jacf summer2011 water infrastructure d haarmeyer

VOLUME 23 | NUMBER 3 | SUMMER 2011

APPLIED CORPORATE FINANCEJournal of

A M O R G A N S T A N L E Y P U B L I C A T I O N

In This Issue: Infrastructure Financing and Public-Private Partnerships

Canada’s Budget Triumph 8 David R. Henderson, Naval Postgraduate School in

Monterey and Hoover Institution

Re-imagining Infrastructure 18 Mark Gerencser, Booz Allen Hamilton

Privatizing Waterworks: Learning from the French Experience 30 Steve H. Hanke, Johns Hopkins University, and

Stephen J.K. Walters, Loyola University Maryland

Reflections on Private Water Supply: Agency and Equity Issues 36 Steve H. Hanke, Johns Hopkins University, and

Stephen J.K. Walters, Loyola University Maryland

A Fresh Look at U.S. Water and Wastewater Infrastructure: The Commercial and Environmentally Sustainable Path Forward

41 David Haarmeyer

The Upside to Fiscal Challenges: Innovative Partnerships Between Public and Private Sector

53 Martha Amram, WattzOn and The Milken Institute, and

Tabitha Crawford, President, Balfour Beatty Energy Solutions

Infrastructure Public-Private Partnerships: “Partnerships” Come to Fruition

60 J. Perry Offutt, James Runde, and Stacie D. Selinger,

Morgan Stanley

The Role of Finance and Private Investment in Developing Sustainable Cities

64 John Macomber, Harvard Business School and

BuildingVision, Inc.

Energy Infrastructure Investment and the Rise of the Uncorporation 75 Larry E. Ribstein, University of Illinois College of Law

Why Financial Institutions Matter: The Case of Energy Infrastructure MLPs

84 Conrad S. Ciccotello, Georgia State University

The Future of U.S. Infrastructure: Proposals for Progress 92 Sadek Wahba, Morgan Stanley

Environmental Finance: Innovating to Save the Planet 99 Franklin Allen, University of Pennsylvania’s Wharton

School of Business, and Glenn Yago, Milken Institute

Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011 41

A Fresh Look at U.S. Water and Wastewater Infrastructure: The Commercial and Environmentally Sustainable Path Forward

“Water—by far the most valuable resource on this planet—is treated as if did not

have any value at all. We often do not even know the cost of providing it;

the true number is buried under open and hidden subsidies, taxes, and sunk

costs of municipal and regional water departments.”

– Peter Brabeck-Letmathe, Chairman of Nestle1

“Constraints on a valuable resource should draw new investment and prompt

policies to increase productivity of demand and augment supply. However, for water,

arguably one of the most constrained and valuable resources we have, this

does not seem to be happening.”

– 2030 Water Resources Group2

“With few exceptions, underinvestment in infrastructure has been a global secular trend.”

– Citi Alternative Investments3

I

by David Haarmeyer*

n most parts of the world, water is increasingly viewed as a critical economic resource—one whose preservation depends in part on finding ways to allow markets to establish its economic

value and regulate its use. Water’s transformation into an economic resource is a key pre-condition for moving the industry toward a more commercially and environmentally sustainable basis. This is expected to bring about more respon-sible use of the resource and ensure greater accountability of organizations that are charged with managing water infra-structure. The payoff should be a significant strengthening of the industry’s ability to address four long-standing problems: insufficient capital; industry fragmentation; paucity of inno-

vation; and lack of environmental sustainability.Each year the news is filled with stories highlighting the

U.S. industry’s perennial problems of aging and broken infra-structure, small systems failing to meet increasingly stringent standards, and the widening gap in the funds required to upgrade and expand the system. At the same time that such problems are being decried in the U.S., warnings of the threat of growing water scarcity and stress are echoing louder and louder from around the world. Helping to amplify these concerns is the fear that global climate change will exacerbate local water availability challenges.

Among the growing signs of global concern about water as a sustainable resource, here are a few telling indicators:

* The National Association of Water Companies commissioned an earlier version of this paper. The author would like to thank Don Chew for his helpful editorial assistance.

1. “Water as a Scarce Resource: An Interview with Nestlé’s Chairman,” McKinsey Quarterly, December 2009..

2. 2030 Water Resources Group, Charting Our Water Future, 2009, p. 4.3. Citi Alternative Investments, Investing in Developed Country Private Infrastructure

Funds, July 2008, p. 3.

42 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011

infrastructure category presents the United States with greater challenges than water.”5

What these and other indicators suggest is that the trans-formation of water into an economic resource is at a tipping point. This transformation can be expected to have major conse-quences for the U.S. water and wastewater sector, since it will require organizations operating in the sector to become environ-mentally as well as commercially sustainable. The U.S. industry, to the extent it succeeds in shifting decision-making away from adversarial politics and toward rational economics, should be in a better position to address its long-running challenges.

Across the world there is a multitude of models for organizing the industry, but none offers a panacea. One common denominator of the better performing private or government-owned utilities is that they face a commercial imperative: operate financially and otherwise independently of the government. The Public Utilities Board of Singapore and the Phnom Penh Water Supply Authority, both govern-ment owned and operated, are commercially oriented and two of the best performing utilities in the world.6 Australia’s water and wastewater utilities, which were recently ranked world leaders in asset management, may be the most transparent in the world in terms of having to publish detailed operating, service and financial data.7 Owned by the Australian state governments, the utilities pay out sizable annual dividends

• Overthepast10years,anumberofworldwaterindexes have been launched (e.g., by Dow Jones, Bloomberg, Credit Suisse) to provide investors with exposure to compa-nies involved in the water industry.

