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Jacf Summer2011 Water Infrastructure D Haarmeyer

  1. 1. V O LU M E 2 3 | N U M B E R 3 | S U M MER 2 0 1 1Journal ofAPPLIED CORPORATE FINANCE A MO RG A N S TA N L E Y P U B L I C AT I O NIn This Issue: Infrastructure Financing and Public-Private PartnershipsCanada’s Budget Triumph 8 David R. Henderson, Naval Postgraduate School in Monterey and Hoover InstitutionRe-imagining Infrastructure 18 Mark Gerencser, Booz Allen HamiltonPrivatizing Waterworks: Learning from the French Experience 30 Steve H. Hanke, Johns Hopkins University, and Stephen J.K. Walters, Loyola University MarylandReflections on Private Water Supply: Agency and Equity Issues 36 Steve H. Hanke, Johns Hopkins University, and Stephen J.K. Walters, Loyola University MarylandA Fresh Look at U.S. Water and Wastewater Infrastructure: 41 David HaarmeyerThe Commercial and Environmentally Sustainable Path ForwardThe Upside to Fiscal Challenges: Innovative Partnerships 53 Martha Amram, WattzOn and The Milken Institute, andBetween Public and Private Sector Tabitha Crawford, President, Balfour Beatty Energy SolutionsInfrastructure Public-Private Partnerships: 60 J. Perry Offutt, James Runde, and Stacie D. Selinger,“Partnerships” Come to Fruition Morgan StanleyThe Role of Finance and Private Investment in 64 John Macomber, Harvard Business School andDeveloping Sustainable Cities BuildingVision, Inc.Energy Infrastructure Investment and the Rise of the Uncorporation 75 Larry E. Ribstein, University of Illinois College of LawWhy Financial Institutions Matter: 84 Conrad S. Ciccotello, Georgia State UniversityThe Case of Energy Infrastructure MLPsThe Future of U.S. Infrastructure: Proposals for Progress 92 Sadek Wahba, Morgan StanleyEnvironmental Finance: Innovating to Save the Planet 99 Franklin Allen, University of Pennsylvania’s Wharton School of Business, and Glenn Yago, Milken Institute
  2. 2. A Fresh Look at U.S. Water and Wastewater Infrastructure:The Commercial and Environmentally Sustainable Path Forwardby David Haarmeyer*“Water—by far the most valuable resource on this planet—is treated as if did nothave 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 sunkcosts of municipal and regional water departments.”– Peter Brabeck-Letmathe, Chairman of Nestle1“Constraints on a valuable resource should draw new investment and promptpolicies to increase productivity of demand and augment supply. However, for water,arguably one of the most constrained and valuable resources we have, thisdoes not seem to be happening.”– 2030 Water Resources Group2“With few exceptions, underinvestment in infrastructure has been a global secular trend.”– Citi Alternative Investments3 n most parts of the world, water is increasingly vation; and lack of environmental sustainability. I viewed as a critical economic resource—one whose preservation depends in part on finding ways to allow markets to establish its economic 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 stringentvalue and regulate its use. Water’s transformation into an standards, and the widening gap in the funds required toeconomic resource is a key pre-condition for moving the upgrade and expand the system. At the same time that suchindustry toward a more commercially and environmentally problems are being decried in the U.S., warnings of the threatsustainable basis. This is expected to bring about more respon- of growing water scarcity and stress are echoing louder andsible use of the resource and ensure greater accountability of louder from around the world. Helping to amplify theseorganizations that are charged with managing water infra- concerns is the fear that global climate change will exacerbatestructure. The payoff should be a significant strengthening of local water availability challenges.the industry’s ability to address four long-standing problems: Among the growing signs of global concern about waterinsufficient capital; industry fragmentation; paucity of inno- as a sustainable resource, here are a few telling indicators: * The National Association of Water Companies commissioned an earlier version of this 2. 2030 Water Resources Group, Charting Our Water Future, 2009, p. 4.paper. The author would like to thank Don Chew for his helpful editorial assistance. 3. Citi Alternative Investments, Investing in Developed Country Private Infrastructure 1. “Water as a Scarce Resource: An Interview with Nestlé’s Chairman,” McKinsey Funds, July 2008, p. 3.Quarterly, December 2009..Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011 41
  3. 3. Figure 1 Growth in Colorado Water Rights Investment Compared with Other Investment Asset Indexes (Maxwell, April 2010) 880 Gold Spot CRB Commodities S&P 599 440 S&P Developed REIT Colorado Water Rights Relative Scale 220 110 100 1989 1992 1995 1998 2000 2003 2005 Year Sources: CRB - Commodity Research Bureau, REIT, real estate investment trust; S&P- Standard & Poors. Values in 1989 normalized to equal 100. • Over the past 10 years, a number of world water infrastructure category presents the United States with greaterindexes have been launched (e.g., by Dow Jones, Bloomberg, challenges than water.”5Credit Suisse) to provide investors with exposure to compa- What these and other indicators suggest is that the trans-nies involved in the water industry. formation of water into an economic resource is at a tipping • The 2030 Water Resources Group (supported by point. This transformation can be expected to have major conse-McKinsey and the World Bank) predicts that by 2030 global quences for the U.S. water and wastewater sector, since it willwater demand will exceed the current accessible and reliable require organizations operating in the sector to become environ-supply by 40%. mentally as well as commercially sustainable. The U.S. industry, • Within the last 10 years, the price of water rights in to the extent it succeeds in shifting decision-making away fromarid regions has risen faster than any other commodity—and adversarial politics and toward rational economics, should be inan investment in Colorado water rights, for example, would a better position to address its long-running challenges.have outperformed other indexes over the