Water Sector Reform #2:
Regulatory Transparency & Fairness
With a major federal investment in water infrastructure possibly on the horizon, the United States has a once-in-a-generation opportunity to leverage that money into transformational, institutional solutions for America’s water sector. This is the second in a series of five posts outlining five broad ideas to reform the management, governance, and regulation of U.S. drinking water, sewer, and stormwater systems. The first proposed reform was consolidation of water utilities.
The second proposed reform is an overhaul of the processes and institutions that regulate water system finance using regulatory models from New Jersey and Wisconsin. The goal of this reform is not to regulate water quality directly, but rather to change the incentives for the organizations that operate water systems.
The need for regulatory reforms follow from the ownership structure of the U.S. water sector.
Another important way in which water is different from energy and other utilities is ownership. The overwhelming majority of Americans get their electricity and/or gas from a private, investor-owned firm, with small minorities receiving service from government utilities. But water is a different story: about 88% of Americans get their drinking water service from a local government, with about 12% served by private firms.
Ownership is crucial because different institutions govern private and public systems, creating different incentives for infrastructure investment.
Public Utilities Commissions
Let’s start with the private sector. The profit motive, constrained by regulation, drives management of investor-owned utilities.
Private utilities of all kinds—water, energy, telecom, whatever—are operated by corporate managers in the interests of their shareholders. But utilities are natural monopolies, and so we can’t count on free markets to guide investment and pricing. Instead, prices are not set by the companies themselves, but rather by the state Public Utilities Commissions (PUCs). The PUCs require utilities to report publicly their asset management plans and financial records in order to justify their pricing. PUC-regulated systems must also report a variety of performance data, which commissioners scrutinize to ensure that utilities are maintaining adequate service.
PUCs allow private utilities to set prices based on the amount of capital they invest in the system: the more capital invested, the more revenue they earn. That can create an incentive for private utilities to over-invest in infrastructure because those investments allow them to raise rates—a problem known as the Averch-Johnson Effect. Much of what the PUCs do is scrutinize all those investments to ensure that they’re justified and that utilities aren’t gold-plating their systems. In other words, PUCs act to prevent over-investment in utility capital.
But remember, that’s only about 12% of the water sector.
The overwhelming majority of water service is provided by local governments—usually cities, counties, towns, villages, authorities, and special districts. These systems are managed by local bureaucrats, with investment and pricing decisions made by local elected officials. For all the talk about federal funding, U.S. water infrastructure investment is mainly a function of local politics.
Local politics are unkind to water infrastructure because the price of water is much more visible than the quality of water. As in all things, people generally like high quality and low prices. Thing is, most contaminants in water are invisible. Unless my water is so bad that I can smell or taste it, unless there are frequent an ongoing outages and main breaks, I really have no idea how good my water system is. Unlike roads and bridges, water systems are literally buried.
But the price of water is easily observable. Voters may not know what contaminants are in the water, but they know for sure what they pay for it when they get the bill each month.
Now suppose I’m an elected official who wants to please my voters. If I make decisions that maintain or improve water quality, that’s good! Alas, my voters may not recognize the improvement. But quality improvement might cause prices to increase, which is bad because higher prices are immediately visible to voters.
But blame avoidance isn’t good for infrastructure investment. That’s a big part of why all those facilities built back in the 1970s and 80s are crumbling today. Back when the CWA and SDWA sent hundreds of billions of dollars to local governments, the idea was never for the US government to own and operate water systems. The goal was for Uncle Sam to help get those systems up and running in compliance with the new environmental laws. Local governments were then supposed to take over responsibility for those systems. In too many cases political forces have led local officials to run those systems to failure. Local politicians don’t neglect water infrastructure because they’re stupid; they do it because they’re responsive to voters.
Jersey to the Rescue?
In 2017 New Jersey passed the Water Quality Accountability Act (WQAA), which requires all water utilities—both government and investor-owned—to develop asset management plans, report on infrastructure conditions, and reinvest adequately in their systems. Rule-making to implement the new law is still under way, but what the WQAA requires of all water systems is similar to what PUCs already require of investor-owned utilities: transparency about infrastructure conditions, evidence that they are managing assets responsibly, and evidence of system performance.
Making all that system information transparent can make water’s quality as visible at its price. We can make water infrastructure a credit-claiming opportunity for local officials, not just a blame-avoidance game. Mayors seeking reelection should point at their cities’ water system performance with pride, not merely seek to duck responsibility for rate increases.