• The2030WaterResourcesGroup(supportedbyMcKinseyandtheWorldBank)predictsthatby2030globalwater demand will exceed the current accessible and reliable supplyby40%.

• Withinthelast10years,thepriceofwaterrightsinarid regions has risen faster than any other commodity—and an investment in Colorado water rights, for example, would haveoutperformedotherindexesoverthepast10years(seeFigure1).

• According to theBureauofLaborStatistics, therelative cost of water and wastewater treatment services has risen well above the general consumer price index since the mid-1980s.4

• AgrowingnumberofinstitutionalinvestorssuchasCalPERSandtheNorwegianGovernmentPensionFundwant to see more disclosure about water-related risks of the compa-nies in which they invest.

• “Infrastructure2010:InvestmentImperative,”astudyconductedbytheUrbanLandInstituteandErnst&Young,links the competitiveness of the U.S. to the state of its infra-structureandcomestotheconclusionthat“Perhapsnoother

Figure 1 Growth in Colorado Water Rights Investment Compared with Other Investment Asset Indexes (Maxwell, April 2010)

Sources: CRB - Commodity Research Bureau, REIT, real estate investment trust; S&P - Standard & Poors.

Values in 1989 normalized to equal 100.

Gold Spot

CRB Commodities

S&P 599

S&P Developed REIT

Colorado Water Rights

880

440

220

110

100

1989 1992 1995 1998 2000 2003 2005

Year

Rel

ativ

e Sc

ale

4. Steve Maxwell, “Historical Water Price Trends,” Journal American Water Works Association, April 2010. pp. 24-27.

5. The Urban Land Institute and Ernst & Young, Infrastructure 2010: Investment Imperative, Washington, D.C., The Urban Land Institute, 2010, p. 42.

6. “Is Private Water a Human Rights Violation?” Global Water Intelligence, March 11, 2010.

7. Water Services Association of Australia, WSAA Report Card 2008-2009: Perfor-mance of the Australian Water Industry and Projections for the Future, 2009.

43Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011

as their liabilities tail on their pension programes. They are perfectly suited for illiquid assets, whether its private equity or infrastructure, so it is almost a perfect fit.

Alan MacKay, Hermes GPE, 20118

One of the biggest long-standing problems faced by the U.S. water sector is its need for capital to meet growing commitments to maintenance, improvements, and expan-sion.Yet,whiletheseneedsstayunmetyearafteryear,thereis a growing pool of public and private capital held by insti-tutional investors that is looking for precisely the kind of stable and predictable returns offered by water infrastructure investments.

The significant ongoing need is understandable. Water is the most capital-intensive utility, which magnifies the challenges in planning and executing capital programs. Water’s relative capital investment-to-revenue ratio is over 3.5,almosttwicethatofthenexthighestutility,electricity,wheretheratiois1.8.Thismeansthatawaterutilitymustinvest$3.50foreverydollaritexpectstoearn,ascomparedto$1.80foranelectricutility.

AsshowninFigure2,thelatestEPAestimateofthe20-yeartotalinvestmentneedsforpublicwatersystemsisover$344billion.Keydriversofthesecapitalrequirementsare maintenance, growth, and meeting stricter water quality standards.ThelatestEPAestimatehasgrownalmost120%since2002,andpointstochronicunderinvestment,raisingconcerns about service quality, safety, industry competitive-ness, and the environment.

Localgovernment-ownedwaterandwastewaterfacilitiesgenerally rely on municipal tax-exempt debt to finance their capital needs. By taking advantage of credit support from city, county, or state governments, they are able to gain AAA bond ratings and thus access debt cheaply. This cheaper source of capital tends to crowd out more expensive private capital and lock municipalities into ownership of assets, discouraging competition.

On the other hand, because of the recent recession, state and local government budgets are particularly constrained and their credit strength under pressure. According to the NationalConferenceofStateLegislatures(NCSL),statesfaceacumulative$280billionofbudgetdeficitsfromFY2008throughFY2011.9 Consequently, there is generally more openness to alternative sources of capital.

But if the needs gap for U.S. water and wastewater infrastructure has been steadily growing, international insti-tutional investors such as pension, endowment and sovereign wealth funds (SWFs) with trillions of dollars of assets under managementaresearchingforattractiveinvestments.Infra-structure is one of the growing new areas of focus for these investors, especially since the long-term investment life

(over60%ofprofits)totheirowners.As the U.S. industry moves toward operating on a more

commercial and sustainable basis, accountability will become increasingly important. This means that water and waste-water organizations will have to raise the bar in terms of meeting obligations to customers, shareholders, and other stakeholders. The fundamental building blocks for ensuring more accountable organizations are clear and transferrable ownership in combination with effective and independent regulation to promote transparency and competition. At present, neither of these can be said to characterize the U.S. water and wastewater sectors, which suggests the difficulty of the economic and political challenges ahead.

This article highlights how the industry’s move to a more commercial and environmentally sustainable basis will help to address its major challenges, including:

• theinvestmentchallenge:matchingthepoolofpublicand private capital with the great U.S. water /wastewater requirements

• thesmallsystemschallenge:consolidationandpartner-ships

• theinnovationchallenge:stimulatingnewtechnolo-gies, practices, and organizations

• theenvironmentalsustainabilitychallenge:fullcostpricing and integrated water management.

While these are indeed significant challenges, the good news is that the road map for the U.S. water and wastewater industry to become more commercially and environmentally sustainable is becoming clearer.

