The late great Speaker of the House, Thomas "Tip" O'Neil, is fondly remembered for his famous line: "All politics is local".  Like politics, this country’s water supply is also very much a local issue.  The unique physical and economic characteristics of water, in contrast to other utilities, are what make water a local matter, and unfortunately, an easy item for local politicians to sweep under the rug.  Today, very little room remains under the proverbial rug and the historic political disregard for our nation’s water systems has created a fragmented landscape of small water utilities ripe for the picking.

Water: Unlike Other Utilities

Electric and gas utilities, particularly on the supply side, lend themselves to grand economies of scale and flexible input solutions.  For instance, if it’s a very hot day in Los Angeles and a cool low power demand day in Denver, additional electric power can immediately be sent over the grid to LA to meet its surging needs.  Similarly, if St. Louis is having a warm winter, but Pittsburgh is frigid, the greater need for natural gas heating fuel in Pittsburgh can quickly be accommodated through a national pipeline system.

Now consider the water utility system.  If California is undergoing drought conditions, it doesn’t much matter that Mississippi is experiencing floods.  With the exception of the very large and costly water transportation system in the arid southwest, mainly California, all water supply and delivery problems have to be solved at the local level.  This is mainly due to the fact that water carries an extremely low unit value when compared with “less-essential” commodities, and is therefore expensive to move over any significant distance.

Water and Politics Don’t Mix

With the understanding that water is indeed a local resource, it then follows that most water systems fall under the purview of local politicians.  The common tendencies of politicians, tendencies which steer their decisions, are to limit the perceived tax burden on their constituents, and above all, to get re-elected.  These political aspirations have historically caused municipalities to shirk their responsibility to properly manage and maintain the local water system –“Out of sight, out of mind”.   This situation is at the root of why our country’s water infrastructure is so dilapidated and in desperate need of rehabilitation.

To give you an idea of the magnitude of this massive problem, the EPA estimates for the funds required to bring our water infrastructure up to minimum standards would require a level of spending that is the single largest expenditure figure projected in our entire economy, except for defense spending and the estimates of what is required to “fix” the Social Security system. This is a huge looming expenditure, and a very big problem that simply will not go away, no matter how studiously the problem is ignored by our politicians.

For the purposes of this discussion “politician” shall refer to any single and/or group of elected officials overseeing the local water system, which might include the mayor of a small town, the board of a homeowner’s association-owned water system, a city or town council, an elected city manager, or perhaps the elected board of a quasi-municipal water district.  In short, a group of people who try to please as many people as possible, while sustaining a level of personal popularity – and an ability to get re-elected.

When looking at a water system through the prism of a local politician’s eyes, the annual decision process, as it relates to the water system, goes something like this:

1. We can raise water billing rates to provide the needed funds to make necessary system upgrades and repairs.

2. We can raise taxes, either through a direct tax or perhaps through a bond issue, to provide the funds necessary for the water system.

3. Or, we can postpone any decisions about the water system this year, and take a look at the problem again next year.

It doesn’t take a rocket scientist to figure out which option most politicians will select.  The same option they’ve been selecting for a very long time.

Most politicians will choose not to spend money on the water system when they can spend money on much more visible and popular projects.  They tend to feel that people won’t notice any decline in their water services, and often expect that if they do develop a serious water crisis, they will be bailed out by a higher level of government with deeper pockets.  These days the pockets are more or less empty all the way up the line, and so this course of thinking is no longer well founded, if it ever really was in the past.

And so it goes for the majority of the vast, but local, water infrastructure systems spread across our land.  Water system needs can either be financed through higher water bills or higher taxes, but politicians don’t like to do either, so they do nothing and each year the infrastructure gets older and falls into ever greater disrepair.

Common sense, however, dictates that option 3 (described above) cannot be selected forever.  Continued lack of action on the water system is not a perpetual option, and the need for investment in water systems does not go away simply because politicians have no backbone when in comes to raising the necessary funds to maintain them.  The need for water investment keeps inexorably increasing and tends to accelerate as the deterioration of these systems advance.

Fragmented and Desperate, yet Attractive

Of all the 260 million people served by community water systems in the U.S., only about 10-15% of that population is served by investor-owned utilities, and about two-thirds of that group is comprised of publicly traded companies.  The publicly-traded companies’ ownership of utility assets is steadily rising, and we shall soon see why.

The many thousands of water utilities range from the extremely small to a relatively few behemoths.  As a general rule, it is at the smaller end of the municipal group where most of the problems lie.  Indeed, for the vast majority of these smaller entities, they have now passed the point where their ability to access the capital markets or other financial resources is substantially exceeded by the cost of the needed repairs for their water system.  These small utilities are facing an intractable dilemma which is becoming ever-harder to ignore.

