United States Environmental Protection Agency

Expert Workshop on Full Cost 

Pricing of Water and Wastewater Service 

November 1-3, 2006 

Michigan State University 

Institute for Public Utilities

Final Summary Report 
Office of Water (4606M) 

EPA 816-R-07-005 

www.epa.gov/safewater

May 2007 

2
Table of Contents

Executive Summary 

1.0 Background 

2.0 Workshop Participants 

3.0 Workshop Structure 

4.0 Definition and Conceptual Model for Full Cost Pricing 

 4.1 Discussion of Definition of Full Cost Pricing 

5.0 Summary of Framing Presentations 

5.1 History of the Safe Drinking Water Act, EPA’s Sustainable 

Infrastructure Initiative, and the Full Cost Pricing Model 

5.2 History of the Safe Drinking Water Act and Clean Water Act 

Implementation and Evolution of the Water Industry 

5.3 The Water Industry Compared and Economic Regulation of the 

Water Industry 

5.4 The Investment Community Perspective on the Water and 

Wastewater Industry 

5.5 An Economist’s First Impressions of the Water Industry 

5.6 Capital Efficiency in the Water Industry

6.0 Level and Means of Provision of Service 

 6.1 Framing the Level of Service in Terms of Full Cost Pricing 

 6.2 Level of Service: An Academic Perspective 

6.3 An Academic/Public Policy Framework for Understanding and 

Evaluating Alternative Institutional Structures for Provision of 

Desired Level of Service 

6.4 Summary of Open Discussion

6.4.1 Drinking Water Quality and Service Reliability 

6.4.2 Nature of Customer Base 

6.4.3 Peak Flow Issues 

6.4.4 Wastewater Level of Service Issues 

6.4.5 Institutional Structure 

6.4.6 Public Education 

6.4.7 Economic Regulation 

3
7.0 Recognition of Full Business Costs & the Annual Revenue 

Necessary for Cost Recovery 

7.1 Framing Presentation on Asset Management 

7.2 Framing Presentation – A Local Elected Officials Perspective on 

Post Employment Benefits 

7.3 Summary of Open Discussion 

7.3.1 Cost Drivers 

7.3.2 Post Employment Benefits 

7.3.3 Asset Management 

8.0 Cost Recovery through Rates, Charges & Other Sources 

 8.1 Framing Presentation on Cost Allocation and Rate Design 

 8.2 Framing Presentation on Decoupling Revenues from Sales 

 8.3 Summary of Open Discussion 

 8.3.1 Decoupling Revenue from Sales 

 8.3.2 Cost Allocation & Rate Design 

 8.3.3 Affordability 

 8.3.4 Subsidies 

9.0 Workshop Conclusions 

Appendix A 

 Appendix B 

4
Executive Summary

The United States Environmental Protection Agency (EPA) convened an expert 

workshop of leading academics, water utility executives, Public Utility Commissioners 

and staff, utility rate setting practitioners, and other experts to explore the issue of “full 

cost pricing” for water and wastewater service. The workshop was held on November 1-

3, 2006 at Michigan State University (MSU) and was co-hosted by MSU’s Institute for 

Public Utilities. 

Workshop participants generally agreed to the following definition and 

conceptual model for full cost pricing: Full cost pricing is a pricing structure for drinking 

water and wastewater service which fully recovers the cost of providing that service in an 

economically efficient, environmentally sound, and socially acceptable manner, and 

which promotes efficient water use by customers. The model below depicts the 

relationship between the level of service a utility provides and how it is structured to 

provide it; the full costs of doing business; the annual revenue necessary to recover costs; 

and cost recovery through some combination of rates and charges, subsidies, and transfer 

payments. 

5
The Workshop consisted of formal presentations to frame key issues and 

extensive structured, facilitated discussion organized around the conceptual model. The 

formal presentations were: 

o History of the Safe Drinking Water Act, EPA’s Sustainable Infrastructure 

Initiative, and the Full Cost Pricing Model 

o History of the Safe Drinking Water Act and Clean Water Act 

Implementation and Evolution of the Water Industry 

o The Water Industry Compared and Economic Regulation of the Water 

Industry 

o The Investment Community Perspective on the Water and Wastewater 

Industry 

o An Economist’s First Impressions of the Water Industry 

o Capital Efficiency in the Water Industry

o Level of Service: An Academic Perspective 

o An Academic/Public Policy Framework for Understanding and Evaluating 

Alternative Institutional Structures for Provision of Desired Level of 

Service

o Framing Presentation on Asset Management 

o Framing Presentation – A Local Elected Officials Perspective on Post 

Employment Benefits 

o Framing Presentation on Cost Allocation and Rate Design 

o Framing Presentation on Decoupling Revenues from Sales 

These presentations were used to tee up issues and concepts for open discussion 

among participants. The Expert Workshop brought together different perspectives on the 

fundamental questions related to full cost pricing of water and wastewater service. The 

objective of the Workshop was to achieve a deeper understanding of these issues from a 

variety of perspectives. The Agency will use the results of the Expert Workshop to help 

better frame the issue of full cost pricing for further deliberation and provide insight into 

a variety of possible approaches to facilitating industry movement toward sustainability. 

Workshop participants generally agree that complete achievement of full cost 

pricing will be possible and successful only in an efficiently structured and managed 

water and wastewater sector. Embedded in the current structure, management, 

operations, and oversight of the water and wastewater sector are potentially significant 

inefficiencies. Eliminating these inefficiencies will help to minimize future cost 

increases and the magnitude of future rate increases. Comprehensive sectoral reform is 

needed and EPA’s role should be to initiate, inform, enable and facilitate a broad national 

dialogue among all stakeholders about how to achieve our national public health and 

environmental protection goals in a cost-effective and socially acceptable manner. 

6
As the workshop drew to a close, participants agreed that a number of key 

specific themes and issues had emerged in the discussions. The group identified and 

organized these themes and issues as presented in the diagram below to assist EPA and 

other stakeholders in better framing future thinking and discussion of full cost pricing and 

water & wastewater system sustainability. 

Expert Workshop on Full Cost Pricing of Water and Wastewater Service

Key Issues Identified

“Meta-Issues”

1. Least Cost Achievement of Environmental & Public Health Protection Goals Across Watersheds.

2. Role of Economic vis-à-vis Environmental & Public Health Regulation.

3. Public Education & Building Public Support.

4. Role of Federal & State Subsidies.

5. Impact of Global Climate Change.

Industry Structure

1. Consolidation

2. Ownership and Management Contestability

3. Level of Service

Utility Management

1. Best Practices for Operational Efficiency

2. Asset Management to drive to least-cost

3. Risk Recognition & Management

4. Cost of Capital

5. Alternative Capital Project Delivery Methods

6. Uniform System of Accounts

7. Information Resources to Support 

Ownership and Management Contestability

8. Pricing Pardigm

7
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8
1.0 Background

The United States Environmental Protection Agency (EPA) convened an expert 

workshop of leading academics, water utility executives, Public Utilities Commissioners 

and staff, utility rate setting practitioners, and other experts to explore the issue of “full 

cost pricing” for water and wastewater service. The workshop was held on November 1-

3, 2006 at Michigan State University (MSU) and was co-hosted by MSU’s Institute for 

Public Utilities. 

Full cost pricing is one of four major themes under EPA’s Sustainable Water 

Infrastructure Initiative. The other themes include: management of utilities; promoting a 

watershed based approach to infrastructure planning; and promoting the efficient use of 

water. Taken together, the Agency believes that these four “pillars” of sustainable 

infrastructure will help enhance the efficiency of the water and wastewater sector in the 

United States and ensure achievement of our nation’s public health and environmental 

protection objectives. The industry is entering an era characterized by significant 

infrastructure replacement need and new investment for enhanced public health and 

environmental protection. Overwhelmingly, the costs of these investments will be borne 

by the utility ratepayers. 

The Expert Workshop brought together different perspectives on the fundamental 

questions related to full cost pricing of water and wastewater service. The objective of the 

Workshop was to achieve a deeper understanding of these issues from a variety of 

perspectives. The Agency will use the results of the Expert Workshop to help better 

frame the issue of full cost pricing for further deliberation and provide insight into a 

variety of possible approaches to facilitating industry movement toward sustainability. 

 

9
This page intentionally left blank.

10
2.0 Workshop Participants

Janice Beecher, PhD 

Director, Institute for Public Utilities 

Michigan State University 

Jack Betkoski 

Commissioner, Connecticut Department of Public Utility Control 

Tom Chesnutt, PhD 

President, A&N Technical Services 

Julius Ciaccia 

Commissioner of Utilities 

Cleveland, OH 

Don Coursey, PhD 

Professor of Public Policy Studies 

University of Chicago 

Debra Coy 

Water Sector Research Practice Leader 

Janney Montgomery Scott LLC 

John Cromwell 

Managing Economist 

Stratus Consulting 

Paul Foran 

Vice President, Regulatory Programs 

 American Water 

Joe Gehin 

Director of Utilities 

Wausau, Wisconsin 

John Guastella, Sr. 

President, Guastella Associates 

John Guastella, Jr. 

Director of Rates and Valuations, Guastella Associates 

Heather Himmelberger 

Director, New Mexico Environmental Finance Center 

New Mexico Institute of Mining and Technology 

11
2.0 Workshop Participants (Continued)

Christine Hoover 

Pennsylvania Office of Consumer Advocate 

John Huber 

General Manager, Louisville, KY Water 

Ralph Jones, PhD 

CEO, The Cadmus Group, Inc. 

Watertown, MA 

Edna Loehman, PhD 

Associate Professor of Agricultural Economics 

Purdue University 

Patrick Mann, PhD 

Professor of Economics 

West Virginia University 

Myron Olstein 

Independent consultant 

John O’Neil 

Wastewater Administrator, Johnson County (Kansas) Wastewater 

Kathy Pape 

Vice President, Treasurer and Rate Counsel, Aqua America, Inc. 

Dave Sheard 

Assistant Administrator, Wisconsin Public Service Commission 

David Williams 

Director of Wastewater, East Bay Municipal Utilities District (California) 

12
3.0 Workshop Structure

 In advance of the workshop, participants received a 5-page “Background Paper on 

Full Cost Pricing” which introduced a preliminary conceptual model for full cost pricing. 

The Workshop consisted of a small number of formal presentations to frame key issues 

and extensive structured, facilitated discussion organized around the conceptual model. 

The background paper and workshop agenda are presented in appendices A and B, 

respectively. 

 In order to promote full and open discussion, EPA decided to summarize the 

meeting without attribution of discussion comments to specific participants. Thus, 

participants were encouraged to speak freely and to represent their own professional 

opinion, not the institutional opinion of the organization with which they are affiliated. 

In this summary report, individual comments by workshop participants are 

paraphrased and presented in bulleted lists organized by topic of discussion. These 

summaries of comments are intended to capture the breadth and depth of the workshop 

discussions. No attempt has been made to reconcile conflicting comments. The 

objective of the workshop was to elicit a variety of perspectives. This summary seeks to 

preserve and accurately reflect the substance of the discussions. 

At the end of the workshop, participants did agree to an overall summary of the 

major issues identified. These workshop conclusions are presented in Section 9.0 of this 

report.

The Expert Workshop on Full Cost 

Pricing of Water and Wastewater Service 

was held at the Kellogg Conference Center 

on the Michigan State University Campus 

in East Lansing, MI. 

13
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14
4.0 Definition and Conceptual Model for

 Full Cost Pricing

The following draft definition of full cost pricing was offered to facilitate 

discussion at the expert workshop: 

Full cost pricing is a pricing structure for drinking water and wastewater 

service which fully recovers the cost of providing that service in an economically 

efficient, environmentally sound, and socially acceptable manner, and which 

promotes efficient water use by customers.

 The conceptual model for full cost pricing is presented in Exhibit 1. The model 

depicts the relationship between the level of service a utility provides and how it is 

structured to provide it; the full costs of doing business; the annual revenue necessary to 

recover costs; and cost recovery through some combination of rates and charges, 

subsidies, and transfer payments.

The model posits that the fundamental determinants of the full cost of water 

and/or wastewater service are the level of service the public desires and the way in which 

a utility (or utilities) is structured and managed to deliver that level of service. Table 1, 

below, presents examples of issues and questions helpful in thinking about level of 

service and utility structure and management. 

15
Table 1: Level of Service and Utility Structure and Management 

Considerations 

System 

Type 

Example Level of Service Issues Example Utility Structure and 

Management Issues 

Water 

• Does system provide fire protection? 

• What peak flow demands can the system 

meet? 

• Number and duration of service interruptions 

per year. 

• Number of water main breaks per year (and 

damage caused by breaks). 

• Quality of water delivered to customer. Does 

it comply with federal/state health based 

regulations? Does it meet the aesthetic 

demands of customers? 

• Time to respond to customer complaints or 

questions. 

• Nature of system’s “environmental 

footprint”—is it a “green” system? 

• Outreach and public education. 

• Opportunities for customer input and 

involvement. 

Wastewater 

• Number and duration of service interruptions 

(such as backups) experienced by customers. 

• Number of times and quantity of untreated 

wastewater discharged per year. 

• Quality of treated effluent: Does it comply 

with federal/state standards? Does it satisfy 

community expectations? 

• Time to respond to customer complaints or 

questions. 

• Nature of system’s “environmental 

footprint”—is it a “green” system? 

• Outreach and public education. 

• Opportunities for customer input and 

involvement. 

• Utility ownership: public or private? 

• Utility scope: water or wastewater 

only? Both? Both including other? 

• Institutional structure: If public; line 

department of city government? 

Enterprise fund? Special district? If 

Private; is it a publicly traded 

corporation or a private owner? 

• Utility management: public or private? 

If owner does not manage, what is the 

nature of the contractual agreement 

under which some other party 

manages the system/utility? 

• Geographic scope of utility: Is it 

system or community specific or 

regional in nature? 

A central question implied by the model is the cost effectiveness with which the 

selected utility structure and management is able to deliver the desired level of service. Is 

the desired level of service being obtained at least cost or the most appropriate cost? If 

not, is it being obtained in a manner optimizing appropriate social outcomes? According 

to whose perspective? 

 Assuming an appropriate level of service is being provided in a manner 

optimizing desired social outcomes, the model next reflects the need to fully identify all 

business costs associated with the provision of that service. At this point, the insights 

from the Better Management Pillar of the Sustainable Infrastructure Initiative are needed. 

In particular, a comprehensive asset management program or a similar planning practice 

through which the utility can estimate its long-term capital and operating costs. In this 

context long-term is defined as the life cycle of the assets of the utility. The planning 

process employed should address the lumpy nature of infrastructure investment and the 

16
intergenerational equity issues associated with that. Critical issues will involve how 

capital projects are delivered (traditional vs. design-build for example), the cost of 

capital, financing alternatives, treatment of depreciation, and the optimum mix of 

maintenance vs. capital replacement in the real world operating environment of the 

utility. 

 Once the full business costs of providing the service have been determined, the 

annual revenue stream necessary to fully cover those costs must be calculated. If systems 

are under the jurisdiction of their State Public Utilities Commissions, this process will be 

governed by the established policies and procedures of the commission. 

 Once the annual revenue stream necessary to sustain the desired level of service 

has been determined, the model moves into the cost allocation and rate design process. 

Principles of cost allocation and rate design are well established. A critical question for 

the expert workshop is the current state of practice in cost allocation and rate design. Is 

there a need for significant innovation in this area? If so, of what nature? How important 

are cost allocation and rate design as opposed to the issues considered earlier in the 

model to achieve full cost pricing? 

 As an essential component of this analysis, the model calls for explicit 

consideration of the role that external subsidies (such as federal or state interest rate 

subsidies or grants) and transfer payments (such as movement of funds between a city’s 

general fund and the utility) will play in meeting the annual revenue requirement. 

Subsidies will decrease the amount of revenue that needs to be recovered from 

ratepayers. Transfer payments from the city’s general fund into the utility will also 

reduced the revenue that needs to be collected. The opposite will hold if the transfer 

payment is from the utility to the city’s general fund. (The model is descriptive, not 

normative. External subsidies and transfer payments are reflected in the conceptual 

model to improve the model’s ability to describe how costs are actually recovered by 

some systems. The model describes how external subsidies and transfer payments may 

play a role in utility cost recovery; the model does not, nor does it seek to, suggest the 

role that subsidies and transfer payments should play.) 

 

 After any correction for subsidies and/or transfer payments and after application 

of the selected cost allocation and rate design methodology, the annual bill for each user 

can be determined, assuming (if necessary) a given level of water use or wastewater 

generation. At this point, decision makers may conclude that the household rates, 

necessary to support the existing or desired level of service under the selected 

management and operational structure, are economically or politically not feasible. This 

would require a return to the beginning of the model to revisit decisions about level of 

service and/or the utility’s structure and management/operations. 

17
4.1 Discussion of Definition of Full Cost Pricing

3⁄4 The proposed definition and model are sound and offer an excellent point of 

departure for this workshop. 