The Investment Challenge: Matching the Pool of Public and Private Capital with the Great U.S. Water/Wastewater Needs“Thegreatthingaboutpensionandmutualfundclientsisthattheyhaveliabilitiesthatrunfrom50to70to90yearsahead

Figure 2 U.S. EPA Estimated 20-Year Total Needs of U.S. Public Water Systems

• 2009: $335 billion

• 2005: $277 billion

• 2002: $154 billion

2009: $335 billion

2005: $277 billion

2002: $154 billion

Transmission &Distribution:$200.8

Treatment:$75.1

Storage:$36.9

Source: $19.8

Other:$2.3

Total: $334.8 Billion

Source: U.S. Environmental Protection Agency, 2007 Drinking Water Infrastructure Needs Survey and Assessment, March 2009.

8. “LP Profile: Alan MacKay, Hermes GPE,” AltAssets, June 28, 2011. 9. Annual Privatization Report, 2009, Reason Foundation, Los Angeles, CA, p. 32.


12yearsbeforeGPsmustreturncapitalplusprofitstoLPs.Table1showsselectparticipationininfrastructurefundsbypension funds.

What is particularly noteworthy about these funds is that they represent capital that is smart, engaged, and account-abletocapitalproviders.GPswillnotbeabletoshareintheprofits, raise additional funds, or maintain a good reputa-tioniftheydonotcreatevaluefortheirLPs.Thisprovidesapowerful incentive for capital to be put to its most efficient use to the best interests of water consumers. Thus, these types of new owners—infrastructure funds and active long-term investors such as Warren Buffett’s Berkshire Hathaway—can transform infrastructure by bringing not only much needed financing and operating expertise, but the governance that helps ensure high performance and good stewardship.

Recognizingthevaluableroletheseinvestorscanplay,the governments of Australia, Canada, the U.K., and other countries have put in place legal structures to facilitate public-private partnership structures that channel private (and public as in public pension fund) capital into transport, energy, water, and telecom infrastructure facilities.

matches their liabilities.10Inaddition,institutionalinvestorsare attracted to infrastructure because of its ability to deliver revenue streams that are stable, predictable, often inflation linked, and long-term. And this is because, as monopolies or quasi-monopolies, the demand for infrastructure services is stable.Consequently,asLeodeBever,CEOofAlbertaInvest-mentManagementCorp.hassaid,“Thenaturalownerofan infrastructure asset is a pension or endowment fund that intends to hold the asset indefinitely.”11Infrastructuremaybean especially good fit for SWFs, which, unlike pension funds, generallydonotfaceredemptiondemands.YngveSylngstad,CEO of Norway’s SWF, which is the second largest in the worldwith$462billioninassets,notedthathisfundhas“a30-yearhorizon.”12

Infrastructurefundpartnershipshaveemergedtotakeadvantage of the growing appetite of institutional investors for infrastructure investment and the growing global need for long-term infrastructure financing, which the OECD estimatesat$40trillionby2030.13Generalpartners(GPs)of these funds raise capital from institutional investors who becomelimitedpartners(LPs)inpartnershipsthatlast7to

Table 1 Select Pension Fund Investments in Infrastructure

Institutional Investor Total Portfolio Assets Classification Target Allocation Range

Investment Objective

Alaska Permanent Fund Corporation US $3.4 billion Infrastructure 3% Hedge inflation risk

California Public Employees’ Retirement System

US $2.07 billion Inflation-Linked 0-3% Enhance risk-adjusted returns; diversify investments; hedge inflation risk

Teachers’ Retirement System of Texas

US $70.6 billion Real Assets 2-5% Diversification due to low or negative correlation to Public Markets portfolio; competitive returns through capital appreciation

Ontario Teachers’ C$87.4 billion Infrastructure -8% Assets with long economic life; low-risk, reliable returns linked to inflation

Ontario Municipal Employees Retirement System

C$43 billion Infrastructure 20% Reliable returns linked to inflation

Caisse de dépôt de placement du Québec

C$120.1 billion Infrastructure 5.5% Stable income flow that matches long-dated financial liabilities

Alberta Investment Management Corporation

C$68.9 billion Infrastructure 2% Tangible long-lived assets that provide essential services

British Columbia Investment Management Corporation

C$74.5 billion Infrastructure 4% Stable cash yields; tangible long-lived assets

CPP Investment Board C$123.9 billion Infrastructure 5% Match inflation-linked liabilities

BT Pension Scheme (Hermes Private Equity)

£31 billion Infrastructure 1% Enhanced risk adjusted returns

ABP (APG Investments) €208 billion Infrastructure 2% Inflation-linked investments

Source: RBC Global Asset Management (U.S.) Inc., The Global Infrastructure Op-portunity, 2010.

10. Angelo cites research showing that pension funds manage over $25 trillion in assets, endowment assets are under $1 trillion, while insurance companies manage between $1 and $2 trillion of assets. Enzo D’Angelo, “Limited Partners’ Perceptions and Management of Risk in Private Equity Investing,” Zell Center for Risk Research, 2009. Preqin puts the total aggregate value of SWFs at $3.98 trillion. Preqin, “The Impact of Sovereign Wealth Funds in 2011, Private Equity Spotlight, March 2011.

11. Vyvyan Tenorio and Christine Idzelis, “Can Private Equity Play the Infrastructure Game,” The Deal Magazine, April 3, 2009.

