Keynote Address to the Schwab Capital Markets' Global Water Conference

Washington, DC - April 15, 2003
Delivered by G. Tracy Mehan, III
Assistant Administrator for Water, U.S. Environmental Protection Agency

"Investing in America's Water Infrastructure"

Introduction

Thank you for this opportunity to address the Schwab Capital Markets Global Water Conference for investors. It is indeed a pleasure to be here. Your focus on the water sector and the role of water in our economy makes this a unique symposium. Three years ago, Fortune magazine (May 15, 2000) published an article describing the $400 billion-a-year water industry and suggested that water companies were betting that "water will be to the 21st century what oil was to the 20th."¹ Last summer, an article on the water industry in Bloomberg Personal Finance declared: "Water is not only wet. It's hot."² For those of us who can appreciate these statements, it's important that we step back and look at the big picture as well as emerging issues.

The Big Picture

For the big picture, I go back a couple of centuries to Adam Smith, the 18th c. philosopher generally credited with laying the foundation of modern economics. Smith described the paradox of diamonds and water and asked: how could it be that water, so essential to life, is so cheap, while diamonds, used only for adornment, are very costly? While Smith used the paradox to explain the basic concepts of supply and demand and to show that prices reflect relative scarcity, today the paradox provides a troubling description of the role of water in our economy. With our enormous population and economic growth, our fresh water supplies are stretched more than ever. Meanwhile, Americans spend more than ever on discretionary items. Instead of diamonds, I'll compare our water and wastewater bills to what we're paying for soft drinks. American households spend an average of $707 per year on soft drinks (carbonated) and other (non-carbonated) refreshment beverages³ compared to an average of $474 per year per household on water and wastewater charges.⁴ Clearly, our prices and expenditures hardly reflect the true value of water. As we spend more on non-essentials (like soft drinks) and less on essentials (like water), the paradox of diamonds and water weighs heavily on us all.

Properly valuing our water resources strikes me as a threshold issue, one that defines how we deal with water issues. Let's look at the issues in the water sector and some ways in which we can bring our prices and expenditures a little closer to the true value of water.

Rising Costs for Water Infrastructure

Our pipes and plants are aging; maintenance is too often deferred; and, as a result, we can expect sharply rising future costs for repair and replacement of water infrastructure. In most cities and towns, the pipes used to distribute clean water and collect wastewater have passed their life expectancy. In fact, based on the dates when most of our water pipes were laid, we can expect a large wave of financial obligation to replace these pipes in the coming decades. Dubbed the "Nessie Curve" by the Australians, it is named after the Loch Ness Monster because so much of this financial obligation (like our pipes) lies beneath the surface.

Last September, EPA issued a report that talked about "a gap between projected clean water and drinking water investment needs over the twenty-year period from 2000 - 2019 and current levels of spending."⁵ We pointed out if investment in water and wastewater systems remains flat and does not increase, we expect a "gap" to occur. Under the flat investment or "no revenue growth" scenario, we estimated a clean water capital payment gap of $122 billion (the mid-range estimate) over the 20 year time period. Our mid-range estimate for the drinking water capital payment gap is $102 billion for the "no revenue growth" scenario.

We acknowledge tremendous uncertainty associated with the analysis. In fact, we put out the report more to encourage a policy discussion of the challenges confronting the nation's clean water and drinking water systems. Our "revenue growth scenario" is dramatically different. If, instead of flat investment, revenue and spending grow at 3%/year over and above inflation, our mid-range estimate for the clean water capital shortfall drops to $21 billion and to $45 billion for drinking water capital.

Obviously assumptions are very important – but so are choices. Where we fall between these two scenarios depends on us.

Addressing Future Challenges: Four Ways

Today's challenges demand a multi-faceted approach to managing and sustaining our infrastructure assets. Not only are we going to have to manage better in both the public and private spheres, we're going to have to use less water, or at least use it more efficiently, and pay more of the full costs of infrastructure.