3⁄4 To get a better grip on full cost pricing, we need to know what it is not. What is 

the relationship between full cost pricing and full cost accounting? Also, what’s 

the difference between full cost pricing and efficient pricing? What’s the 

relationship with this and triple bottom line accounting? 

3⁄4 The definition of full cost pricing presented refers to economic efficiency. We 

need to give more thought to this as the definition is further fleshed out.

3⁄4 I have a concern that including subsidies and transfer payments in the conceptual 

model tends to make it appear as if subsidies and transfer payments should be 

recognized as a legitimate part of the full cost of service pricing paradigm, when 

I’m not sure they are in fact consistent with it. One of the main goals of full cost 

pricing should be to send more accurate pricing signals to customers so that more 

informed and rational decisions can be made about consumption and better 

resource allocation and supply choices can be made. Rather than reflect subsidies 

and transfer payments as part of the full cost paradigm, perhaps it would be better 

to recognize them as issues that need to be addressed in terms of affordability and 

the need to perhaps target relief more specifically to those that need it rather than 

being part of the general pricing structure. 

18
5.0 Summary of Framing Presentations

 The workshop opened with 6 formal presentations designed to help frame the full 

cost pricing issue for discussion during the workshop. The framing presentations were: 

1. History of the Safe Drinking Water Act, EPA’s Sustainable Infrastructure 

Initiative, and the Full Cost Pricing Model. 

2. History of the Safe Drinking Water Act and Clean Water Act Implementation and 

Evolution of the Water Industry 

3. The Water Industry Compared and Economic Regulation of the Water Industry 

4. Capital Efficiency in the Water Industry 

5. The Investment Community Perspective on the Water and Wastewater Industry 

6. An Economist’s First Impressions of the Water Industry 

Summaries of each presentation follow. 

19
5.1 History of the Safe Drinking Water Act, EPA’s Sustainable Infrastructure 

Initiative, and the Full Cost Pricing Model

Peter E. Shanaghan, USEPA 

 

Early Federal oversight of drinking water dates back to the 1912 Common Cup 

Standard issued by the Public Health Service. This standard prohibited the use of a 

common cup for drinking water aboard interstate common carriers (trains and ships). 

Regulatory standards for the quality of drinking water aboard common carriers soon 

followed. As the 20th century progressed, the Public Health Service issued nonenforceable guidelines for the quality of tap water. States independently established their 

own regulatory programs for drinking water. In 1969, the General Accounting Office 

documented that only 60% of water systems delivered water meeting the PHS guidelines 

and over 50% of water treatment facilities had significant deficiencies. 

In 1974, growing concern about the safety of tap water and the uneven patchwork of 

regulatory programs led to passage of the Federal Safe Drinking Water Act (SDWA). 

The SDWA authorized USEPA to develop enforceable public health protection based 

standards for drinking water quality. The law sought to build upon existing State 

regulatory programs through the concept of primacy. States having primacy for a Federal 

regulation have demonstrated the legal and institutional capability to enforce the Federal 

standard and assume the day-to-day oversight responsibilities for implementing that 

regulation. 

From 1974 to 1986 EPA promulgated regulatory standards for 23 contaminants and 

48 States obtained primacy. In 1986, Congress, impatient with what they felt was EPA’s 

slow pace developing regulations, passed a set of SDWA Amendments that mandated 

regulatory standards for 83 contaminants within 3 years and standards for an additional 

25 contaminants every three years thereafter. EPA, State drinking water programs, and 

water utilities all struggled to meet the ambitious agenda established by the 1986 

amendments. By the mid-1990’s it had become clear that the prescriptive formulation of 

the 1986 amendments was not working well and Congress significantly amended the law 

in 1996. 

The 1996 SDWA Amendments emphasized comprehensive, multiple barrier public 

health protection. The amendments preserved the fundamental public health protection 

focus for standard setting and provided for a much more focused and science based 

approach to identifying the contaminants needing to be regulated. The amendments also 

established important new programs aimed at preventing unsafe drinking water. These 

included water system capacity development, operator certification, and source water 

protection. Furthermore, the amendments established the only Federal financial 

assistance program for water utilities focused on regulatory compliance, the Drinking 

Water State Revolving Fund (DWSRF) Loan Program. The DWSRF is designed to 

provide States with exceptional flexibility to tailor the program to their unique needs, 

including provisions authorizing optional set-asides which can be used to support 

20
implementation of the new prevention programs as well as the base drinking water 

program. 

The SDWA has consistently required that regulatory standards be set as close as 

feasible to the level at which no known or anticipated adverse health effects would occur 

with an adequate margin of safety. 

Under the SDWA, any water system providing water for human consumption through 

pipes or other constructed conveyances, which serves at least 15 connections or an 

average of at least 25 persons per day, for at least 60 days per year, is defined as a Public 

Water System (PWS). There are presently 158,000 PWS’s in this country. About 53,000 

of them serve permanent communities and are referred to as Community Water Systems 

(CWS’s). About 19,000 serve institutions such as schools or factories having their own 

water supply serving the same group of people over extended terms, and are referred to as 

Non-Transient Non-Community Water Systems (NTNCWS’s). Finally, about 86,000 

serve establishments such as road side rest stops, providing service to different people 

every day and are referred to as Transient Non-Community Water Systems (TNCWS’s). 

CWS’s are overwhelmingly quite small. About 1/3 of the 53,000 systems serve fewer 

than 100 people each. Another 1/3 serve between 100-500 people each. Nearly 9 out of 

10 serve fewer than 3,300 persons each. In addition to their small size, CWS’s are 

institutionally diverse. 43% are publicly owned; 33% are privately owned; and 24% are 

mobile home parks or similar systems operated as part of a larger business enterprise. Of 

the 33% that are privately owned, about half are investor owned systems, about 35% are 

systems owned by homeowner associations, and the remaining 16% by individuals and 

others. Institutional diversity is most pronounced among systems serving fewer than 500 

people each. About 40% of these systems are mobile home parks, 40% are private 

(overwhelmingly associations and individuals), and only 20% are publicly owned. 

From 1997 through 2005 the number of CWS’s decreased by nearly 4% while the 

total population served by all CWS’s increased by 12%. CWS’s now serve 95% of the 

population in the United States. The decrease in number of CWS’s has been entirely in 

the number of systems serving fewer than 1,000 persons each. The number of systems 

serving fewer than 100 persons declined by about 13% during this period. The numbers 

of systems in larger size categories increased, in some cases by as much as 20-25%. It 

appears consolidation of smaller systems is occurring slowly and that population growth 

is being accommodated by larger systems. 

If one postulates that Total Coliform Rule monitoring and reporting is a crude 

operational proxy for “system capacity” and operator competence; then it appears that 

larger systems do perform better than smaller systems as demonstrated in the chart below. 

21
 

EPA’s 2002 Clean Water and Drinking Water Infrastructure Gap Analysis 

documented that the 21st century will be marked by a significant need to replace drinking 

water distribution system pipe and wastewater collection system pipe that will reach the 

end of its useful life. Expenditures for capital replacement and operations and 

maintenance will need to annually grow by 3% above the rate of inflation in order to 

prevent the emergence of a spending “gap” with serious public health and environmental 

protection outcomes. 

 In response to these findings, and in consultation with stakeholders, the Agency 

established a long-term strategic focus of “sustainable infrastructure”. The objectives of 

this strategic focus are to increase the efficiency of the water and wastewater sector 

(through better utility management, water use efficiency, and a watershed based 

perspective) and to facilitate movement of the sector to full cost recognition and recovery 

through full cost pricing. 

Full cost pricing is a pricing structure for drinking water and wastewater 

service which fully recovers the cost of providing that service in an economically 

efficient, environmentally sound, and socially acceptable manner, and which 

promotes efficient water use by customers.

 The following conceptual model for full cost pricing served as the basis of 

discussion at the workshop: 

22
The model posits that the fundamental determinants of the full cost of water 

and/or wastewater service are the level of service the public desires and the way in which 

a utility (or utilities) is structured and managed to deliver that level of service. Table 1, 

below, presents examples of issues and questions helpful in thinking about level of 

service and utility structure and management. 

Table 1: Level of Service and Utility Structure and Management Considerations 

System 

Type 

Example Level of Service Issues Example Utility Structure 

and Management Issues 

Water 

• Does system provide fire protection? 

• What peak flow demands can the system meet? 

• Number and duration of service interruptions per year. 

• Number of water main breaks per year (and damage caused by 

breaks). 

• Quality of water delivered to customer. Does it comply with 

federal/state health based regulations? Does it meet the 

aesthetic demands of customers? 

• Time to respond to customer complaints or questions. 

• Nature of system’s “environmental footprint”—is it a “green” 

system? 

• Outreach and public education. 

• Opportunities for customer input and involvement. 

Wastewater 

• Number and duration of service interruptions (such as 

backups) experienced by customers. 

• Number of times and quantity of untreated wastewater 

discharged per year. 

• Quality of treated effluent: Does it comply with federal/state 

standards? Does it satisfy community expectations? 

• Time to respond to customer complaints or questions. 

• Nature of system’s “environmental footprint”—is it a “green” 

system? 

• Outreach and public education. 

• Opportunities for customer input and involvement. 

• Utility ownership: public or 

private? 

• Utility scope: water or 

wastewater only? Both? Both 

including other? 

• Institutional structure: If 

public; line department of city 

government? Enterprise fund? 

Special district? If Private; is 

it a publicly traded corporation 

or a private owner? 

• Utility management: public or 

private? If owner does not 

manage, what is the nature of 

the contractual agreement 

under which some other party 

manages the system/utility? 

• Geographic scope of utility: Is 

it system or community 

specific or regional in nature?

23
A central question implied by the model is the cost effectiveness with which the 

selected utility structure and management is able to deliver the desired level of service. Is 

the desired level of service being obtained at least cost? If not, is it being obtained in a 

manner optimizing appropriate social outcomes? According to whose perspective? 

 Assuming an appropriate level of service is being provided in a manner 

optimizing desired social outcomes, the model next reflects the need to fully identify all 

business costs associated with the provision of that service. At this point, the insights 

from the Better Management Pillar of the Sustainable Infrastructure Initiative are needed. 

In particular, a comprehensive asset management program or a similar planning practice 

through which the utility can estimate its long-term capital and operating costs. In this 

context long-term is defined as the life cycle of the assets of the utility. The planning 

process employed should address the lumpy nature of infrastructure investment and the 

intergenerational equity issues associated with that aspect. Critical issues will involve 

how capital projects are delivered (traditional vs. design-build for example), the cost of 

capital, financing alternatives, treatment of depreciation, and the optimum mix of 

maintenance vs. capital replacement in the real world operating environment of the 

utility. 

 Once the full business costs of providing the service have been determined, the 

annual revenue stream necessary to fully cover those costs must be calculated. If systems 

are under the jurisdiction of their State Public Utility Commissions, this process will be 

governed by the established policies and procedures of the commission. 

 Once the annual revenue stream necessary to sustain the desired level of service 

has been determined, the model moves into the cost allocation and rate design process. 

Principles of cost allocation and rate design are well established. A critical question for 

the expert workshop is the current state of practice in cost allocation and rate design. Is 

there a need for significant innovation in this area? If so, of what nature? How important 

are cost allocation and rate design as opposed to the issues considered earlier in the 

model to achieve full cost pricing? 

 As an essential component of this analysis, the model calls for explicit 

consideration of the role that external subsidies (such as federal or state low interest rate 

loans, loan subsidies or grants) and transfer payments (such as movement of funds 

between a city’s general fund and the utility) will play in meeting the annual revenue 

requirement. Subsidies will decrease the amount of revenue that needs to be recovered 

from ratepayers. Transfer payments from the city’s general fund into the utility will also 

reduce the revenue that needs to be collected. The opposite will hold if the transfer 

payment is from the utility to the city’s general fund. However, such subsidies and 

transfer payments can also mask the full cost of service, skew price signals to customers 

and generally undercut the concept and goals of full cost of service pricing. A key 

question for the expert workshop is the role that subsidies and transfer payments do and 

should play in the pricing of water and wastewater services. 

24
 After any correction for subsidies and/or transfer payments and after application 

of the selected cost allocation and rate design methodology, the annual bill for each user 

can be determined, assuming (if necessary) a given level of water use or wastewater 

generation. At this point, decision makers may conclude that the household rates, 

necessary to support the existing or desired level of service under the selected 

management and operational structure, are not economically or politically feasible. If 

additional subsidies and/or transfer payments are not available, the only option is a 

return to the beginning of the model to revisit decisions about level of service and/or the 

utility’s structure and management/operations. 

25
5.2 History of the Safe Drinking Water Act and Clean Water Act Implementation and 

Evolution of the Water Industry

Ralph Jones, PhD; The Cadmus Group, Inc. 

Federal involvement in the regulation of drinking water and wastewater came in 

the last quarter of the 20th century. Prior to the passage of the Clean Water Act (CWA) in 

1972 and the Safe Drinking Water Act in (SDWA) 1974, regulation of both drinking 

water and wastewater was a State responsibility. Generally, State programs for both 

water and wastewater were located in a Department of Health since the primacy concern 

of the State programs was public health and sanitation, specifically to reduce or eliminate 

the spread of disease by waterborne contaminants. 

 Each of the federal statutes had its own unique history. In the case of the Clean 

Water Act, it had become clear that the 1965 Water Quality Act had failed. States were 

required to set water quality standards, but there was no effective enforcement of those 

standards. In 1969, the nation witnessed a burning river. The Cuyahoga River in 

Cleveland was so contaminated with flammable materials that it caught on fire. The 

Congress decided to launch a federal program to make waters of the United States 

fishable and swimmable by expanding the federal role, especially in enforcement. 

 The Safe Drinking Water Act had no preceding federal statute. States set 

standards for drinking water quality, and the nation’s utilities were (by and large) 

providing a high-quality product. Two events changed the course of history. First, the 

Public Health Service conducted a survey of community water systems in 1969. It 

reported that many water systems, especially the small ones, did not produce water that 

met federal public health standards. Second, in the City of New Orleans, research 

suggested a causal relationship between contaminants in the city’s water supply and 

elevated levels of cancer in city residents. It therefore was time for federal standards and 

enforcement. 

 The federal role in funding infrastructure began much earlier than the federal 

regulatory programs. In the 1930's, construction of wastewater treatment plants and 

collection systems was part of the Works Progress Administration (WPA). Even after the 

WPA, the federal role continued. In 1965, the Water Quality Act initiated a construction 

grants program. This program was substantially enlarged in the 1972 Act when the 

Congress sought to invest in upgraded treatment of municipal wastewater. The federal 

government built Publicly Owned Treatment Works (POTWs). There was no 

comparable investment in infrastructure for drinking water. 

 Since 1980, there has been a steady decline in federal investment in water and 

wastewater infrastructure. In 1980, the investment was $10 billion. By 1988, it had 

dropped to $4 billion, on its way to $2B in 1995. The major change came in 1987 when 

the Clean Water Act was reauthorized. Authorization for the construction grants program 

was ended. In its place, Congress authorized capitalization grants for State Revolving 

Funds (SRF). After funding at an annual pace of about $4 billion, appropriations began 

to decline in 1993. Funds increased slightly in 1996 with the passage of the SDWA 

26
Amendments which authorized the creation of a Drinking Water SRF (DWSRF). 

 Reflecting on the implications of federal investment in water and wastewater 

infrastructure, it is clear that the funding of the Clean Water SRF (CWSRF) was 

consistent with the objectives of the 1972 Act which was an ambitious statute designed to 

achieve significant improvements in water quality as fast as possible. The POTWs 

substantially reduced contaminants in receiving waters. At the same time, however, 

economic historians note that the rapid expansion of federal funding displaced, to some 

extent, local and state investment that would have taken place in this period. 

 When one compares the current federal programs for drinking water and 

wastewater, there are striking differences. One major objective of the CWA is to permit 

dischargers in a manner that will enable receiving waters to achieve water quality 

standards. Municipal dischargers (POTWs) are a portion of the regulated community. 

EPA currently regulates about 16,000 POTWs, plus hundreds of thousands of private 

dischargers. 

 The drinking water industry is comprised of about 200,000 entities that provide 

drinking water to the public (defined as any system that serves more that 25 people or 

more than 15 connections). The industry has both publicly owned systems and privately 

owned systems. Water systems are needed to provide piped water to any dense 

development. These same developments can rely on septic systems for wastewater 

disposal. 

 The histories of these two programs has implications for full-cost pricing. 

Wastewater systems were constructed with substantial federal funding. They are 

“publicly owned” treatment works. When it came to developing rates, most systems 

emphasized the costs of operations and management. Insufficient attention was paid to 

the need to plan for eventual rehabilitation and replacement. It is not surprising that the 

National Association of Clean Water Agencies (NACWA) continues to advocate for 

enhanced federal investment in wastewater infrastructure. 

 For drinking water systems, adjustment to full-cost pricing may be a bit easier. 

These systems were built without substantial federal investment. The DWSRF provides 

loans (not grants), and it is only a decade old. Drinking water systems traditionally have 

been forced to consider both O&M and infrastructure as they established rates. The only 

weakness in current behavior of water systems is that they may not be properly 

accounting for the replacement cost of their legacy infrastructure, e.g., distribution pipe 

installed 100 years ago which will soon need replacement. 