12. Loch Adamson, “Going Mainstream,” Institutional Investor, September 2010.13. Organization for Economic Co-operation and Development, OECD Policy Brief:

Infrastructure to 2030, January 2008. http://www.oecd.org/dataoecd/24/1/39996026.pdf.


develop asset management plans that identify the level of investment required to maintain and improve capital assets over five-year periods. Annual audits help ensure that planned improvements aremade. InMarch2010, the industryannouncedplanstomakerecordinvestmentsof$35billionin capital equipment, infrastructure and operational activities over the next five years.14

Although asset management groups have acquired a few U.S. water companies, providing evidence of their commercial viability and attractiveness, the pool of private investor-owned and commercially viable private water utilities is limited. For example,onlyabout12percentofthecountry’spopulationisservedbyprivatewaterorganizations,andthereareonly10publicly traded water company stocks (and no publicly traded wastewater company stocks). This suggests that fundamental changes in ownership and financing arrangements will be required before the sector can truly take advantage of the smart and engaged capital waiting on the sidelines.

The Small Systems Challenge: Consolidation and PartnershipsThe significant capital and operational improvement needs for U.S. water and wastewater infrastructure are in large part a function of the industry’s highly fragmented structure. Small systems are less likely to have the financial, managerial, and technical capacity to meet regulatory requirements and are less likely to be under formal rate-setting processes that would help ensure services are fully funded. Thus, a more commer-cially rational approach to the industry’s economics would remove barriers to consolidation to create more economically viable water enterprises.

IntheU.S.therearesome54,000communitywatersystemsthatsupplydrinkingwaterand16,000wastewatertreatment systems that provide sewer systems. Most utili-tiesaresmall,withover90percentofcommunitydrinkingwatersystemsandover70percentofwastewatersystemsserving10,000peopleorfewer(seeFigure3).Compound-ing its economic disadvantages, the small, suboptimal scale of operations is likely to have high safety and environmental costs as well. For example, the majority of drinking water violationssince2004haveoccurredatwatersystemsservingfewerthan20,000residents.15

Competition and market forces tend to encourage consol-idation of assets, which brings efficient operation through economiesofscale.Largeroperationsenablefirmstospecial-ize in providing services at lower costs and spurs innovation. According to Moody’s, larger, investor-owned utilities can mitigateratehikes“byapplyingsignificantcapitalcostsover a broader customer base.”16Yet,inthewaterbusiness

Infrastructurefundsandassetmanagementgroupsareincreasingly targeting water infrastructure assets. Among prominent examples:

• InOctober2006,HastingsFundsManagementLtd.,an Australian infrastructure and alternative investment fund, agreedtobuySouthEastWaterLtd.(SEW),for$1.2billion.SEW is the U.K.’s second-largest water-only utility. Hastings also owns U.K. water utility Mid Kent and Ballarat Water, which owns six water treatment plants in central Victoria, Australia.

• InOctober 2006, Australian investment groupMacquarie led a consortium that purchased Thames Water for at£8billion.ThamesistheUK’sbiggestwatercompany.

• October2006,aconsortiumthatincludedColonialFirst StateGlobalAssetManagement (divisionof theCommonwealth Bank of Australia), Canada Pension Plan, 3iGroup,andotherspurchasedAWGplcfor£2.2billion.AWGisoneoftheleadingU.K.watercompaniesservingapproximately 6 million customers in the east of England. AWGalsoownsanunregulatedbusinesscalledMorrisonsGroup,whichprovidessupportservicestothefacilitiesandutilities sectors in the U.K.

• InOctober2007,JPMorganInfrastructureInvest-mentGroupledaconsortiumthatannounceditspurchaseofSouthernWaterCapitalLimitedinadealvaluedat£4.195billion. SWC is the seventh largest water and sewer company in the U.K.

• March2010,JPMorganAssetManagementandWaterAssetManagementLLCannounceditspurchaseofSouth-westWaterCompanyforapproximately$275million.SWChas water utility and contract operations in California and other western states.

• December2010,theCarlyleGroupannounceditspurchase of Park Water, a family owned California-based waterutility.Thismarkedthefirm’s$1.5billioninfrastruc-ture fund’s first investment in the water sector.

Increasedtransparencyofoperationalandfinancialmetrics is an important benefit that the participation of more engaged investors is expected to bring given their high standards in due diligence and monitoring performance metrics. At the same time, such investors tend to require clear, stable, and fair regulatory frameworks, which are essential in ensuring predictable cash flows over the investment life of the asset.

The U.K. regulatory system, for example, is renowned for providing users and investors with significant insight into the operations and investment performance of each utility and how this compares across utilities, thus encouraging “yardstickcompetition.”Theregulatorrequiresutilitiesto

14. “Water Industry in UK Set for Record Investment Over Next Five Years,” Water-world, March 3, 2010.

15. Charelese Duhigg, “Millions in U.S. Drink Dirty Water, Records Show,” New York Times, December 8, 2009.

16. “Moody’s Report Suggests U.S. Water Utility Consolidation Likely Soon,” U.S. Water News Online, July 2000.


Table 2 Select Pension Fund Investments in Infrastructure

6/30/05 Equity MarketCapitalization

U.S. Electric Utilities (49 companies) (e.g., Duke, Exelon)

$382.7 billion

U.S. Gas Utilities (28 companies)(e.g., Laclede Gas, Atmos Energy)

$ 68.8

U.S. Water Utilities (11 companies)(e.g., Aqua America, California Water)

$5.5

Total Equity Market Value $457.0 billion

Source: A.G. Edwards, Sept 2005, http://www.puc.idaho.gov/RELATEDSITES/ACCT/2005/21AM%20Krone%20NARUC%20Conf%202005.ppt

contrasts sharply with the nearly all private owned pattern found in other utility sectors such as gas, telecom and electric. AsshowninTable2,investorownedwaterutilitiesmakeuponly around one percent of the total market capitalization of U.S. utilities. Thus, the majority of the country’s water and wastewater utilities face high barriers to ownership changes and consolidation, including the absence of access to the capital, valuation, or monitoring benefits that the stock market provides.