I'd like to offer four directions water utilities may wish to pursue in order to deal with the challenges of increased demands and future costs:

1. Better Management
2. Efficiency
3. Full Cost Pricing
4. Watershed Approach.

Better Management

In the Office of Water, we've been looking at the potential for asset management techniques to reduce a utility's long-term costs and improve performance. This is a structured management approach that is based on information about the condition of a system's assets. Knowing the condition of your assets and linking that information to inventory, service levels, useful life, and repair costs will provide the information needed to make optimal management decisions – including decisions about funding future renewal and replacement.

Recently, the Orange County Sanitation District approved an investment of $22-38 million, over a six year period, to implement its Asset Management Plan, as part of a $2 billion investment strategy over the next twenty years. This front-end investment in manpower, planning and assistance, information systems, software, training and other process changes will yield a 20 year return on investment in the range of 9:1 to 16:1. This translates into a reduction of $150 million in their capital improvements program and a total life cycle cost savings of at least $200 million.⁶

This 10% savings from just one utility, admittedly a very large one, is equivalent to the current full amount of the federal contribution to California's Clean Water State Revolving Fund (SRF) over two years!

Environmental management systems (EMS) are another important tool to help utilities manage better and reduce costs. The EMS approach involves a comprehensive assessment of an organization's impact on the environment followed by specific targets and objectives and continual checking to make sure the desired results are achieved. EMS and asset management can complement each other and give utilities a powerful way to continually manage for better results and greater efficiency.

Back in 1998, the National Association of Water Companies issued a report that compared the water industry to the electric and natural gas utilities.⁷ One overwhelming observation from that study still stands out. The water sector is far more fragmented than the electric and natural gas utilities. There are some 54,000 drinking water systems versus 3200 electric and 2700 gas utilities. EPA has found that, oftentimes, there are cost savings that can be achieved by small systems through consolidating ownership or management with other small systems. Although consolidation is not always a viable option, by combining resources, systems can achieve a more sustainable level of technical, financial and managerial capacity.

For instance, the system serving the city of Panora, Iowa consistently violated the public health standards for nitrate in drinking water. Rather than incur the cost of installing treatment, the city decided to purchase raw water of a higher quality from a neighboring system. In addition, the city pursued a partnership agreement with another neighboring system to assist with operating and monitoring its water treatment plant. This agreement enabled the city to take advantage of the other system's technical expertise and reduced the need for on-site operators.

I probably don't need to remind this audience of the importance of the private sector in the provision of clean and safe water. This is particularly true on the drinking water side where nearly 70% of systems are privately owned. In appreciation of this fact, Congress, in its 1996 Amendments to the Safe Drinking Water Act, made investor-owned utilities eligible for loans under the Drinking Water State Revolving Fund (DWSRF). Approximately 10% of the 2400 loans provided since 1997 under DWSRF has gone to private systems and 4.5% of the $5 billion in assistance provided has gone to private systems.

Public-private partnerships and private companies have helped a number of communities provide both water and wastewater treatment at reduced cost. Whether providing basic water or wastewater treatment supplies (e.g., chemicals), maintaining a portion of the collection or treatment system under a contract, or providing contract operation and maintenance for all of a municipality's facilities, the private sector can serve an important role in the effort to maintain water quality across the country. Over the past decade, we've seen an increased interest in using the private sector to meet water and wastewater funding needs. A Presidential Executive Order (12803) was issued in 1992 directing federal agencies to remove obstacles to privatization. My staff works with the Office of Management and Budget to review and approve a number of these privatization agreements for wastewater systems every year.

EPA recognizes the efficiency advantages that can accompany privatization or public-private partnerships. Nevertheless, our overriding interest is in fostering management excellence in water systems – whether government-owned or investor-owned.

Efficiency

In addition to managing better, we're going to have to learn to use water more efficiently. With 8% of the world's fresh water, the United States is relatively blessed; yet even our eastern states are beginning to suffer water quantity problems; and on both coasts, we're reaching the end of the era in which we could always expand water supply. At the very least, the marginal cost curve for expanding our water supply is very steep indeed.