 

27
5.3 The Water Industry Compared and Economic Regulation of the Water Industry

Janice Beecher, PhD; Michigan State University 

Utilities provide: products; services; commodities; infrastructure; networks; 

access; economic foundations (development); strategic targets (terrorism); comforts 

(heat, light, safe drinking water); and, basic human rights (subjectively). 

The structural status of the public utility sector can be viewed along a spectrum, 

with the water industry as arguably the most monopolistic utility, due to market failures. 

The electricity sector is less monopolistic; restructuring has introduced competition (with 

mixed results). Less monopolistic still are the gas and telecommunication sectors. The 

gas sector has seen the development of competitive wholesale markets. The 

telecommunications sector is arguably the least monopolistic sector, primarily due to 

technology. 

In the private sector, water and sewer have a comparatively small share of the 

economy (0.07% of the gross domestic product [GDP], compared with 2.35% for 

electricity distribution, and 2.27% for wired telecom carriers). In reality, however, the 

water and wastewater industry is a $100 billion business (water utilities accounting for 

$33.8 billion, wastewater utilities for $32.6 billion, equipment and chemicals for $23.6 

billion, and engineering and consulting for $10 billion). 

Key characteristics of the water and wastewater industries include: 

• Their highly essential nature (drinking water, wastewater service, fire protection). 

• The quality/safety/health dimension. 

• Technical/resource constraints (e.g., weight, hydrogeology, and transience). 

• Economies of scale/scope. 

• Capital intensity and the long lives of assets. 

• Cost profile (rising costs; t&d). 

• Demand patterns (flat, inelastic, peaks). 

• Pricing and (under)pricing practices. 

• Fragmented and bifurcated industry structure; limits to networks, competition. 

• Regulatory environment (quality, quantity, price, and jurisdiction issues). 

It’s difficult to find comparable statistics within other industries. It is difficult to 

compare the water and wastewater industry with the electricity sector, for example, 

because water is a storable commodity for which there is no real-time pricing. In 

addition, there is a strong seasonal component—the source of supply is depleted when 

demand is greatest. Available data show great economics of scale with water, though 

some economies are lost in the distribution network. The smallest systems struggle the 

most. Telecom equipment depreciates very rapidly, while the water industry has 

extremely long-lived assets with very long depreciation schedules. Compared with other 

industries, the water and wastewater industries are extremely capital intensive and 

therefore fundamentally different in nature; capital intensity is also trending upwards. 

28
Water utility revenue and expense data (from the National Association of Water 

Companies [NAWC], 2004) demonstrate how heavily the industry relies on residential 

business (which accounted for 63% of revenue). In addition, the water industry’s 

industrial customers have adopted conservation and efficiency practices (according to 

NAWC, industrial customers accounted for only 4% of revenue in 2004). NAWC 

expenses include depreciation (12%), taxes (16%), deductions (10%, including debt), 

dividends (9%), and operations and maintenance (O&M) expenses (50%). Net income 

was limited (3%). 

 

 Comparing the O&M expenses of an electric utility with that of a water utility, it is 

evident that the electric utility is focused far more on source and supply, while the 

primary focus of the water utility is transmission. Source of supply and productionrelated O&M expenses account for nearly 90% of the electric utility’s expenses and less 

than 5% of the water utility’s expenses. Treatment, transmission and distribution, and 

pumping expenses account for the majority of the water utility’s O&M expenses, 

followed by administrative and general (A&G) expenses. 

When looking at household expenditures, water and sewer service are still a 

relative bargain (0.75% of household expenditures, compared with 2.38% for electricity 

and 2.19% for telephone). Overall, the percentage of household incomes going to utilities 

is relatively stable. As household incomes increase, so does spending on utilities. 

However, the percentage of income spent on utilities is much higher for lower-income 

households. Between 1970 and 2005, water/wastewater was one of the only industries (in 

addition to cable television and garbage services) with price trends above the rate of 

inflation. 

There are several key pressures impacting water prices: 

• Rising costs coupled with flat or declining demand. 

• Combined water, wastewater, stormwater costs. 

• Infrastructure replacement needs. 

• Regulatory compliance costs. 

• Impact of energy markets and costs. 

• Historic under-pricing (public systems). 

• Incentives for conservation and efficiency. 

• Rate shock and rate design options. 

• Affordability and regressivity. 

• Comparison to other utilities and to bottled water. 

The water industry itself is fragmented (there are many water systems nationwide), 

bifurcated (by size and ownership), and pluralistic (there are many interests invested in 

the industry). The industry’s structural character is defined in terms of size and ownership 

of assets, management of operations, and interconnection (in limited local and regional 

instances). 

A water “system” is not always a utility—utilities may own multiple systems and 

some systems are interconnected and purchase water on a wholesale basis (about 15%). 

29
Municipal gas utilities in the U.S. are generally breaking even, while municipal 

electric utilities may even be losing money. Municipal wastewater utilities are 

conceivably undercharging customers, as are municipal transportation authorities and 

water utilities. Cities are subsidizing and undercharging for certain services. 

Surprisingly, the private share of the water market has remained very stable. Many 

very small systems (those serving 500 or fewer persons) are privately owned, while the 

majority of small, medium, large, and very large systems are publicly owned. 

Water quality regulation at the federal level is the responsibility of Congress and 

EPA. At the state and local levels, Safe Drinking Water Act (SDWA) primacy agencies 

and local health departments oversee water quality. Water quantity issues are regulated to 

a limited extent by river basin commissions (for interstate matters), and to a greater 

extent by state resource commissions and water management districts (at the sub-state 

level). Ultimately, regulation of the water industry is done primarily at the local and state 

level. All but five public utility commissions (PUCs) have jurisdiction over water pricing; 

there may also be additional local controls on pricing. 

Key considerations on the economic regulation of the water industry include the 

following: 

• Economic regulation by the states is based on persistent market failure in the form 

of monopoly (private, some publics). 

• Forty-five states regulate about 8,000 jurisdictional water utilities and about 1,000 

sewer companies (including combined utilities). 

• Commission jurisdiction covers about 20% of all community water systems; some 

are “multi-system utilities.” 

o About half are investor-owned (private); the rest are divided evenly 

between municipals, water districts or authorities, and nonprofits and 

cooperatives. 

• Many non-jurisdictional utilities (municipal utilities) follow the lead of regulators 

on accounting (Uniform System of Accounts and Records [USOA]), ratemaking, 

and other practices. 

• Economic regulation focuses on prudence, profits, prices, but PUCs may also 

impose service-quality standards, including water pressure and aesthetics (color, 

taste, and odor). 

• In the presence of persistent market failure—particularly monopoly—economic 

regulation is a proxy for competition to prevent abuse of market power. 

Overall, we have seen the introduction some auctioning/and competitive 

bidding/metering/outsourcing, but ownership of assets and operation remains 

fundamentally monopolistic. This is not necessarily a bad thing, as long as accountability 

remains. 

30
5.4 The Investment Community Perspective on the Water and Wastewater Industry

Debra Coy, Janney Montgomery Scott 

The global water market is $350-$400 billion, dominated by municipal water and 

wastewater utilities. From an investor standpoint, these utilities are viewed as having 

steady/moderate growth, tied to the rate of investment and population growth. There is 

more investment interest in higher growth areas related to these industries, such as new 

technologies and infrastructure supply and equipment; there is more net profitability in 

the latter areas. 

Why are investors looking at this industry? Reasons include: the need for 

investment in infrastructure and supply; an increase in political, public, and media 

awareness; an increase in the number and types of companies entering the water business. 

However, many consumers don’t understand the economics of water provision. 

Technology industries are being brought into the water industry through more 

sophisticated treatment (UV, membrane filtration) and other technologies (e.g., 

automated meter reading). 

U.S. and international water utility and equipment stocks have dramatically 

outperformed broader market indexes, but have also become more volatile. This is partly 

related to uncertainties about politics and pricing of water. There have been recent 

corrections due to excess valuation and concerns about slowing economic growth and 

rising interest rates. The rebound in market earnings has somewhat assuaged investor 

fears. 

The perception of risk in the water industry is rising; it used to be viewed as a 

sleepy/slow growth investment. Now, however, there is pressure on critical supplies, 

costly regulations and infrastructure, more security concerns, high capital expense 

requirements and low depreciation, tariff lag effects (low rates - takes a long time to 

recoup investment), local political risks. This is a quandary for investors not used to 

investing in companies with a disparate (capital expense) gap. 

The pros to investing in this industry include the following: water is an 

irreplaceable commodity; utilities have a natural monopoly; stable municipal service; 

high capital expense requirements drives need for investment; large project opportunities, 

technology development is accelerating industry growth; the active mergers and 

acquisition market drives valuation 

The cons to investing in this industry include the following: political risk; the 

limitations that government controls place on profitability; insufficient market pricing; 

higher capital intensity creating the risk of lagging return; significant project risks; 

industry fragmentation (with many small companies); mixed industry experience with 

corporate business strategy execution. 

31
Ultimately, this is a very small industry relative to the gas and 

telecommunications industries. In addition, it is difficult to turn a social good into a 

business/commodity. 

Due to high capital intensity and flat per capita usage (plus low prices), industry 

investment needs consistently outpace cash flow. Most utilities can’t finance their own 

operations from internal cash flow, let alone invest in growth—they require frequent 

infusions of capital. How can this be sustainable? Investors have concerns about 

constantly having to provide new infusions of capital (debt or equity). 

Investors need to get comfortable with the regulatory compact; that is, that PUCs 

will continue to allow reasonable returns on ongoing investment, supporting perpetual 

negative cash flow. Water utility investors understand that high capital expenditure 

generates asset expansion and earnings growth, as long as reasonable returns are allowed. 

There is significant regulatory risk for investors; the regulatory structure doesn’t allow 

for a smooth pattern of earnings with ongoing demand. 

Again, tariff lag also creates uncertainty. Capital spending needs are increasing 

while rate increases won’t keep up with spending. Delays or unfavorable treatment of 

mergers and acquisitions can also have a large impact on returns, impacting utility 

consolidation efforts. 

There are also local political issues concerning who should own the assets and 

setting prices, opposition to rate increases and private sector involvement, regular 

changes in political and personnel structure of local governments and PUCs. 

The sources of capital are also finite and limited, and include: government 

funding (SRFs/earmarks/state grants); debt, which requires debt service coverage 

(municipal or corporate bonds, project finance debt, vendor financing); equity, which 

requires a return on investment (public equity, private equity funds); and user fees, the 

ultimate source of funding. 

The relative cost of various sources of capital may not always be as it appears due 

to tax implications, administrative costs, operating efficiencies, and equity valuation. 

IOUs are generally approximately 50% equity funded. Municipal systems are 

almost all funded by debt. There is not much equity going into the market, but this is 

starting to change. We are seeing a lot of large infrastructure funds being raised (upwards 

of $10 billion) by larger banks and companies; these institutions are looking at buying 

companies and investing directly in local infrastructure. This represents a new pool of 

capital on the equity side, coming into the industry, with interesting implications. Equity 

won’t go anywhere without return and the new market players understand that this is a 

business in which they can expect a 10-12% return on equity. If more investors are 

willing to accept this return, this may expand the pool of investors in the industry. 

32
The industry has limited political visibility for industry; we have done a fairly 

poor job educating the public about the full value of water. 

Equity investors have shorter term views than debt investors, which does create 

new pressure on performance and may create some additional potential volatility, as 

equity moves more quickly in and out of markets. However, the perception that all equity 

investors only look at short-term returns is incorrect. We’re seeing that with the pension 

fund industry, which are attracting investors who want steady long-term returns. As we 

move through the learning process, there probably will be some volatility as investors 

become more educated. 

33
5.5 An Economist’s First Impressions of the Water Industry

Don Coursey, PhD; University of Chicago 

I’ve been asked to offer future perspectives on full cost pricing. In the past, I’ve 

been involved with some water-related issues, trying to apply market-based solutions to 

public policy questions. Currently, I’m working on developing water trading systems in 

water basins in New Mexico. 

The rationality and efficiency of a market is tied to the notion that both partners 

are better off from the exchange. I have been taking this concept and trying to apply it to 

much larger public policy questions. On the surface is a bid; below the surface, there are 

many constraints. One example of the solutions realized through market development is 

energy trading, which has led to incredible amounts of efficiency gains. 

Looking ahead 20 years in the drinking water industry, there are a number of 

questions and issues that arise. Why do so few systems serve so many people, and why 

are there so many systems serving so few people? Should EPA be providing above 

market subsidies for water systems to consolidate? While deregulation was blamed for 

the California energy crisis, Californians’ electricity costs are approximately a quarter of 

those for Midwesterners. In New Mexico, people pay about one-half as much for water 

as those in the Great Lakes area. In my own community, water is drawn from Lake 

Michigan and filtered. With new security measures around the facilities, water costs have 

quadrupled. The water industry and consumer costs are being impacted by homeland 

security and electrical reliability. 

We need to put costs for water and wastewater in context; people are willing to 

pay far more for soft drinks and other beverages than for tap water. In addition, 

Americans tend to understand the bigger environmental issues such as global warming 

and deforestation, but do not understand local issues such as sources of local resources 

and how water, electricity, etc., is delivered to them. Public education focuses on bigger 

problems, leaving most with no sense of connection to their local utilities and how they 

operate. In addition, people generally also have no sense of how much water costs; even 

examining local utility bills, it can be difficult to understand. The prices of other 

resources (e.g., gas) are far more obvious and visible. 

We also need to consider peak load pricing—would it be difficult to do some of 

the things we’ve seen in the electric industry, such as peak load shifting? I have never 

heard of an industry in which the base load was decreasing while the peak load increased. 

Full cost pricing will not be a complete solution until it includes peak load pricing. 

The education issue seems to be dire. The public’s understanding of the sources, 

price, etc., of water is so limited and there is a lack of transparency with water pricing. 

We need to remind the public that they will always be paying for water in some way, 

either through taxes or otherwise. Is it more efficient to pay the full cost directly, through 

rates, or to send money through the state and local government through other fees and 

taxes before it goes back to the water system? 

34
5.6 Capital Efficiency in the Water Industry

Myron Olstein, Consultant 

Water and wastewater are two of the most capital-intense industries; capital is the 

single largest cost of water utilities and capital needs are increasing. Some utilities can 

increase their capital efficiency (amount of dollars in plant required to generate $1 of 

revenue): 7.03 for water; 7.85 for wastewater (vs. 1.61 for electric, 0.94 for gas 

distribution, 1.11 for telecom, and 0.35 for S&P 500) Usually half or more than half of a 

typical utility’s costs is capital–related (far more than O&M). 

What does a high asset ratio mean? That the utility is not efficient? That its rates 

are too low? Is it impossible to compare these industries, because water and wastewater 

assets are very long-lived? Are other industries underfunding their needs? 

Capital costs are a large and growing percentage of utility costs. Debt service as a 

percentage of annual revenue requirements is also on the rise. At the same time, capital 

needs are increasing (as reflected in the sudden jump in the needs estimated in the 2003 

Drinking Water Infrastructure Needs Survey). 

In addition, bids are coming in significantly above (up to two times) engineers’ 

estimates. Several factors are driving this: dramatic increases in the price of raw 

materials (China is doubling its use of raw materials; the price of pipe has increased 

significantly); aging skilled construction workers; supply-demand conditions (if two 

adjacent communities put out simultaneous bids, they are drawing from same pool of 

contractors—the communities will either get an inflated bid or no bid); stacking of 

subcontractors (there has been an increase in the parsing out of risk; more subcontractors 

marks up the bid); surety driven pricing (sureties demanding that contractors put in 

bigger contingencies). 

 Other factors include: increasing interest rates (debt service will be more 

expensive); the retirement of senior utility personnel and loss of their knowledge of their 

systems; and, declining federal support. 

Why isn’t problem the being noticed? High growth utilities are being funded by 

developer fees; while the impact is not being felt today, it will over time. In addition, 

utilities are not seeing significant resistance to rate increases. This year, New York City 

went in for a 9.4% increase without much resistance. New York City surveyed rate 

increases at 24 large water systems and found that the average was a 9.2% increase. 

What are the solutions? Increased federal support is a possible option, though 

unlikely to happen (in addition, more money to the market can lead to dramatic 

construction cost increases). Asset management systems will help, once systems are able 

to use their infrastructure data to become more capital efficient. In the meantime, 

however, most utilities are seeing capital costs increase when they implement asset 

management as they will identify needs that they were previously unaware of. 

35
In the 1990s, there was a focus on O&M efficiency that resulted in unit staffing 

reductions. However, this trend is reversing and NACWA surveys indicate that O&M 

costs are increasing once again. With O&M cost increases and factoring in the rate of 

inflation, rates will have to increase at up to three times the rate of inflation to keep up 

with increasing costs. 

Non-construction/light construction alternatives are more likely to be costeffective. The single biggest area where utilities can lower capital costs is in achieving 

a fairer allocation of risks in their contracts. Current contracts typically put all the risk 

on the contractors, which can result in no bidders for contracts. 

