1. V O LU M E 2 3 | N U M B E R 3 | S U M MER 2 0 1 1
Journal of
APPLIED CORPORATE FINANCE
A MO RG A N S TA N L E Y P U B L I C AT 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: 41 David Haarmeyer
The Commercial and Environmentally Sustainable Path Forward
The Upside to Fiscal Challenges: Innovative Partnerships 53 Martha Amram, WattzOn and The Milken Institute, and
Between Public and Private Sector Tabitha Crawford, President, Balfour Beatty Energy Solutions
Infrastructure Public-Private Partnerships: 60 J. Perry Offutt, James Runde, and Stacie D. Selinger,
“Partnerships” Come to Fruition Morgan Stanley
The Role of Finance and Private Investment in 64 John Macomber, Harvard Business School and
Developing Sustainable Cities 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: 84 Conrad S. Ciccotello, Georgia State University
The Case of Energy Infrastructure MLPs
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
2. A Fresh Look at U.S. Water and Wastewater Infrastructure:
The Commercial and Environmentally Sustainable Path Forward
by David Haarmeyer*
“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
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 stringent
value and regulate its use. Water’s transformation into an standards, and the widening gap in the funds required to
economic resource is a key pre-condition for moving the upgrade and expand the system. At the same time that such
industry toward a more commercially and environmentally problems are being decried in the U.S., warnings of the threat
sustainable basis. This is expected to bring about more respon- of growing water scarcity and stress are echoing louder and
sible use of the resource and ensure greater accountability of louder from around the world. Helping to amplify these
organizations that are charged with managing water infra- concerns is the fear that global climate change will exacerbate
structure. 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 water
insufficient 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. 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 greater
indexes have been launched (e.g., by Dow Jones, Bloomberg, challenges than water.”5
Credit 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 will
water 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 from
arid regions has risen faster than any other commodity—and adversarial politics and toward rational economics, should be in
an 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 for
Figure 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 or
relative cost of water and wastewater treatment services has government-owned utilities is that they face a commercial
risen well above the general consumer price index since the imperative: operate financially and otherwise independently
mid-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 two
to see more disclosure about water-related risks of the compa- of the best performing utilities in the world.6 Australia’s water
nies 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 in
conducted 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 state
structure 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, March
Association, 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. 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. 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 that
quasi-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 efficient
an especially good fit for SWFs, which, unlike pension funds, use to the best interests of water consumers. Thus, these types
generally do not face redemption demands. Yngve Sylngstad, of new owners—infrastructure funds and active long-term
CEO of Norway’s SWF, which is the second largest in the investors such as Warren Buffett’s Berkshire Hathaway—can
world with $462 billion in assets, noted that his fund has “a transform infrastructure by bringing not only much needed
30-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 other
for 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 public
of 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 Infrastructure
assets, 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. Infrastructure funds and asset management groups are develop asset management plans that identify the level of
increasingly targeting water infrastructure assets. Among investment required to maintain and improve capital assets
prominent 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 activities
SEW is the U.K.’s second-largest water-only utility. Hastings over the next five years.14
also owns U.K. water utility Mid Kent and Ballarat Water, Although asset management groups have acquired a few
which owns six water treatment plants in central Victoria, U.S. water companies, providing evidence of their commercial
Australia. viability and attractiveness, the pool of private investor-owned
• In October 2006, Australian investment group and commercially viable private water utilities is limited. For
Macquarie 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 traded
First State Global Asset Management (division of the wastewater company stocks). This suggests that fundamental
Commonwealth Bank of Australia), Canada Pension Plan, changes in ownership and financing arrangements will be
3i Group, and others purchased AWG plc for £2.2 billion. required before the sector can truly take advantage of the
AWG 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: Consolidation
Group, which provides support services to the facilities and and Partnerships
utilities 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 a
ment Group led a consortium that announced its purchase function of the industry’s highly fragmented structure. Small
of Southern Water Capital Limited in a deal valued at £4.195 systems are less likely to have the financial, managerial, and
billion. SWC is the seventh largest water and sewer company technical capacity to meet regulatory requirements and are
in 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 would
west Water Company for approximately $275 million. SWC remove barriers to consolidation to create more economically
has 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 scale
more engaged investors is expected to bring given their high of operations is likely to have high safety and environmental
standards in due diligence and monitoring performance costs as well. For example, the majority of drinking water
metrics. 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.15
in 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 can
and 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 York
Times, December 8, 2009.
Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011 45
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 East
ACCT/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 important
especially, assets are more difficult to buy and sell because the benefits:18
vast 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 two
and 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. 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 system's 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 Managerial
Efficiencies 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 arrangements
run 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 Figure
David Owens, when he claimed that if Thames were allowed 4). The partnerships offer a flexible means to address acute
to take over the water-only companies within its sewerage technical scarcities, raise capital, reduce capital and operating
franchise, 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 will
investor-owned water utility, has been a consolidator. The be instrumental in transforming small water systems into
company 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 and
Water’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 of
combinations that promote access to capital at cost-effective tax-exempt financing to government-owned entities.
rates should be encouraged.” One important lesson learned
from 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 Organizations
holder 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 meet
facilitate 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 industries
increasing reliance on partnerships for sharing resources and manage not only to address growing challenges with fewer
expertise. 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 sector
Water 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: Looking
2009. 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. 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.22
independent gas drilling companies recently pioneered new The good news, however, is that innovation takes place not
oilfield 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 and
importer 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 partnerships
ownership of water and wastewater assets has served to such as leases and concession contracts. These contractual
discourage normal operation of market forces that encourage innovations introduced competition to monopoly services
companies and individuals to transform challenges into profit and provided greater flexibility for private-sector providers
opportunities that can be captured by innovating, “thinking to meet the needs of the public sector. Similarly, markets for
outside the box.” Both rate-of-return regulation of investor- trading water rights—an old concept but one that has become
owned utilities and widespread government ownership of more attractive with technological advances—is growing as
utilities 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 ability
of the benefits of transforming publicly owned water authori- to draw out innovative and cost-effective solutions. When
ties into private water companies with the help of innovative a number of leading firms go head-to-head for the right to
regulation. For example, since 1989 when ten multipur- provide multiyear services, they tend to sharpen their pencils
pose investor-owned water companies were created through and think hard about how to provide the highest level of
privatization, the government has focused on minimizing service at the lowest cost. The efficacy of this process has been
the heavy hand of regulation and leveraging competition by demonstrated by a winning contractor’s ability generally to
implementing 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 innovative
a five-year price control cycle and enables utilities to profit new services. Veolia, one of the bigger global water and energy
from 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 the
ments of company performance are reflected in relative share evaluation of a project’s impact on the city’s water and carbon
prices footprint, use of the Index can help ensure that decisions are
• Common carriage opportunities in which individual consistent with sustainability.24
water company networks can be accessed by third parties to Desalination is another area where innovation is playing
provide 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 in
to 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.25
innovation, 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, but
half of one percent (as compared to an average of 2 percent also through project delivery models that involve integration
across 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 Carbon
natural 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 by
dustry 21st Century Challenges and Opportunities, March 2009. 2016,” December 20, 2010.
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.
48 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011
10. is a revolution underway to measure and use water more water and wastewater organizations that are accountable to
efficiently. Among notable examples, customers, shareholders and stakeholders (including regula-
• General Electric, through its Ecomagination program, tors) must operate under principles of commercial and
expects to double its R&D spending to $1.5 billion by 2010 environmental sustainability. For example, water should be
and 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 and
water” 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 revolution
quality effluent streams and alternative cooling techniques. in water measurement and use discussed above indicates how
Using seawater cooling for its largest manufacturing site in the private marketplace can be organized and coordinated
Freeport, Texas has helped the company avoid more than $35 to advance sustainability. Competition, the need to earn
million 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 strong
improve efficiency by 20 percent by 2012, as compared with incentives to search for ways to minimize their economic and
2004. Although the company’s water usage is expected to social costs, such as conserving water resources and looking
increase, 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, in
2011.27 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 to
the water utility business. The problem is that much of it ensure efficient water use and ability to provide necessary
is occurring outside the industry. For a real step-change to infrastructure. Mark Strauss of American Water has explained
occur, 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 between
models, and practices. At minimum, this will require opening potable water and wastewater management. Water poured
up the industry to more competition and private capital. A down drains, Strauss says, can be treated and reused for golf
further 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.”29
efficient technology that has a longer payoff. What are some of the important concepts and principles
around sustainability that would offer a more integrated and
The 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 to
ties 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. 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 and
institutional 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 survey
cost of meeting service and sustainable water infrastructure showed that the average price of water in the United States
requirements. 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 survey32
ing 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 water
play 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 greatest
value has increased to the point where it is finally becom- price inflation (see Figure 5).33
ing 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. 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 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.
and impacts. By providing better and timelier information The promise of tomorrow’s water and wastewater industry
on 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 passion
that the sector is more resilient and capable of adapting to for investing in energy infrastructure assets. There is no
change, thus advancing sustainability. Moreover, increasing obvious reason why an engaged investor like Buffett, who is
the 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 revenue
environmentally sustainable by becoming accountable for streams of well-run water utilities. The participation of these
entire watersheds. kinds of investors as well as an increase in public-private
partnerships would also go a long way to address the country’s
Conclusion challenge with small systems.
“Charlie and I are equally enthusiastic about our utility busi- The promise of a more vibrant commercially oriented
ness, which had record earnings last year and is poised for industry is reflected in the innovation presently being
future 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 in
business these ventures are often large. Such projects offer water’s transformation into an economic resource. The need for
Berkshire the opportunity to put out substantial sums at innovation and new thinking is particularly important inside
decent 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. 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 economic
small 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 with
community, regulators, and other stakeholders means taking
a long-term holistic view of water development and manage- david haarmeyer is an independent, Boston-based consultant and
ment. More accountable and adaptable water and wastewater writer who focuses on private equity and infrastructure. He contributed
organizations are also the best defense for addressing future the article “The Revolution in Active Investing: Creating Wealth and Better
risks 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 road
52 Journal of Applied Corporate Finance • Volume 23 Number 3 A Morgan Stanley Publication • Summer 2011
