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The Business Differences Of

For-Profit

Versus

Not-For-Profit

Water And Sewer Utilities

Follow The $$ Money $$

Introduction

This is about economics and financial management - a topic that makes many people's eyes glaze over.  But, fear not.  Our objective is to keep it simple and easy to understand.  

 

The cost differences between a for-profit and a non-profit water or sewer utility are dramatic.  These differences are the very reason that rates go up sharply when a for-profit utility purchases a non-profit one.  If your non-profit system is the target of a buy out, understanding the differences will help you evaluate a purchase offer and lead to asking key questions about how you will be impacted.  

 

The topics addressed are:

 

#1 - The non-profit municipal utility business. 

 

#2 - Why would a municipal system want to sell? 

 

#3 - The for-profit Big Water business. 

 

#4 - The cost structure of a for-profit utility. 

 

#5 - The cost structure for a non-profit utility. 

 

#6 - What happens to customers when their non-profit is bought out.

 

#7 - Estimating rate increases. 

 

#8 - What if major system improvements are needed? 

#9 - A less costly alternative to selling

 

#10 - Who pays interest costs? 

Municipalities In The Water And Sewer Utility Business

Should a local government provide water and sewer service?  We think so.  It is a common need fulfilled in a very cost effective way.  The Big Water companies will claim that this kind of thing should be left to the “pros” – i.e. themselves.  This is developed further here: (LINK

 

Reading on you will find that the cost structure for a municipal utility strongly favors cost efficient operation of these services. 

??? So Why Sell A Municipal Utility ???

Good question.  There are two major reasons that are offered repeatedly.  We do not think either one is valid.  They both apply the old axiom of follow the money.  Here are the claims:

We get a huge sum of cash – FREE CASH, that can be used for all sorts of good causes in our community.  This is addressed here: (LINK).  But, there is no free lunch.  The customer will be paying.  But, local politicians can be seduced by the large sums of money being offered.

The system is falling apart and we cannot afford the repairs.  Those repairs would require large rate increases.  We have to sell.  Are those repairs really needed?  They may not be.  It might be a contrived reason for selling.  This is developed in more detail here: (LINK).

Or, those repairs may really be needed.  Then, yes, a rate increase may be needed.  However, the reality is that when those repairs are made by Big Water, the rate increase will be larger, much larger. 

There are also good reasons that a water or sewer utility should NOT be sold.  A key one is that there is a cheaper alternative available:  Raise the same amount of money via a bond.  That is developed in detail here: (LINK).

Why Big Water Wants To Buy Municipal Utilities

This is a simple case of follow the money.  Business success is driven by growing profits.  Water and sewer utilities are not businesses where you can run an advertising campaign to attract new customers.  It is a very slow growth business in that regard.  Their solution to that problem is to acquire existing municipal systems.  This is covered in more detail here: (LINK) and here (LINK). 

For-Profit Cost Structure

The for-profit utility is pretty much a standard business financial cost structure.  A very large part of the costs are driven by the investment in facilities.  In the regulatory world, this investment is called the “rate base”.  It is essentially all the money spent on plants, pipes, equipment and any other permanent facilities. 

 

The major costs for running a Big Water business are:

 

Operating Cost –This is all the people, supplies, customer service and all the other things necessary to run and maintain a system on a day to day basis.  For Big Water in Pennsylvania, about 25% of your water or sewer bill goes to operating cost. 

 

Depreciation – This is essentially the cost for “wearing out” the physical facilities as they are used.  It definitely is a cost that for-profit utilities charge to their customers.  Depreciation is driven by the rate base and usually runs in the range of 2% - 4% of the company’s rate base.  From the customer’s perspective, about 20% of our water or sewer bill goes to depreciation.  There is a detailed discussion of depreciation here (LINK). 

 

Let’s illustrate depreciation with a car analogy.  Assume you buy a car for $40,000 and will drive it 100,000 miles at which point it will be kaput – totally worn out and unusable.  For every 1,000 miles you drive that car, 1% of the original purchase price or $400 will be “used up”.  For personal use of a car we never even think about that.  Personal use is a “non-profit” operation.  But if you were in business for yourself driving that car doing meter reading for a water utility, you need to charge enough for your services to recover that cost and be able to buy a new car when the old one wears out.  The car “depreciates” as you drive it reading meters and you need to get paid for that depreciation cost. 

