancing all capital funds for new construction and working
capital, the private firm manages the operation and maintains facilities, and
bills and collects from the customer. Concessions usually are granted for a
long period (for example, as long as 30 years in some countries and 20 years or
less in the U.S., due to tax considerations) so that the concessionaire can
recoup his investment. At the end of the contract, the government would acquire
the assets and the contract likely would be rebid.
In general, fully utilizing the resources
and capabilities of the private sector is a very strong argument in favor of
these full privatization alternatives. Another, potentially more telling
argument, is that a franchise can inject competition into a monopoly market.
The competition is for the rights to the franchise. Since the bidding is stated
in terms of rates and services to be provided, the franchisee has the incentive
to reduce costs and employ the optimum technology. If the firm's managers
perform poorly in terms of cost containment and profit maximization, the
managers may be removed or the firm itself may be subject to penalties if
contract provisions are violated.
Under varying circumstances,
governments have decided to rely solely upon private utilities to provide water
and wastewater services. In some cases, private ownership developed the local
market, as was the case of investor owned water utilities in the United States.
There remains a viable private sector in the U.S. In 1995 investor owned water
systems accounted for one-third of the nation’s community water systems and
served 13 percent of the U.S. population, or more than 30 million people (Hudson
Institute, 1999).
In other cases, the government owned the water
or wastewater utility and decided to sell the assets to a private utility.
Great Britain accomplished this "load shedding" in a dramatic fashion
in the 1980's when it sold 10 government owned and operated English and Welsh
water and sewerage companies.
Normally, the private company is
awarded a monopoly right to serve a particular franchise area and, in some
cases, a companion wastewater market. Since the private utility is a monopoly
and is not subject to competitive constraints as to output or price, the government
regulates the utility in terms of rates, quality of product, and service.
Operating a regulatory system that
can enforce effectively an economically efficient level of rates, costs,
productivity, product quality, and service are very difficult at best. The
various approaches to regulation; i.e. rate of return, price cap, or New
Zealand’s regulation by threat, are not as distinct in practice as in theory.
The dilemma of regulation is to provide incentives for cost reduction while
ensuring that prices that are not too far out of line with costs. Also the
regulators should attempt to allow a reasonable chance of cost recovery without
condoning excessively high costs. Moreover, the regulator might resist
regulatory opportunism; i.e., taking advantage of the regulated company if it
earns high profits because of efficient operations or moving sluggishly to
adjust rates in the face of rising costs. Conditions for efficient regulation
include commitment and stability of regulation, openness, transparency, consistency,
and accountability.
THE
MOVEMENT TOWARD PUBLIC PRIVATE PARTNERSHIPS
While all of the alternatives outlined
above are widely used, U.S. experiences at the end of the 20th
century vary significantly from category to category. The major change that is
occurring in the U.S. is to move to some version of full contracting out
operations to privately owned water companies in addition to a small number of
asset sales. In the decade of the 90’s, privatization rose by 84% and increased
by another 13% in 2001 (Reinhardt, 2002). At the end of 2001, approximately
1,100 water systems and 1,300 wastewater systems had been privatized (Segal,
2003: 4).
In the United States, the strongest
privatization trend of the last decade has been in operations and maintenance
(O&M) contracting and some form of leasing. From about 400 in 1997,
contracts for water system operations now total about 1,100. Perhaps reflecting
the widespread involvement of French investors and parent companies among the
major contract operators, this rapidly evolving model mimics loosely the
competitive system of France. At the same time, however, this practice has
clearly been spurred on by favorable changes in the U.S.’ own tax code.
Following substantial lobbying from
the United States Conference of Mayors, the Department of the Treasury issued
new tax regulations in 1997 supporting long-term contracting for the operation
and management of water and wastewater facilities. Under previous rules, if a
facility was under contracted 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 rendered practicable, necessary capital investments
can be incorporated into O&M or leasing agreements and amortized over a
period that makes such agreements more cost-competitive.
Within this general category,
contract lengths and provisions have varied significantly. In both the water
and wastewater, many recent contracts range from 5 to 30 years. Table 4 notes
some recent contracts among major cities.
Table 4
Ten Largest
Cities With Long-Term Contracts
(out of 33
cities)
Municipality System
Type Capacity (mgd) Yrs. Of Contract
Augusta, GA wastewater 46 10
Evansville,
IN water 60 10
Hamilton, Ont water/wastewater 300/5 10
Indianapolis,
IN wastewater 250 14
Milwaukee, WI wastewater 550 10
New Haven, CT wastewater 45 15
Seattle, WA DBO water 120 25
Springfield,
MA wastewater 67 20
Tampa, FL DBO water 66 15+5
Wilmington,
DE wastewater 105 20
Source:
(Reinhardt, 2001)
Some longer-term privatization
initiatives have also been noteworthy for the payment of cash upfront to the
municipality. In Cranston, Rhode Island, for example, an existing short-term
O&M contract was rebid in 1996 as a 25-year lease that included $48 million
in upfront cash for the city and significant capital improvements. As part of
this Cranston transaction, current federal regulations permitted the
Environmental Protection Agency to forgive repayment of over $5 million in
undepreciated grant funds (U.S. Conference of Mayors, 1997). In
Hawthorne, California, the first long-term (15-year) lease for an existing
system in the water industry was reached in 1996, featuring an upfront payment
to the city of $6.5 million and $100,000 annual lease payments (Reason,
1997). In North Brunswick, New Jersey, a 20-year franchise was also
negotiated in 1996 for both the water and wastewater systems of the township.