Demand side management is needed to complement our supply side approach. During the next 100 years, we're going to have to become experts on the demand side of the equation: conservation, recycling, reuse and improved water-use efficiency. If we can reuse our treated wastewater for beneficial purposes such as irrigation, manufacturing or groundwater recharge, the environmental and economic benefits are manifold. If we can bring metering to those communities that still lack the means to measure their consumption, then we've provided a basis for price incentives to begin to work. For example, Westfield, Massachusetts went from no meters to a fully metered system. The installation of meters enabled the city to set a metered water rate that allowed for complete cost recovery of its existing and projected expenses. Also the city found that it could abandon plans to develop a new surface water source, as its customers began to conserve water. Imagine the water savings if cities the size of Chicago and Sacramento fully metered their systems.

I want to salute Mayor Daley for his recent announcement of Chicago's plan to meter 350,000 households presently charged a flat fee. This will result in conserving precious Lake Michigan water while sustaining the City's infrastructure for a long time.

EPA has a number of resources available to assist water efficiency efforts. We published the Water Conservation Plan Guidelines in 1998 for public water systems and we sponsor a voluntary partnership program for businesses and institutions called WAVE (Water Alliances for Voluntary Efficiency). On our website ⁹ you can also find a number of other publications and links to WaterWiser, the water conservation clearinghouse that we started in conjunction with the American Water Works Association.¹⁰

Full Cost Pricing

The most obvious way to address the discrepancy between the value of water and its price is through the price mechanism. At a minimum, we're going to have to pay more of the actual costs of maintaining our water systems over time. A cost-based rate structure that incorporates all of the costs of building, maintaining and operating a system into the price is called full cost pricing. We regard this as essential for sustainable infrastructure. When cost-based pricing is supplemented with incentives for consumers to conserve, we move into conservation pricing. You can read more about these different types of rate structures for water and wastewater pricing in a paper written by one of our economists and posted on our website.¹¹

The Congressional Budget Office recently issued a report entitled Future Investment in Drinking Water and Wastewater Infrastructure (November 2002) which points out that increased future infrastructure costs will either have to be paid by taxpayers or ratepayers¹². To quote CBO: "Ultimately, society as a whole pays 100 percent of the costs of water services, whether through ratepayers' bills or through federal, state, or local taxes." CBO raises strong efficiency arguments for ratepayers picking up the increased costs rather than taxpayers. Certainly the most direct route for funds to flow is straight from the ratepayer to the utility. In addition, we know that when prices rise, quantity demanded falls. Moreover, in this same report, CBO estimates that combined water and sewer bills currently average 0.5% of income in this country (i.e. one half of one percent of average household income). There appears to be room for higher water bills among most households. In a recent draft report from the Organization for Economic Cooperation and Development,¹³ the United States had the lowest percentage of income going to water charges among the 18 OECD countries for which data was available. CBO, in its report, calculated that even if future infrastructure needs fall into the very high range, average water bills will still only account for 0.9% of income on average. In a recent article, Harvard economist Robert Stavins describes our water prices as "muffled"¹⁴. He suggests that ratepayers need to hear stronger price signals so that they see a connection between their consumption and their water bill.

This is not to overlook the affordability problems that low-income households may face. To alleviate these hardships, communities can offer rate structures that mitigate impacts on low-income customers. The most prominent example is "lifeline rates" where the charge for an amount of service considered non-discretionary (the minimum sanitary requirement) is kept low, but then higher unit charges are levied on water consumption beyond that amount. Affordability programs are offered by only 14% of water utilities.¹⁵ There is still much to learn from the gas and electric utilities in their many years' experience in offering low-income assistance. We want rates that are affordable for most households, but not so "muffled" that we can't hear a price signal, a signal which conveys important information on the condition of the infrastructure which it supports. Differential pricing would reconcile equity and efficiency.