Providing an instructive contrast, the U.K’.s private water industry provides insights into potential benefits of consolida-tion. Mergers are expected to bring efficiency and lower capital costs, and thus potential reductions in customer bills.

TakethecaseofHastingsFundsManagementLtd.,theowneroftheU.K.watercompanyMidKent,whichin2006announced its purchase of U.K. water company South East WaterLtd.AccordingtoPaulButler,managingdirectorofMid Kent, the merger has resulted in a number of important benefits:18

• Thereisnowasinglecustomerservicecenter,controlroom, and head office where before there were two.

• Waterresourcesplanningandsharingcanbeaccom-plished much more efficiently across a larger geographic space and organization, which was more difficult across two separate legal entities.

• Thelargercombinedcompanyisnowinabetter

especially, assets are more difficult to buy and sell because the vast majority are in the hands of municipalities, which have limited economic incentive to rationalize assets. For example, almost85percentofallmunicipaldrinkingwatersystemsarecategorizedas“small”(servingfewerthan3,300people).17

Atthesametime,only16percentofU.S.watersystemsand two percent of wastewater systems are investor-owned. This lowproportionofprivate investor-ownedutilities

Public &

Other

84%

Public &

Other

98%

Owner

Invested

16%

Owner

Invested

2%

Figure 3 The U.S. Water Industry Remains Highly Fragmented and with Limited Investor Ownership

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%< 500 501-3,300 3,301-10,000 10,001-100,000 > 100,000

System Size by Population Served

Percentage of Drinking Water Systems and Population served by Size Class(Based on 51,988 total water systems in U.S.)

Systems Population

Source: U.S. Environmental Protection Agency, Drinking and Ground Water Statis-tics, 2008.

17. Steve Maxwell, “A Look at the Challenges—and Opportunities—in the World Water Market,” Journal of American Water Association, May 2010, p. 112.

18. “Merger of South East and Mid Kent Water Brought Benefits for Customers,” Util-ity Week, July 17, 2009.


studies that focused on a range of collaborative arrangements from informal cooperation (e.g., sharing of equipment and mutual aid agreements) to ownership transfers (see Figure 4). The partnerships offer a flexible means to address acute technical scarcities, raise capital, reduce capital and operating costs, introduce full-cost pricing schemes (including meters), and increase sustainability.

Moving toward a more commercially viable industry will involve more consolidation and partnerships, which will be instrumental in transforming small water systems into economically viable water enterprises. A key step in that direc-tion will be to put municipalities on the same financial and regulatory footing as private water companies by, for example, removing the federal tax subsidies provided in the form of tax-exempt financing to government-owned entities.

Innovation Challenge: Stimulating New Technologies, Practices, and OrganizationsThe U.S. water and wastewater sectors face tremendous invest-ment, operational, and organizational challenges to meet consumers’needsnowandinthefuture.Takenbroadly,inno-vation is often a key factor in how organizations and industries manage not only to address growing challenges with fewer resources, but to leapfrog existing practices, services, and tech-nologies. For example, innovation in the electric utility sector is helping to drive down the cost of wind and solar power, thus

position to recruit for the full range of the skills necessary to run any water company.

These benefits were echoed by Thames chief executive David Owens, when he claimed that if Thames were allowed to take over the water-only companies within its sewerage franchise, the savings it could make on head office overheads, billing systems, operational call centers and other facilities couldcutconsumertariffsbyatleast5%.19

Meanwhile in the U.S., American Water, the largest investor-owned water utility, has been a consolidator. The companyiscomposedofmorethan350individualwatersystems.Ina2010presentationtoNARUC,AmericanWater’sthenpresidentDonCorrell,commentedthat“accesstocapitalismoreimportantthanever”andthus“businesscombinations that promote access to capital at cost-effective rates should be encouraged.” One important lesson learned from the company’s consolidation and merger involvement isthat“waterislocal”andthat“customerserviceandstake-holder involvement are key.”20

Besides fundamental institutional changes that would facilitate changes in ownership to spur consolidation of small private and municipal systems, there is likely to be an increasing reliance on partnerships for sharing resources and expertise.InOctober2009,theEPApublishedareportcalled“GainingOperationalandManagerialEfficienciesThroughWater System Partnerships” that identified a number of case

Figure 4 The System Partnership Spectrum

2005: $277 billion

2002: $154 billion

Informal Cooperation Joint Powers Agency Ownership TransferContractual Assistance

Increasing Transfer of Responsibility

Work with other systems, but without contractual obligations

Examples:. Sharing equipment. Sharing bulk supply purchases. Mutual aid arrangements

Requires a contract, but contract is under system's control

Examples:. O&M. Engineering. Purchasing water

Creation of a new entity by several systems that continue to exist as independent entities

Examples:. Shared system management. Shared operators. Shared source water

Takeover by existing or newly created entity

Examples:. Acquisition and physical interconnection. Acquisition and satellite management. Transfer of privately- owned system to new or existing public entity

19. “Thames Re-Opens Consolidation Debate,” Global Water Intelligence, July 2009.

20. Don Correll, President and CEO, American Water, “American Water: Looking Ahead,” National Association of Regulated Utility Commissioners Winter Committee Meetings, Washington, DC, February 16, 2010.