past 10 years (see Across the world there is a multitude of models forFigure 1). organizing the industry, but none offers a panacea. One • According to the Bureau of Labor Statistics, the common denominator of the better performing private orrelative cost of water and wastewater treatment services has government-owned utilities is that they face a commercialrisen well above the general consumer price index since the imperative: operate financially and otherwise independentlymid-1980s.4 of the government. The Public Utilities Board of Singapore • A growing number of institutional investors such as and the Phnom Penh Water Supply Authority, both govern-CalPERS and the Norwegian Government Pension Fund want ment owned and operated, are commercially oriented and twoto see more disclosure about water-related risks of the compa- of the best performing utilities in the world.6 Australia’s waternies in which they invest. and wastewater utilities, which were recently ranked world • “Infrastructure 2010: Investment Imperative,” a study leaders in asset management, may be the most transparent inconducted by the Urban Land Institute and Ernst & Young, the world in terms of having to publish detailed operating,links the competitiveness of the U.S. to the state of its infra- service and financial data.7 Owned by the Australian statestructure and comes to the conclusion that “Perhaps no other governments, the utilities pay out sizable annual dividends 4. Steve Maxwell, “Historical Water Price Trends,” Journal American Water Works 6. “Is Private Water a Human Rights Violation?” Global Water Intelligence, MarchAssociation, April 2010. pp. 24-27. 11, 2010. 5. The Urban Land Institute and Ernst & Young, Infrastructure 2010: Investment 7. Water Services Association of Australia, WSAA Report Card 2008-2009: Perfor-Imperative, Washington, D.C., The Urban Land Institute, 2010, p. 42. mance of the Australian Water Industry and Projections for the Future, 2009.42 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011
  4. 4. Figure 2 U.S. EPA Estimated 20-Year Total Needs as their liabilities tail on their pension programes. They are of U.S. Public Water Systems perfectly suited for illiquid assets, whether its private equity or infrastructure, so it is almost a perfect fit. Total: $334.8 Billion Alan MacKay, Hermes GPE, 20118 Storage: Source: $36.9 $19.8 Other: One of the biggest long-standing problems faced by $2.3 the U.S. water sector is its need for capital to meet growing Treatment: 2009: $335 billion commitments to maintenance, improvements, and expan- $75.1 sion. Yet, while these needs stay unmet year after year, there Transmission & 2005: $277 billion is a growing pool of public and private capital held by insti- Distribution: $200.8 2002: $154 billion 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 Source: U.S. Environmental Protection Agency, 2007 Drinking Water Infrastructure is the most capital-intensive utility, which magnifies the Needs Survey and Assessment, March 2009. challenges in planning and executing capital programs. (over 60% of profits) to their owners. Water’s relative capital investment-to-revenue ratio is over As the U.S. industry moves toward operating on a more 3.5, almost twice that of the next highest utility, electricity, commercial and sustainable basis, accountability will become$335 billion where the ratio is 1.8. This means that a water utility must increasingly important. This means that water and waste- invest $3.50 for every dollar it expects to earn, as compared $277 billion water organizations will have to raise the bar in terms of to $1.80 for an electric utility. meeting obligations to customers, shareholders, and other$154 billion As shown in Figure 2, the latest EPA estimate of the stakeholders. The fundamental building blocks for ensuring 20-year total investment needs for public water systems is more accountable organizations are clear and transferrable over $344 billion. Key drivers of these capital requirements ownership in combination with effective and independent are maintenance, growth, and meeting stricter water quality regulation to promote transparency and competition. At standards. The latest EPA estimate has grown almost 120% present, neither of these can be said to characterize the U.S. since 2002, and points to chronic underinvestment, raising water and wastewater sectors, which suggests the difficulty concerns about service quality, safety, industry competitive- of the economic and political challenges ahead. ness, and the environment. This article highlights how the industry’s move to a more Local government-owned water and wastewater facilities commercial and environmentally sustainable basis will help generally rely on municipal tax-exempt debt to finance their to address its major challenges, including: capital needs. By taking advantage of credit support from city, • the investment challenge: matching the pool of public county, or state governments, they are able to gain AAA bond and private capital with the great U.S. water /wastewater ratings and thus access debt cheaply. This cheaper source of requirements capital tends to crowd out more expensive private capital and • the small systems challenge: consolidation and partner- lock municipalities into ownership of assets, discouraging ships competition. • the innovation challenge: stimulating new technolo- On the other hand, because of the recent recession, state gies, practices, and organizations and local government budgets are particularly constrained • the environmental sustainability challenge: full cost and their credit strength under pressure. According to the pricing and integrated water management. National Conference of State Legislatures (NCSL), states face While these are indeed significant challenges, the good a cumulative $280 billion of budget deficits from FY 2008 news is that the road map for the U.S. water and wastewater through FY 2011.9 Consequently, there is generally more industry to become more commercially and environmentally openness to alternative sources of capital. sustainable is becoming clearer. But if the needs gap for U.S. water and wastewater infrastructure has been steadily growing, international insti- The Investment Challenge: Matching the Pool tutional investors such as pension, endowment and sovereign of Public and Private Capital with the wealth funds (SWFs) with trillions of dollars of assets under Great U.S. Water/Wastewater Needs management are searching for attractive investments. Infra- “The great thing about pension and mutual fund clients is that structure is one of the growing new areas of focus for these they have liabilities that run from 50 to 70 to 90 years ahead investors, especially since the long-term investment life 8. “LP Profile: Alan MacKay, Hermes GPE,” AltAssets, June 28, 2011. 9. Annual Privatization Report, 2009, Reason Foundation, Los Angeles, CA, p. 32. Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011 43