Meanwhile, in Madison…
A thousand miles away, Wisconsin employs a unique regulatory system that’s a perfect complement to New Jersey’s new law. All fifty states and the District of Columbia have Public Utilities Commissions, but Wisconsin is the only state where all systems—public and private—are subject to PUC financial regulation. That is, Wisconsin local governments must get approval of their rates from the PUC (or the Public Services Commission, as they call it there).
As with other utilities commissions, the traditional role of the Wisconsin PSC with respect to rates is to guard against over-pricing by private monopolies. But in the case of local government utilities, the PSC’s authority could include New Jersey-style asset management requirements and a guard against underpricing due to inadequate reinvestment. At the same time, the PSC provides something of a shield for local leaders. As a 2012 Alliance for Water Efficiency report observed:
“The Wisconsin Public Service Commission regulates both public and private water systems, and assumes the responsibility for approving all changes to water rate-making in the state. Thus, the political ‘heat’ is off at the local level and water systems can more easily approach the PSC for needed changes to their revenue structures.”
In theory, if a utility isn’t adequately investing in maintenance and upgrades, the Wisconsin PSC might actually be able to compel rate increases. (I’m not sure that’s ever actually happened).
Together, the Garden State’s new WQAA and the Badger State’s PSC authority over local governments would be a potent regulatory combination. So my second proposed reform is to require comprehensive asset management and performance reporting for all water utilities (as in New Jersey), and to extend PUC pricing regulation to government utilities (as in Wisconsin). The idea is broadly consistent with Australia’s model for urban water price regulation. As with my other proposed reforms, achieving such a significant overhaul to the nation’s regulatory institutions will require federal leverage.
The great promise of the regulatory regimes pioneered in New Jersey and Wisconsin is that transparency and fairness can make buried infrastructure more visible, and so shift the political incentives for sound management of water systems.
A Kansas water utility gets affordability measurement right
And lo, there arose from the Kansas City suburbs a mighty measurement
Recently we’ve seen progress in affordability measurement, as more water utilities are using better metrics when evaluating affordability.* Last year I published a new methodology for measuring water and sewer utility affordability (AR20and HM), and followed that up with a national assessment using those metrics. AR20 is the Affordability Ratio of basic water and sewer service price divided by disposable income at the 20th percentile household income. HM is basic water and sewer service expressed in Hours of labor at Minimum wage.These metrics seek to capture the trade-offs that low-income households must make in paying for water and sewer services. Utilities have begun to use these and other improved metrics, which is encouraging!
The main objection I’ve seen to the real-world use of AR20 is that it can seem too complicated. You need to know the community’s 20th percentile income and essential non-water/sewer costs of living in order to calculate AR20. But there’s no convenient, off-the-shelf source for those numbers. You have to think about economic conditions in your community.
I usually include housing, health care, taxes, food,and home energy as essential non-water/sewer costs, and I use statistical models to estimate those expenses.† Statistical models are important in my research because I’m analyzing affordability across hundreds of communities. Apparently that’s led some to think that regression models of consumer data are the only way to estimate AR20, which can seem impossibly difficult.
Fortunately, it’s not really that hard. Since publishing my 2018 article, I’ve heard from folks in utilities large and small about efforts to use these metrics exactly as they were intended: adapting AR20 to fit local needs, calculating it with local data, and using it to shape local decisions.
WaterOne’s excellent measurement adventure
An especially encouraging case is WaterOne, a special district that provides drinking water to a population of about 425,000 in the Johnson County suburbs southwest of Kansas City. As in plenty of other utilities, WaterOne’s leaders have long been interested in the affordability of their service, but had also long used the conventional 2%MHI to gauge affordability. Dissatisfied with that nonsensical number, WaterOne’s financial planning team decided to use AR20 to assess affordability and help guide policy for their own system.
Making AR20 work for WaterOne required adapting it to local preferences and conditions in a few ways. First, the original AR20 was calculated for water and sewer combined; since WaterOne provides only drinking water, its AR20 calculation included only water rates, not sewer rates. Second, WaterOne analyzed its own customer data and decided that 45 gallons per capita per day and a 2.6-person household were the appropriate basic water consumption level for its customers (my published studies assume a 4-person household at 50 gpcd). Third, WaterOne chose to exclude home energy from their calculation of essential non-water/sewer costs. Rather than constructing an econometric model to estimate essential non-water costs, WaterOne’s finance team used available data and guidelines from the Census, IRS, USDA, and Bureau of Labor Statistics to estimate appropriate costs for its service area.
