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The Story Behind Private Water's Rise

Andrew T. Gillies, 08.06.03

WASHINGTON - You don't have to look far to find statistics suggesting the United States' water and sewage systems are in sorry shape. At the homepage of the Environmental Protection Agency's Office of Water, for example, a report suggests the current pace of spending on drinking-water infrastructure falls $263 billion short of what's needed over the next two decades.

Those kinds of numbers haven't been lost on Congress, or, for that matter, stock investors who have taken a strong interest in companies working in the water business. Many of the stocks trade within a stone's throw of their 52-week highs and carry price-to-earnings ratios above their five-year averages.

Among water sector winners: investor-owned water utilities. These include outfits like Philadelphia Suburban and San Jose Water. The former company, the largest of its kind in the U.S., provides water and wastewater services to two million customers in Pennsylvania, Ohio, Illinois, New Jersey, Maine and North Carolina. SJW owns San Jose Water, a utility supplying drinking water to a million people in Silicon Valley.

So why would Wall Street get so worked up about boring old water utilities? Mergers and acquisitions, for one. Not only has there been heavy consolidation among domestic players, but big foreign companies like France's Veolia Environnement and Germany's RWE AG have also gotten involved, paying significant premiums to buy U.S. utilities.

Another plus: The water utility business could well benefit from the outsourcing trend now evident in other government areas like defense and information technology. "The United States is probably the most attractive market from a privatization point of view," says Phillipe Rohner, who co-manages the Pictet Global Water Fund, a portfolio devoted to companies in the water business.

Rohner notes that U.S. water utilities going private have the advantage of "the most advanced capital markets in the world" when it comes time to raise the funds necessary for infrastructure improvements.

But the National Association of Water Companies (NAWC), the industry group representing investor-owned utilities, complains U.S. policy still gives public utilities an edge. In a position paper, the group says that private water companies still "operate under numerous competitive disadvantages which include payment of federal, state and local taxes, and limited access to tax-exempt financing."

In fact, Congress has made low-cost financing available to investor-owned utilities involved in drinking-water projects in the form of low-interest loans known as State Revolving Loan Funds. But the industry has had less success on the sewage side. In July, for example, the House Subcommittee on Water Resources and Environment unanimously approved a bill, H.R. 1560, authorizing $20 billion worth of revolving loans for wastewater; none of those loans would be available to private outfits.

Another sticking point: Private activity bonds, a category of municipal bonds where 10% or more of the bond's benefit goes to parties other than a government unit. The industry's primary gripe is that the amount of private activity bonds each state can issue is capped (to protect federal revenue) and not enough of the bond allotments flow to water uses. "It's not unusual for water and sewerage projects to be last in line and not get the money," says Peter L. Cook, NAWC's executive director.

The private utilities want the tax code amended to eliminate any volume caps on private activity bonds when they're used for water and sewage projects. That idea was introduced in the 107th Congress but hasn't gotten anywhere so far in the current session. H.R. 1560 doesn't address the issue.

Cook remains confident the change will come about, describing absence of the provision as purely a matter of committee jurisdiction and one more appropriate for the Committee on Ways and Means. Says he: "The substantive idea is one that's alive and well."

Maybe, but there are competing funding ideas alive and well out there too. One of those, floated by groups such as the American Water Works Association and the National Utility Contractors Association, is to have the federal government create a dedicated funding source for water infrastructure similar to the trust funds for highway projects and aviation. Like the railroads, however, private water utilities reject the notion of a
trust fund on the grounds that it would invite inefficiency and require burdensome new taxes.

That anti-tax message, at least, should play well in the Republican- controlled Congress.