  5. 5. Table 1 Select Pension Fund Investments in Infrastructure Institutional Investor Total Portfolio Assets Classification Target Allocation Investment Objective Range Alaska Permanent Fund Corporation US $3.4 billion Infrastructure 3% Hedge inflation risk California Public Employees’ US $2.07 billion Inflation-Linked 0-3% Enhance risk-adjusted returns; diversify Retirement System investments; hedge inflation risk Teachers’ Retirement System US $70.6 billion Real Assets 2-5% Diversification due to low or negative correlation of Texas 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 C$43 billion Infrastructure 20% Reliable returns linked to inflation Retirement System Caisse de dépôt de placement C$120.1 billion Infrastructure 5.5% Stable income flow that matches long-dated du Québec financial liabilities Alberta Investment Management C$68.9 billion Infrastructure 2% Tangible long-lived assets that provide essential Corporation services British Columbia Investment C$74.5 billion Infrastructure 4% Stable cash yields; tangible long-lived assets Management Corporation CPP Investment Board C$123.9 billion Infrastructure 5% Match inflation-linked liabilities BT Pension Scheme £31 billion Infrastructure 1% Enhanced risk adjusted returns (Hermes Private Equity) ABP (APG Investments) €208 billion Infrastructure 2% Inflation-linked investments Source: RBC Global Asset Management (U.S.) Inc., The Global Infrastructure Op-portunity, 2010.matches their liabilities.10 In addition, institutional investors 12 years before GPs must return capital plus profits to LPs. are attracted to infrastructure because of its ability to deliver Table 1 shows select participation in infrastructure funds by revenue streams that are stable, predictable, often inflation pension funds.linked, and long-term. And this is because, as monopolies or What is particularly noteworthy about these funds is thatquasi-monopolies, the demand for infrastructure services is they represent capital that is smart, engaged, and account-stable. Consequently, as Leo de Bever, CEO of Alberta Invest- able to capital providers. GPs will not be able to share in the ment Management Corp. has said, “The natural owner of profits, raise additional funds, or maintain a good reputa-an infrastructure asset is a pension or endowment fund that tion if they do not create value for their LPs. This provides a intends to hold the asset indefinitely.”11 Infrastructure may be powerful incentive for capital to be put to its most efficientan especially good fit for SWFs, which, unlike pension funds, use to the best interests of water consumers. Thus, these typesgenerally do not face redemption demands. Yngve Sylngstad, of new owners—infrastructure funds and active long-termCEO of Norway’s SWF, which is the second largest in the investors such as Warren Buffett’s Berkshire Hathaway—canworld with $462 billion in assets, noted that his fund has “a transform infrastructure by bringing not only much needed30-year horizon.”12 financing and operating expertise, but the governance that Infrastructure fund partnerships have emerged to take helps ensure high performance and good stewardship.advantage of the growing appetite of institutional investors Recognizing the valuable role these investors can play, for infrastructure investment and the growing global need the governments of Australia, Canada, the U.K., and otherfor long-term infrastructure financing, which the OECD countries have put in place legal structures to facilitate public-estimates at $40 trillion by 2030.13 General partners (GPs) private partnership structures that channel private (and publicof these funds raise capital from institutional investors who as in public pension fund) capital into transport, energy,become limited partners (LPs) in partnerships that last 7 to water, and telecom infrastructure facilities. 10. Angelo cites research showing that pension funds manage over $25 trillion in 11. Vyvyan Tenorio and Christine Idzelis, “Can Private Equity Play the Infrastructureassets, endowment assets are under $1 trillion, while insurance companies manage Game,” The Deal Magazine, April 3, 2009.between $1 and $2 trillion of assets. Enzo D’Angelo, “Limited Partners’ Perceptions and 12. Loch Adamson, “Going Mainstream,” Institutional Investor, September 2010.Management of Risk in Private Equity Investing,” Zell Center for Risk Research, 2009. 13. Organization for Economic Co-operation and Development, OECD Policy Brief:Preqin puts the total aggregate value of SWFs at $3.98 trillion. Preqin, “The Impact of Infrastructure to 2030, January 2008. http://www.oecd.org/dataoecd/24/1/39996026.Sovereign Wealth Funds in 2011, Private Equity Spotlight, March 2011. pdf.44 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011
