Nevertheless, there have always been advocates for privatizing these assets. Sometimes the motives involve local politics, sometimes operating efficiency, and sometimes financial desperation. Putting aside sheer anti-government ideology that private owners are inherently better operators, the most common justifications for private ownership are economies of scale — spreading fixed and overhead costs over a large customer base — or raising cash to pay for replacement facilities or unrelated costs like unfunded pensions. Look for these arguments to come up time and time again.
Of course, there are many places throughout America where private companies already own these natural monopolies. Very commonly, the regional electric utility and its local distribution system are privately owned, and those operations are typically regulated by a state agency that oversees their budgets and pricing structure to protect the public from monopoly pricing power. The more a company controls the “upstream” source of electricity, the more likely it is to also have control of local distribution systems. As a result, many of today’s electric utilities go back in time far enough that local power plants were self-sufficient for their customer base.
In the case of water-supply utilities, municipal ownership is more likely when the water comes from a local freshwater source or where the state’s special-district laws enable areawide agencies to serve multiple jurisdictions. Where the local municipality or a special district does not own the water at its source and is just a distributor, there is an opening for private businesses to provide that service. Something like 12 percent of Americans receive water from a private local utility, and the number is triple that in nine states where private operations are more common. Most often, these franchises were a creature of historical situations where local governments were incapable of financing and operating the water utility themselves. Some of them have come to regret it.
In the case of sewerage systems, the original cost of their infrastructure was most often paid from municipal budgets or regional sewerage authorities and billed as a quasi-consumption surcharge through the water supply system or by general taxation, making them far less likely to be privatized. Nevertheless, there have been cases in this century where sewerage systems were sold to private companies, with Pennsylvania becoming a hub for several such privatizations.
This issue is not uniquely American. In England, considerable controversies have arisen after a bout of privatizations in past decades. Absent public oversight through a regulatory body, there’s evidence abroad to question whether consumers and communities’ interests will come first when utility managers put investor profits foremost.
So that’s the simplified history of local utility ownership, as a general framework. Nowadays municipal utility privatization in the U.S. usually occurs when local officials find themselves unable to finance necessary system improvements or compelled to sell the family jewels to raise capital to meet their budget or pension deficits — and that’s where the challenges lie in today’s world of public finance.
Twenty years ago, the focus of many of these privatization sales was driven by municipal retirement fund deficits, whereby the unfunded liabilities could be satisfied by the proceeds of selling a local utility. Free-market advocates published “white papers” to explain the virtues and benefits of asset sales or capital leases to rebalance the books for public pensions. In many cases, the decision to privatize was simple economics: The municipality needed to unlock the equity value of its system to redeploy it for other purposes. Not surprisingly, economic efficiency has often taken a back seat to economic or political necessity.
The lean-government argument in favor of privatization is that the presumably more efficient private sector can deliver the same or better services at lower cost. In the case of small local utilities, their “dis-economies of scale” could support privatization, with the costs of major equipment and capital facilities distributed over an acquiring regional company’s larger consumer base. The other argument is operating cost efficiencies. Here the premise is that private business managers run a leaner operation more effectively, free of bureaucracy and unions. Both are possible in theory, but the burden of proof should be placed on such acquirers to provide clear evidence before public assets are sold off.
In coming years, there may come yet another impetus for privatization, as the federal Environmental Protection Agency has just issued a ruling to require all water supply systems to replace lead pipes with safer alternatives within 10 years. Think of Flint, Mich., as the backdrop for this edict. For some local water utilities, this could be the proverbial straw that breaks the camel’s back, unless the public finance community comes up with municipal-bond funding solutions that result in lower costs to water consumers than the private sector can deliver.
Astute investors may also sense a potential hidden motive for local utility privateers: the growing demand for water and electricity to feed new data centers that operate all those artificial intelligence chips and servers that are today’s hottest topic on Wall Street. Already the stocks of larger private utility companies are surging. Could it be that private utility companies are catching on to something that local elected officials are overlooking — that their control of water and electricity is an underpriced asset?
Public Utilities’ Cost Advantages
There are two reasons why public ownership and operation of municipal utilities may still be able to survive the various financial pressures that local officials face. First, they have access to the tax-exempt municipal bond market for funding their capital facilities. In most cases, that conveys a federal tax subsidy enjoyed by the bond purchaser who is willing to accept a lower interest rate. So as long as the credit quality of the utility operation is roughly equivalent under public versus private ownership, it ought to be cheaper in the long run for a municipality to own and operate the system. In addition, private companies are expected to pay dividends to their owners, who expect more than muni bond interest rates for their investment returns.
Secondly, a private company must pay taxes on profits even when its rates are regulated. Municipal systems are exempt from income and property taxation, and they typically operate at-cost, with allowance for normal depreciation as part of their rate structure. They don’t need to pad their billing rates to deliver a profit to shareholders.
The third argument in favor of municipal ownership is the somewhat abstract but still relevant economics of monopolies: Astute private owners will seek to maximize profits by constraining supply, whereas a nonprofit public utility will operate and price at average cost, which is more likely to be lower and with more product supplied to the market and thus more consumer benefits. For those who want to visualize the difference and grasp the basic concepts, this link provides a classical textbook diagram with a clear accompanying narrative.
The Recapitalization Alternative
Despite all these conceptual reasons to keep local utilities in public ownership, it’s foolhardy to impose these theoretical arguments on local officials facing serious and severe financial stress. Instead, the states can provide a third alternative that provides municipalities with the ability to cash out their ownership while still leaving their constituents with the advantages of public finance: a recapitalization authority.
Whether it’s controlled by the local municipality or set up under its own freestanding charter, a special purpose municipal authority can be established that provides for the recapitalization of a financially distressed utility system. Where special purpose legislation is needed, state legislators would have to pass enabling laws, but it would be hard to find reasons why they should not. The recapitalization authority would then sell tax-exempt municipal bonds to finance the purchase of the community’s utility assets and take over operations, which could include simply transferring the existing management and employees — assuming that they are not themselves the reason for financial distress by virtue of incompetence or excessive compensation.
There are some nuances in federal tax law that would have to be worked through, such as the limits on advance refunding bonds and certain arbitrage profit restrictions, which are familiar topics for a seasoned municipal bond attorney. But as a general principle, a fully recapitalized buy-out that conveys local utility ownership to a new entity to accomplish a public purpose should be something that Congress and the states would allow and that the public finance community would welcome.
The point here is not to belittle or besmirch the role of privately owned local utility monopolies. In many cases they provide a necessary and well managed service at a fair price. But before handing over the keys, local and state officials need to do their homework and exhaust all their viable alternatives.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
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