The Watershed Approach

Finally, in addition to managing better, using less and adequately pricing services, we're going to have to use the watershed approach to target strategic, cost-effective actions to meet water quality standards. EPA views watersheds as the basic unit to define and gauge the nation's water quality. The watershed approach is a term generally invoked to mean broad stakeholder involvement, hydrologically defined boundaries, and coordinated management across all aspects of policy that affect water. Leading the way are over 4,000 local watershed organizations in the U.S. working to advocate watershed restoration, source water protection, improved site design, erosion control, land conservation, stormwater management and many other aspects of water resource management. I have asked EPA's senior managers to identify ways to advance the watershed approach, including how to increase our training and technical assistance for these local, state, and tribal watershed partnerships.

Several facets of the watershed approach can be advanced by jurisdictions at all levels to reduce the cost of future infrastructure. I'll mention just two:

1. Targeting. Under the 1987 Amendments to the Clean Water Act and the1996 Amendments to the Safe Drinking Water Act, Congress created the State Revolving Fund programs to provide a water infrastructure funding resource in perpetuity. To the extent that flexibility is available under these Amendments, federal, state, local and tribal governments need to target those watersheds and projects that have the greatest impact on human health issues, sources of drinking water and ecosystem protection. Some 19 states use an integrated planning and priority setting approach so that highest priority water quality problems are addressed first with Clean Water SRF funds. This integrated approach helps direct SRF funds toward projects with the greatest water quality benefit – particularly those nonpoint source control and estuary protection projects that can, in many situations, reduce the need for more costly point source controls.

The Safe Drinking Water Act Amendments of 1996 encourage a watershed approach to drinking water protection. As directed by the Amendments, each of the states has developed a Source Water Assessment Program which analyzes existing and potential threats to the quality of drinking water. States may use funds from the Drinking Water SRF to conduct source water assessment and protection activities including land acquisition and wellhead protection. Protecting drinking water sources from contamination in the first place has been shown to reduce costs significantly. An EPA study has shown that prevention can be up to 40 times more cost effective than remediating or finding new drinking water sources.¹⁶ Clearly, targeting our assistance to control nonpoint sources and protect source waters are promising ways of bringing down the costs of future infrastructure.

2. Watershed Trading. Watersheds are ideal for experimenting with market-based incentives; and our Water Quality Trading Policy¹⁷ released on January 13th of this year renews our efforts to pursue water-quality trading for nutrients, sediments and other pollutants to reduce the cost of compliance with water-quality based requirements. With this policy, we're supporting states and tribes in developing trading programs that meet the requirements of the Clean Water Act. A water quality "credit" could be created by reducing pollution loads beyond required levels (e.g., for an NPDES permittee, reductions below a water quality based effluent limitation). For example, a landowner or a farmer could create credits by changing cropping practices and planting shrubs and trees next to a stream. A municipal wastewater treatment plant then could purchase and use these credits to meet water quality limits in its permit, thereby taking advantage of differentials in pollution control costs. Our policy supports trading among and between regulated and unregulated sources.

In its analysis of the Clinton Administration's Clean Water Initiative, EPA concluded that the total potential savings from all types of trading range from $658 million to $7.5 billion annually. A current example of a successful trading effort, between point sources only, can be found on Long Island Sound where nitrogen trading among publicly owned treatment works in Connecticut is expect to save over $200 million in control costs.

A study of three watersheds in Minnesota, Michigan and Wisconsin by the World Resources Institute (2000)¹⁸ found that the cost of reducing phosphorous from point sources, traditional pipe-in-the-water dischargers, was considerably higher than those based on trading between point and non-point, or diffuse, sources of runoff which are not regulated by the Clean Water Act. The estimates for point source controls ranged from $10.38 per pound of phosphorus in the Wisconsin watershed to $23.89 in the Michigan watershed. Using trading between point and non-point sources, these costs could be lowered to $5.95 per pound in Wisconsin, a reduction of over 40%, and to $4.04 in Michigan, a reduction of over 80%.