  6. 6. Infrastructure funds and asset management groups are develop asset management plans that identify the level ofincreasingly targeting water infrastructure assets. Among investment required to maintain and improve capital assetsprominent examples: over five-year periods. Annual audits help ensure that planned • In October 2006, Hastings Funds Management Ltd., improvements are made. In March 2010, the industry an Australian infrastructure and alternative investment fund, announced plans to make record investments of $35 billion agreed to buy South East Water Ltd. (SEW), for $1.2 billion. in capital equipment, infrastructure and operational activitiesSEW is the U.K.’s second-largest water-only utility. Hastings over the next five years.14also owns U.K. water utility Mid Kent and Ballarat Water, Although asset management groups have acquired a fewwhich owns six water treatment plants in central Victoria, U.S. water companies, providing evidence of their commercialAustralia. viability and attractiveness, the pool of private investor-owned • In October 2006, Australian investment group and commercially viable private water utilities is limited. ForMacquarie led a consortium that purchased Thames Water for example, only about 12 percent of the country’s population is at £8 billion. Thames is the UK’s biggest water company. served by private water organizations, and there are only 10 • October 2006, a consortium that included Colonial publicly traded water company stocks (and no publicly tradedFirst State Global Asset Management (division of the wastewater company stocks). This suggests that fundamentalCommonwealth Bank of Australia), Canada Pension Plan, changes in ownership and financing arrangements will be3i Group, and others purchased AWG plc for £2.2 billion. required before the sector can truly take advantage of theAWG is one of the leading U.K. water companies serving smart and engaged capital waiting on the sidelines.approximately 6 million customers in the east of England.AWG also owns an unregulated business called Morrisons The Small Systems Challenge: ConsolidationGroup, which provides support services to the facilities and and Partnershipsutilities sectors in the U.K. The significant capital and operational improvement needs for • In October 2007, JP Morgan Infrastructure Invest- U.S. water and wastewater infrastructure are in large part ament Group led a consortium that announced its purchase function of the industry’s highly fragmented structure. Smallof Southern Water Capital Limited in a deal valued at £4.195 systems are less likely to have the financial, managerial, andbillion. SWC is the seventh largest water and sewer company technical capacity to meet regulatory requirements and arein the U.K. less likely to be under formal rate-setting processes that would • March 2010, JPMorgan Asset Management and Water help ensure services are fully funded. Thus, a more commer-Asset Management LLC announced its purchase of South- cially rational approach to the industry’s economics wouldwest Water Company for approximately $275 million. SWC remove barriers to consolidation to create more economicallyhas water utility and contract operations in California and viable water enterprises.other western states. In the U.S. there are some 54,000 community water • December 2010, the Carlyle Group announced its systems that supply drinking water and 16,000 wastewater purchase of Park Water, a family owned California-based treatment systems that provide sewer systems. Most utili-water utility. This marked the firm’s $1.5 billion infrastruc- ties are small, with over 90 percent of community drinking ture fund’s first investment in the water sector. water systems and over 70 percent of wastewater systems Increased transparency of operational and financial serving 10,000 people or fewer (see Figure 3). Compound-metrics is an important benefit that the participation of ing its economic disadvantages, the small, suboptimal scalemore engaged investors is expected to bring given their high of operations is likely to have high safety and environmentalstandards in due diligence and monitoring performance costs as well. For example, the majority of drinking watermetrics. At the same time, such investors tend to require clear, violations since 2004 have occurred at water systems serving stable, and fair regulatory frameworks, which are essential fewer than 20,000 residents.15in ensuring predictable cash flows over the investment life Competition and market forces tend to encourage consol-of the asset. idation of assets, which brings efficient operation through The U.K. regulatory system, for example, is renowned economies of scale. Larger operations enable firms to special-for providing users and investors with significant insight into ize in providing services at lower costs and spurs innovation.the operations and investment performance of each utility According to Moody’s, larger, investor-owned utilities canand how this compares across utilities, thus encouraging mitigate rate hikes “by applying significant capital costs “yardstick competition.” The regulator requires utilities to over a broader customer base.”16 Yet, in the water business 14. “Water Industry in UK Set for Record Investment Over Next Five Years,” Water- 16. “Moody’s Report Suggests U.S. Water Utility Consolidation Likely Soon,” U.S.world, March 3, 2010. Water News Online, July 2000. 15. Charelese Duhigg, “Millions in U.S. Drink Dirty Water, Records Show,” New YorkTimes, December 8, 2009.Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011 45
  7. 7. Figure 3 The U.S. Water Industry Remains Highly Fragmented and with Limited Investor Ownership Percentage of Drinking Water Systems and Population served by Size Class (Based on 51,988 total water systems in U.S.) 100% Systems Population Owner 90% Invested 16% 80% Public & 70% Other 84% 60% 50% Owner 40% Invested 2% 30% Public & Other 20% 98% 10% 0% < 500 501-3,300 3,301-10,000 10,001-100,000 > 100,000 System Size by Population Served Source: U.S. Environmental Protection Agency, Drinking and Ground Water Statis-tics, 2008.Table 2 Select Pension Fund Investments contrasts sharply with the nearly all private owned pattern in Infrastructure found in other utility sectors such as gas, telecom and electric. As shown in Table 2, investor owned water utilities make up only around one percent of the total market capitalization 6/30/05 of U.S. utilities. Thus, the majority of the country’s water Equity Market Capitalization and wastewater utilities face high barriers to ownership U.S. Electric Utilities (49 companies) $382.7 billion changes and consolidation, including the absence of access (e.g., Duke, Exelon) to the capital, valuation, or monitoring benefits that the stock U.S. Gas Utilities (28 companies) $ 68.8 market provides. (e.g., Laclede Gas, Atmos Energy) Providing an instructive contrast, the U.K’.s