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  • Water Today, Electricity Tomorrow

    Posted by Carl from Chicago on June 18th, 2008 (All posts by )

    WATER DISTRIBUTION COMPANIES

    A recent Wall Street Journal article was titled “Calls Rise for Public Control of Water Supply”. This article described how the small town of Felton, CA cheered as their local water district (a municipal utility)

    “Officially wrested control of the town’s water from a unit of American Water Works Co. Residents of Felton… had been unhappy ever since the company bought their water system from another corporation in 2002 and proposed a 74% rate increase.

    The city threatened and cajoled American Water Works to sell them the local water utility, as described below:

    “One common tactic that communities are using in this water fight is eminent domain, the power that cities and other local agencies have to seize a corporate water system in the public’s interest. Earlier this year, the cities of Fort Wayne, IN and Cave Creek, AZ condemned all or parts of water systems owned by private companies.”

    WHY WATER COMPANIES ARE VULNERABLE

    Water companies are vulnerable for a number of reasons. First of all, their assets are “in the ground” and plainly available for takeover. Water systems are also relatively simple to run, and the existing work force can just become city or local employees.

    Water systems also require money for expansion and maintenance. The only way in which this money can be raised is through the local community’s water bills, so these costs are passed along right away to the community, and can result in a rapid rise for local citizens.

    Water also appears to be a necessity. Some utilities are viewed as luxury items (i.e. cellular phones, internet service) but everyone “needs” water. This is a simplistic view, of course, because very little water is used for drinking when compared to the water used for washing, flushing toilets, and irrigation. However, there is generally a strong bias against the privatization of water utilities, whether rational or not, and this is supported by the fact that the vast majority of US citizens get their water from a locally owned utility and not a private company.

    WATER AND ELECTRICITY

    There are 4 main components to electricity 1) generation (plants) 2) transmission (major lines) 3) local distribution 4) customer service / billing. If you strip away 1) and 2) then a local electrical company that is just doing distribution looks a lot like a water utility in the sense that it has local trucks, local infrastructure, and a customer service function.

    Electricity has many elements that make it harder to run than a water utility, including 1) much of their infrastructure is above ground and subject to damage during storms or high winds 2) it is more dangerous to work with electricity than water 3) electricity demand is more subject to significant fluctuations and is a “real time” system; water pretty much gives you what you get out of the tap on your end (obviously having no water or limited water is a problem, but the system doesn’t go into blackout mode).

    WHO PAYS FOR LOCAL SERVICE AND UPGRADES

    If you look at the “traditional” vertically integrated utilities, they had the whole process end-to-end, from generation to transmission then distribution and local customer service. While costs for distribution would practically change by city depending on whether or not that city was expanding (causing new investment in local facilities) or aging (requiring retrofitting and upgrades), these are only a relatively small part of the “total” cost of energy, which is really spread over a wide area. For example, huge nuclear plants benefit an entire metropolitan area, and major transmission lines can benefit a whole state (and even other states if it allows low cost generation to flow to areas that require more power). This is just a guess and it varies but maybe 20-40% of the total cost was local service and distribution, with the rest being the cost of generation and transmission of power. Since MOST or much of the cost was not really specific to a town, average costing was used so a particular municipality would pay the same as other towns (mostly) even if they required upgrades or were coasting on a good system.

    Distribution, however, is a far more localized model, so if you strip off generation and transmission (as has often occurred, especially with generation) then each town will definitely feel the pinch depending on their requirements. However, an even heavier burden will be that the local distribution company has to “pass on” the full cost of generating power, so even if it delivers service efficiently, its customers might be enraged as costs rise due to ever-rising costs of generating power (since we aren’t building any new coal, nuclear or hydro plants, this is bound to occur).

    Another problem is that the costs of energy-conservation measures are usually dumped on the distribution company. Hear about “smart meters”, meters that measure real time power use? These meters cost money, and someone needs to raise that money up front. The distribution company has to pony up for this, because the generation company doesn’t care (after all, their entire load is going to be sold). Any local efforts to reduce electricity use (flyers, advertising, campaigns, etc…) are being paid for by the local utility, also running up their costs (while reducing their bills for power generation, but these are “passed on” to customers).

    Finally, there is a lot of precedent for locally owned energy distribution companies. Major cities like Los Angeles, Colorado Springs, and Naperville IL all have local distribution utilities (LA also has a generation capability, but they are among the most sophisticated of all the locally owned companies due to their size, scale and financial means). As with water, the assets are all “on the ground”, the workers can be converted to city employees, and it isn’t that hard to run a distribution system.