 

Interest Cost –Large for-profit utilities have sophisticated management of their rate base.  Most of them finance about 50% of their rate base via debt.  The interest cost of that debt is paid for by their customers.  In effect it is a “forever” ongoing cost.  This is a significant cost for Big Water utilities.  For their customers, it is 10% - 12% of their bills. 

 

Profits – Any water or sewer utility is a monopoly business.  Monopolies have a rich history of extorting huge profits from their captive customers.  In theory, this is limited by a regulatory agency setting how much the utility can earn.  The normal practice is to set an allowable return on the utilities investment (i.e. “rate base”).  The utility then sets rates to deliver that return.  This is by far the biggest cost paid by customers.  In Pennsylvania, over 40 cents of every dollar paid on a water or sewer bill goes to the company’s profit. 

 

Here are two charts depicting the cost structures of the two largest for-profit water and sewer utilities in Pennsylvania: (LINK).  It is visually obvious the large impact profit has on rates.  It is actually a bit surprising what a small part the actual operating cost is.  This is a characteristic of a business driven by large investments. 

Non Profit Cost Structure

At a basic level, the financial management of a non-profit utility is really very simple.  It is essentially just managing the cash flow:  balancing revenue coming in and expenses being paid out.  There are only two major cost elements to manage:

 

Operating Cost – Just like the for-profit utility, this is the people, supplies, customer service and all the other things necessary to run and maintain a system on a day to day basis.  For similar sized systems, the costs are likely to be quite comparable.  And, there is economy of scale for larger systems. 

 

Depreciation – This is zero expense for a cash management system.  It is listed here to show a major difference opposite the for-profit utilities.  A non-profit system will calculate depreciation for balance sheet purposes.  But, depreciation does not figure in rate setting.  A more technical discussion on why depreciation does not matter for a non-profit is addressed here: (LINK).

 

Debt Service – Most municipal systems carry some debt in the form of revenue bonds they issued in the past.  Those bonds typically paid for investments in expansion, upgrades or major repairs.  Debt service is the periodic payments to pay off those bonds over time.  This is the non-profit version of interest cost.  A key difference is that both principal and interest are being paid off. 

 

Profit – By definition, this is zero for a non-profit utility.  It is listed here to show the other  major difference opposite the for-profit utilities.  And, it is a MAJOR difference. 

 

The management of the non-profit system normally would set rates to collect the operating and debt service costs plus a little extra.  The extra would go into a cash reserve fund.  The reserve fund would gradually build over time and be used to pay for unexpected expenses caused by things like weather events or an accident.  If the reserve fund grew too large, rates could be adjusted to hold it steady. 

 

If a major expense came along bigger than the cash reserve, new bonds could be issued.  Payments on those bonds would increase the funds needed for debt service and rates may or may not be adjusted. 

 

Let’s use another car analogy to illustrate finances for a non-profit utility:

 

Operating Cost – The gas, insurance and routine maintenance costs of owning and driving a car. 

 

Depreciation – The car is for personal use and depreciation is ignored.  Not many people keep track of their driving and toss 40 cents in a jar for every mile they drive. 

 

Debt Service – The payments you must make on the loan used to buy the car.  Each payment consists of principal and interest.  After the last payment, you fully own the car. 

 

Profit – This is personal use, profits are zero. 

 

You also might put away a few dollars each month to prepare for infrequent expenses like new tires or a brake job.  That would be your cash reserve. 

 

But what if your “check engine” light came on and you were facing a $2,000 repair that was way beyond your cash reserve.  That could be managed by some form of a personal loan.  The car gets repaired and continues to serve you.  But, the new loan payments get added to your debt service. 

 

It is really that simple – at least we hope you see it as simple. 

My Non-Profit Utility Wants To Sell To Big Water

What Will Happen To My Rates?

Ratepayer Victims_edited.jpg

When a for-profit company buys a municipal utility, all or most of the purchase price will be added to the buyer’s rate base.  That means the buyer will be increasing somebody’s rates to collect the depreciation and profit for the new system. 

A key question is whose rates will go up.  Until there is a rate case after the acquisition, the answer to that question is not knowable.  The Big Water companies and the Public Utilities Commission (PUC) regularly use Act 11 (LINK) to move costs from sewer systems to water customers.  This is a form of Beggar Thy Neighbor (LINK).  The rationalization is that it reduces “rate shock” and promotes “socialization” of total system costs.  The question that never seems to be asked is why should existing water customers pay for the high priced acquisitions enabled by via Act 12 (LINK).  We fail to see any element of fairness in this practice. 