This agreement included an upfront payment of $30 million, $24 million of which
was used to retire existing system debt, and also featured concession fees
throughout the contract term (Reason, 1997).
For cash-strapped municipalities, such
substantial upfront payments are clearly often attractive. As pointed out in a
recent draft EPA Guidance on the Privatization of Federally Funded Wastewater
Treatment Facilities, however, such upfront payments do not come without a
price. Rather, “any payment a local government receives from the sale or lease
of a wastewater infrastructure asset is like a loan from the buyer or lessee
which must be repaid with interest by the wastewater users in the form of
additional user fees.” (US EPA, 1998c). In some cases, the
private operator may achieve efficiencies that enable user fees to remain
stable (or even decrease) in spite of the cost of this “loan.” Even in such cases, however, user fees could
have been lowered even further had such a loan not been taken out upfront.
Therefore, while such practices may make good sense in the context of an
individual community’s circumstances, it is more accurate to think of such
upfront payments as more of a potential financing tool than as a windfall.
Whether or not such upfront payments
are part of the package, however, it is clear that many communities are
benefiting financially from contracting. Moreover, to date, the service quality
and environmental records of such arrangements generally have been strong.
Absent further change to the current tax code and regulatory structures that
present few barriers to such arrangements (particularly relative to asset sale
and full private ownership), it is likely that contracting will continue to be
the fastest growing strategy for communities privatizing their water and
wastewater systems.
Design-Build-Operate (DBO); Design-Build-Finance-Operate
(DBFO)
Where publicly owned systems are faced
with the decision to meet increasing demand by new construction the
Design-Build-Operate (DBO) approach has been attractive. This technique that
requires bidding that would lead to a single contractor being engage to design,
construct, and operate a facility. This approach gives control over a project
to a single entity, and focuses them on long-term performance of the facility.
As a result of this more interactive and integrated process, some analysts
estimate potential savings of 15 to 25 percent of construction costs and 20 to
40 percent of operating costs (Dysard and Callahan, 1998: 62).
A leading example of the DBO
approach in the U.S. water industry is the Seattle Public Utilities 1997 Tolt
River project. In this initiative, Seattle competitively selected a private
contractor to design, build, and provide 25 years of operation for a new, 120
million gallon per day filtration/ozonation water treatment plant. Pursuant to
the contract structure negotiated, Seattle Public Utilities provides project
financing, retains ownership, and assumes liability for future capital
improvements. At a cost of $101 million ($56 million for design and
construction and $36 million for 25 years of operation), Seattle estimates that
it has saved 40 percent over its estimated total cost of $171 million had it
used conventional design, low-bid construction, and City operations (U.S.
Conference of Mayors, 1997).
In the Build-Own-Finance-Operate (DBFO) approach, the primary change from the DBO model is that the private sector finances the project. Generally, this approach is not advantageous under the current U.S. tax code, given the lower interest rates available to public sector because of the tax-exempt status of municipal debt. When a public entity’s debt capacity is constrained, however, DBFO does provide an alternative financing option.
Table 5 lists the major contracts that
have been negotiated in the last several years. Generally, the partnerships
anticipate significant cost savings for the municipal systems.
Table 5
Public-Private
Partnerships in Selected Cities
Municipality Service Term Type* Private Partner Total Savings
Population (yrs) (estimated)
(1,000s) ($
million)
Atlanta 1,500 20 O&M United Water 400-
20 yrs
Bessemer, AL 45 20 DBO Ogden
Water
100- 10 yrs
Camden, NJ 85 20 O&M US
Water 2-
annually
Chester, NJ 1 20 O&M Earth Tech 1.9- total
Danville, VA 54 10 O&M American
Water W 0.8-first yr
Devens, MA
3.5 20+10 DBO Earth
Tech N/A
Easton, PA 80 10 O&M US
Water 0.6-annually
Gardner, MA 23 20 DBO Earth
Tech 11- 20 yrs
Gary, IN 179 10 O&M White
River 20- 10 yrs
Honolulu N/A 20 DBFO US
Filter N/A
Milwaukee 1,200 10 O&M United
Water 140- 10 yrs
San Antonio 250 10 DBO United
Water 0.6
annually
Plymouth, MA 36 20 DBFO US
Filter 15- 20 yrs
Scranton, PA 78 5 O&M American Water W 0.5 annually#
Tampa &
St.
Petersburg 2,000 30 DBFO Poseidon Resources 300- 30 yrs
Woonsocket,
RI 55 20 O&M US
Filter 0.8- annually
Source: U.S.
Conference of Mayors, 2000.
# for years 2
to 5.
*
O&M = Operation & Maintenance,
DBO = Design, Build, Operate, DBFO = Design, Build, Finance, Operate
Table 6 lists the major private water
companies that bid for the contracts. The dominant ones are international. The
European companies have been the most active participants. In fact, the recent
acquisition of American Water Works by RWE means that American owned companies
have become even less than a factor in the private market.
Table 6
Value Of
Investor-Owned Water Companies
(in milli