Clearly, if we use some of these watershed techniques, we can more efficiently address clean water and drinking water needs.

Conclusion

In conclusion, I've suggested 4 broad directions that both privately owned and publicly owned water utilities should pursue in order to better capture the true value of water: better management, efficiency, full cost pricing and the watershed approach. Those of you involved in the water industry probably have numerous other ideas for enhancing our stewardship of America's water resources, and I'd be interested in hearing from you. The provision of clean and safe water for the 21st century is sufficiently challenging as to demand the energy, talent and creativity of both the private and public sectors. I welcome your contribution to this important work.

Thank you.

¹/ Tully, Shawn. "Water, Water Everywhere." Fortune. May 15, 2000.

²/ Picerno, James. "Economics: For Better or Worse, Water is the Wellspring of a New Growth Industry." BLOOMBERG Personal Finance, June 2002

³/ Total retail sales for bottled beverages in 2001 were obtained from the Beverage Digest Fact Book 2002, Beverage Digest Company, Bedford Hills, NY. Website: http://www.beverage-digest.com . Total retail sales for 2001 carbonated, non-carbonated and bottled water was $82 billion. Dividing $82 billion by 116 million households in U.S. (obtained from U.S. Census information at http://quickfacts.census.gov/hunits/states/06000.html ) yields spending of $707 per household per year. These calculations were made by Holly Stallworth, Ph.D., EPA Office of Water economist.

⁴/ Raftelis Financial Consulting 2002 Water and Wastewater Rate Survey reports an average of $474 per household per year for combined water and sewer bills. http://www.raftelis.com/survey.htm

⁵/ EPA-816-R-02-020, The Clean Water and Drinking Water Infrastructure Gap Analysis, Office of Water, September 2002. Website: http://www.epa.gov/owm/gapreport.pdf

⁶/ The full text of this plan can be found on the Orange County Sanitation District website at http://www.ocsd.com/about/reports/special_studies.asp .

⁷/ National Association of Water Companies and Beecher Policy Research, The Water Industry Compared: Structural, Regulatory, and Strategic Issues for Utilities in a Changing Context, September 1998.

⁸/ EPA-832-B-02-003, Cases in Water Conservation, Office of Water, July 2002. Website: http://www.epa.gov/OW-OWM.html/water-efficiency/utilityconservation.pdf

⁹/ The Office of Water's website is http://www.epa.gov/ow/.

¹⁰/WaterWiser is a water efficiency clearinghouse and website initiated with funding from EPA and maintained by the American Water Works Association. http://www.waterwiser.org/

¹¹/ Holly Stallworth, Ph.D., Office of Water, EPA, "Conservation Pricing of Water and Wastewater," http://www.epa.gov/owm/water-efficiency/water7.pdf .

¹²/ Congressional Budget Office, Future Investment in Drinking Water and Wastewater Infrastructure, November 2002, ISBM 0-16-01243-3.

¹³/ OECD, 11-20-02 Draft, "Social Issues in the Provision of Water Services" Table 2-2.

¹⁴/ Sheila M. Cavanagh, W. Michael Hanemann, and Robert N. Stavins, "Muffled Price Signals: Household Water Demand Under Increasing-Block Prices," December 31, 2001 ASSA Paper.

¹⁵/ Raftelis Financial Consulting, 2002 Water and Wastewater Rate Survey. Ordering information for this publication is available from http://www.raftelis.com/.

¹⁶/ EPA-813-B-95-005, Office of Water, Benefits and Costs of Prevention: Case Studies of Community Wellhead Protection - Volume I. 1996.

¹⁷/ EPA, Office of Water, Final Water Quality Trading Policy, January 13, 2003. Website: http://www.epa.gov/owow/watershed/trading/finalpolicy2003.html.

¹⁸/ Paul Faeth, Fertile Ground: Nutrient Trading's Potential to Cost-effectively Improve Water Quality, Washington, D.C.: World Resources Institute, 2000.

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