Unlocking the hidden value in public water utilities

There was an interesting court ruling in Germany last month. The town of Wetzlar in Hessen was found guilty of overcharging for water by a margin of 30% and ordered to cut the amount it charged residents for their water service. It is an unusual event, because in Germany water services are generally provided by municipalities and it is usually accepted that the political control of municipal water utilities will always ensure that prices are kept as low as possible.

It raises some interesting questions. Germany, together with Britain, has been one of the few countries in the world where tariffs are set at the full cost-recovery level. That is to say tariff income to water utilities not only covers the operating cost, but also the full capital cost of providing the service. The problem is that the “full cost of capital” is not widely understood. In a privatised system such as the UK, the cost of capital is the average cost of debt and equity. The regulator calculates it on the basis of pricing in the bond markets, and the level of dividends expected by equity investors.

In a municipal water company, the cost of debt is straightforward, but the cost of equity is a more difficult matter. Over the years, a municipality may have sunk millions of Euros into its water infrastructure both in terms of capital grants and reinvested surpluses. Should it expect a return on this investment, or should it be expected to forfeit that return in favour of lower tariffs?

From a populist political point of view, it is a no-brainer – give back the money in the form of lower tariffs: it belongs to the customers anyway. From a financial point of view, it is more complicated. The additional free cash flow being generated represents a return on historic investment: it is likely that the municipality will have incurred debt elsewhere as a result of financing the utility during the investment phase, and if it fails to earn a return on its utility investment, it will have to charge higher rates of local taxation. Furthermore, if a municipality does not expect a financial return from its investment in water, then it becomes very difficult to invest efficiently. Once the utility has paid down its historic debts, it can then start thinking about handing back the surplus to its rate payers or utility customers. The key point is that you need an economic regulator to draw the line between what is a reasonable return on equity for the municipality and what amounts to over-charging by the water utility. Germany is probably the only country in the world where this is an issue.

It is interesting to contrast the Hesse case with the experience of the water utilities in the Melbourne metropolitan area in Australia seven years ago. The state government took the view that it had too much equity in these bodies, and squeezed them for a special dividend, financed by increased debt issued by the utilities.

The bottom line is that municipalities around the world are sitting on equity potentially worth trillions of dollars, but instead of managing it for the benefit of their rate payers, they write it off. This not only undermines municipal finances, it also creates a situation in which there is essentially no return on capital employed in the water sector. The result is under-investment in water infrastructure, and an expectation of poor performance of water utilities.

The message should go out loud and clear to municipalities: if you don’t set tariffs that give you a return on capital employed, then you are penalising your taxpayers in order to protect your water service customers, and in the long run this will undermine your water service.