AwwaRF is currently documenting case studies that treat conservation as an 

alternate source of supply (New York City has spent $330M to save $1 billion in water 

supply expansion costs); foreign utilities generally have higher levels of capacity 

utilization, smaller footprints, and more zealously pursue alternative project delivery. 

36
6.0 Level and Means of Provision of Service

6.1 Framing the Level of Service in Terms of Full Cost Pricing

The conceptual model posits that the fundamental determinants of the full cost of 

water and/or wastewater service are the level of service the public desires and the way in 

which a utility (or utilities) is structured and managed to deliver that level of service. 

Table 1, below, presents examples of issues and questions helpful in thinking about level 

of service and utility structure and management. 

A central question implied by the model is the cost effectiveness with which the 

selected utility structure and management is able to deliver the desired level of service. Is 

the desired level of service being obtained in the most cost-effective manner? If not, is it 

being obtained in a manner optimizing appropriate social outcomes? According to whose 

perspective? 

Table 1: Level of Service and Utility Structure and Management Considerations 

System Type Example Level of Service Issues Example Utility Structure and 

Management Issues 

Water 

• Does system provide fire protection? 

• What peak flow demands can the system meet? 

• Number and duration of service interruptions per 

year. 

• Number of water main breaks per year (and 

damage caused by breaks). 

• Quality of water delivered to customer. Does it 

comply with federal/state health based 

regulations? Does it meet the aesthetic demands of 

customers? 

• Time to respond to customer complaints or 

questions. 

• Nature of system’s “environmental footprint”—is 

it a “green” system? 

• Outreach and public education. 

• Opportunities for customer input and involvement. 

Wastewater 

• Number and duration of service interruptions 

(such as backups) experienced by customers. 

• Number of times and quantity of untreated 

wastewater discharged per year. 

• Quality of treated effluent: Does it comply with 

federal/state standards? Does it satisfy community 

expectations? 

• Time to respond to customer complaints or 

questions. 

• Nature of system’s “environmental footprint”—is 

it a “green” system? 

• Outreach and public education. 

• Opportunities for customer input and involvement. 

• Utility ownership: public or private? 

• Utility scope: water or wastewater only? 

Both? Both including other? 

• Institutional structure: If public; line 

department of city government? Enterprise 

fund? Special district? If Private; is it a 

publicly traded corporation or a private 

owner? 

• Utility management: public or private? If 

owner does not manage, what is the nature 

of the contractual agreement under which 

some other party manages the 

system/utility? 

• Geographic scope of utility: Is it system or 

community specific or regional in nature? 

37
 The discussion of level of service and means of provision of service was preceded 

by two formal presentations to help frame the issues: 

1. Level of Service: An Academic Perspective 

2. An Academic/Public Policy Framework for Understanding and Evaluating 

Alternative Institutional Structures for Provision of Desired Level of 

Service 

Summaries of these presentations follow. 

38
6.2 Level of Service: Economic Perspectives on the Range of Social Choices

Edna Loehman PhD; Purdue University 

Types of management decisions that must be made regarding water supply 

include short term decisions (supply quantities, supply sources); medium term decisions 

(operations, maintenance, and reliability, level of source and treatment quality); and long 

term decisions relating to sustainability (infrastructure needs; development of new 

sources; environmental considerations; community acceptability of the management 

system). For example, long term sustainability may require investment in infrastructure 

such as aquifer storage and retrieval, advanced water treatment for recycling and re-use, 

dual piping systems, desalination, etc. Particularly for the longer term issues, EPA 

studies have shown that decisions involve great cost, complexity, and require value 

judgments. 

Social choices associated with making such decisions exhibit a wide range: 

management, organization, and institutions; decision criteria, analysis methods, and 

decision methods; and funding methods. Below issues about application of these means 

are summarized, emphasizing the potential contributions of economics. 

● Types of Economic Goods and Implications 

Economists have identified different types of economic goods with an eye toward 

making prescriptions about appropriate economic institutions and organization. For 

water systems, different types of goods include: 

○ consumption goods (one person’s consumption excludes another’s); 

○ public goods (all consumers experience the same quality); 

○ shared facilities (outputs produced in common facilities); 

○ externalities (decisions can have downstream impacts); 

○ inter-temporal goods (infrastructure is shared over time); 

○ common pool goods (for groundwater, one generation’s choices can affect 

 another’s); 

○ risky goods (e.g., supply needs subject to weather). 

From welfare economics concepts: different types of pricing rules and production 

arrangements are needed for different types of goods. While private production and 

markets are appropriate for pure consumption goods, more complex decision processes 

and economic institutions are needed for externalities, public goods, inter-temporal 

goods, and risky goods. 

In particular, “level of service” , i.e. quality aspects of water supply, has the 

nature of a public good and so cannot be correctly determined via only market forces. 

However, the alternative is not purely government determination and provision. 

Participants in water management and decisions include: water suppliers, water 

consumers, local health departments, hydrologic region water managers, state 

39
environmental quality agencies, and federal agencies, i.e. involvement in management is 

poly-centric. If change in the level of service is considered socially desirable, it will be 

accomplished through a mix of government, private, and non-profit participation. 

 

● Economic Organization 

 Organization has to do with assignment of decision-making, resources, and 

rewards. Economic principles for organization  brought into focus by Oliver 

Williamson  concern the transactions costs associated with different types of 

organization, and reducing transactions costs is desirable. The nature of hierarchy has 

been a focus, and more generally, centralization versus decentralization of production and 

decision-making. Decentralization is thought to reduce information and incentive costs. 

The scale of organization has also been of interest (see Werner Hirsch). 

Economies of scale in service provision have been studied in police services, health care, 

and education). Generally, there is a scale for which total costs  when both provision 

and transactions costs are included  are minimized. 

Both transactions costs and scale questions are relevant for water provision. 

To reduce costs of water provision –including information, monitoring, and enforcement 

costs as well as direct water supply costs – we need to consider the appropriate scale of 

organization. For example because of resources, continuity, and quality control, data 

management and modeling may be more appropriately carried out by state or federal 

agencies rather than by a local agency. On the other hand, some supply aspects may need 

to be locally tailored, e.g. supply issues are treated differently in eastern and western 

regions because of geographic and legal differences; contamination sources are different 

for rural and urban areas. 

To identify more specific improvements in water provision, it may be helpful to 

think about water provision as an economic system. Generally in an economic system, 

functions include production, allocation, finance, income distribution, monitoring, 

enforcement, transactions and administration. Additional functions carried out by 

organizations include planning and investment, information and research, and education. 

A paradigm for water management/ organization design is to determine which agent – 

among governments, private producers, non-profit agencies – would be best suited to 

carry out each function. Criteria for adoption of improved management include 

implementation costs, transaction costs, effectiveness, fairness, and freedom of 

choice/flexibility/resilience. Economists add the criterion of efficiency to this list. 

● Economic Institutions 

Economic institutions – or rules of the “game” – are important tools for water 

management. Such tools include: contract design; pricing rules; methods of finance; cost 

sharing rules (government subsidy for improving efficiency, or several parties sharing 

costs of a joint project); and trading institutions to help allocate water among public and 

private uses (e.g., “cap and trade”, water banking, and other exchange process). 

40
Economic institutions may not have been given sufficient attention for water 

provision. For example, until recently cost recovery for water services has been 

predominantly with flat rates. Adoptions of increasing block rates indicate new attention 

to conservation concerns among water providers. 

Cost recovery and finance methods are of great interest for water provision. 

Without cost recovery for needed service improvements, water systems will not be 

sustainable. Besides recovering costs, users paying full costs of service is an important 

economic incentive: inefficient consumer choices may be made if user costs are 

subsidized, because users are then not comparing their benefits with cost of service. On 

the other hand, subsidies may be appropriate when smaller communities cannot afford the 

costs of quality service, when a level of quality is deemed necessary for the public good. 

Appropriate institutions can help to integrate decisions of public, non-profit, and 

private agencies. For example, a contractual arrangement between a local government 

and a private water supplier – with appropriately specified terms and incentives – may 

result in reducing cost of water supply. Government as a representative of the public 

trust should be involved in specifying quality aspects for contracts as well as providing 

incentives and enforcing contract terms. In turn, the involvement of citizen groups may 

reduce the cost of monitoring service quality. 

● Economic Analysis Methods 

According to Douglas North, social change occurs when perceived benefits of 

change exceed perceived costs. The problem is to determine the balance ex ante. 

Benefit-cost analysis can be a useful tool to help identify desirable changes. Not 

only is benefit-cost analysis relevant for evaluating investment alternatives, it can also be 

applied to evaluate regulations (as EPA has done) and to evaluate alternative types of 

organization and institutions for water provision. In this case, not only direct supply 

costs but also costs of transactions, information, monitoring, and enforcement are 

relevant. 

In any application, the analysis should include appropriate accounting for nonmarket goods, temporal goods, risky goods, and discount rate(s). In benefit-cost analysis 

for non-market goods such as public and quality goods, methods of valuation of 

willingness to pay (or accept compensation) are required. The discount rate reflects the 

willingness to pay for returns at various time periods relative to up-front costs. The dollar 

amount that a person is willing to pay (or accept) for a good may differ from a market 

value because it is a reflection of personal values and priorities as well as personal ability 

to pay. Because such values are personal, they are difficult to measure. 

EPA has conducted many studies of non-market values and costs to help make 

decisions about quality-related goods. EPA frequently uses the method of “benefit 

transfers” to avoid difficulties and costs of specialized measurement. It remains to be 

seen whether the benefit transfer method adequately reflects values at a local level. 

41
● Collaborative Process 

“Experts” aren’t necessarily suited for making choices about social organization 

and management. In the face of difficulties of governments and experts in establishing 

desired management/ organization and institutions, a deliberative process or collaboration 

among citizens, governments, and experts could help to identify and adopt appropriate 

means. Collaboration refers to the direct involvement of relevant publics in determining 

a common future, aimed at finding voluntary agreement over mutually chosen outcomes. 

When there are difficulties in formal analysis and differences in value systems, a 

deliberative process can replace the need for formal analysis if relevant values and costs 

are well-represented in the process. Frank Fisher has been a proponent of the ability of 

citizens to deal with complexity and incomplete or uncertain information. 

There are certain difficulties that arise regarding selecting and adopting changes 

in water management and organization. First, there are multiple interest groups who may 

have different concepts about desirable outcomes as well as different notions of 

appropriate roles for government. Some of these differences may be attributed to 

complexity and lack of information, but some have to do with basic values. There are 

also issues of property rights as well as resistance to trying new things. 

Though the notion of a collaborative approach appears idealistic, experiments 

have shown that people appear to place a value on achieving a successful group outcome, 

i.e. the deliberating group reaching agreement. Agreements found by “values juries” 

show that people can give up strict self interest if they feel that they are contributing 

toward the common good in a difficult social situation. Agreement among diverse groups 

can be based on identifying shared meaning and common ethics. Education and direct 

communication among interested parties can help to develop these shared values. 

Because good decisions should be science-based – i.e., based on knowledge of 

human and natural systems as well as good logic – it is essential to incorporate the 

physical and social sciences into deliberative process. In this context, we need to 

consider which types of communication, information, and opinion tools will be most 

efficacious. Correspondingly, process may need to be modified according to the kinds of 

issues and situations under deliberation. 

Related needs for government involvement in water supply provision are to act as 

organizers and facilitators of deliberative process, developers of information and 

education materials, and providers of funding for such purposes. 

[It should be noted that public participation in hearings and public reviews is not 

the same as collaboration. For public participation, there are concerns about what is done 

with public input (i.e., how should it impact decisions), inadequate time for interchange 

and information exchange, and inadequate levels of participation.] 

42
6.3 An Academic/Public Policy Framework for Understanding and Evaluating 

Alternative Institutional Structures for Provision of Desired Level of Service

Janice Beecher PhD: Michigan State University

The structural dimensions of the water industry include: 

• Ownership versus operation 

• Large versus small 

• Wholesale versus retail 

• Regulated versus nonregulated 

The 1996 SDWA Amendments do include restructuring incentives, including: 

• Capacity assurance—technical, managerial, financial—for new and existing 

water systems (§1420) 

• Consolidation Incentive - Enforcement (§1455) 

• Variances (§1415) 

• Exemptions (§1416) 

• State Revolving Fund (§1452) 

• Research (§1420) 

The institutional options for publicly owned/nonprofit water systems include: 

• Government owned 

o Municipalities and states 

o Districts (local) 

o Authorities (regional) 

• Associations 

• Cooperatives 

• Nonprofit organizations and corporations 

 The institutional options for privately owned water systems include: 

• Private/single owner (private but not publicly traded) 

• Publicly traded (a utility that operates multiple systems and issues stock) 

• Holding company/multistate utility (a utility organized as a holding company 

that operates multiple utility companies, usually in several states) 

Other hybrid institutional options include: 

• Municipal corporations 

o Epcor in Alberta 

o Louisville, Kentucky 

 City of Louisville is the sole stockholder 

 Not organized as a municipal agency 

 The system is publicly owned and privately operated as a forprofit agency with an appointed board of directors 

• Public trust (i.e., assets are placed in public trust, as with the Citizens Gas 

Company of Indianapolis) 

43
There are numerous rationales for privatization. There are philosophical 

underpinnings to some arguments for privatization, including (in increasing order): 

• Populist rationales (privatization will be better for society in general) 

• Ideological rationales (privatization will limit government involvement or the 

need for government institutions) 

• Pragmatic rationales (privatization leads to great efficiency) 

• Commercial rationales (privatization generates more business) 

Additional rationales for privatization include the following: 

• Privatization complements competition and contestability 

• Privatization provides an influx of private-sector resources 

• Privatization introduces a profit motive to achieving social, environmental, 

and other goals 

• Privatization promotes operational efficiency (e.g., labor, energy, chemicals) 

• Privatization encourages innovation in management 

• Privatization contributes to labor-force professionalism and mobility. 

When considering the “ethics” of the public versus private debate, there are several 

key positive and negative arguments for both options. The positive aspects to keeping 

utilities in the public sector can be seen from a public service perspective, and include: 

openness and accountability, fairness and equity, and environmental stewardship. The 

negative aspects relate to the political and bureaucratic elements of necessary oversight of 

public utilities, including: rules and regulations, patronage and expediency, and 

inefficiency and stagnation. 

The positive aspects to the private sector option include performance-optimizing 

practices such as efficiency practices, technological innovation, and entrepreneurship. On 

the other hand, private sector utilities also aim to maximize profits, which may result in a 

neglect of public goods, a tendency towards monopoly, and secrecy and inaccessibility. 

Advocates of privatization have hypothesized that public water systems: 

• Experience more construction-cost overruns 

• Postpone improvements 

• Overcapitalize (even more than private systems) 

• Overutilize debt 

• Incur higher capital and operating costs 

• Are less efficient in procurement and scheduling 

• Innovate slowly if at all 

• Provide longer tenure 

• Have greater debt capacity and access to capital 

• Are more risky and realize lower returns 

• Subsidize or receive subsidies from other local government entities 

• Set rates further from costs (and marginal costs) 

• Favor voters, businesses, and organized groups 

44
Private sector involvement can occur along a continuum from limited 

involvement to complete privatization. Options along this continuum include: limited 

partnerships; lease financing; build and transfer; build, own, and operate; contract 

operations; merchant facilities; and, complete asset sale. 

There are two distinct models of privatization—contracts and ownership. Under 

the contracts model there is: public ownership with “delegated” management; limited use 

of private capital for major projects; intense short-term competition for contracts. With 

this model, there is public ownership and the competitive market “substitutes” for 

regulations (i.e., there is very limited review by state regulators). Potential advantages to 

the contracts model include efficiency and professional expertise, lower cost of capital 

for infrastructure, and the perception of local control. Potential disadvantages include: the 

decoupling of ownership and operations, costs, and rates; lack of accountability and the 

associated potential for the abuse of monopoly; and, the potential for conflicts of interest. 

Under the ownership model, ownership is in the hands of investors and private 

capital is used for major projects. There is limited (structured) competition and state 

regulatory oversight through public utility commissions. Potential advantages to the 

ownership model include private capital investment and long-term commitment, costeffective regionalization, and accountability via independent regulatory oversight 

(assuming it is effective). Potential disadvantages include concerns about lack of local 

control and responsiveness, ownership instability, foreign ownership, private control of 

vital resources and assets. 

Since 1980, the private market share of the U.S. water market has stayed 

relatively flat, but annual water utility revenues have continued to increase. 

We have seen several hard lessons of privatization, including Indianapolis and 

Atlanta. 

Municipal systems are spending money on capital, however, and bond issues 

have increased significantly. However, there is still a significant gap between charges and 

revenues at municipal systems. 

Reasons for the rate disparities between private and public utilities include: profits 

(need return on equity; taxes (which usually overwhelm profits); financing; subsidies; 

costing (depreciation expense); rate practices (outside rates); charges (system 

development); investment deferral; cost differentials; and, economic regulation (cost of 

service). 