Source: U.S. Environmental Protection Agency, Gaining Operational and Managerial Efficiencies Through Water System Partnerships, October 2009.


expendituresolutionsandagainstR&Dbyprovidinginsuf-ficient rewards for the latter.22

The good news, however, is that innovation takes place not only in the form of valuable changes in products, processes, and services, but also in changes in organizational forms and practices. For example, a key institutional change in utility economics was the introduction of public-private partnerships such as leases and concession contracts. These contractual innovations introduced competition to monopoly services and provided greater flexibility for private-sector providers to meet the needs of the public sector. Similarly, markets for trading water rights—an old concept but one that has become more attractive with technological advances—is growing as water becomes increasingly scarce.

O&M,Design-Buildcontracts,concessions,andotherservice and construction contracts provide an opportunity for the industry to take advantage of competition and its ability to draw out innovative and cost-effective solutions. When a number of leading firms go head-to-head for the right to provide multiyear services, they tend to sharpen their pencils and think hard about how to provide the highest level of service at the lowest cost. The efficacy of this process has been demonstrated by a winning contractor’s ability generally to comein10-20percentbelowexistingcosts.23

Private contractors can also be the source of innovative new services. Veolia, one of the bigger global water and energy contract operators, recently initiated a new service to measure the water and carbon footprint for the city of Milwaukee. Itpresentlymanagesthecity’swastewatertreatmentplant.Veolia’sWaterImpactIndexisaninnovativeservicethatprovides a comprehensive assessment of the impact of human activity on water and energy resources. By making possible the evaluation of a project’s impact on the city’s water and carbon footprint,useoftheIndexcanhelpensurethatdecisionsareconsistent with sustainability.24

Desalination is another area where innovation is playing a critical role, given the opportunity for the private sector to compete in meeting the growing need for drinking water in aridenvironments.Forexample,PikeResearchforecaststhat,overtheperiodfrom2010to2016,worldwidenewinvestmentindesalinationplantsisexpectedtototalabout$88billion.25 Private companies are competing to lower the costs of desali-nation not only through the use of membrane technology, but also through project delivery models that involve integration of engineering, procurement, and construction.

Outside the sphere of regulated utilities, where compe-tition and profit opportunities are clearly limited, there

enabling a more cost-efficient, environmentally friendly source of electric power. Similarly, in the natural gas industry, small independent gas drilling companies recently pioneered new oilfield techniques that are unlocking vast tracts of gas-bear-ing shale, and in the process changing the U.S. from a major importer of oil to the world’s largest producer.21

Lackofcompetitionandthelocked-innatureintheownership of water and wastewater assets has served to discourage normal operation of market forces that encourage companies and individuals to transform challenges into profit opportunitiesthatcanbecapturedbyinnovating,“thinkingoutside the box.” Both rate-of-return regulation of investor-owned utilities and widespread government ownership of utilities have the effect of suppressing the valuable signal that profits can play in fostering innovation and creativity in the sector.

IntheU.K.,EnglandandWalesofferagoodcasestudyof the benefits of transforming publicly owned water authori-ties into private water companies with the help of innovative regulation.Forexample,since1989whentenmultipur-pose investor-owned water companies were created through privatization, the government has focused on minimizing the heavy hand of regulation and leveraging competition by implementing the following:

• Pricecapregulation(RPI-X)thatsetspricelimitsovera five-year price control cycle and enables utilities to profit from increasing efficiency

• Yardstickcompetitionandregulatorybenchmarkinginwhich regulators compare utility performance across a range of benchmarks and companies are rewarded or penalized accordingly, and best practices are widely shared

• Capitalmarketcompetitioninwhichinvestors’assess-ments of company performance are reflected in relative share prices

• Commoncarriageopportunitiesinwhichindividualwater company networks can be accessed by third parties to provide water services.

This regulatory framework has helped attract capital to the industry and establish a competitive industry that competes globally in providing water and wastewater services. But despite such progress, price controls continue to limit innovation,ascanbeseeninanR&D“intensity”(R&Dasa percentage of sales) for water companies that is less than one halfofonepercent(ascomparedtoanaverageof2percentacross all U.K. industry). And as the U.K. Council for Science andTechnology(amongmanyothers)hasconcluded,theregulatory regime creates a bias towards short-term capital

21. In 2009, the U.S. overtook Russia to become the world’s largest producer of natural gas. BP Statistical Review of World Energy, June 2011.

22. U.K. Council for Science and Technology, Improving Innovation in the Water In-dustry 21st Century Challenges and Opportunities, March 2009.

23. See Paul Seidenstat, David Haarmeyer, and Simon Hakim, Reinventing Water and Wastewater Systems: Global Lessons for Improving Water Management, John Wi-ley & Sons Inc., 2002.

24. “Veolia Water Introduces Water Impact Index as Part of First-Ever Water Carbon Footprint Study,” Business Wire, July 19, 2010.

25. Pike Research, “Desalination Plants to Attract $87.8 Billion in Investment by 2016,” December 20, 2010.


water and wastewater organizations that are accountable to customers, shareholders and stakeholders (including regula-tors) must operate under principles of commercial and environmental sustainability. For example, water should be priced to reflect its true costs to encourage conservation, to pay for infrastructure upgrades, and to stimulate new supplies. Adaptive organizations that operate according to these princi-ples will be better able to respond to future environmental and business risks such as climate change.

As a precious environmental resource and vital neces-sity for human life, water’s sustainability depends on it being valued properly and subject to integrated holistic manage-ment approaches that take in its full life cycle. The revolution in water measurement and use discussed above indicates how the private marketplace can be organized and coordinated to advance sustainability. Competition, the need to earn profits, as well as the value of a good reputation in both the marketplace and community, provide businesses with strong incentives to search for ways to minimize their economic and social costs, such as conserving water resources and looking for substitute resources.