private water U.S. Water Utilities (11 companies) $5.5 industry provides insights into potential benefits of consolida- (e.g., Aqua America, California tion. Mergers are expected to bring efficiency and lower capital Water) costs, and thus potential reductions in customer bills. Total Equity Market Value $457.0 billion Take the case of Hastings Funds Management Ltd., the owner of the U.K. water company Mid Kent, which in 2006 Source: A.G. Edwards, Sept 2005, http://www.puc.idaho.gov/RELATEDSITES/ announced its purchase of U.K. water company South EastACCT/2005/21AM%20Krone%20NARUC%20Conf%202005.ppt Water Ltd. According to Paul Butler, managing director of Mid Kent, the merger has resulted in a number of importantespecially, assets are more difficult to buy and sell because the benefits:18vast majority are in the hands of municipalities, which have • There is now a single customer service center, control limited economic incentive to rationalize assets. For example, room, and head office where before there were two.almost 85 percent of all municipal drinking water systems are • Water resources planning and sharing can be accom-categorized as “small” (serving fewer than 3,300 people).17 plished much more efficiently across a larger geographic At the same time, only 16 percent of U.S. water systems space and organization, which was more difficult across twoand two percent of wastewater systems are investor-owned. separate legal entities.This low proportion of private investor-owned utilities • The larger combined company is now in a better 17. Steve Maxwell, “A Look at the Challenges—and Opportunities—in the World 18. “Merger of South East and Mid Kent Water Brought Benefits for Customers,” Util-Water Market,” Journal of American Water Association, May 2010, p. 112. ity Week, July 17, 2009.46 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011
  8. 8. Figure 4 The System Partnership Spectrum Increasing Transfer of Responsibility Informal Cooperation Contractual Assistance Joint Powers Agency Ownership Transfer 2005: $277 billion Work with other Requires a contract, but Creation of a new entity Takeover by existing or 2002: $154 billion systems, but without contract is under by several systems that newly created entity contractual obligations systems control continue to exist as independent entities Examples: Examples: Examples: Examples: . Sharing equipment . O&M . Shared system . Acquisition and . Sharing bulk supply . Engineering management physical interconnection purchases . Purchasing water . Shared operators . Acquisition and . Mutual aid . Shared source water satellite management arrangements . Transfer of privately- owned system to new or existing public entity Source: U.S. Environmental Protection Agency, Gaining Operational and ManagerialEfficiencies Through Water System Partnerships, October 2009.position to recruit for the full range of the skills necessary to studies that focused on a range of collaborative arrangementsrun any water company. from informal cooperation (e.g., sharing of equipment and These benefits were echoed by Thames chief executive mutual aid agreements) to ownership transfers (see FigureDavid Owens, when he claimed that if Thames were allowed 4). The partnerships offer a flexible means to address acuteto take over the water-only companies within its sewerage technical scarcities, raise capital, reduce capital and operatingfranchise, the savings it could make on head office overheads, costs, introduce full-cost pricing schemes (including meters),billing systems, operational call centers and other facilities and increase sustainability.could cut consumer tariffs by at least 5%.19 Moving toward a more commercially viable industry Meanwhile in the U.S., American Water, the largest will involve more consolidation and partnerships, which willinvestor-owned water utility, has been a consolidator. The be instrumental in transforming small water systems intocompany is composed of more than 350 individual water economically viable water enterprises. A key step in that direc-systems. In a 2010 presentation to NARUC, American tion will be to put municipalities on the same financial andWater’s then president Don Correll, commented that “access regulatory footing as private water companies by, for example,to capital is more important than ever” and thus “business removing the federal tax subsidies provided in the form ofcombinations that promote access to capital at cost-effective tax-exempt financing to government-owned entities.rates should be encouraged.” One important lesson learnedfrom the company’s consolidation and merger involvement Innovation Challenge: Stimulating New Technologies,is that “water is local” and that “customer service and stake- Practices, and Organizationsholder involvement are key.”20 The U.S. water and wastewater sectors face tremendous invest- Besides fundamental institutional changes that would ment, operational, and organizational challenges to meetfacilitate changes in ownership to spur consolidation of consumers’ needs now and in the future. Taken broadly, inno-small private and municipal systems, there is likely to be an vation is often a key factor in how organizations and industriesincreasing reliance on partnerships for sharing resources and manage not only to address growing challenges with fewerexpertise. In October 2009, the EPA published a report called resources, but to leapfrog existing practices, services, and tech-“Gaining Operational and Managerial Efficiencies Through nologies. For example, innovation in the electric utility sectorWater System Partnerships” that identified a number of case is helping to drive down the cost of wind and solar power, thus 19. “Thames Re-Opens Consolidation Debate,” Global Water Intelligence, July 20. Don Correll, President and CEO, American Water, “American Water: Looking2009. Ahead,” National Association of Regulated Utility Commissioners Winter Committee Meetings, Washington, DC, February 16, 2010.Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011 47