Subsidies include tax revenues, general revenue bonds, intergovernmental 

transfers, below-market financing rates, federal and state grants, and water projects. In 

addition, subsidies sometimes flow from the utilities and are used for social goals. 

Informed decisions and transparency are critical. 

45
There is also the consideration of whether subsidies should be provided to 

systems or households. 

Subsidies can potentially weaken or undermine price signals, causing inefficient 

behavior. 

Public policy considerations regarding privatization include: 

• Delineating core government functions (ownership, operation, or regulation) 

• Determining the appropriate roles of the public, nonprofit, and private sectors 

in achieving long-term societal goals 

• Understanding the tradeoffs involved in alternative privatization models 

• Developing capacity for economic regulation, as well as health and resource 

regulation and mechanisms of coordination 

• Establishing and maintaining standards, accountability, and incentives for 

performance 

When we do privatize, we do have to look at our capacity for oversight and 

regulation. The State Environmental Resource Center in Wisconsin noted that: “Lack of 

government oversight and public scrutiny has been one of the strongest criticisms of 

water privatization. Without proper government supervision, privatization will not 

address issues related to conservation, water quality, or fair access to water regardless of 

income. To ensure public-private water agreements are carefully designed and 

implemented to protect public interests concerning these issues, strong public regulatory 

oversight should be a fundamental requirement before a public agency shifts its 

responsibility for water utilities to a private entity.” 

(http://www.serconline.org/waterPrivatization/index.html) 

Key considerations on privatization and public monopolies include the following: 

• Competitive bids and private contracts do not alter the basic public monopoly 

• There is the potential for mutual exploitation (city and contractor) 

• Control over rates is not necessarily responsive 

• Decoupling of costs and rates can lead to inefficiency and inequity for 

ratepayers (subsidization) 

• Significant private involvement in a public monopoly raises accountability 

issues 

• Profits raise legal and tax implications (e.g., tax-exemption) 

• Requires an informed, engaged, and mobilized public – with political acumen 

and clout 

• Can you really “throw the bums out” (local officials)? 

• Regulation of the ultimate monopoly (city) may be justified by public-interest 

considerations 

In the context of privatization, regulation can provide: 

• The legitimacy, authority, and accountability of state oversight 

• Review of costs and prices and promotion of cost-based pricing 

46
• The opportunity to ensure contract prudence 

• A level playing field for structured competition 

• A degree of certainty for private investors 

• More oversight capacity than local governments and economies of centralized 

regulation (freeing local resources) 

• An expeditious forum for hearing disputes and resolving complaints among 

utilities, contractors, and customers 

• Additional regulatory safeguards for cities and customers 

• Less need to micromanage utility decisionmaking; fewer opportunities for 

coercion, corruption, or politicization 

• Attention to long-term social, environmental issues 

Ownership may be less important than other factors affecting performance. 

Ownership and profit incentive are somewhat important to performance; competition or 

regulation are more important factors. The most important factors affecting performance 

are economies of scale and efficiency practices. 

Neither the public nor the private model is the “better” model or a panacea. A 

good public-sector water system follows “good business practices” while a good privatesector water system acts as a responsible “public steward” and is relatively transparent. 

The two models share much in common—indeed, their commonalities may be greater 

than their differences. 

Ultimately, we have yet to discover the ideal institutional form. 

47
6.4 Summary of Open Discussion

Drinking water quality and service reliability

3⁄4 There are many points where level of service decisions can be made, including 

system staff, a governing body, and customer surveys. How many agencies 

actually put a price tag on meeting level of service? How many have told 

customers that having great tasting water 100% of the time will cost $X, having 

great tasting water 95% of the time will cost $Y, etc. Agencies rarely put a price 

tag on these services for customers; they only get feedback on customers’ desired 

level of service. 

3⁄4 We take a different approach to level of service. To determine level of service 

we consider customer satisfaction (which determines rate capacity), which we 

measure and track across the board. Another key consideration is having equal 

levels of service for different customers. We also considered investments in taste 

and odor control. If there is a taste and odor event, customer satisfaction will 

drop; it takes a long time to recover customer confidence after just one taste and 

odor event, as it makes customers question the quality of their water. We want to 

meet the regulations and manage health risks. If something creates a health risk, 

how can you manage it to the optimum point beyond regulation, looking at costs 

and benefits? We also want to minimize risks from those issues on the current 

regulatory agenda. 

3⁄4 We consider outages to be unacceptable. Ultimate reliability is very important for 

our city government; this is achieved through redundancy. 

3⁄4 From the capital investment standpoint, the question is where can there be 

additional economies in capitalization? Systems could be sharing assets rather 

than installing new ones. 

3⁄4 We have a customer advisory council to offer input on any significant issues. 

3⁄4 Survey results confirm that people are willing to pay more to avoid some level of 

service outage from main breaks, up to a point. Customers will accept breaks, as 

long as they know that water service will be returned quickly. Customers are not 

accepting of taste and odor or pressure performance problems. 

3⁄4 Aesthetic issues really illustrate how tricky water economics are. People are 

willing to pay high amounts for bottled water, but there is a disconnect between 

that and their willingness to accept a more economical approach to improving 

taste of tap water. Ultimately the issue goes back to engaging and educating the 

public. 

48
3⁄4 Studies on risk preferences show that the unknown affects confidence; if 

consumers smell or taste something in their water, it will trigger a strong reaction 

and impact their trust. 

3⁄4 Fundamentally, we consider our utility to be in the business of building public 

trust. If that trust erodes, it’s a huge problem. 

6.4.2 Nature of Customer Base

3⁄4 Now, when looking at capital efficiency and capital investment per capita, we are 

seeing much smaller household sizes. We’re serving the same number of people, 

but spread over more households. More investment is needed to serve the same 

population. Also, with recent drops in interest rates, people living in multi-family 

homes have acquired single family homes; apartment vacancy rates are also much 

higher in some communities now. 

6.4.3 Peak flow issues

 

3⁄4 While the base load is decreasing, peak demand is increasing

3⁄4 Customers still use a lot of water even in drought conditions. The peak is 

determined by outdoor water use and the base is determined by indoor water use. 

3⁄4 Systems losing large industrial customers will have very different characteristics 

than those based on large residential customer bases. 

3⁄4 The trend is towards more efficient plumbing and appliances, so consumption of 

water for indoor use is trending downward. However, systems still have to build 

plants to accommodate maximum daily use (driven by fireflow and outdoor uses) 

even if revenue and consumption is decreasing. 

3⁄4 The need for increases in pipe size are based more on increasing demand for fire 

protection than anything else. My utility is growing and one level of service 

issue that has to be addressed is accommodating fire protection for new 

customers.

6.4.4 Wastewater level of service issues

3⁄4 The biggest capital driver at my utility is a combination of growth and more 

stringent effluent limitations.

3⁄4 My utility faces different pressures. Our capital costs are being driven by 

infrastructure rehabilitation and replacement costs, sanitary sewer overflow 

issues, and third party lawsuits.

49
3⁄4 Our treatment plants have a lot of capacity, due to the loss of the high strength 

industrial waste generators in the area. The system is doing resource recovery by 

bringing in many new and different waste types (e.g., animal processing waste, 

fats, oil, and grease, etc.). Flow has remained fairly steady for the past 20 years, 

though it can vary based on whether the year is very wet or dry. There has been a 

slight trend in flow dropoffs, due to conservation.

6.4.5 Institutional Structure

3⁄4 Ownership may not be the top factor affecting performance. More important is 

competition or regulation and economies of scale and efficiency practices. 

3⁄4 Neither the local government nor investor ownership model is panacea for the 

water industry. 

3⁄4 On the issue of full cost pricing and the ability to achieve it versus the desire to do 

it—from the municipal system perspective, ability and desire are not related. The 

system’s governing body is sometimes elected and their primary job is to get 

reelected. They will compare their utility’s rate and rate structure to those of 

other local utilities. In my area, some utilities haven’t raised their rates in 10 

years—the board won’t want to raise rates when no other local entity has done the 

same. 

3⁄4 Problems aren’t limited to municipal systems; small private systems are also 

struggling.

3⁄4 If you’re looking at municipal systems and the amount of dollars spent on capital 

compared to revenue, part of what you see is related to less efficient municipal 

management of asset acquisition and contracting. 

3⁄4 Investor Owned Utilities (IOUs) also have the records to put asset management 

systems in place and place controls on costs. It’s easier for them to set rates and 

establish the full costs of providing service. If they don’t make the best decisions, 

management and stockholders are at risk. Who controls cost considerations for 

municipal systems? 

3⁄4 The public ownership/contract operations model sounds good in theory, but in 

reality it can be very limited and uncompetitive. Contracts are often renewed very 

quietly without bidding, transparency, or public knowledge. When you disconnect 

ownership and operation, you have very skilled and well intended operators that 

are still dependent on the city for funding. This introduces potential 

inefficiencies. 

50
6.4.6 Public Education

3⁄4 We’ve gone around to towns and used local newspapers to educate the public on 

water rate increases. We’ve been able to get newspaper endorsements for rate 

increases. At public hearings, we’ve been able to get water companies to present 

on the reasons for rate increases. People will still be upset about the increases, but 

not to the same extent.

3⁄4 The education process is still very fragmented and local.

3⁄4 Part of the issue is that IOUs have been traditionally run by managers and top 

executives who were very focused on technology, producing a service, and 

putting money into the ground. Public Utility Commissions (PUCs) are more 

focused on public awareness.

3⁄4 The telecommunications and gas industries do know how to market. The water 

industry can’t make the leap to focus on how they’re perceived by the public.

3⁄4 Marketing is the one thing the industry could spend money on with great benefit. 

3⁄4 Effective marketing could shift the whole argument. If people don’t understand 

the value of something, they won’t place any value on it. It’s difficult to come to 

conclusions on things like affordability when you don’t understand the value of 

the product.

3⁄4 The education issue seems to be dire. The public’s understanding of the sources, 

price, etc., of water is so limited and there is a lack of transparency with water 

pricing. We need to remind the public that they will always be paying for water in 

some way, either through taxes or otherwise. Is it more efficient to pay the full 

cost directly, through rates, or to send money through the state and local 

government through other fees and taxes before it goes back to the water system? 

3⁄4 Behavioral economists and public finance experts don’t abandon the neoclassical 

model that assumes rational actors, but recognize that decision-making isn’t 

always rational. Understanding the biases involved can inform our understanding 

and how we use economics to overcome these problems. 

3⁄4 A technique called “cue methodology” looks at how people frame their values. 

People may have the same ultimate goal but different reasoning for why that is 

their goal; the latter can be just as important to examine as the former.

51
6.4.7 Economic Regulation

3⁄4 At least for systems not subject to PUC jurisdiction, there’s no entity (other than 

possibly the state drinking water program) to help people recognize existing 

opportunities for more efficient deployment of capital. Is there an institutional 

option missing from the equation?

3⁄4 Rate regulation has done a great service to rate payers, providing limited profit 

margins and turning IOUs into very efficient machines. If they don’t make the 

best decisions, management and stockholders are at risk. 

3⁄4 Wisconsin’s regulatory model has been in place for a long time, and the state has 

regulated water supplies (mostly municipal systems) since 1907. The PUC 

regulates construction, customer standards, and sets rates. 

3⁄4 If full cost pricing is a realistic goal, there is a level of authority or decision 

making capacity that’s missing. What does “full cost pricing” mean? What costs 

are included and how are they determined? If you don’t have that capacity, there 

will be no consistency to the application of full cost pricing. We also need a level 

of transparency and access to data to make sure the full cost pricing process is 

working. The absence of a body to consistently define terms, the absence of data 

access, and the lack of consistently maintained data are significant roadblocks. 

3⁄4 My State Public Utility Commission regulates some publicly owned systems. The 

state program is underfunded and the staff are underpaid and don’t have the time 

to closely examine proposed projects. 

3⁄4 It’s all about cost of capital and how much it costs you to get the money and put 

the infrastructure in place. There’s a lack of oversight to put capital to efficient 

uses. Rating agencies are paying more attention to this, but have been less 

vigilant historically; as long as they were assured that there would be coverage of 

debt service, they hadn’t cared. The overall capital allocation processes put into 

the industry are random and very inefficient. We need rational capacity planning 

and some basic level of operating requirements applied regionally or on 

watershed basis, along with some basic public education as to why it was 

necessary. 

3⁄4 We’ve been seeing these trends develop over a long time. What’s the right 

direction to go in? A Federal Energy Regulation Commission (FERC)-type 

structure that deals with federal water policy? State PUCs? Municipal level 

regulation? 

52
3⁄4 Look at the Securities and Exchange Commission (SEC) model. The SEC does 

not set the price of stocks and only requires entities to go through the SEC for 

access to the publicly traded equity and debt market, which comes with certain 

requirements (transparency for investors). We need to move away from 

micromanagement.

3⁄4 The alternative to government and regulations are the industry associations. Are 

they serving any function here? 

3⁄4 We’ve been doing a lot of work with sustainability. Ultimately, if you fail to 

properly conduct your business, you will be regulated. As an industry, we need to 

take heed from that and work through professional organizations and public 

outreach to get people on board. Regulation is a sign that your system isn’t 

working right. 

3⁄4 Investor-owned utilities (IOUs) have targeted profits but are constrained by 

regulations; they have to be very efficient in how they spend their money. They 

look for the lowest cost construction because it comes out of the stockholder 

bottom line. 

3⁄4 Municipal systems need to be more efficient with how they spend their money. 

3⁄4 I’ve never been strong proponent of economic regulatory oversight, but if it 

prompted recognition of the need to increase rates to maintain infrastructure, it 

could be beneficial. It’s probably best to limit regulation to that one aspect. I do 

strongly support the idea of combining the economic and environmental 

regulatory oversight. 

3⁄4 The Public Utility Commissioner’s job is to serve the public interest, and 

therefore they need to set rates to cover the full and adequate cost of service 

provision. If rates are set below costs, the utility will under-earn and cost of 

capital will be too high. The challenge for utilities is to find the optimal balance 

where they’re seeing a return on their investment and attracting capital at the 

lowest cost. The returns for equity investors suffer if rates are inadequate. 

3⁄4 Now, faced with an impending increase in the rate of infrastructure replacement, 

there is an enormous need for capital in the industry. The cost of capital will to 

some extent depend on whether rates achieve full cost recovery. We need 

regulatory agencies to do a better job of establishing cost of service provision and 

ensuring that rates cover this cost. If not, customer rates will be even higher in the 

future. 

3⁄4 One key problem is that you can’t base 2007 rates on 2006 costs. Still, some 

states refuse to base their rates on anything other than historical information. 

Utilities have to be efficient to generate reasonable profit margins for 

stockholders (IOUs). Changes in the rate setting process can only come from rate 

53
regulators, not utilities. The trick is to get more states to adopt innovative 

methodologies. The suggestion of combining economic and environmental 

regulators is ideal. Right now, we’re seeing a whipsaw action between the two, 

but for the first time there is the true opportunity to meet in the middle. 

3⁄4 On the jurisdiction issue—in Indiana, cities can choose to be regulated. Sixty-odd 

cities chose to be regulated and can now blame the regulators when they have to 

raise rates. This also builds in an audit function and accountability to some extent. 

3⁄4 Just because adjustments are made to a utility’s original rate filing does not mean 

that rates are not set to recover the full cost of service. My concern is that 

removing the snapshot of the test year starts to disassemble the ratemaking 

process. There are areas for discussion on whether there are additional 

innovations or improvements that could be made, though. 

3⁄4 Another aspect to this is that risks are increasing and existing risks have not been 

thoroughly recognized in ratemaking process. Even with enhanced efficiency, 

rates won’t go down, they’ll just increase more slowly.

54
7.0 Recognition of Full Business Costs & the 

Annual Revenue Necessary for Cost Recovery

7.1 Framing Presentation on Asset Management

John Cromwell, Stratus Consulting 

 

 In Australia, asset management was driven by institutional change and 

widespread restructuring in the entire utility sector as a part of the process of preparing 

the national economy to participate more broadly in a freer world trade environment 

envisioned under the Global Agreements on Tariffs and Trade (GATT) that were under 

negotiation at the time the reforms were implemented. State and local monopolies were 

commercialized, and the municipal utilities converted to “commercial” status. In the 

“commercialization” model of utility reform, the state or local government is the sole 

shareholder of assets, but the utilities have autonomous finances and practice full cost 

recovery through rate revenue with state oversight of pricing. The utilities are run 

completely as commercial businesses. State rate regulators and environmental regulators 

both have a role in rate setting. 

