Water and Wastewater Utilities: Risky Business

The frenzied deregulation of the electric, telecommunications and gas industries has created a perception that these companies formerly known as public utilities have become the riskiest of enterprises. Such risk has its privileges–opportunity to earn a higher return.

Overlooked in the dust of this commotion, however, is the ever-increasing risk being experienced by water and wastewater utilities, not because of deregulation but because of regulation. With such increasing risk is the increasing, urgent need to mitigate risk by accounting for it in the ratemaking process and by other strategies.

What are the drivers of this "new" risk? There are many, some more obvious than others. Without question, the Safe Drinking Water Act (SDWA) and the Clean Water Act (CWA) continue to impose increasingly stringent requirements on water and wastewater utilities. Particularly in the water industry, new Maximum Contaminant Levels (MCLs) for presently regulated contaminants, new MCLs for newly regulated contaminants, new treatment technique requirements and new water treatment rules will impose billions of dollars of capital and operating costs. Estimates for the next twenty years range from $138 billion to more than $300 billion. It would be naive to believe that such costs do not impose increasing risk to finance and pay for such improvements and to comply with the changing regulations.

A corollary of these effects of the SDWA and CWA is the risk of non-compliance. On the civil side of the ledger, water and wastewater utilities face not only potential enforcement actions by U.S. EPA and state environmental agencies but also lawsuits for damages claimed by persons allegedly injured in some way by a contaminant, whether regulated or not. Litigation in California over unregulated contaminants and in Milwaukee over Cryptosporidium attests to this risk.

However, perhaps even more threatening is the risk of criminal charges for non-compliance. Two recent federal Court of Appeals decisions have held that a person can be convicted of a crime and sentenced to a jail term for ordinary negligence in violating discharge limits under the Clean Water Act or an NPDES permit, even if the person does not know that the conduct at issue is a violation. United States v. Hanousek, 176 F.3d 1116 (9 Cir. 1999, cert. denied 2000); United States v. Weitzenhoff, 35 F.3d 1275 (9 Cir. 1993). It is difficult to imagine a more risky business than being a water or wastewater system operator if a person can be convicted for ordinary negligence.

Another risk is that many water and wastewater systems are old. Mains and treatment plant infrastructure eventually need replacement. Chances are many systems have deferred any replacement program, making catch-up an enhancer of risk. Take a simple example: if a utility has 500 miles of main at an average age of 80 years and a remaining useful life of 20 years, it would need to replace mains at the rate of 25 miles a year.

Moreover, if a utility serves a fully developed area, the replacements will be fully non-revenue producing, resulting in a full burden on existing ratepayers. On the other hand, if a utility is in a growing service area, it likely faces a need not only to replace any aged infrastructure, but also to add new infrastructure to meet demand. This risk is compounded if the utility’s existing water supply source is insufficient to meet growing demand.

Water and wastewater utilities also face new regulations in previously unanticipated ways. For example, the recent developments in watershed management requirements, source water quality assessment and protection, and rules on technical, managerial and financial capacity demonstration all add to risk.

In addition, there can be risks resulting from a limited or diminishing water supply, conservation in customer use, bypass and competition for new customers.

Ultimately, risk arises from the inherent nature of water and wastewater operations. They involve public health and safety. Any mistake, whether in monitoring, compliance, upgrading replacement of mains, etc., can lead to serious consequences and expense.

How can a water or wastewater utility mitigate these and other risks? Most important, a utility must take the first step of recognizing what risks it is facing and likely will face. In other words, it should make inventory of risks.

A second step is an acknowledgement that risk must be accounted for in the ratemaking process. Risk typically is reflected in the return on rate base (or investment) component of cost of service. Where a utility determines its rates on a cash basis rather than the utility basis, planning for risk may be embodied in specific reserve accounts.

In addition, it must be recognized that frequent rate review and adjustments may be necessary. Particularly for a municipal-owned utility, the political expediency of ignoring rates so as to avoid confrontation with customers can be a mistake. A system should be managed prudently.

Another rate-related approach is reflected in the example of recent Illinois legislation that authorizes the Illinois Commerce Commission to allow regulated water and sewer utilities to place into effect surcharges to automatically adjust rates for the cost of purchased water; the cost of purchased treatment service; other costs that fluctuate for reasons beyond a utility’s control or are difficult to predict; or costs for infrastructure maintenance, defined as return on investment and depreciation expense related to non-revenue-producing replacement mains, meters, services, hydrants and other plant items. Periodic "true-ups" of costs and revenue are provided (220 ILCS 5/9-220.2) These rate adjustment provisions serve as a model for unregulated utilities and in other jurisdictions.

Other responses to risk can include capital budget forecasting with rate setting based on forecasted financial requirements; review of the adequacy of insurance coverages with purchase of insurance for potential risks such as pollution liability; installation of redundancy to provide back-up in the event of equipment failure; and development of contingency plans for major plant failures, natural disasters, contamination releases and the like.

Sometimes dealing with risk may require outside help. Such assistance can include the use of professional expertise in the form of accounting, financial, engineering and legal consultants. Alternately, risk mitigation may include consolidation with another utility or, in the case of municipal-owned systems, privatization. Indeed, perhaps the best solution for handling risk can be to give the risk to someone else.

Dan Kucera is a partner in the law firm of Chapman and Cutler, 111 W. Monroe St., Chicago, Illinois 60603–4080, (312) 845–3000.

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