Private Water Firms Tap Profit From Struggling Public Utilities

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By David Schultz

A cash crunch for public water utilities is creating an opportunity for the growing for-profit water companies—but it’s one that might drain customers’ wallets.

Companies like American Water Works Co. and Aqua America Inc. are finding the time is right to purchase small, troubled water utilities from local governments that are facing political pressure to keep rates low—often by delaying infrastructure upgrades.

Acquisitions like these are helping private water companies grow even while per capita water consumption continues its long-term downward trend. And private companies say they can use their economies of scale to make the infrastructure investments that local politicians can’t, or won’t.

The CEOs of several of these companies told Bloomberg BNA that the leaders of municipal-run water systems are motivated sellers, particularly as many cities have been spooked by public health crises like the lead contamination in Flint, Mich. Such incidents have led some local leaders to question whether public control of drinking water still makes sense.

‘Very Local, Very Political’

And laws recently passed in Pennsylvania, Illinois, and California removed some of the financial barriers that made these kinds of municipal-to-private utility transactions difficult in the past.

Still, a for-profit water company must walk a very fine line when it buys a public water system to avoid triggering an intense political backlash. The idea of a town ceding control of its drinking water to a company still makes some people squeamish.

“There’s just something about water that gets everyone uneasy about selling their [utility],” said Ryan Wobbrock, a utilities industry analyst with Moody’s Investors Service. “Water is very local, very political.”

Prime Acquisition Targets

Unlike with gas or electric power, most Americans get their water from a utility that is owned and operated by their local government.

Private water companies serve less than one-fifth of the U.S. population, according to Chuck Firlotte, chief executive officer of Aquarion Water, which provides water to more than 600,000 people across New England. That’s very different from how water delivery works in the U.K. and the rest of Europe, where it’s operated by mostly private companies.

“One of the great mysteries to me is how, in the heart of global capitalism, we have a rather primitive view of how our infrastructure should be ... owned and operated,” Firlotte told Bloomberg BNA.

The prime acquisition target for these companies is a small, troubled water utility that serves just a couple hundred homes and businesses, according to Firlotte. For-profit firms can use their resources and expertise to eliminate inefficiencies in these small systems while accomplishing the companies’ ultimate goal of growing their customer base.

Companies like Firlotte’s are thriving within this niche market, with typical annual revenue growth hovering around 5 percent for most for-profit water firms, according to Bloomberg Terminal data.

“We hope to make advances in that area,” he said. These utilities “don’t have the operational, financial or engineering expertise and they usually have a boatload of investment needs and probably shouldn’t be in business.”

State Laws Changing

Chris Franklin, CEO of Aqua America, said he’s seeing more interest in doing a deal from these smaller utilities than at any time in his 24 years in the industry.

He attributes this uptick to four factors.

First, the Flint, Mich., lead contamination crisis spurred many local leaders to start asking more questions about how their water systems are run.

Second, many leaders realized that the cost of upgrading their water infrastructure has ballooned, Franklin said.

Third, they realized that the costs of complying with state and federal water quality regulations were becoming increasingly expensive and scientifically complex.

The fourth factor in this new wave of deals is the so-called fair value laws that have been enacted now in several states, Franklin said. These laws change the way for-profit water companies are allowed to raise their rates after making an acquisition.

‘Fair Value’

In states without a fair value law, companies can raise their customers’ rates only enough to recoup the value of the assets of the utility they’re purchasing. But with a fair value law, a water company can recoup the full amount of the price they paid to buy the utility. Essentially, fair value laws take into account the fact that most companies sell for more than the sum total of their assets in an acquisition.

Versions of fair value laws have passed in Pennsylvania, Illinois, and California and have been brought up in several others states.

These laws have the effect of allowing small, fiscally distressed towns to sell their water systems at a much higher price than they would otherwise be able to get, according to Franklin. In essence, he said, fair value laws can provide the final push these towns need.

“What’s happening now is that municipals are saying, ‘Why are we in this business?’” Franklin told Bloomberg BNA.

‘Financing Solution’

There are actually very good reasons for local governments to be in the water business, according to Mary Grant, a campaign director with environmental and consumer group Food & Water Watch.

For one, she told Bloomberg BNA, they have access to the tax-free municipal bond market and therefore can pass along those lower borrowing costs to their customers. This is crucial when considering the mammoth amounts many water utilities spend on capital expenses to maintain their infrastructure.

Also, Grant said, private companies are more likely to raise their customers’ rates than municipal-run systems with leaders who are either directly or indirectly accountable to voters. Private companies could save money on the margins by using economies of scale to operate more efficiently, but ratepayers ultimately will be footing the massive bill for infrastructure upgrades.

More federal spending—not privatization—is needed, according to Grant. “Private companies are offering a financing solution, not a funding solution,” she said.

‘Already Under-Investing’

It’s a familiar criticism for these companies, and one they’re particularly sensitive to. Dennis Doll, the CEO of mid-Atlantic based Middlesex Water, said it’s not totally inaccurate to say that for-profit companies often raise rates after taking over a municipal system. But, he said, that’s only because these systems were likely under political pressure to keep their rates artificially low.

“So they’re already under-investing,” Doll told Bloomberg BNA. “Then the private company comes in and they, unfortunately, have to charge the rates to make that investment. Sometimes there are ways to reduce operating costs,” but not always.

That’s why Doll is actually leery of fair value laws, a minority among the water company CEOs who spoke to Bloomberg BNA. He said he worries they create a perverse incentive because the laws make it easier for local governments to sell a dilapidated system at a higher price.

“The troubled municipal entity is getting a bit of a windfall above value despite the fact that they haven’t been keeping the system in good repair,” Doll said. “It can be a reward for bad behavior.”

Mandatory Consolidation

Ultimately, Doll said, for-profit companies should only step in when municipal water systems won’t, or can’t, raise rates high enough to keep their system in good shape—for example, in a town with a shrinking population where there aren’t enough ratepayers to cover a system’s costs.

A 2015 California law aimed at making this easier, SB 88, gives the state water board the authority to force a small, troubled utility to merge with a larger, healthier one nearby. The board hasn’t had to use this authority yet, according to Jack Hawks, head of the California Water Association, which represents for-profit water companies in the Golden State.

But soon many other states could find that they now also have this authority.

Language similar to that in SB 88 was inserted into a federal drinking water bill that cleared a key congressional committee earlier this summer. The bill, H.R. 3387, was approved on a voice vote in the House Energy and Commerce Committee.

Like SB 88 in California, the House bill would give the company acquiring a troubled system some flexibility in paying out any environmental penalties the system may have racked up before being purchased.

That would be a welcome development for private water companies, according to Kathy Pape, a former senior executive at American Water Works who is now an attorney at the Pennsylvania firm McNees Wallace & Nurick.

She said it’s often difficult for an acquiring company to grapple with decades of mismanagement immediately after getting handed the keys. That’s especially the case with for-profit companies, which often enjoy no leniency from regulators, she said.

“When they get their hands on a private party, now they believe they can clamp down,” Pape told Bloomberg BNA.

To contact the reporter on this story: David Schultz in Washington at dschultz@bna.com

To contact the editor responsible for this story: Rachael Daigle at rdaigle@bna.com

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