  9. 9. enabling a more cost-efficient, environmentally friendly source expenditure solutions and against R&D by providing insuf-of electric power. Similarly, in the natural gas industry, small ficient rewards for the latter.22independent gas drilling companies recently pioneered new The good news, however, is that innovation takes place notoilfield techniques that are unlocking vast tracts of gas-bear- only in the form of valuable changes in products, processes,ing shale, and in the process changing the U.S. from a major and services, but also in changes in organizational forms andimporter of oil to the world’s largest producer.21 practices. For example, a key institutional change in utility Lack of competition and the locked-in nature in the economics was the introduction of public-private partnershipsownership of water and wastewater assets has served to such as leases and concession contracts. These contractualdiscourage normal operation of market forces that encourage innovations introduced competition to monopoly servicescompanies and individuals to transform challenges into profit and provided greater flexibility for private-sector providersopportunities that can be captured by innovating, “thinking to meet the needs of the public sector. Similarly, markets foroutside the box.” Both rate-of-return regulation of investor- trading water rights—an old concept but one that has becomeowned utilities and widespread government ownership of more attractive with technological advances—is growing asutilities have the effect of suppressing the valuable signal water becomes increasingly scarce.that profits can play in fostering innovation and creativity O&M, Design-Build contracts, concessions, and other in the sector. service and construction contracts provide an opportunity for In the U.K., England and Wales offer a good case study the industry to take advantage of competition and its abilityof the benefits of transforming publicly owned water authori- to draw out innovative and cost-effective solutions. Whenties into private water companies with the help of innovative a number of leading firms go head-to-head for the right toregulation. For example, since 1989 when ten multipur- provide multiyear services, they tend to sharpen their pencilspose investor-owned water companies were created through and think hard about how to provide the highest level ofprivatization, the government has focused on minimizing service at the lowest cost. The efficacy of this process has beenthe heavy hand of regulation and leveraging competition by demonstrated by a winning contractor’s ability generally toimplementing the following: come in 10-20 percent below existing costs.23 • Price cap regulation (RPI - X) that sets price limits over Private contractors can also be the source of innovativea five-year price control cycle and enables utilities to profit new services. Veolia, one of the bigger global water and energyfrom increasing efficiency contract operators, recently initiated a new service to measure • Yardstick competition and regulatory benchmarking in the water and carbon footprint for the city of Milwaukee.which regulators compare utility performance across a range It presently manages the city’s wastewater treatment plant. of benchmarks and companies are rewarded or penalized Veolia’s Water Impact Index is an innovative service that accordingly, and best practices are widely shared provides a comprehensive assessment of the impact of human • Capital market competition in which investors’ assess- activity on water and energy resources. By making possible thements of company performance are reflected in relative share evaluation of a project’s impact on the city’s water and carbonprices footprint, use of the Index can help ensure that decisions are • Common carriage opportunities in which individual consistent with sustainability.24water company networks can be accessed by third parties to Desalination is another area where innovation is playingprovide water services. a critical role, given the opportunity for the private sector to This regulatory framework has helped attract capital compete in meeting the growing need for drinking water into the industry and establish a competitive industry that arid environments. For example, Pike Research forecasts that, competes globally in providing water and wastewater services. over the period from 2010 to 2016, worldwide new investment But despite such progress, price controls continue to limit in desalination plants is expected to total about $88 billion.25innovation, as can be seen in an R&D “intensity” (R&D as Private companies are competing to lower the costs of desali-a percentage of sales) for water companies that is less than one nation not only through the use of membrane technology, buthalf of one percent (as compared to an average of 2 percent also through project delivery models that involve integrationacross all U.K. industry). And as the U.K. Council for Science of engineering, procurement, and construction.and Technology (among many others) has concluded, the Outside the sphere of regulated utilities, where compe-regulatory regime creates a bias towards short-term capital tition and profit opportunities are clearly limited, there 21. In 2009, the U.S. overtook Russia to become the world’s largest producer of 24. “Veolia Water Introduces Water Impact Index as Part of First-Ever Water Carbonnatural gas. BP Statistical Review of World Energy, June 2011. Footprint Study,” Business Wire, July 19, 2010. 22. U.K. Council for Science and Technology, Improving Innovation in the Water In- 25. Pike Research, “Desalination Plants to Attract $87.8 Billion in Investment bydustry 21st Century Challenges and Opportunities, March 2009. 2016,” December 20, 2010. 23. See Paul Seidenstat, David Haarmeyer, and Simon Hakim, Reinventing Waterand Wastewater Systems: Global Lessons for Improving Water Management, John Wi-ley & Sons Inc., 2002.48 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011