PrivatewaterutilitiesandO&Mcontractorshavebeenpioneers in environmental stewardship of water resources, in large part since their livelihood depends on the sustainability of the water cycle and economic pricing of their services to ensure efficient water use and ability to provide necessary infrastructure. Mark Strauss of American Water has explained thatprivatewaterutilitiesarewell-placedtopractice“totalwater management” by harnessing the synergies between potable water and wastewater management. Water poured down drains, Strauss says, can be treated and reused for golf courses, heating-cooling and flush systems, thereby conserv-ing a city’s precious ground-water resource for drinking.”29

What are some of the important concepts and principles around sustainability that would offer a more integrated and holisticviewofwatermanagement?In2008-2009,theAspenInstitutebroughttogetherkeystakeholdersintheU.S.watercommunityfora“DialogueonSustainableWaterInfrastruc-ture.”30 Among the report’s high-level recommendations and principles are the following:

• “Waterinfrastructure”shouldberedefinedtoincludeboth physical water infrastructure and the natural water-shed to provide a more integrated, holistic and helpful way of thinking about sustainability.

• Waterutilitiesshouldleadinbuildingpartnershipsthatuse integrated water resource planning and management to meet human and ecosystem needs.

is a revolution underway to measure and use water more efficiently. Among notable examples,

• General Electric, through its Ecomagination program, expectstodoubleitsR&Dspendingto$1.5billionby2010andreduceitswaterusageby20%by2012.26

• IBM, which has been involved in the development of the smart grid for electric power and smart traffic technolo-gies,announcedinMarch2009thatitwasentering“smartwater” business with introduction of services and products that monitor waterworks such as pipes, reservoirs, rivers and harbors.

• Dow Chemical has identified potential water savings in everything from elimination of steam leaks to reuse of high-quality effluent streams and alternative cooling techniques. Using seawater cooling for its largest manufacturing site in Freeport,Texashashelpedthecompanyavoidmorethan$35million in capital spending.

• Coca-Cola is also focusing on water, aiming to improveefficiencyby20percentby2012,ascomparedwith2004.Althoughthecompany’swaterusageisexpectedtoincrease,itsobjectiveistoeliminateabout50billionlitersofthatincreasein2012andsoavoid$150millioninwateracquisitiontreatmentanddischargecostsbetween2008and2011.27

This dynamism is important and should positively impact the water utility business. The problem is that much of it is occurring outside the industry. For a real step-change to occur, innovation needs to occur inside the industry—at the core of the water and wastewater business organizations, models, and practices. At minimum, this will require opening up the industry to more competition and private capital. A further big step would be to change the regulatory framework to enable water and wastewater firms to invest in new, more efficient technology that has a longer payoff.

The Environmental Sustainability Challenge: Full-Cost Pricing and Integrative Water Management “Charginglessthanitcoststodeliverasafe,reliablewatersupply is neither good business nor good public policy.”

Richard G. Little, Director, Keston Institute for Public Finance and Infrastructure Policy, University of Southern California28

Sustainability is now a part of water resource development and management. Wise resource use today should help ensure that future generations have access and water use opportuni-ties that are comparable to those we now enjoy. By definition,

26. Jon Freedman, “General Electric, Water & Process Technology,” Water Summit Chamber Commerce, March 18 2010.

27. Sarah Murray, “Credentials that Make Money-Men Happy,” Financial Times, March 16, 2009.

28. Richard G. Little, “It Costs Real Money to Run Municipal Water Systems,” Wall

Street Journal, Letter to the Editor, June 27, 2008.29. Mark Strauss, “Partnering to Build Better Infrastructure,” Water & Wastes Digest,

October 7, 2007. 30. The Aspen Institute, Sustainable Water Systems: Step One—Redefining the

Nation’s Infrastructure Challenge, Energy and Environment Program, 2009.


Table 3 Average Tariffs ($/m3) and Water Usage in Some Major Countries

Source: “Water Tariffs Continue Upward Momentum,” Global Water Intelligence, Sep-tember 2010.

Country Combined Tariff Water Tariff Wastewater Tariff Change % Domestic Use 1/head/day

Denmark $7.81 $7.81 $0.00 2.7% 114

Germany $4.26 $2.74 $1.52 0.1% 151

Australia $4.18 $2.17 $2.01 12.1% 605

France $3.92 $3.54 $0.38 4.7% 232

United Kingdom $3.76 $1.82 $1.94 0.1% 139

Czech Republic $2.75 $1.39 $1.36 3.1% 213

Canada $2.75 $1.70 $1.05 8.5% 778

United States $2.71 $1.13 $1.58 9.7% 616

Poland $2.21 $1.02 $1.19 6.5% 149

Japan $2.19 $1.26 $0.93 1.2% 373

Spain $1.83 $1.22 $0.61 12.6% 342

Portugal $1.77 $1.23 $0.54 1.0% 308

Turkey $1.69 $1.39 $0.30 14.6% 238

Italy $1.47 $0.81 $0.66 7.1% 483

Russia $0.71 $0.43 $0.28 25.1% 368

South Korea $0.69 $0.51 $0.18 4.3% 552

Mexico $0.59 $0.50 $0.09 15.7% 200

China $0.42 $0.29 $0.13 7.0% 95

India $0.16 $0.13 $0.03 17.3% 139

in arid regions such as Australian’s Murray Darling Basin and NewMexico’sMiddleRioGrandeRiver,rawwaterpriceshaveincreasedbymorethan10%peryear.31

