The recent efforts of France's Vivendi SA to acquire U.S. Filter Corp in a multi-billion dollar transaction, as well as the announced spin-off of Enron Corp.'s Azurix, made headlines on both sides of the Atlantic as harbingers of increased competition and interest in the U.S. water and wastewater markets. In reporting on the Vivendi/U.S. Filter transaction, The Wall Street Journal noted that the U.S. Environmental Protection Agency estimates that about $140 billion will be required for U.S. water infrastructure over the next 20 years, while the World Bank estimates that about $600 billion will be needed over the next 10 years to address international water and wastewater needs. A number of factors have converged recently to spark interest in the water and wastewater sectors domestically and abroad. Indeed, the water and wastewater sector shows all the signs of becoming the next "hot" sector, much as power and telecommunications sectors previously dominated the world infrastructure market. This article will discuss some of the factors leading to the growing interest in this sector, especially in the United States.
Mechanical Obsolescence
Many of the water and wastewater systems operating in the United States contain equipment which is nearing the end of its functional useful life, having been installed sometime between the turn-of-the-century and the end of World War II. By their very nature, water and wastewater systems require substantial mechanical infrastructure that is often spread out over great distances, with much of the system's equipment underground or located in other remote places. Although today's systems frequently contain remote monitoring equipment allowing operators to monitor system performance even in underground or submerged pipes and pumps, such technology was not widely used in past installations. Likewise, in some cases decades-old records have been lost or insufficiently updated regarding the precise location of piping and valves, leading to an inability to easily locate systems for purposes of monitoring or repair. Mechanical efficiency gains in pumps and piping materials have greatly increased over the last fifty years. Thus, in many cases although systems remain operational, they are not efficient, leading to higher all-around operating costs.
Additionally, leakage factors in modern day materials are much lower than in years past, and with water itself becoming an increasingly scarce and valuable commodity in some areas, newer equipment promises better delivery rates, once again lowering overall operating costs. As noted below, some equipment is simply not adequate to satisfy newer regulatory requirements regarding filtering standards for impurities. Lastly, as environmental awareness increases worldwide, leakage in wastewater disposal systems (carrying, for example, not only "safe" wastewater but also water deemed hazardous because of chemical content due to runoff from parking lots, roadways and other developed surfaces) is becoming a topic of sub-surface concern.
Resource Protection
The western United States (and many other areas around the world) have for many years viewed potable water as a precious commodity. Many of these areas continue to see expanding population growth not only in terms of residential but industrial activities. Consequently, this leads to increased water demand and wastewater treatment requirements. Indeed, a number of industrial activities such as pharmaceutical and microchip production facilities often require substantial amounts of water in highly purified forms. In some areas, such as Florida and the Middle East, de-salinization systems are being actively proposed to offset the effects of increased pumping of ground water resources, leading to an influx of sea water into previously secure potable water sources. Newer treatment technology helps to answer these resource protection concerns, not only by using more efficiently the existing potable water resources, but also by helping to create more potable water on a cost-effective basis out of previously inefficient raw water sources such as sea water.
Increased Environmental Regulation
Increased environmental regulation is also leading to greater activity in the water and wastewater sector, as many countries, including the United States, turn greater attention to the protection of their water supplies and delivery systems. Likewise, environmental forces around the world have become more critical of how wastewater systems are managed, pointing to poorly operated systems as a major contributor to surface water pollution problems. For example, in the United States, regulations were recently issued which are aimed at imposing stricter compliance standards for water-borne microbes and viruses and minimizing the public's exposure to disinfection by-products. These regulations, set forth in the Interim Enhanced Surface Water Treatment Rule and the Stage 1 Disinfectants By-products Rule, are expected to be joined by further regulations in this area, sometime in 2000 to 2002 timeframe. This topic is covered in greater detail in "U.S. Tightens Drinking Water Standards" beginning on page 10.
This increased regulatory activity has had two effects; first, it has made the public more aware of its water supply and the health problems that may be associated with a poorly designed or operated system, thus leading to growing political concerns over a commodity that is necessary for life itself. Second, many of the new laws and regulations require equipment upgrades to achieve compliance with stricter potability standards. These upgrade requirements not only provide opportunities for vendors of this equipment, but also for companies willing to package both the upgrade work and the operation and maintenance of the upgraded system into a single service contract.
Privatization Forces
By interesting coincidence, the factors noted above requiring heavy capital investments to upgrade new water and wastewater systems are occurring in a political climate that supports and encourages the privatization of many commodities we use in daily life. Public policy in the United States, and many other countries, has moved away from a belief that certain utilities such as electricity, telephone, television, waste disposal, etc. are natural monopolies wherein pricing and the terms and conditions of delivery of services should be highly controlled by a central regulatory body overseeing one or two providers in a given franchise or service area. Rather, there is a growing acceptance that the private sector is more nimble than the government sector in the delivery of many of these basic services. Coupled with this trend is a growing acceptance that competitive market forces will do a better job than regulatory oversight in encouraging the best service for the lowest price.
Likewise, the general philosophical trend that "less government is better" is still finding a receptive audience, particularly in the United States, leading local governments to seek ways to shrink their budgets and oversight activities by outsourcing what were traditionally public sector services. Thus, when faced with the prospect of raising taxes to undertake many of the extensive capital projects associated with water and wastewater system upgrades and modifications, cities, towns and municipalities are more than willing to embrace the private sector's offer not only to handle the logistics of the upgrade work, but also the capital requirements as well. Indeed, the author has been involved in some water projects wherein a private sector operator not only assumes complete responsibility for the upgrading, operation and maintenance of an entire city's system, but has also offered to make upfront cash payments of tens or even hundreds of millions of dollars in return for long term concession contracts. What is even more remarkable is that these payments can be recouped by the private operator without material increases in the cost of services simply by running the system in a more efficient manner.