 Australian reforms also involved appointment of independent boards composed of 

business people to govern the utilities and run them as businesses. The utilities pay taxes 

and earn full commercial returns on their assets. Board members observed that to be 

sustainable, a capital intensive business has to be able to continually attract capital. This 

is the business definition of sustainability. Utilities were given 5 years to develop a 

comprehensive asset management plan demonstrating that the utility was on track with 

this concept of sustainability. To make this demonstration, it was necessary to show, on 

one hand, that rates were not being artificially suppressed by investing too little in 

infrastructure renewal and allowing a deterioration in the level of service quality 

delivered to customers. On the other hand it was also necessary to demonstrate that rates 

were not any higher than they needed to be as a result of investing too much in 

infrastructure renewal – that is, by not using capital assets as efficiently as possible and 

getting the most value out of them on a total lifecycle cost basis before retiring them 

(while maintaining the level of service to customers). The form of these twin 

demonstrations was the asset management plan which had to show that the amount of rate 

revenue required for asset management (including both capital and operating 

expenditures) was, in effect, a “Goldilocks” solution – not too little and not too much, but 

just right.. When the asset management plans were approved, the state and local owners 

of the utilities received significant amounts of trade adjustment dollars from the federal 

government as an incentive to spur the reform process. 

 Infrastructure is tremendous risk factor for the industry and threat to 

sustainability. The upcoming replacement costs have never been seen before. This raises 

a risk management question: do you know what costs are coming at you and can you 

handle them? 

55
Asset management is seen as a risk management problem. The first step is 

identification and characterization of the risk. For this, the utility must consider both 

reinvestment and maintenance costs for assets and must understand the concept of each 

asset’s economic life. The utility needs to project replacement needs and wear-out costs 

(increases in maintenance, repair, and operation costs). These are the two cash flows that 

go into asset management. Both need to be considered and refined to determine what the 

least cost option is. Ultimately, much of the job entails getting the most out of assets 

rather than just replacing them. 

 We often hear that utilities should replace 1% of their pipes per year, but from the 

patterns we see, it’s clear that this has no relation to the true demographic pattern. Also 

we often hear that utilities should replace their oldest mains first. However, utilities have 

to study their assets and problems to see where the greatest replacement needs lie. 

 Deferred replacement is generally thought to be bad, but if you can push some of 

it back, it can save you money. As long as the asset can be kept in service economically 

and is delivering the level of service required, you’ll get more value out of the assets 

without needing as significant a replacement budget. It is the same thing as trying to get 

the most value and satisfaction out of a family automobile. If it has lots of miles of good 

service left in it, maybe it’s not time to replace it yet. 

 The Australian example also shows that you don’t necessarily need to replace all 

assets before they break; critical assets may need to be replaced sooner, but the majority 

of assets do not. Also, we’ve learned that no mater how much a system optimizes, main 

break rates can’t be held constant because of the demographic bulge that is headed 

towards us in the echo wave of replacement needs. Other lessons learned from the 

Australian example is that utilities shouldn’t benchmark spending against other utilities 

because the optimal approach to asset management is unique to each location and that 

having a Capital Improvements Plan in place does not constitute asset management 

because asset management involves optimizing the relationship between capital and 

operating expenditures. 

 Ultimately, system infrastructure is not in dire straits; it is not all failing at once 

and does not need to be replaced all at once; we are just at the dawn of the infrastructure 

replacement era. We are at a turning point when we have to make critical decisions about 

managing and addressing the risk. There’s no one solution to the problem for any utility; 

solutions will be developing over decades and allowing time to continually improve asset 

management and lower the cost of meeting infrastructure renewal needs. 

 Financial risk is a true threat, but it can be managed. Continuous improvement of 

data to support these analyses is key. Opportunities to economize are myriad and 

paybacks are compelling. Priorities are clear and are uniquely local to each utility; 

utilities should progress into asset management gradually based on where the risks are, 

rather than striving for comprehensiveness; some asset management challenges pose 

greater risks that need attention first. 

56
 In the U.S. we now need to put into place the right processes to start and sustain 

asset management. 

 The second step to asset management is risk management. This is defined as: 

managing assets to minimize the total costs of owning and operating them while 

delivering the level of service that customers desire. Asset management maximizes value 

by identifying the most economical intervention strategies to deliver the desired level of 

service. The desired level of service is achieved by balancing three levels of expenditure: 

diagnostic and preventive maintenance, rehabilitation and replacement, and reactive 

maintenance. These defining principles of asset management are wholly consistent with 

the business definition of sustainability stated above. This is why the Australian reform 

process elevate asset management plans as the true test of sustainability. 

 The final step in asset management is risk communication. This is the step where 

utilities need to fully recover their costs and convince customers that it is in their best 

interest for the utility to move forward with asset management. Asset management plans 

help guard against false economies. An arbitrary cut in diagnostics and preventive 

maintenance must be balanced by spending on the other two components or customers 

must accept a lower LOS. Ultimately, a utility cannot cut one level of expenditure 

without increasing the other two. 

 If a utility is following these asset management principles and has found a least 

cost/full cost strategy, they should be able to reflect this in their financial reporting in a 

way that makes sense and gives investors/shareholders the assurance they were looking 

for in an asset management plan. 

 The GASB 34 depreciation approach is not useful and the depreciation approach 

used by IOUs isn’t much better. Many Australian utilities are using replacement costs 

accounting, which is a work in progress. 

 The number one performance criterion for Australian utilities is the rate of return 

on assets, which ties back in directly to the business definition of sustainability. The 

public deserves to get full market facing rate of return on capital. Utilities that are not 

delivering this are not doing their job as efficiently as it could and should be done. 

57
7.2 Framing Presentation – A Local Elected Officials Perspective on Post Employment 

Benefits

Ralph Jones PhD, The Cadmus Group Inc. 

 One development that may help to shape the future of full-cost pricing is the 

implementation of GASB Statement No. 34. Its purpose was to improve public 

accounting in a manner that would increase information about public officials’ long-term 

stewardship of public assets. The required reporting on assets was designed to enable an 

enlightened public to hold their officials accountable for the condition of these assets. In 

the drafting of GASB 34, two alternative positions were considered. The first option was 

to have public entities include depreciation on their balance sheets. As implemented, this 

approach has not produced information that the public can readily use to increase 

accountability. The second (called the “Modified Approach”) public officials would need 

to produce an asset management plan that provided sufficient information so that readers 

could understand whether the net value of public fixed assets was increasing or 

decreasing. Failure to invest sufficiently in infrastructure would be evident when net 

asset values were declining. 

 Another recent development that may have an impact on full-cost pricing is 

increased sophistication of credit analysis. As one credit analyst recently explained: 

“Credit analysis has moved beyond a simple current rate comparison between the 

utility’s rates and its income levels or the utility’s rates and those of its neighbors. 

[The] key question is whether rates will be set such that the available revenues are 

consistently sufficient to meet all of the ongoing needs and obligations of the 

utility, now and in the future.” 

As credit analysts look with increased sophistication at debt offerings, water and 

wastewater systems will need to demonstrate that they have long-range infrastructure 

plans and rate revenues to fund that plan. 

 In 2008, public utilities and municipalities will have to report, in their financial 

statements, an actuarial estimate of the size of unfunded “other post-employment 

benefits,” primarily retiree health insurance. Utilities and municipalities already must 

disclose the actuarial estimate of their unfunded pension liabilities. As these disclosures 

begin to appear, the public is going to hear some shocking numbers. Experts in the field 

estimate that unfunded pension liabilities for state and local governments could range 

from $300 billion to $800 billion. Unfunded OPEB estimates are $600 billion to $1.3 

trillion, and these liabilities are increasing at a double-digit rate as health care costs 

increase. 

 Because water and wastewater utilities are capital-intensive, the impact of 

personnel-related unfunded liabilities is less important for them than for the rest of state 

and local government. Nevertheless, from my experience with local enterprise funds for 

water and sewer, if my local government decided to fully fund pension obligations by 

2028 and OPEB obligations by 2038, it would double the cost of fringe benefit expenses 

(from 45% to 90%) in ten years. If that happened, it would have a significant impact on 

rates. 

58
 Another way to look at the implications of pensions and retiree health care is to 

consider the impact of these costs on the average rate payer. Ratepayers also are 

taxpayers. Therefore, if uncontrolled, the costs of pensions and retiree health care are 

going to hit the consumer/taxpayer first in increased taxes for general government (which 

is much less capital-intensive). That will leave even less room for the increases that will 

be required eventually to fund increased O&M costs for utilities. 

 

59
7.3 Open Discussion

7.3.1 Cost-Drivers

3⁄4 In terms of O&M expenses, increases are also linked to pensions and increasing 

health insurance costs. Utilities used to only have to think about capital costs 

when increasing rates. Now they have to account for increasing capital costs and 

increasing O&M costs. 

3⁄4 One additional reason for the increase in cost is the costs of road restoration. The 

increases in pipe replacement are disproportionately the result of increased costs 

in road restoration. 

3⁄4 The biggest capital driver for my wastewater utility is a combination of growth 

and more stringent effluent limitations. 

3⁄4 My wastewater utility’s capital costs are being driven by infrastructure 

rehabilitation and replacement costs, sanitary sewer overflow issues, and third 

party lawsuits. 

3⁄4 With water, you can’t substitute any other resource. 

3⁄4 We also need to consider the demands placed on public utilities to achieve 

broader social objectives (for example through targeted contracting); these can 

lead to higher costs. 

3⁄4 Low income customers are usually not the ones driving peak demand, which 

impacts the costs. 

3⁄4 Utility risks are increasing and existing risks have not been thoroughly recognized 

in ratemaking process. Some people think as we become more efficient rates will 

go down. The cost drivers are such that rates keep going up, efficiency gains 

simply slow the pace of the increase. 

3⁄4 Water utilities are in a rising cost environment. 

3⁄4 In the IOU industry, for every dollar in expense that goes up, it takes 8 dollars in 

capital that you can’t spend. 

3⁄4 The big drivers in O&M costs are labor, energy, and chemicals. Labor alone 

accounts for about 40% of O&M cost. 

3⁄4 The big drivers in capital cost are materials, skilled labor, and risk management. 

60
7.3.2 Post Employment Benefits

3⁄4 We’ve seen that there is often a tendency to equate FAS87 reporting for 

accounting purposes with minimum funding requirements. FAS87 is just a 

recording convention. The Employee Retirement Income Security Act (ERISA) 

establishes funding requirements. We’re looking at the funding requirements 

under ERISA as the least cost method for ensuring the viability of a pension while 

placing the least burden possible on customers to cover that. 

3⁄4 In Massachusetts, we’re required to fully fund pensions in accordance with GASB 

87 by 2028. Every year, each employee earns every year one-30th of what you’re 

promising them when they retire. We’re just trying to keep straight who’s 

subsidizing whom. These liabilities can be very burdensome on general 

government and could result in substantial increases in taxes. 

3⁄4 In my utility the retirement/pension piece is appropriately funded but health care 

benefits were added when the stock market was strong. We are required to make 

a contribution in accordance with the actuarial study. The contribution on the 

employee’s side has grown from 7% to up to 14% next year. By 2016, we 

estimate the contribution will be 21% of an employee’s salary. We’re also 

proposing a 6.5% rate increase. We explained the problem to our customer 

advisory and got support to some extent, but customers do not understand why 

they’re paying for pensions and retiree healthcare benefits that are more extensive 

that what most employers provide. 

7.3.3 Asset Management

3⁄4 I was impacted by the idea that all is not yet lost (perhaps not quite the crisis we 

sometimes paint it) and there is yet time to address the "ramping up" needs if 

system managers take it to heart...soon. We are embarking on a new era relative 

to infrastructure replacement. The Australia model and the use of Asset 

Management to develop a better picture of what it may take to ramp up to full cost 

pricing models that will adequately service future infrastructure replacement 

needs is one interesting approach. There is much need for more debate and 

understanding on all these related issues and approaches. 

 

3⁄4 We look at what our peak season is for main breaks and look to see what we can 

do with our assets to shave those peaks. We haven’t seen the peaks disappear 

anywhere, but we have seen peak dampening. Every year, we’re looking for more 

ways to improve efficiencies and costs. We’re shifting away from reactive 

maintenance to planned maintenance, but the typical U.S. utility is primarily 

reactive. 

3⁄4 Australian utilities went through a reform process in the mid-1990s driven by 

preparation to enter into world trade. There was a unique opportunity to start 

61
from scratch, using trade investment money. Our job is to look at what they did 

and see what we can adapt (at the process level). We can’t erase the board like 

they did. Australian utilities all underwent competitive transformation and the 

asset management process together. U.S. utilities began with competitive 

improvements and asset management came along later. Seattle is grafting asset 

management on top of their current model. Every utility in the U.S. is in a 

different place. Australia had the benefit of undergoing a sweeping trade-driven 

reform process across the board. 

3⁄4 Hunter Water is a leading Australian utility. For them, every investment choice is 

driven by lifecycle cost/business case. It’s called “whole life optimization,” 

addressing external costs. They are working heavily on customer service side and 

examine the whole spectrum of options, from repair to replacement (for critical 

assets). They are using the full suite of available technology. Everyone 

understands asset management principles and the reasons for searching for leastcost solutions. They understand that it’s a risk management issue and a 

continuous improvement process. 

3⁄4 A lot of people are saying that we need to focus on asset management and 

efficient use of capital. Australia developed a model that encouraged finding the 

most efficient means of addressing each problem. How can we incentivize 

innovation and efficient use of capital? A utility’s ability to recover costs may not 

be as limited if they’re spending more efficiently. 

3⁄4 The asset management plan is where a utility outlines its solution to the tradeoff 

problems for each class of assets and shows how they’ll deliver the expected 

performance for each class. 

3⁄4 Asset management helps you figure out objectively where you are and what your 

options are. You then take that knowledge to the public and figure out what 

you’re going to do with it and how you’ll fund it. There are also technical 

tradeoffs that affect intergenerational equity. A lot of utilities have pipe 

replacement programs that involve abandoning pipes more than they involve 

replacing them. This is a legacy that remains a problem. 

3⁄4 There are 2 distinct aspects to the Australian approach—one is using asset 

management to identify the full least cost of doing business---the other is a choice 

to set rates based on replacement cost accounting to fully recover cost, or a “pay 

as you go approach”. Either one could be employed: 

o Pay as you go – Some Australian utilities have tried to use replacement 

cost accounting so the depreciation cash flow funds replacement. They do 

not incur debt for mains but do for treatment plants and cost spike-type 

assets. 

o Annuity option – Using the results of comprehensive asset management 

planning, the projected cost over the life cycle of the assets is annualized 

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3⁄4 There’s a compelling argument for more research—the more you understand 

about the life of your assets, the better understanding you have of your utility’s 

needs. 

3⁄4 Full costs have to be separate from rates. My concept of rate-setting is that 

municipal systems are driven by coverage and IOUs are driven by the rate of 

return. We need to keep looking towards getting a better understanding of asset 

lives and how long assets will last before they’re repaired or replaced. Only then 

can you do full cost pricing. Right now, anything that happens beyond 10 years 

from now is pure guesswork. 

3⁄4 There are still serious issues with the speculative nature of valuing the assets. This 

can undermine the incentive innovation and for efficient asset management 

looking forward and lose some incentive for innovation. 

3⁄4 We may have to accept that our planning will always be an approximation. 

3⁄4 If you opt to repair or renovate assets rather than repair, replacement has to occur 

some other time. This presumably will increase the cost of replacement. 

3⁄4 Our asset management programs are not focusing on improving the ability to 

predict the remaining life of assets or on capital cost reduction. One theory of why 

we’re sidetracked is that we were unlucky to have the interest in asset 

management occur at same time as the implementation of GASB 34—we got 

hung up on inventorying and assessing condition. 

3⁄4 Equity considerations may be a constraint on cost functions. There’s a longstanding debate on what “least cost” means in utility sector. Some people use the 

term “best cost” instead. 

3⁄4 Affordability is starting to appear in more cases, in terms of safety nets. The new 

way of thinking in this area is to acknowledge that households having problems 

with water bills are likely having problems paying any and all bills. 

3⁄4 In surveys of utility practices, we have seen that utilities can take steps to reduce 

capital costs up to 30 to 40%. 

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64
8.0 Cost Recovery Through Rates, Charges & 

Other Sources

8.1 Framing Presentation on Cost Allocation & Rate Design

Patrick Mann PhD; West Virginia University 

There has been very little done on integrating incremental and average costing, 

but you can’t have efficient pricing if you don’t have efficient operations. Integrating 

these two will allow a system to meet their costs and sent efficient price signals. There is 

additional work needed in the area of estimating the incremental costs of capital and 

estimate avoided costs. 

There is also the issue of whether we want to retain declining block rates or 

uniform rates. Washington Suburban, for example, uses an increasing step rate (not a 

block rate – all usage is charged at a set rate). 

We’re also seeing the emergence of seasonal rates, which are being used as a 

conservation pricing mechanism. Now we’re thinking about applying it to second home 

communities. This raises the question of fairness—who pays for peak usage, the yearround residents or second-home owners? 

A fourth issue is rate differentials for user classes, which would eliminate a 

singular rate schedule for large utilities. The issue would be one of choosing between 

lifeline rates, inclining block rates, uniform rates or implementing seasonal rates. 

 Another issue is single tariff pricing versus zonal rates. Single tariffs are very 

contentious, especially when a large system acquires a system with higher costs. The 

issue is: why pay higher rates to subsidize the customers of the acquired system. 