    As the local distribution company is saddled with the rising cost of power (that it must pass on or it will go bankrupt immediately), many of these companies will end up being prey for local governments. The more money that the local distribution company needs to pay for generation, upgrades, smart meters, and the like, the higher the rates will go, and the “louder” will grow the cacaphony for “change”. There clearly has to be a profit for distribution companies, since they must raise capital for stockholders and dividends as well as service their debt. This profit will rankle the local cities more and more, since it just looks like an additional cost on top of what will ultimately be soaring utility rates (due mainly to the fact that generation will become priceless since nothing new is coming on line except for high priced peaking units).

    THE FUTURE OF ELECTRICITY

    In the simplest terms, electricity will be divided into the “haves” and the “have nots”. Anyone who has generation will do well, and anyone stuck with distribution (who pays the bills for generation) will be in a very tough position.

    This doesn’t necessarily mean the the stocks of generation will go up and distribution will go down, since this is presumably “baked in” to their prices, but you often can’t see it in the remaining vertically integrated utilities (since both components are comingled and not seperately traded, although it might be hard to trade an asset with negative value, which is what some of the pure-play distribution companies might have, depending on their cash needs for investment).

    Entergy is spinning off its nuclear generation, these assets have enormous value. The remaining distribution company will have a modest value, and this value will be under pressure from the forces listed above. It has been said that for Exelon the value of their local Com Ed subsidiary that distributes electricity in Chicago is effectively zero in the stock price… it is merely a conduit to collect the vast riches that the generating plants bring to the table.

    This is quite a change from past thinking, when the local distribution company was viewed as a safe “cash cow”, good for widows and orphans. Their costs were known and relatively low, and they made a nice profit on top. This thinking is dangerously outmoded in today’s world of ever tightening generation supplies, and the fact that smart utilities are realizing that owning both ends of the chain (generation and distribution) limits the value of generation since local government won’t allow rate increases and can force the distribution arm to run at a loss since the generation arm is so profitable. You cannot allow the local distribution arm to run at a loss when it is a stand-alone company, because it will go bankrupt and no one will have power. As the local distribution companies are forced to raise rates just to stay alive, expect it to look more and more like water distribution, where local (government) control becomes the norm and rate increases cause the citizens to demand that the local authorities take over the facilities using their powers at hand.

    If you own distribution-only electric companies, expect them to come under heavy pressure, and don’t forget that the local authorities have a lot of tricks up their sleeve including eminent domain to keep rates down. In the end they don’t care for shareholders, and expect to see value fall as the distribution companies start to face hard times.

    Cross posted at LITGM

     

    7 Responses to “Water Today, Electricity Tomorrow”

    1. Dan from Madison Says:

      Wow, great post Carl.

    2. fred lapides Says:

      It would be wise to read more deeply on what is taking p;lace worldwide as corporations take over water and as drinkable water is fast disappearing because of use, pollution, population pressures. Not by chance that China is in Tibet. Northern China is drying up and most of the available water comes from the mountains in Tibet Australia: drought for 5 years. India? drilling holes everywhere and deeper and deeper. and on and on. Investment advisors often these days advise getting involved with –water. As some guy said: you can do without love for a lifetime. But you need water daily.

    3. david foster Says:

      There is also a connection between water and electricity…most (almost all?) water pumps in the U.S. are electrically powered, and I think backup power is relatively rare since we’re talkig significant horsepower for some of these pumps. So, lose the grid and–as soon as the gravity tanks are empty–you will also lose water.

    4. Shannon Love Says:

      Fred Lapidies,

      Kind of interesting that you think that corporations owning water is a problem on par with pollution. Says a lot about your ego identification with the State.

      In any case, the water shortage is another fake crisis. Fresh water can be recycled endlessly and the seas need only desalination. Its estimated that Mississippi cycles through manmade water systems several times over before it reaches the sea.

    5. Jonathan Says:

      A brilliant post.

      As for global trends supposedly favoring state-run water distribution: Why are there water shortages? This is Econ 101 – if you lower prices too much, as always happens when water infrastructure is politically controlled, demand will outstrip supply. This is typically what happens in areas with state-run water infrastructure, and it’s why water-supply privatization is a durable trend in Latin America and other place that have been ill-served by government-run water systems. When you penetrate the logic of privatization opponents you usually find a quasi-religious belief that water and other life necessities should be available free to consumers.

      Here’s an extreme example of what happens when water is distributed and priced politically. Rhetorical question: Do you think California rice farmers are paying market rates for water?

      Here’s another rhetorical question: How come there’s never a beer shortage?

    6. Robert Schwartz Says:

      On this evenings news there was a press conference of Democrat Reps from the House seeking to rebut the President’s call for offshore drilling. A couple of them were calling for nationalization of the oil refiners.

    7. toad Says:

      Way back in ye days of yore, it was proposed that large breeder reactors should be built on the coasts and the power be used to desalinize water and then pumpe the water into the interior. Standardized reactors in the interior would be used for local power and and watr pumping purification. Of course this was to be a big federal program and it also was proposed when the anti-nuke crowd was heading for their peak of influence. And so here we are.