Last month, the CEOs of 181 leading U.S. corporations repudiated the long-held principle of shareholder primacy — that shareholders are the only stakeholders who matter. The Business Roundtable (BT) said corporations should be committed to all of their stakeholders, including their communities.
The big three corporate water and sewer utilities in New Jersey — American, Aqua and Suez — don’t belong to the Business Roundtable, but if the group’s statement influences them, it would be a change for the better.
The investor-owned utilities (IOUs) have recognized that the backlog of capital upgrades and repairs in aging water and sewer systems presents an opportunity to make huge profits for shareholders. It may not always be apparent, but shareholder primacy seems to have guided many of the activities of IOUs in New Jersey and around the country. It underpins aggressive efforts to privatize public water and sewer systems through sales and lease/concession agreements, and it has been behind successful efforts to change regulations and laws.
In order to create a more favorable investment environment for shareholders, the IOUs have sought to reduce public input, limit transparency, accelerate the selling process, and maximize the value they can draw out of water and sewer systems. Aqua has characterized these efforts as overcoming “regulatory hurdles.”
All of this is to the disadvantage of another group of corporate stakeholders — the landlords, businesses and residents who are users of the IOU-run water/sewer systems. IOUs serve about 40 percent of state residents and businesses and a smaller but growing percentage of sewer customers. These ratepayers tend to pay as much as 10, 20, 50 — even 100 — percent more than customers of most publicly owned and operated systems, even if you account for the fact that some public systems are under-invested.
Legislation that favors shareholders
One example of pro-shareholder legislation is the Water Infrastructure Protection Act (WIPA), which might more accurately be called the “shareholder protection act.” After WIPA became law in 2015, it became much easier for a governing body to bypass the public referendum that has been a longstanding prerequisite to selling a water or sewer system. A system can be sold in a matter of months, under the radar of most of the community. WIPA also modified the method of appraising a system, permitting the so-called “fair market value” (FMV) approach. FMV inflates selling prices and, because the full amount of the selling price can be recovered in rates, it increases the burdens on ratepayers. The higher the price of the system, the higher the amount that ratepayers must cover subsequently.
Another shareholder-friendly modification occurred when the New Jersey Board of Public Utilities (BPU) approved the Distribution System Improvement Charge (DSIC). The DSIC allows investor-owned utilities to impose rate increases relating to capital improvements without prior BPU approval. At the time IOUs requested the improvement charge, the public was becoming more and more aware of the problems of old and worn-out water and sewer systems. The IOUs presented the DSIC as a “solution” for aging infrastructure. They said they needed additional “incentive” and better cash flow to support capital work. But it wasn’t just about capital needs. They also needed cash to support the price of their stock. As one article put it, IOUs like American “need to maintain investment grade credit ratings to raise funds for [their] growth capital investments and for paying out dividends.”
The Rate Counsel, a consumer advocate for New Jersey utility ratepayers, strongly criticized the DSIC and WIPA. At legislative hearings, it said WIPA would reduce transparency, limit public input, inflate selling prices, and burden ratepayers. Rate Counsel told the BPU that the DSIC bypasses “traditional ratemaking,” a process put in place to protect ratepayers. There is evidence that the Rate Counsel’s view is valid. In Pennsylvania, which has a fair market value law like WIPA, Aqua outbid by $43 million the next lowest bidder in the sale of the Limerick Township sewer system. Total selling price: $75 million — all to be recovered in rates.
Currently, there are more efforts to benefit water/sewer corporate shareholders and remove so-called “regulatory hurdles” in New Jersey. A bill (S-3870/A5391) recently released from Senate committee would eliminate the prerequisite public referendum for a sewer system sale, and it would allow the value of the sewer system to be determined by “fair market value.” Unlike WIPA, this bill does not even require certain conditions to be met before the referendum is eliminated. It simply does away with it. Meanwhile, at the BPU, the IOUs are asking for a sewer version of the DSIC — called a Wastewater System Improvement Charge. Once more they are presenting it as a “solution” for aging systems and playing down the fact that accelerated cash flow supports share price.
What happened in Bayonne…
The principle of shareholder primacy is at work in leasing deals too. In 2012, the IOU Suez, the private equity firm KKR, and the City of Bayonne signed a concession agreement. KKR provided 90 percent of the $150 million upfront payment to Bayonne. Suez put up the other 10 percent and agreed to run Bayonne’s water and sewer systems for 40 years. The partners in the agreement said publicly that rates would remain flat for several years. But that did not happen because provisions in the complex concession agreement required rate hikes to make up shortfalls in certain revenue targets. The deal uses a “revenue path” model meant to protect investors and guarantee an 11-percent rate of return for 40 years. Since 2012, Bayonne rates have risen 50 percent.
In 2017, KKR sold its interests in Bayonne and another system in Middletown, Pa., to Argo Infrastructure Partners. The transaction resulted in a gross internal rate of return of 36 percent and 2.8 times gross money on $75 million invested capital for KKR. An article in the Public Financing newsletter said that although KKR “touted its long-term vision when signing the [Bayonne and Middletown] water/wastewater deals, it appears to have found a better use for its money.”
Edison is currently considering a similar deal involving Suez and KKR. Residents there, concerned about cost impacts and potential loss of control, spoke out in large numbers, and the township council decided to hold a special election on the deal this month. Public input matters.
Critics of FMV and deals like the one in Bayonne suggest that these transactions can have a predatory flavor. Local officials, eager to erase municipal debt or address pension liabilities, see them as sources of quick cash. Higher bids mean larger upfront amounts. Local elected leaders may not be aware or may not want to acknowledge the downside — that the IOUs’ customers will have to “pay back” the sales price by way of their water and/or sewer bills. Middletown, Pa. actually sued Suez several years after it sold its sewer system, trying to stop a rate hike. But a judge said their contract with Suez was sound and dismissed the case.
Privatization often pushed as best solution
Along with aging infrastructure, New Jersey communities face many challenges, including the need to address lead, emerging contaminants, and combined sewer overflows. Privatization approaches are often presented as the only real solution. The WIPA statute actually states that systems can be so far gone as to be “beyond governmental capacity to restore.” But that is not the case. Municipal leaders, especially those whose constituents have lower incomes, don’t need to resort to corporate agreements heavily favoring shareholders to address water/sewer issues. Their options include regionalizing with other public systems or entering into service contracts with other public systems. They can hire qualified water sector professionals who know how to manage infrastructure-related debt to stabilize rates and limit rate shocks, and who understand how to leverage the low-cost borrowing of the New Jersey I-Bank. Public solutions don’t mean that rates won’t ever rise, but they would remove the cost of profits for shareholders from the equation.
In the event that a governing body is considering selling or leasing a system, it should be required to do so by way of referendum, transparently, and with appropriate public input. Governing bodies should be cognizant of the unintended consequences of selling or leasing agreements. Laws and regulations should not favor private ownership over public, and they should protect ratepayers from price gouging. Upfront payments supposedly based on the value of the system should not be used for non-system purposes. Affordability needs to be considered.
The Business Roundtable is rethinking shareholder primacy. New Jersey should follow its lead and make sure the interests of all stakeholders in water and sewer systems are well-protected.