The result was a WaterOne-specific AR20 that showed the remarkable difference between the conventional %MHI method and the more meaningful AR20. After they’d done all that work, WaterOne staff contacted me to ask for feedback. We had a terrific phone call with WaterOne managers where I offered some comments on their execution, but I didn’t have much of a critique to give—they pretty much got it right.
From analysis to decision
The results were reported with the district’s 2019 budget and written up in a white paper for WaterOne’s governing board. Crucially, the paper uses the affordability metrics to frame a discussion of goals and guidelines, not to declare WaterOne’s rates “affordable” or “unaffordable” according to some arbitrary threshold. They also warned against comparing AR20 values to my published works and to other systems’ AR20 values, since WaterOne’s AR20 is based on different assumptions and WaterOne’s values may not align with others.’
Measurement principles in practice
Complexity isn’t an excuse for crummy measurement; it’s a reason to be careful with measurement. A modicum of creativity can get you there. Want to know what low-income families pay for health insurance locally? Go to healthcare.gov. Need an estimate for local low-income housing costs? Check craigslist.org. Ask local charitable organizations what low-income families pay for food or home energy. You don’t need a PhD or advanced econometric skill to do sound affordability analysis.
WaterOne answered the affordability measurement challenge with a thoughtful, nuanced analysis that applied community values to the best available data. Adapting AR20 for WaterOne—WOAR20?—is a fine example of how utilities can put measurement principles into practice.
*The conventional approach to water affordability measurement (average bill as a percentage of Median Household Income (%MHI) is deeply flawed, as I’ve blogged previously. Despite its well-document problems,use of %MHI remains widespread, mainly because it’s easy and familiar.
†My estimates use publicly-available Consumer Expenditure Survey data and Ordinary Least Squares regression. They’re not especially sophisticated.
A California surprise: update
California has been enjoying a great deal of rain and snow over the past several months—a pleasant rebound in precipitation after the brutal drought that plagued the state from 2011-2017. It’s now early 2019, reservoirs are full, the mountain snowpack is deep, and water managers in the Golden State are breathing easier than they have in a long time. Though water use has crept up since the end of the drought, overall water consumption remains lower than its pre-drought levels.
A California surprise
A surprising finding emerged from my analysis of California’s drought data with Youlang Zhang and David Switzer: the state’s private, investor-owned utilities conserved significantly more water than did local government utilities during the crisis. We linked the difference in drought response to the institutions that govern water finance. Nerds interested readers can read the full study in Policy Studies Journal for the details.
In a blog post last summer, I observed that a public-private conservation gap of 2-3% persisted in 2017 even after the drought ended, and wrote that financial imperatives would likely cause the trend to continue:
This consistent public-private difference lends greater weight to the idea that rate decoupling facilitates water conservation for private utilities, and that political constraints hamper public sector conservation. If 2018 holds to form, public and private conservation will converge in the spring and diverge again in the summer and autumn.
If financial and political considerations are really behind the public-private differences in conservation, then it stands to reason that the greatest differences would come during summer months, when water demand–and therefore rate revenue–fluctuations are greatest.
Now that full 2018 data are posted, it’s time to revisit conservation performance for the Golden State’s water utilities. Was the forecast valid? Did private systems conserve more than public systems again last year?
Are my water conservation predictions any better than my NCAA Tournament picks?*
Overall urban water use remained significantly lower in 2018, with average monthly conservation of about 14% compared with 2013. The public-private disparity in overall conservation also persisted. This graph plots average conservation (relative to the same month in 2013) for public and private utilities from January-December 2018:
As you can see, public and private conservation moved in pretty close parallel through 2018, but private utility conservation was consistently higher than public. The difference was negligible during winter months, but during the May-September peak demand season, California’s investor-owned utilities saved an average of 2.3% more than their local government counterparts.
As always when discussing water, it’s important to give percentages some context. Had public utilities saved at the same rate as private utilities in 2018, the difference would have been about 27 billion gallons—more water than San Francisco uses in a year.
Decoupling, man. Decoupling.
The persistent seasonal swing in public-private water conservation suggests that the difference is due to differences in outdoor irrigation behavior. That the pattern is now consistent over three years adds to the mounting evidence that rate decoupling encourages conservation for investor-owned water systems.
This isn’t a story of environmental angels or devils, it’s about governance institutions and the incentives that they create. In light of the political challenges of managing local government water finance, it’s impressive that public utilities have continued to conserve as much as they have—a testament to local water managers’ commitment to efficiency in the face of political headwinds.
*They could hardly be worse. I didn’t get a single Final Four team right.