Likeothercommodities,waterpriceshavebeenontheupswing. NUS Consulting annual international water survey showed that the average price of water in the United States soaredby7.3percentduringtheyearendingJuly1,2008.Morerecently,GlobalWaterIntelligence’sannualsurvey32 releasedSeptember2010showeda9.7percentincrease,whichwasatthehighendcomparedwithothercountries(seeTable3).Finally,BureauofLaborStatisticsdatacollectedbywatereconomist Janice Beecher show that the relative cost of water and wastewater treatment services have risen well above the generalconsumerpriceindexsincethemid-1980sandbeenamong the top three utility services exhibiting the greatest priceinflation(seeFigure5).33

Asdiscussedearlier,privatecompaniessuchasGEandIBMaswellascontractorslikeVeoliaareofferinginnovativenew processes and services to measure water consumption

• Federal,state,andlocalgovernmentsshouldaddressinstitutional practices that act as barriers to sustainable water resource management.

• Utilitiesandregulatorsshouldensurethatthepriceofwater services fairly charges ratepayers or customers the total cost of meeting service and sustainable water infrastructure requirements.

The participants in the dialogue emphasized that assign-ing responsibility and using economic concepts such as full-cost pricing are important first principles. Moreover, it was acknowledged that given their position near the center of the water cycle, water utilities have an important role to play in advancing sustainability.

By most measures, the price of water is beginning to reflect its true costs. This is a sign that water’s scarcity value has increased to the point where it is finally becom-ing accepted as economic good. Across the globe, organized markets for tradable water rights have started to emerge as a means to allocate scarce water resources more efficiently. And

31. Steve Maxwell, “Historical Water Price Trends,” Journal American Water Works Association, April 2010. pp. 24-27.

32. “Water Tariffs Continue Upward Momentum,” Global Water Intelligence, Sep-tember 2010.

33. Janice A. Beecher, “Trends in Consumer Prices (CPI) for Utilities Through 2010,” Institute of Public Utilities Regulatory Research and Education, Michigan State Univer-sity, February 2011.


The promise of tomorrow’s water and wastewater industry to become both commercially and environmentally sustain-able is reflected in Warren Buffett’s remark about his passion for investing in energy infrastructure assets. There is no obvious reason why an engaged investor like Buffett, who is a shareholder of the water filtration company, Nalco Holding, would not want to invest in the stable and predictable revenue streams of well-run water utilities. The participation of these kinds of investors as well as an increase in public-private partnerships would also go a long way to address the country’s challenge with small systems.

The promise of a more vibrant commercially oriented industry is reflected in the innovation presently being unleashedbyfirmsoutsidethesectorsuchasIBM,GE,Nestle,and Coca-Cola, which see significant profit opportunities in water’s transformation into an economic resource. The need for innovation and new thinking is particularly important inside the industry, where new practices, technologies, processes, and organizational structures could make the biggest difference.

and impacts. By providing better and timelier information on the quality and quantity of water, these commercially and financially accountable organizations can help to ensure that the sector is more resilient and capable of adapting to change, thus advancing sustainability. Moreover, increasing the scale of water company operations and customer bases should enable them to become more commercially and environmentally sustainable by becoming accountable for entire watersheds.

Conclusion“CharlieandIareequallyenthusiasticaboutourutilitybusi-ness, which had record earnings last year and is poised for futuregains...Iloveitwhenthey[ourutilitymanagers]come up with new projects because in this capital-intensive business these ventures are often large. Such projects offer Berkshire the opportunity to put out substantial sums at decent returns.”

Warren Buffett, Berkshire Hathaway34

Figure 5 Trends in the Consumer Price Index for Utilities (1979-2010)

Source: Janice A. Beecher, “Trends in Consumer Prices (CPI) for Utilities Through 2010,” Institute of Public Utilities Regulatory Research and Education, Michigan State University, February 2011. The index is set to 100 for 1982-1984 except for telephone, wireless, and internet services, where the index is set to 100 for 1997.

40

80

120

160

200

240

280

320

360

400

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Trends in Consumer Prices (CPI) for Utilities

Garbage (1985)

Water & sewer (1953)

Cable/sat. television (1984)

Fuels (1935)

Local phone (1978)

Postage (1935)

CPI (1913, 1983=100)

Electricity (1913)

Natural gas (1935)

CPI (1997=100)

Tel. services (1997=100)

Landline intrastate (1978)

Internet (1997=100)

Wireless (1997=100)

Landline interstate (1978)

34. Warren Buffett, Berkshire Hathaway Inc., Annual Letter to Shareholders 2008, p. 4.


tocommercialandenvironmentalsustainability.Toensurethat it arrives at the destination of accountability to all its stakeholders will require increased political and economic engagement to address the thorny issues of ownership, regula-tion, and competition.

david haarmeyer is an independent, Boston-based consultant and

writer who focuses on private equity and infrastructure. He contributed

the article “The Revolution in Active Investing: Creating Wealth and Better

and Better Governance” to the Winter 2007 issue of this journal. He can

be reached at [email protected].

Exposure to competition, private capital, and the ability to earn reasonable profits will be important catalysts.

More and smarter (more accountable) capital, stronger small systems, and a more innovative industry will all work to increase environmental sustainability. Commercial viability requires full-cost pricing and ensuring a good reputation with community, regulators, and other stakeholders means taking a long-term holistic view of water development and manage-ment. More accountable and adaptable water and wastewater organizations are also the best defense for addressing future risks such as climate change.

Inachievingthestatusofaneconomicresource,waterispassing a key milestone that has put the industry on the road

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