  10. 10. is a revolution underway to measure and use water more water and wastewater organizations that are accountable toefficiently. Among notable examples, customers, shareholders and stakeholders (including regula- • General Electric, through its Ecomagination program, tors) must operate under principles of commercial andexpects to double its R&D spending to $1.5 billion by 2010 environmental sustainability. For example, water should beand reduce its water usage by 20% by 2012.26 priced to reflect its true costs to encourage conservation, to • IBM, which has been involved in the development of pay for infrastructure upgrades, and to stimulate new supplies.the smart grid for electric power and smart traffic technolo- Adaptive organizations that operate according to these princi-gies, announced in March 2009 that it was entering “smart ples will be better able to respond to future environmental andwater” business with introduction of services and products business risks such as climate change.that monitor waterworks such as pipes, reservoirs, rivers and As a precious environmental resource and vital neces-harbors. sity for human life, water’s sustainability depends on it being • Dow Chemical has identified potential water savings valued properly and subject to integrated holistic manage-in everything from elimination of steam leaks to reuse of high- ment approaches that take in its full life cycle. The revolutionquality effluent streams and alternative cooling techniques. in water measurement and use discussed above indicates howUsing seawater cooling for its largest manufacturing site in the private marketplace can be organized and coordinatedFreeport, Texas has helped the company avoid more than $35 to advance sustainability. Competition, the need to earnmillion in capital spending. profits, as well as the value of a good reputation in both the • Coca-Cola is also focusing on water, aiming to marketplace and community, provide businesses with strongimprove efficiency by 20 percent by 2012, as compared with incentives to search for ways to minimize their economic and2004. Although the company’s water usage is expected to social costs, such as conserving water resources and lookingincrease, its objective is to eliminate about 50 billion liters for substitute resources.of that increase in 2012 and so avoid $150 million in water Private water utilities and O&M contractors have been acquisition treatment and discharge costs between 2008 and pioneers in environmental stewardship of water resources, in2011.27 large part since their livelihood depends on the sustainability This dynamism is important and should positively impact of the water cycle and economic pricing of their services tothe water utility business. The problem is that much of it ensure efficient water use and ability to provide necessaryis occurring outside the industry. For a real step-change to infrastructure. Mark Strauss of American Water has explainedoccur, innovation needs to occur inside the industry—at that private water utilities are well-placed to practice “total the core of the water and wastewater business organizations, water management” by harnessing the synergies betweenmodels, and practices. At minimum, this will require opening potable water and wastewater management. Water pouredup the industry to more competition and private capital. A down drains, Strauss says, can be treated and reused for golffurther big step would be to change the regulatory framework courses, heating-cooling and flush systems, thereby conserv-to enable water and wastewater firms to invest in new, more ing a city’s precious ground-water resource for drinking.”29efficient technology that has a longer payoff. What are some of the important concepts and principles around sustainability that would offer a more integrated andThe Environmental Sustainability Challenge: Full-Cost holistic view of water management? In 2008-2009, the Aspen Pricing and Integrative Water Management Institute brought together key stakeholders in the U.S. water “Charging less than it costs to deliver a safe, reliable water community for a “Dialogue on Sustainable Water Infrastruc-supply is neither good business nor good public policy.” ture.”30 Among the report’s high-level recommendations and Richard G. Little, Director, Keston Institute for Public principles are the following:Finance and Infrastructure Policy, University of Southern • “Water infrastructure” should be redefined to include California28 both physical water infrastructure and the natural water- shed to provide a more integrated, holistic and helpful way Sustainability is now a part of water resource development of thinking about sustainability.and management. Wise resource use today should help ensure • Water utilities should lead in building partnerships that that future generations have access and water use opportuni- use integrated water resource planning and management toties that are comparable to those we now enjoy. By definition, meet human and ecosystem needs. 26. Jon Freedman, “General Electric, Water & Process Technology,” Water Summit Street Journal, Letter to the Editor, June 27, 2008.Chamber Commerce, March 18 2010. 29. Mark Strauss, “Partnering to Build Better Infrastructure,” Water & Wastes Digest, 27. Sarah Murray, “Credentials that Make Money-Men Happy,” Financial Times, October 7, 2007.March 16, 2009. 30. The Aspen Institute, Sustainable Water Systems: Step One—Redefining the 28. Richard G. Little, “It Costs Real Money to Run Municipal Water Systems,” Wall Nation’s Infrastructure Challenge, Energy and Environment Program, 2009.Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011 49