 

A good first guess is that rates will have to double to collect the added costs.  Here is a more detailed look at the comparison: (LINK).  And, here is what happened to New Garden after Aqua bought the system and raised rates (LINK)

 

Since Act 12 was passed in 2016, the large majority of acquisitions have been sewer systems.  Sewer operations are a small part of Big Water’s operations in Pennsylvania – about 11% for Aqua PA and 20% for PA American.  What Act 11 allows is foisting a significant portion of the sewer acquisition rate increases off on their water customers.  Since the water revenue is so much larger, the percentage increase is not as eye popping.  The Act 11 link above has examples of how much increase the Big Water companies wanted to foist off on water customers and what the PUC actually allowed. 

 

We at Keep Water Affordable are currently benefiting from water customers paying for part of sewer increase resulting from Aqua’s acquisition.  We still think the practice stinks because it hides the real cost of these acquisitions. 

Estimating Rate Increases

If your system wants to sell out to Big Water, your first assumption should be that you will be hit with the full rate increase that results.  That may not happen, but it gives you some idea of what the upper limit of the damage could be.  Even if you are not hit with the full increase at first, later rate cases could reduce the subsidy paid by other customers meaning your rate goes up.  Also bear in mind that you could be paying the cost of future acquisitions made by your new company by having part of that cost foisted off on you.  It is the old principle of what goes around comes around. 

 

When Big Water has offered to buy your system, either the buyer or seller will usually provide some estimate of future rate increases.  The Public Utilities Commission (PUC) will require notification AFTER the sales contract is signed.  But, at that point all you can do is complain in the PUC approval process.  It is not likely that your complaint will carry any weight. 

 

It is important to have a good estimate before the sales contract is signed.  It is really fairly easy to make a very good estimate of your own.  You need to know the selling price, some very basic cost data for your current system and a few financial parameters of the buyer.  All of this should be public information that should be easy to access.  Good places to start are audited annual financial reports of the seller and rate filings by the buyer.  This is covered in detail here: (future link).  There is even a spreadsheet to help with the calculations. 

What If Major Improvements Are Needed

A common justification for selling a municipal system is that very expensive repairs are needed and we cannot afford them.  Let the Big Water “pros” handle that problem.  We think that an objective analysis of the costs will show it is significantly cheaper for the customer if the municipal system makes the needed investment. 

 

The first step should be to question the claims being made about the cost needed.  In our New Garden sale we feel the costs were substantially inflated to help justify the sale.  Our New Garden experience with this issue is covered here (LINK). 

 

If the improvement costs are legitimate, there is still the issue of what it will cost the customer in terms of future rate increases.  The main driver here is the investment related costs.  If the non-profit makes the investment, then debt service costs will go up.  If Big Water makes the investment, their interest, depreciation and profit costs all go up.  And, as you have seen from the above information the profit costs are a big driver of higher rates.  A side by side example is shown here: (future LINK). 

A Less Costly Alternative To Selling

The main benefit from selling a municipal utility is the large sum of money the municipality receives.  It is usually multiples of their annual budget.  For New Garden it was 6X their budget at the time they signed the sales contract.  This amount of money can be seductive.  Just imagine all the wonderful things that money can provide to the community.  And, the attraction between politicians and money is pretty well known. 

What is not generally considered is the cost that ratepayers will be stuck with after the sale is complete and the new owner has raised rates to cover his increased costs and realize the profits the regulator entitles him to.  What should be considered is how that same benefit could be realized at lower cost to ratepayers.  In almost every case it would be cheaper to issue a bond for the same amount of money as the sale.  That is developed in detail here: (LINK).

Who Pays Interest Costs

There is a 1972 Pennsylvania Supreme Court opinion that on the surface clearly states that for-profit utility companies cannot collect interest costs from their customers.  This seems unusual because interest costs are a normal part of doing business. 

 

The rate setting process in Pennsylvania very definitely collects interest costs from utility customers.  Yet, to do so they go through some very unusual contortions in their financial statements.  This is explained in detail here: (LINK). 

 

We would really like to hear from anyone who has knowledge about this issue.  Is there a legal basis for what the utility companies are doing?  Or, have they distorted the appearance of their profit and loss statements to make it look like interest costs are not being charged to customers? 

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