 Vintage rates are a bad idea. There is a tradeoff between efficiency and fairness. 

Vintage rates may reflect economic costs and let systems protect current customers from 

the effect of growth, but they are abused. 

 There is also the issue of incorporating fairness into rate design criteria. An 

investor owned utility (IOU), would keep it out of the rate proceeding because it 

interferes with cost of service. For municipal systems, however, this issue can never go 

away. “Fairness” can be a very ambiguous concept. We have to think about phase-in 

plans for rates to limit the impact of and customer reaction to rate increases. 

 On non-rate financing, we need to rely more on system development and 

availability charges. 

 On affordability, we have the question of whether we need to think about 

alternative standards (versus the traditional 2.5 % Median Household Income [MHI] 

standard that EPA uses). Data on MHI can be distorted and unreliable. Should we apply 

65
an MHI percentage to water and wastewater combined? There are also alternative 

standards to consider. Using county data or ZIP code data can distort the income picture. 

There is also the impact of second home communities on the income statistics. 

 Gas and power utilities use Low Income Home Energy Assistance Programs 

(LIHEAPs), a potential model for the water industry. In the water industry, we have to 

consider whether subsidies should go to the customers or to the systems? 

 The longevity of assets is another concern. Up until about 20 years ago, the 

Butte, Montana water company had some wooden mains. 

66
8.2 Framing Presentation on Decoupling Revenues from Sales

Paul Foran, American Water 

 Revenue decoupling is a form of ratemaking designed to separate a utility’s 

revenue from its sales; it has primarily been implemented in the gas and electric 

industries. This process can reduce the financial incentive to promote consumption and 

reduce the financial disincentive to promote conservation. The approach is not 

inconsistent with full cost pricing, but is certainly different than approaches used in the 

past. It has its advocates and opponents. 

 Mechanisms for decoupling sales from revenue include increasing fixed cost 

recovery through rates (rather than linking rates to volumes), revenue adjustment 

mechanisms, and surcharges. 

 We have an underlying social responsibility to use water resources wisely, which 

decoupling can help do. It can also help control long term costs to customers by 

positively impacting source of supply, treatment and distribution costs.. 

 One of the biggest challenges is to overcome the idea that the public will be 

paying more for less. Even if you explain that costs are reduced in the long-term, it can 

still be a hard sell. 

 There are some decoupling initiatives under way in the water industry but there is 

no widespread implementation—traditional ratemaking is still most prevalent approach to 

pricing. American Water is currently proposing certain rate designs that would allow for 

some decoupling. 

 We have to be careful with comparing levels of capital intensity among the 

various utility services, such as electric, gas, water, and telecommunications, and 

equating it with efficiency. The facilities necessary to provide safe and reliable water 

service are inherently more capital intensive than for the other utilities and the level and 

cost of those facilities is greatly affected by geographic location and weather. American 

Water has systems all over the country, serving over 29 million persons on a regulated 

and unregulated basis in every topography and climactic zone. From 1980 through 2005, 

water use per customer has remained constant or decreased (between 1990 and 2004, 

decline in indoor water usage was 30% per capita) while net plant investment per 

customer has skyrocketed in response to SDWA and the condition of aging infrastructure. 

As a result, the unit price of water is rising. We can’t expect to be able to fund those 

increases through increased per capita demand, which is not and likely will not be 

occurring. 

 The drivers of reduced consumption include plumbing codes (national codes came 

into effect in 1998), fewer people per household, higher average age of household 

occupants, public education on wiser water use, price elasticity, fixture retrofit and rebate 

programs, water audits, and full value pricing. 

67
 Seventy percent of all water utility costs are fixed and approximately 25% are 

variable. However, the revenue structure is reversed—72% of revenues are variable 

(based on quantity sold) and 28% are recovered through fixed charges on bills. 

 Conservation reduces demand and revenue but our capital needs are unchanged—

we have to examine rate structures. Decoupling is part of the answer to realizing the 

benefits of conservation but has wider implications and potential benefits including rate 

stability, timely recovery of capital investment, and capital attraction. 

 

68
8.3 Open Discussion

8.3.1 Decoupling Revenue from Sales

3⁄4 NRRI has put out a paper on decoupling and the gas industry. You can also better 

align fixed and variable costs, but that undermines the price signal to conserve. 

3⁄4 In the water industry, there is usually a far greater divergence between the private 

value of water and the social value. This is a much bigger issue with water than 

with gas. 

3⁄4 Decoupling isn’t a panacea and there are many different tools available. 

8.3.2 Cost Allocation & Rate Design

3⁄4 We know that energy prices are rising, because the cost of the raw sources of 

energy is increasing. For drinking water, we aren’t paying for the raw water; 

we’re paying for the service 

3⁄4 Part of the issue is differentiating rates from household costs. With conservation, 

you can increase rates but you can’t increase household costs. It presents a 

conflict for the utility: should we pursue conservation if it’s going to decrease our 

revenue stream, causing rates to increase at a more accelerated pace? 

3⁄4 I’d disagree that there’s customer opposition to conservation and full cost pricing. 

But utilities are expected to do things other than just sell a product—we have 

conservation and watershed management responsibilities. Separating costs puts 

utilities in a position to sell a product and be socially and environmentally 

responsible. 

3⁄4 Moving from flat rates to metering sent signals to customers, but now we’re 

telling them that rates will still go up, even if they moderated their usage. 

Utilities have to do a lot of talking to customers and explaining their long term 

goals. 

3⁄4 Setting individual rates by customer class is important—it supports conservation 

and sends price signals. 

8.3.3 Affordability

3⁄4 In most low-income houses, the amount of money they spend on water is a 

significant percentage, compared to their overall income. Many low income 

households are struggling to pay any of their utility bills; there are health tradeoffs, since many people will put off doctor visits in order to be able to cover 

69
utility bills. This may only be happening in a small proportion of households, but 

there is a tangible health effect that we need to be aware of. 

3⁄4 A new AwwaRF project will compare practices across utilities and the banking 

industry on how to help low-income customers and what kinds of assistance 

programs to apply 

8.3.4 Subsidies

3⁄4 In many cases, current subsidies may disincentivize good behavior. The systems 

with the greatest problems get the money. 

3⁄4 It’s valid to have subsidies for quality issues, but we shouldn’t be rewarding bad 

management. In all things, auditing and public information is one of the more 

powerful things we can have. 

3⁄4 If some kind of physical or non-physical consolidation or regionalization is not 

possible, there are limited options. You can let people drink unsafe water, you can 

abandon the system, or you can subsidize systems. 

3⁄4 In the U.S., access to safe drinking water can be considered a basic human right. 

Providing subsidies to provide access to safe drinking water as a basic human 

right could be one reason to provide subsidies, but I can’t think of any other. 

3⁄4 If you have subsidies now, how can you do the least harm with them and how can 

you begin to reform them? Why are subsidies the least cost path and what are the 

other alternatives? 

3⁄4 The endpoint is sustainability—you can use the incentive part of subsidies to get 

sustainable solutions. So the perfect subsidy program is one that has the endpoint 

of putting itself out of business (but providing a safety net for extreme situations). 

3⁄4 We can’t let people choose to keep drinking contaminated water. 

3⁄4 There are health-based regulations related to source water quality that have 

nothing to do with how the water system is being run. We could possibly provide 

subsidies for those types of problems, just to fund the incremental part of ensuring 

that the water is safe to use. 

70
9.0__Workshop Conclusions

Workshop participants generally agree that full cost pricing will be possible and 

successful only in an efficiently structured and managed water and wastewater Sector. 

Embedded in the current structure, management, operations, and oversight of the water 

and wastewater sector are potentially significant inefficiencies. Eliminating these 

inefficiencies will help to minimize future cost increases and the magnitude of future rate 

increases. Comprehensive sectoral reform is needed and EPA’s role should be to initiate, 

inform, enable and facilitate a broad national dialogue among all stakeholders about how 

to achieve our national public health and environmental protection goals in the least cost 

and most socially acceptable manner. 

As the workshop drew to a close, participants agreed that a number of key themes 

and issues had emerged in the discussions. The group identified and organized these 

themes and issues as presented in the diagram below to assist EPA and other stakeholders 

in better framing future thinking and discussion of full cost pricing and water & 

wastewater system sustainability. 

Expert Workshop on Full Cost Pricing of Water and Wastewater Service

Key Issues Identified

“Meta-Issues”

1. Least Cost Achievement of Environmental & Public Health Protection Goals Across Watersheds.

2. Role of Economic vis-à-vis Environmental & Public Health Regulation.

3. Public Education & Building Public Support.

4. Role of Federal & State Subsidies.

5. Impact of Global Climate Change.

Industry Structure

1. Consolidation

2. Ownership and Management Contestability

3. Level of Service

Utility Management

1. Best Practices for Operational Efficiency

2. Asset Management to drive to least-cost

3. Risk Recognition & Management

4. Cost of Capital

5. Alternative Capital Project Delivery Methods

6. Uniform System of Accounts

7. Information Resources to Support 

Ownership and Management Contestability

8. Pricing Pardigm

The issues and themes were organized into three major categories: “meta issues”, 

issues related to industry structure, and issues related to utility management. These 

categories and the individual issues within them are further discussed below. 

71
“Meta Issues”

Workshop participants identified 5 issues which share the characteristics of being 

high-order issues and being issues requiring action from many other major stakeholders 

to address. These are issues which utilities and utility regulators cannot address on their 

own. The group classified these issues as “meta issues”. 

1. Least Cost Achievement of Environmental and Public Health Protection 

Goals Across Watersheds.

At the watershed scale, participants believed that significant opportunities exist to 

identify least cost (or some would say best cost) approaches to achieving 

environmental and public health protection goals. Decision making at a lesser 

scale misses such opportunities and fails to achieve economic efficiency, resulting 

in greater cost to society to achieve given environmental and public health 

protection goals than is necessary. Recognizing that significant cross 

jurisdictional cooperation and coordination (at the utility, local government, and 

regulatory agency levels) would be necessary to undertake decision making at the 

watershed scale, participants characterized this issue as a “meta issue”. 

2. Role of Economic vis-à-vis Public Health and Environmental Regulation.

Workshop participants generally believed that the major issues standing in the 

way of greater progress toward utility sustainability are issues of utility 

organization, ownership and management and the terms and conditions under 

which utilities provide service. These issues are generally the province of 

economic regulatory authorities (in the United States, Public Utility 

Commissions). Participants agreed that a robust, well informed dialogue among 

all appropriate stakeholders about the potential role of economic regulation or 

oversight (or some other application of the insights and principles of economic 

regulatory oversight) vis-à-vis existing public health and environmental regulation 

would be an important step in advancing application of full cost pricing. 

Existing PUC practice regarding regulation of the water sector varies greatly from 

State to State, offering many different examples and models which could form the 

basis for further dialogue. 

Participants did not collectively endorse or recommend expansion of existing 

Public Utility Commission authority and oversight. They did endorse a 

systematic, robust and well informed dialogue within each State on how economic 

regulatory oversight of the water sector might change and how such changes 

might advance attainment of sustainable public health and environmental 

protection. 

72
3. Public Education and Building Public Support.

Workshop participants expressed a strong belief in the need for greater water 

sector emphasis on public education about infrastructure issues and on building 

public support for the rate increases necessary to achieve full cost pricing. 

Participants believe the public education mission is largely, although by no means 

exclusively, a utility responsibility. Since public education arguably includes the 

need to educate decision makers, and others influencing public opinion, at all 

levels, it is characterized as a “meta issue” in recognition of the need to broadly 

engage diverse stakeholders in the effort. 

4. Role of Federal and State Subsidies

Unconditional, uncoordinated, and untargeted subsidies distort utility behavior, 

and, in the opinion of many workshop participants, represent a serious barrier to 

progress toward full cost pricing and sustainability. Of particular concern were 

subsidies with no explicit tie to requirements for utility actions to move toward 

sustainability. Some participants noted the essential role of subsidies in helping 

make water and wastewater service affordable for low income households. A 

commonly expressed concern about subsidies provided to the utility is that the 

benefit of the subsidy accrues to all customers, regardless of their need. Most 

participants agreed that such subsidies should best be delivered to the household, 

not the utility, and that delivery through an existing program such as LIHEAP 

(low income heating and energy assistance program) would be most efficient. 

Another subsidy of significant concern to participants is that provided through 

earmarked Federal and State appropriations. Such subsidies seriously distort 

utility behavior by encouraging utilities to ignore well structured financial 

assistance programs offering subsidies conditioned on movement toward 

sustainability in favor of essentially unconditional assistance provided via the 

political process. 

5. Impact of Global Climate Change

Utilities participating in the workshop report experiencing extreme weather events 

at significantly greater frequency in recent years. The impacts of global climate 

change on the quantity and quality of source water available to utilities is a matter 

of study, discussion and conjecture at present. It appears plausible that utilities 

may in the future face additional capital and/or operating costs associated with 

mitigating the impacts of global climate change on the hydrologic and quality 

characteristics of their source waters. 

73
Industry Structure Issues

Workshop participants identified significant issues associated with utility size, scope, 

ownership, management and capabilities. These issues are grouped together as issues 

related to the structure of the water and wastewater industry. 

1. Partnerships & Consolidation

From an economic and business perspective, workshop participants agreed that 

the present structure of the drinking water industry, with 2/3 of systems serving 

fewer than 500 persons and many of them being owned and operated by entities 

not principally focused on potable water provision, is not sustainable. Even 

among larger systems, participants identified unexploited potential efficiencies of 

closer coordination and partnership that would more fully utilize existing 

infrastructure and operational/management capabilities. 

The drinking water sector offers many different models of successful utilities. 

Public ownership, private ownership, and many operational and management 

approaches across the public-private spectrum are all in place today. Workshop 

participants identified the urgent need for ongoing rigorous reexamination of the 

status quo by utilities and regulators with an eye to enhancing efficiency and 

looking for ways to partner with other utilities for mutual benefit. The 

efficiencies thus realized will reduce the extent to which rates will have to go up 

to achieve full cost pricing and sustainability. 

Workshop participants identified an important nexus between this issue and the 

“meta issue” related to economic regulation. In many States, there appears to be a 

vacuum in terms of an oversight, advisory, or other agency or entity to help 

utilities see potential partnerships across greater geographical scales. Participants 

emphasized the importance of the “match making” function, in addition to the 

importance of economic and public health/environmental regulation. 

2. Ownership and Management Contestability 

Workshop participants identified ownership and management contestability as a 

key market force that can help drive the industry to exploiting partnerships and 

consolidation efficiencies. Ownership and management contestability requires 

that the industry have viable and vigorous players in both the public and private 

sectors and that opportunity for healthy competition exist between them. If there 

is a viable and realistic option for private owners or managers to displace public 

ones, or vice-versa, then both will be incentivized to perform at optimal 

efficiency. 

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3. Level of Service

Level of service was identified by workshop participants as a very important 

consideration at the individual utility level and at the level where utility decisions 

about structure are reflected in the overall structure of the industry. Level of 

service is understood in a broad sense, encompassing all aspects of the utility’s 

connection to and interaction with its customers. Of fundamental importance is 

an effective dialogue between the utility and its customers about the level of 

service customers desire and the cost of that service, including options available 

to the utility to deliver that level of service at the least cost. 

Utility Management Issues

 Practical utility management issues associated with delivering the target level of 

service at least cost were one of the major topics of discussion at the workshop. 

1. Best Practices for Operational Efficiency 

Both water and wastewater utilities have demonstrated significant operational 

efficiency improvements in recent years. Workshop participants attributed these 

efficiency gains to 2 major forces. The first was the widespread interest in the 

potential for privatization in the late 1990’s. The second was the concurrent 

availability and application of effective telemetry systems such as Supervisory 

Control and Data Acquisition (SCADA) Systems. Such systems allow for much 

more efficient deployment of labor. 

Many specific practices have been documented and techniques developed to 

assess operations to identify potential efficiencies. As an essential first step 

towards sustainability, all utilities should be employing the best practices for 

operational efficiency and should continue to seek further efficiency gains as part 

of a continuous improvement culture. 

2. Asset Management to drive to least-cost 

Delivering the target level of service at the least cost requires that the utility 

effectively optimize its mix of capital replacement and operation and 

maintenance. Asset management is a tool that enables utilities to assess and 

optimize this mix. Workshop participants emphasized the importance of applying 

asset management for this purpose. Participants noted the danger of utilities 

satisfying themselves with asset inventories, and failing to achieve least cost 

optimization. Another important point is that utilities won’t necessarily see 

immediate cost savings from applying asset management. In fact, it will probably 

result in a much fuller understanding of infrastructure investment need , and in the 

short term appear to possibly increase costs. 

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3. Risk Recognition & Management 

Workshop participants emphasized the importance of utilities recognizing and 

managing the business and operating risks they face. Some utilities perceive their 

risk exposure is growing, for example the reliability of the electric grid is 

decreasing, placing utilities at greater risk of losing power. Recognizing and 

managing risks is an essential component of providing service at least cost or 

“best cost”. Many publicly owned utilities may be seeking to transfer all risks 

associated with capital projects to their contractors when in fact the utility itself 

may be best able to assume some of those risks. Transferring risk to another party 

increases costs, and to minimize cost risks should be parsed out to the party best 

able to manage them. 