  11. 11. Table 3 Average Tariffs ($/m3) and Water Usage in Some Major Countries 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 Source: “Water Tariffs Continue Upward Momentum,” Global Water Intelligence, Sep-tember 2010. • Federal, state, and local governments should address in arid regions such as Australian’s Murray Darling Basin andinstitutional practices that act as barriers to sustainable water New Mexico’s Middle Rio Grande River, raw water prices resource management. have increased by more than 10% per year.31 • Utilities and regulators should ensure that the price of Like other commodities, water prices have been on the water services fairly charges ratepayers or customers the total upswing. NUS Consulting annual international water surveycost of meeting service and sustainable water infrastructure showed that the average price of water in the United Statesrequirements. soared by 7.3 percent during the year ending July 1, 2008. The participants in the dialogue emphasized that assign- More recently, Global Water Intelligence’s annual survey32ing responsibility and using economic concepts such as released September 2010 showed a 9.7 percent increase, which full-cost pricing are important first principles. Moreover, it was at the high end compared with other countries (see Table was acknowledged that given their position near the center 3). Finally, Bureau of Labor Statistics data collected by water of the water cycle, water utilities have an important role to economist Janice Beecher show that the relative cost of waterplay in advancing sustainability. and wastewater treatment services have risen well above the By most measures, the price of water is beginning general consumer price index since the mid-1980s and been to reflect its true costs. This is a sign that water’s scarcity among the top three utility services exhibiting the greatestvalue has increased to the point where it is finally becom- price inflation (see Figure 5).33ing accepted as economic good. Across the globe, organized As discussed earlier, private companies such as GE and markets for tradable water rights have started to emerge as a IBM as well as contractors like Veolia are offering innovative means to allocate scarce water resources more efficiently. And new processes and services to measure water consumption 31. Steve Maxwell, “Historical Water Price Trends,” Journal American Water Works 33. Janice A. Beecher, “Trends in Consumer Prices (CPI) for Utilities Through 2010,”Association, April 2010. pp. 24-27. Institute of Public Utilities Regulatory Research and Education, Michigan State Univer- 32. “Water Tariffs Continue Upward Momentum,” Global Water Intelligence, Sep- sity, February 2011.tember 2010.50 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011
  12. 12. Figure 5 Trends in the Consumer Price Index for Utilities (1979-2010) Trends in Consumer Prices (CPI) for Utilities 400 Garbage (1985) Water & sewer (1953) 360 Cable/sat. television (1984) 320 Fuels (1935) Local phone (1978) 280 Postage (1935) CPI (1913, 1983=100) 240 Electricity (1913) 200 Natural gas (1935) CPI (1997=100) 160 Tel. services (1997=100) Landline intrastate (1978) 120 Internet (1997=100) 80 Wireless (1997=100) Landline interstate (1978) 40 1978 2000 2002 2004 2006 2008 2010 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 Source: Janice A. Beecher, “Trends in Consumer Prices (CPI) for Utilities Through2010,” Institute of Public Utilities Regulatory Research and Education, Michigan StateUniversity, 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.and impacts. By providing better and timelier information The promise of tomorrow’s water and wastewater industryon the quality and quantity of water, these commercially to become both commercially and environmentally sustain-and financially accountable organizations can help to ensure able is reflected in Warren Buffett’s remark about his passionthat the sector is more resilient and capable of adapting to for investing in energy infrastructure assets. There is nochange, thus advancing sustainability. Moreover, increasing obvious reason why an engaged investor like Buffett, who isthe scale of water company operations and customer bases a shareholder of the water filtration company, Nalco Holding,should enable them to become more commercially and would not want to invest in the stable and predictable revenueenvironmentally sustainable by becoming accountable for streams of well-run water utilities. The participation of theseentire watersheds. kinds of investors as well as an increase in public-private partnerships would also go a long way to address the country’sConclusion challenge with small systems.“Charlie and I are equally enthusiastic about our utility busi- The promise of a more vibrant commercially orientedness, which had record earnings last year and is poised for industry is reflected in the innovation presently beingfuture gains. . . I love it when they [our utility managers] unleashed by firms outside the sector such as IBM, GE, Nestle, come up with new projects because in this capital-intensive and Coca-Cola, which see significant profit opportunities inbusiness these ventures are often large. Such projects offer water’s transformation into an economic resource. The need forBerkshire the opportunity to put out substantial sums at innovation and new thinking is particularly important insidedecent returns.” the industry, where new practices, technologies, processes, and Warren Buffett, Berkshire Hathaway34 organizational structures could make the biggest difference. 34. Warren Buffett, Berkshire Hathaway Inc., Annual Letter to Shareholders 2008,p. 4.Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011 51
  13. 13. Exposure to competition, private capital, and the ability to to commercial and environmental sustainability. To ensure earn reasonable profits will be important catalysts. that it arrives at the destination of accountability to all its More and smarter (more accountable) capital, stronger stakeholders will require increased political and economicsmall systems, and a more innovative industry will all work to engagement to address the thorny issues of ownership, regula-increase environmental sustainability. Commercial viability tion, and competition.requires full-cost pricing and ensuring a good reputation withcommunity, regulators, and other stakeholders means takinga long-term holistic view of water development and manage- david haarmeyer is an independent, Boston-based consultant andment. More accountable and adaptable water and wastewater writer who focuses on private equity and infrastructure. He contributedorganizations are also the best defense for addressing future the article “The Revolution in Active Investing: Creating Wealth and Betterrisks such as climate change. and Better Governance” to the Winter 2007 issue of this journal. He can In achieving the status of an economic resource, water is be reached at dhaarmeyer@gmail.com.passing a key milestone that has put the industry on the road52 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011
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