Effective Regulation of Public Utilities

          Mergers and acquisitions have come to the water industry. The targets are small companies—some private, some municipally owned, each a monopoly. Some are merging with each other; others are being acquired by large investor-owned companies. As infrastructure ages, environmental costs rise, and population grows, economies of scale may justify larger service territories. But as with all M&A activity in monopoly markets, these transactions display tension between the parties’ strategic objectives and the public’s long-term interests. 

Price prevailing over performance

          Here’s what’s happening in State X: State law lets investor-owned acquirers and municipal system owners negotiate their own prices, subject to deferential state commission review. But deference is problematic because each side has an incentive to inflate the purchase price. The municipal seller can use the extra proceeds to build soccer fields or fix pension deficits. The acquirer can put the acquisition cost into rate base; so, oddly, the more it pays the more it profits. (Try explaining that one to a neighbor uninfected by a career in utility regulation.) And the acquirer can spread its purchase cost among its multiple water subsidiaries—so small, gradual rate increases tend to go unnoticed. Assume, further, that the state regulator approves these rising acquisition prices, as long as they don’t exceed some standard borrowed from the real estate industry—a standard like “reproduction cost new”—that that has no relevance to the acquired system’s real value.

          Worsening the situation: Acquirer 1’s willingness to pay high acquisition prices is contagious. So rivalry among acquirers drives up the acquisition prices beyond the already wrong prices. The result? A race to the bottom, with municipal sellers choosing acquirers based on price instead of performance— ironically so, since the reason to encourage water mergers, we are told, is to lower cost and improve performance.

          This picture fails the public because it lacks discipline.  It lacks competitive discipline because each negotiator is a monopolist.  It lacks regulatory discipline because the cap on the purchase price—reproduction cost new—has no relation to a water system’s actual cost or value.  And the municipal seller’s priority?  Today’s proceeds rather than tomorrow’s performance.  A real trifecta—failures of competition, regulation, and politics.  How do we fix it?