Tax Law Changes
Many municipal water and wastewater systems were built with capital raised through long-term tax-exempt bond financings. In many cases, these bonds may still be outstanding. Although a complete discussion of the tax law regime affecting water systems is beyond the limited scope of this article, a brief discussion of the recently revised rules regarding "private activity bonds" is instructive to show how the tax law climate has also moved in ways favoring private sector activity in the water area. Briefly summarized, prior to 1997 certain United States federal tax laws discouraged long-term outsourcing of services associated with water and wastewater systems financed using tax-exempt bonds. This is because these laws could cause the tax-exempt bonds to lose their tax-exempt status if private entities (such as a private water/wastewater operator) were to operate these systems under contracts having a stated duration of more than five years. IRS Revenue Procedure 97-13 modified these rules to permit service contracts -- including service contracts associated with water systems -- to extend out to 15 and even 20 years, so long as certain compensation formulas are adhered to.
The availability of these longer contract terms facilitates more private sector involvement in the water and wastewater sector because it allows municipalities to hire private sector companies to operate plants on a long term basis even when financed with tax exempt debt. To comply with the safe-harbor provisions of Revenue Procedure 97-13 the following requirements must be satisfied: (i) compensation must be reasonable and not based on the facility's net profits; (ii) the management contract must conform to certain term and compensation limitations; and (iii) the service provider must not have any relationship that effectively limits the issuer's ability to exercise its rights under the management contract based on all the facts and circumstances.
Bond Covenants
Municipalities have also been attracted to private sector participation in the water area for another reason, their existing bond covenants. As noted above, many municipal water systems in the United States were built with tax-exempt (as well as taxable) bonds. In many cases, the old indentures under which these bonds were offered have restrictions on the ability of the issuing entity (such as the municipal water and sewer authority) to issue additional debt directly, but not on the ability of that entity to outsource operation and maintenance services for a fee. By outsourcing the operation and maintenance services to a third party that private entity incurs the cost of any necessary financing for capital work (the costs of which are passed through to the municipality as part of an aggregate operation and maintenance fee). Thus, the municipality effectively increases its ability to obtain financing indirectly, thereby eliminating any requirement to seek a waiver from its existing bond holders.
Competitive Forces
Competitive forces have also encouraged greater activity in the water and wastewater sector. A number of new entrants in the sector are affiliates of strategic players from the other sectors of the utilities marketplace that have determined that the power, cable television and telecommunications markets have too many competitors chasing too few deals, driving down margins for all players. In the United States, participants in the water and wastewater markets are following, to a certain extent, the trail blazed by the independent power producers (IPPs) approximately 20 years ago when private power suppliers began a formidable assault on the natural monopoly status of the investor-owned utility sector, leading to its eventual conversion into what is now essentially a competitive marketplace. Indeed, it is interesting to note that many of the early entrepreneurs in the forefront of today's domestic water market are executives who "cut their teeth" in the IPP markets of the 1970s and 80s.
Moreover, competitive forces of another sort are driving foreign companies to bid aggressively for water and wastewater projects in the United States market. Many of the most active companies in the water and wastewater area are French and English companies who have been building, operating and maintaining privatized water systems in their home countries for many years. From a management and operations standpoint, these European companies are often far ahead of their US counterparts, particularly in the depth of their knowledge and experience in working with privatized systems. While these companies have actively pursued new projects in underdeveloped countries around the world, they have also come to view the United States as a perfect market to target because it provides great privatization potential without the attendant political, credit and currency risks associated with work in many emerging markets.
Capital Availability
As will be discussed in more detail in a future article in this series, increased capital availability for water projects, both in the form of debt and equity, is also trending positive. Like many infrastructure sectors that were once developed solely on the balance sheet of large well capitalized companies, water and wastewater projects are also finding a hospitable reception in the non-recourse markets, as well as with capital markets investors, export financing agencies and multi-lateral development banks. These non-traditional financing sources are warming up to the water and wastewater sector as they become more familiar with the unique issues associated with water and wastewater projects (also the subject of a later article in this series). A number of features associated with water and wastewater projects lead to this result. For example, debt and equity investors often note that customer demand for water and wastewater services is not "demand optional;" that is, customers of these systems do not have the same flexibility to readily reduce usage as with other utilities such as telephone and cable television. Water systems are also less prone to easy "pirating" or "slamming" of customers, as there is often no practicable ability to switch service providers, in contrast to the telecommunications and cable television markets, and now the electric sector in a growing number of states. Water and wastewater investors are also enthusiastic about the potential for supplying value-added services typically associated with controlling a major utility being delivered to each home and office within a given service sector, such as supplying metering, billing and collection services or bundling water service (by joint venture or outright combination) with the delivery of other services such as electric and telephone. Multi-lateral development banks have come to actively support water and wastewater projects abroad because they often provide direct and immediate social benefits to the local population of a developing country, while also providing a more viable climate for industrial growth as well.
Conclusion
The varied forces described above are quickly converging to create an exceptionally hospitable atmosphere for water and wastewater projects around the globe, and especially in the United States. Financiers, equity providers, operators, construction companies and government authorities involved with water and wastewater systems all have a variety of new challenges and opportunities before them. Future articles on the water and wastewater sector will address those challenges and opportunities in greater detail.