4. Cost of Capital 

Minimizing the cost of capital is one of the core requirements for achieving least 

cost provision of service. Effective risk recognition and management is an 

important element of minimizing the cost of capital. For investor owned systems, 

the ability to actually earn the allowed rate of return is key. For all systems, the 

better managed the system is, and the stronger the system is institutionally, the 

lower will be its cost of capital. 

5. Alternative Capital Project Delivery Methods 

Participants noted the potential cost savings available from more widespread 

utilization of alternative capital project delivery methods. The traditional 

approach of separating project design and construction leads to inefficiencies. 

Approaches such as design-build, applied effectively, can eliminate such 

inefficiencies. However, some State procurement laws will not allow State funds 

to be used for design-build projects. 

6. Uniform System of Accounts 

The National Association of Regulatory Utility Commissioners (NARUC) has 

developed a uniform system of accounts for use by commission regulated, 

investor owned utilities. A number of workshop participants felt that 

development of an analogous system of accounts for publicly owned systems 

would be beneficial. Many participants were concerned about how depreciation is 

treated in publicly owned utilities. A set of systems of accounts that would more 

readily facilitate comparison of utility financial performance, regardless of 

ownership, is seen as an important step forward. 

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7. Information Resources to Support Ownership and Management 

Contestability 

A number of workshop participants noted that public sector decision makers need 

better information products to assist them in evaluating, negotiating, and 

managing contracts with the private sector. Equipping public sector decision 

makers to effectively evaluate contract proposals is an essential element of 

maintaining ownership and management contestability. 

8. Pricing Paradigm

Workshop participants noted that pricing water and wastewater service to fully 

recover the cost of providing that service may require broader application of 

innovative approaches to cost allocation and rate design. This is especially true as 

concerns about the impact of rising rates on the poorest of households receives 

greater attention. 

Another factor complicating pricing is flat or declining base demand at a time of 

rising costs. Discussion of the concept of decoupling revenue from sales is just 

beginning. An informed and robust discussion of the options available for 

establishing rates will be essential. 

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Appendix A

Background Paper on Full Cost Pricing

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United States Environmental Protection Agency 

Office of Water 

Sustainable Infrastructure Initiative 

Full Cost Pricing Expert Workshop

November 1-3, 2006 

Institute for Public Utilities-Michigan State University 

Background Paper on Full Cost Pricing

Summary 

 The United States Environmental Protection Agency (EPA) is convening an 

expert workshop of leading academics, water utility executives, Public Utilities 

Commissioners and staff, utility rate setting practitioners, and other experts to explore the 

issue of “full cost pricing” for water and wastewater service. The industry is entering an 

era characterized by significant infrastructure replacement need and new investment for 

enhanced public health and environmental protection.1

 Overwhelmingly, the costs of 

these investments will be borne by the utility ratepayers. 

 Full cost pricing is one of four major themes under EPA’s Sustainable Water 

Infrastructure Initiative. The other themes include: management of utilities; promoting a 

watershed based approach to infrastructure planning; and promoting the efficient use of 

water. Taken together, the Agency believes that these four “pillars” of sustainable 

infrastructure will help enhance the efficiency of the water and wastewater sector in the 

United States and ensure achievement of our nation’s public health and environmental 

protection objectives. 

The Expert Workshop brings together different perspectives on the fundamental 

questions related to full cost pricing of water and wastewater service. The objective of the 

Workshop is to achieve a deeper understanding of these issues from a variety of 

perspectives. The Agency hopes the Expert Workshop will help us better frame the issue 

for further deliberation and provide insight into a variety of possible approaches to 

facilitating industry movement toward sustainability. 

 

1 This paper uses the following definitions to distinguish between the physical infrastructure and the ownership/management of that 

infrastructure: 

Water System: The physically interconnected infrastructure designed to deliver potable water to individual retail connections. The 

simplest water system consists of a well, hydropneumatic tank, and distribution piping to about 15 household connections. The most 

complex systems consist of multiple large treatment plants (treating hundreds of millions of gallons per day or more) feeding into 

enormous distribution systems containing hundreds of miles of pipe and providing service to a full array of residential, commercial, 

and industrial users as well as wholesale service to other water systems. 

Water Utility: The physical infrastructure designed to deliver potable water to individual wholesale or retail connections together with 

the organizational entity legally responsible for the ownership and management of the infrastructure and the quality of the water 

delivered to the customer. A water utility may own and operate a large number of physically separate water systems. 

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Defining Full Cost Pricing 

The following draft definition of full cost pricing is offered to facilitate discussion 

at the expert workshop: 

Full cost pricing is a pricing structure for drinking water and wastewater 

service which fully recovers the cost of providing that service in an economically 

efficient, environmentally sound, and socially acceptable manner, and which 

promotes efficient water use by customers.

EPA’s Preliminary Conceptual Model 

The internal EPA Working Group on Full Cost Pricing has developed a draft 

definition and preliminary conceptual model of full cost pricing to facilitate discussion of 

what full cost pricing means and how it relates to other major elements within the 

Sustainable Infrastructure Initiative. The Agency hopes the definition and preliminary 

conceptual model will prove useful to the expert workshop participants as tools around 

which they may organize their thoughts and discussion on the subject. A brief description 

of the model (Exhibit 1) and some related questions for participants to consider in 

preparing for workshop discussions is included below.

The model posits that the fundamental determinants of the full cost of water 

and/or wastewater service are the level of service the public desires and the way in which 

a utility (or utilities) is structured and managed to deliver that level of service. Table 1, 

below, presents examples of issues and questions helpful in thinking about level of 

service and utility structure and management. 

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Table 1: Level of Service and Utility Structure and Management Considerations 

System 

Type 

Example Level of Service Issues Example Utility Structure and 

Management Issues 

Water 

• Does system provide fire protection? 

• What peak flow demands can the system 

meet? 

• Number and duration of service interruptions 

per year. 

• Number of water main breaks per year (and 

damage caused by breaks). 

• Quality of water delivered to customer. Does 

it comply with federal/state health based 

regulations? Does it meet the aesthetic 

demands of customers? 

• Time to respond to customer complaints or 

questions. 

• Nature of system’s “environmental 

footprint”—is it a “green” system? 

• Outreach and public education. 

• Opportunities for customer input and 

involvement. 

Wastewater 

• Number and duration of service interruptions 

(such as backups) experienced by customers. 

• Number of times and quantity of untreated 

wastewater discharged per year. 

• Quality of treated effluent: Does it comply 

with federal/state standards? Does it satisfy 

community expectations? 

• Time to respond to customer complaints or 

questions. 

• Nature of system’s “environmental 

footprint”—is it a “green” system? 

• Outreach and public education. 

• Opportunities for customer input and 

involvement. 

• Utility ownership: public or private? 

• Utility scope: water or wastewater 

only? Both? Both including other? 

• Institutional structure: If public; line 

department of city government? 

Enterprise fund? Special district? If 

Private; is it a publicly traded 

corporation or a private owner? 

• Utility management: public or private? 

If owner does not manage, what is the 

nature of the contractual agreement 

under which some other party 

manages the system/utility? 

• Geographic scope of utility: Is it 

system or community specific or 

regional in nature? 

A central question implied by the model is the cost effectiveness with which the 

selected utility structure and management is able to deliver the desired level of service. Is 

the desired level of service being obtained at least cost? If not, is it being obtained in a 

manner optimizing appropriate social outcomes? According to whose perspective? 

 Assuming an appropriate level of service is being provided in a manner 

optimizing desired social outcomes, the model next reflects the need to fully identify all 

business costs associated with the provision of that service. At this point, the insights 

from the Better Management Pillar of the Sustainable Infrastructure Initiative are needed. 

In particular, a comprehensive asset management program or a similar planning practice 

through which the utility can estimate its long-term capital and operating costs. In this 

context long-term is defined as the life cycle of the assets of the utility—in the case of 

pipes 70+ years. The planning process employed should address the lumpy nature of 

infrastructure investment and the intergenerational equity issues associated with that. 

Critical issues will involve how capital projects are delivered (traditional vs. design-build 

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for example), the cost of capital, financing alternatives, treatment of depreciation, and the 

optimum mix of maintenance vs. capital replacement in the real world operating 

environment of the utility. 

 Once the full business costs of providing the service have been determined, the 

annual revenue stream necessary to fully cover those costs must be calculated. If systems 

are under the jurisdiction of their State Public Utilities Commissions, this process will be 

governed by the established policies and procedures of the commission. 

 Once the annual revenue stream necessary to sustain the desired level of service 

has been determined, the model moves into the cost allocation and rate design process. 

Principles of cost allocation and rate design are well established. A critical question for 

the expert workshop is the current state of practice in cost allocation and rate design. Is 

there a need for significant innovation in this area? If so, of what nature? How important 

are cost allocation and rate design as opposed to the issues considered earlier in the 

model to achieve full cost pricing? 

 As an essential component of this analysis, the model calls for explicit 

consideration of the role that external subsidies (such as federal or state interest rate 

subsidies or grants) and transfer payments (such as movement of funds between a city’s 

general fund and the utility) will play in meeting the annual revenue requirement. 

Subsidies will decrease the amount of revenue that needs to be recovered from 

ratepayers. Transfer payments from the city’s general fund into the utility will also 

reduced the revenue that needs to be collected. The opposite will hold if the transfer 

payment is from the utility to the city’s general fund. A key question for the expert 

workshop is the role that subsidies and transfer payments do and should play in the 

pricing of water and wastewater services. 

 After any correction for subsidies and/or transfer payments and after application 

of the selected cost allocation and rate design methodology, the annual bill for each user 

can be determined, assuming (if necessary) a given level of water use or wastewater 

generation. At this point, decision makers may conclude that the household rates, 

necessary to support the existing or desired level of service under the selected 

management and operational structure, are economically or politically not feasible. This 

would require a return to the beginning of the model to revisit decisions about level of 

service and/or the utility’s structure and management/operations. 

Discussion Topics 

The objective of the Workshop is to hear from a variety of perspectives to achieve 

a deeper understanding of the broader implications of full cost pricing. Therefore, we are 

also hoping to discuss a broad range of key issues that tie into the elements of full cost 

pricing as presented in the model. These include: 

• Accounting for future infrastructure costs 

• The impact of utility decision making on costs 

• Equity considerations 

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• Affordability 

• Institutional options (e.g., private-public partnerships) 

• Framing the argument for full cost pricing to reduce customer resistance 

• Implementing a full cost pricing structure 

• Addressing cases in which repayment does not match the useful life of the asset 

• Whether utilities can charge for goods and services that have been free 

• Unfunded pension and other post-employment benefit (OPEB) liabilities 

• The link between full cost pricing, home values, and economic development 

• The implications of Governmental Accounting Standards Board (GASB) 34 

 

 

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Appendix B 

Workshop Agenda

85
Agenda 

EPA Expert Workshop on Full Cost Pricing for Water and Wastewater Service 

The Kellogg Hotel and Conference Center at Michigan State University 

East Lansing, MI 

November 1-3, 2006 

Wednesday, November 1, 2006 

5 p.m. Meet & Greet and Workshop Check-in 

Room 101, The Kellogg Center 

6 p.m. Dinner 

The State Room Restaurant 

Framing Discussions 

Room 101, The Kellogg Center 

History of the Safe Drinking Water Act, EPA’s 

Sustainable Infrastructure Initiative, and the Full 

Cost Pricing Model 

Peter Shanaghan, EPA

History of Safe Drinking Water Act and Clean Water 

Act Implementation and the Evolution of the Water 

Industry 

Ralph Jones, The Cadmus Group

The Water Industry Compared and the Economic 

Regulation of the Industry 

Jan Beecher, MSU IPU

7:30 p.m. 

Capital Efficiency Myron Olstein, Independent Consultant

Thursday, November 2, 2006 – Room 103A/B, The Kellogg Center 

8:30 a.m. Framing Discussions, continued 

The Investment Community Perspective on the 

Water and Wastewater Industry 

Debra Coy, Janney Montgomery Scott, 

LLC

An Economist’s First Impressions of the Water 

Industry 

Don Coursey, University of Chicago

9:15 a.m. Determining Level of Service 

Overview of Key Issues – Framing level of service 

in terms of full cost pricing 

Peter Shanaghan, EPA

Level of Service: An Academic Perspective 

• Where are decisions on level of service made? 

• Trade-offs between different levels of service 

• The economic impact and benefits of chosen 

level of service 

Edna Loehman, Purdue University

Panel Discussion: Utility Level of Service 

Perspectives 

• Actual experiences with level of service issues 

David Williams, East Bay MUD 

Julius Ciaccia, Cleveland Utilities 

John Huber, Louisville Water

Joe Gehin, Wausau, WI Utilities 

John O’Neil, Johnson County, KS 

Wastewater

Kathy Pape, Aqua America

Paul Foran, American Water 

Panel Discussion: Economic Regulatory Level of Jack Betkoski, Connecticut DPUC 

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Service Perspectives 

• Actual experiences with level of service issues 

Dave Sheard, Wisconsin PSC 

Christine Hoover, PA Office of 

Consumer Advocate 

Open Discussion All participants 

10:45 a.m. Break

Thursday, November 2, 2006 – Room 103A/B, The Kellogg Center (continued) 

Means of Provision of Service – Institutional Structures

Overview of Key Issues – Framing the issue from a 

national perspective 

Peter Shanaghan, EPA

11:00 a.m. 

An Academic/Public Policy Framework for 

Understanding and Evaluating Alternative 

Institutional Structures 

Jan Beecher, MSU IPU

Panel Discussion: Public/Private – The Utility 

Perspective 

David Williams, East Bay MUD 

Julius Ciaccia, Cleveland Utilities 

John Huber, Louisville Water

Joe Gehin, Wausau, WI Utilities 

John O’Neil, Johnson County, KS 

Wastewater

Kathy Pape, Aqua America

Paul Foran, American Water 

Panel Discussion: The Academic Economists’ 

Perspectives on Alternative Institutional Structures 

Edna Loehman, Purdue University 

Patrick Mann, West Virginia University

Don Coursey, University of Chicago

12:15 Lunch 

12:45 p.m. 

(Working 

Lunch) 

Panel Discussion: The Economic Regulators’ and 

Consumer Advocates’ Perspective on Alternative 

Institutional Structures 

Jack Betkoski, Connecticut DPUC 

Dave Sheard, Wisconsin PSC 

Christine Hoover, PA Office of 

Consumer Advocate 

Open Discussion All participants 

1:30 p.m. Break

Recognition of Full Business Costs 

Overview of Key Issues Peter Shanaghan, EPA

1:45 p.m. 

Using Asset Management to Understand the Full 

Long-Term Costs of Doing Business 

John Cromwell, Stratus Consulting

The Local Elected Official’s Perspective on GASB 

34 and Unfunded Pension and Other PostEmployment Benefit Liabilities 

Ralph Jones, The Cadmus Group 

Open Discussion All participants 

3:45 p.m. Break

Annual Revenue Necessary for Full Cost Pricing 

Overview of Key Issues Peter Shanaghan, EPA

The Effect of Demand Depression on Revenue 

Requirements

Paul Foran, American Water 

4:00 p.m. 

Panel Discussion: Cost of Service John Guastella, Guastella Associates

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Tom Chesnutt, A&N Technical Services

Dave Sheard, Wisconsin PSC

Open Discussion All participants 

5:30 p.m. Adjourn

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Friday, November 3, 2006 – Room 103 A/B, The Kellogg Center 

Cost Allocation and Rate Design 

Overview of Key Issues 

• The role of rates and charges vis-à-vis subsidies 

and transfer payments 

• Addressing concerns regarding household 

affordability 

Peter Shanaghan, EPA

Cost Allocation and Rate Design: Major Issues and 

Considerations

Patrick Mann, West Virginia University

Panel Discussion: The Utility Perspective David Williams, East Bay MUD

Julius Ciaccia, Cleveland Public Utilities

John Huber, Louisville Water 

Joe Gehin, Wausau, WI Utilities

John O’Neil, Johnson County, KS 

Wastewater 

Kathy Pape, Aqua America 

Paul Foran, American Water 

8:30 a.m. 

Panel Discussion: The Consultants’ Perspective Tom Chesnutt, A&N Technical Services 

John Guastella, Guastella Associates 

John Cromwell, Stratus Consulting 

Heather Himmelberger, NM EFC 

Myron Olstein, Independent Consultant 

9:45 a.m. Break

10:00 a.m. Panel Discussion: The Economic Regulators’ 

Perspective 

Dave Sheard, Wisconsin PSC 

Christine Hoover, PA Office of 

Consumer Advocate 

Open Discussion All participants 

11:00 a.m. Concluding Open Discussion 

• Major themes 

• Next steps: How to advance adoption of full cost 

pricing by utilities? What is the federal role? 

What is the policy research agenda? What is the 

technical research agenda? 

All participants 

12 p.m. Adjourn

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