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April 12, 2007

Water, Water, But Not Everywhere
    by Erik Wilkins-McKee

The entry of private equity firms and consolidation of utility operations by large conglomerates are poised to change the water industry over the next 20 years. -- A recent article published in Nature reviewed current models and recent trends in precipitation in the southwestern United States, one of the fastest-growing areas of the country. The authors concluded that it, along with other subtropical regions around the world, is likely to experience “an imminent increase in aridity” over the next century, primarily due to climate change.

SRI Mutual Funds GuideOn the other side of the country, the South Florida Water Management District recently imposed a new rule that prohibits future applicants for water use permits from drawing water from the Everglades. The Biscayne or Floridan Aquifers will serve as replacements, and both require desalination.

Water issues in the United States are indicative of larger developments worldwide. Freshwater is increasingly scarce, as industry, agriculture, and local populations compete for access and use. Scarcity is not the only problem.

"Municipalities which manage most of the water and wastewater treatment in this country are between a rock and a hard place – they need to make vast expenditures in order to maintain and expand the crumbling water infrastructure, yet most politicians are loathe to raise taxes or user fees, preferring to delay and pass the problem on to their successors,” said Steve Maxwell of TechKNOWLEDGEy Strategic Group, a consulting firm that specializes in the environmental sciences and water resource industries.

In addition, not all of the freshwater on the planet is clean and safe. The United Nations Millennium Development Goals, which set targets for alleviating the most serious health and human welfare problems facing the nations of the world by 2015, call for providing clean water to the additional 1 billion people worldwide currently without it. This, too, requires more funds than politicians have been willing to allocate.

A new report from The Progressive Investor titled "Investing in Water", notes that the current system worldwide is fragmented and inefficient, with the vast majority of utilities operating at a municipal or small regional level. Rona Fried, the report’s author, estimates from current trends, however, that privatization will increase, as much as 500% over the next decade, along with major consolidation of smaller companies by large conglomerates such as Aqua America, Siemens, General Electric, and Danaher.

The entry of private equity firms into the water market will further consolidation, and Fried believes these developments will have beneficial effects, primarily by allowing more efficient and sustainable technologies to be introduced at the local level and by spurring infrastructure updates.

If these projections are accurate, they will mark substantial changes in the industry, writes Fried, since “only about 10% of customers worldwide are served by investor-owned utilities today.” For this to be profitable, however, prices will have to rise, and that is not without other costs.

The main issues around the social impact of water privatization depend on what exactly is being discussed. Privatization, whether through outsourcing operations or through the sale and regulation of municipal utilities, is quite different from the private control of water itself.

The latter raises many issues, including even the ethics of drinking bottled water; the former may raise concerns about pricing, but Maxwell points out that a gradual price rise linked to privatization would be more sustainable and efficient than future drastic cost increases that might occur if the system nears collapse and shortages become more severe.

Since existing public water supplies are almost never privatized, the issue is more one of proper pricing and regulation. As Steve Hoffmann, co-founder of Palisades Water Index Associates and a contributing analyst to the “Investing in Water” report, notes, “I believe that there is a 'human right' component in the privatization of water argument. But water must be treated to drink and to protect the environment. This entails a cost that has not and will not be incurred unless the benefit can be captured in the marketplace.”

In order to make this equitable and to truly influence consumption patterns, Hoffmann believes that pricing mechanisms should operate by the class of users. “Pricing should be arranged,” he states, “so that all customers within a class (which have different and characteristic cost considerations) served under identical cost conditions pay the same amount equal to the marginal cost. Between classes prices should differ,” and future pricing might operate on a “peak daily use” system, such as that used in the energy markets.

Thus single-family residences are more variable in their daily water use than companies that use water in their production processes, and prices should reflect that. Hoffmann believes that prices should guarantee equal access to water, and provide incentives for making rational decisions about consumption levels.

Fried agrees that there is “absolutely a human rights issue” involved, but that some combination of public-private partnerships may be the best solution. She notes that Brazil has had success with this, and believes that it can be applied to water markets worldwide. At the same time, there has been criticism of similar efforts in Britain, where privatization has not always led to infrastructure improvements.

The general consensus in the industry seems to be that public institutions have failed to remedy problems; critics suggest that this is not proof that public utilities could not operate differently. Nonetheless, according to Hoffmann, “A combination of reformed governing institutions and free market forces can act in tandem to create the sustainable and socially responsible management of water.”

Complete privatization would raise social justice issues, but as private operation of water delivery and treatment systems increases, both the infrastructure and the end use of water should become more sustainable. Industry experts believe that while further reform is needed, the current trajectory is toward more of a hybrid system that has a role for private investors.

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