A look at the numbers will help define what is involved here:

According to the EPA, there are more than 53,000 community water systems in the United States serving approximately 260 million people.  A community water system is defined as water system that serves at least 15 service connections used by year-round residents or regularly serves at least 25 year-round residents.  The total number of water systems in the U.S. grows to an astounding 170,000 when you include non-community/transient systems such as those you might find connected to schools and universities, office buildings, military bases, and campgrounds.

Of the 53,000 community water systems, about 50% are privately owned, meaning that the assets of the system are owned by private individuals, groups, or businesses.  Although about half of the 53,000 systems are privately owned, most private systems are disproportionately small and altogether only serve between 10 and 15% of the population.  The remaining fifty percent of community water systems are owned by municipal entities, and these serve some 85% of the market.

Breaking down the number of community water systems by the size of the system, clearly shows that the overwhelmingly majority of the systems are very small.  In fact, more than half the systems serve less than 500 people, with another 25% of the systems serving between 500 and 3,300 customers.

There are only 514 municipal systems serving more than 100,000 people, and while members of this small group generally have enough ‘critical mass’ to have access to capital markets, most of the roughly 26,000 remaining small municipal systems face bleak prospects for financing their water system needs, and for that matter, many of the other 26,000 systems that are privately owned face the same problems.

Most of the 26,000 small municipal utilities that have suffered from the benign neglect of the local politicians will likely have to eventually confront the reality that they either must consolidate their system with others or privatize by selling their assets to an investor-owned water system, usually a publicly-traded water utility that has become the regional consolidator in each respective operating area.

If a small municipal utility chooses the option to consolidate, and assuming that option is available to them, it usually means combining their water system with other municipal systems in a contiguous geographic area, together creating the ‘critical mass’ that raises the prospects of the larger entity having access to either municipal and/or revenue bond financing or perhaps specific project financing.  In short, the Smith Village Water District is probably too small to realistically obtain financial help, but perhaps the Jones County Consolidated Water Authority will be large enough to get financial attention, while enjoying economies of scale such as lower wholesale water costs, more efficient billing and administrative features and more efficient management of system maintenance.

The privatization option usually emerges when all potential sources for obtaining any kind of financing for the small municipal system have been exhausted, and the consolidation option is not practical in their location for a host of possible reasons.  The purchase of a small community system by an investor-owned entity, particularly if it is a public company, is ironically a very attractive proposition for the buyer, even though the system being purchased may be in dire need of upgrading.  The key consideration here is the price paid to privatize the system.

Most customers of a community water system don’t really care who owns their system, they just want to have reliable water service at a reasonable price.  Few homeowners in an area take a ‘stakeholder’ interest in their water system, even though each household may technically “own” a piece of the system through their non-profit homeowner’s association or similar device.  Thus, they are not looking to get their “cost” out of the water system if it is sold.  Indeed, if they take any interest at all, they are far more likely to simply want to ensure that their water system meets regulatory standards and that problems with their water system do not begin to diminish local property values.

These conditions create a true buyer’s market for system purchasers.  This usually allows the purchaser to acquire a system, after acquisition costs and all necessary system repairs are accounted for, for a price that allows for a substantial and persistent return on investment from the point of view of the buyer.  And, for that matter, the constituents of the seller really don’t care, because they get their system upgraded and their service remains uninterrupted.  This is a pretty nice outcome for everyone involved after the transaction emerges from what started out as a very difficult situation for the small community owned system.

Problems Breed Opportunity

And so we find that the problems of our national water infrastructure system, often stemming from the benign neglect of local politicians, actually are creating very attractive opportunities for water industry investors. Indeed, within the public company sector of the water industry, the results show that the operating philosophy should be “The more acquisitions the better”, and this seems to be confirmed by the stock market itself.

The following is a table of the eleven domestic public water utilities that have been in business for the last 10 years.  The interesting thing about this table is the fact that those companies who have done a lot of acquisitions tend to lead the performance race and vice-versa.  The correlation between pace of acquisitions and stock performance is very high.  Indeed, until it was bought by a German company in 2003, the best performing utility by far was American Water Works and, sure enough, it was easily the most active acquirer, and in the process also became our largest publicly traded water company.  From a stockholder point of view, one would hope that the management of any utility would get this message and mount a more active acquisition program.

This is a Very Young Trend

An analysis of the fragmented market clearly tells an observer that the process of consolidation and privatization of U.S. water utility systems has a very long way to go.  Indeed, we are just in the early stages of what will inevitably prove to be a persistent and pervasive trend.  What other outcome can emerge?  Is it likely that the Federal and State governments will decide to come to the aid of these ailing small systems?  Is it reasonable to think that the psyche of local politicians across the land will undergo a metamorphosis, and they will confront these problems head on? Will the average water customer volunteer for, say, a quadrupling of their water bills?

Human nature changes a lot more slowly than our water system is becoming dilapidated, and thus we expect the consolidation trend to continue.

John Dickerson

Robert Anfuso

© 2005 John Dickerson
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