Water Infrastructure: Information on Financing, Capital Planning,
and Privatization (16-AUG-02, GAO-02-764).			 
                                                                 
According to the Environmental Protection Agency (EPA) and water 
utility industry groups, communities will need as much as $1	 
trillion during the next 20 years to repair, replace, or upgrade 
aging drinking water and wastewater facilities; accommodate a	 
growing population; and meet new water quality standards. GAO	 
found that the amount of funds obtained from user charges and	 
other local sources of revenue was less than the full cost of	 
providing service--including operation and maintenance, debt	 
service, depreciation, and taxes--for more than a quarter of	 
drinking water utilities and more than 4 out of 10 wastewater	 
utilities in their most recent fiscal year. GAO also found that  
more than a quarter of utilities lacked plans recommended by	 
utility associations for managing their existing capital assets, 
but nearly all had plans that identify future capital improvement
needs. A privatization agreement's potential to generate profits 
is the key factor influencing decisions by private companies that
enter into such agreements with publicly owned utilities or the  
governmental entities they serve, according to the companies GAO 
contacted.							 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-764 					        
    ACCNO:   A04575						        
  TITLE:     Water Infrastructure: Information on Financing, Capital  
Planning, and Privatization					 
     DATE:   08/16/2002 
  SUBJECT:   Financial management				 
	     Privatization					 
	     Water quality					 
	     Water treatment					 
	     Wastewater management				 
	     Wastewater treatment				 
	     Funds management					 
	     Cost analysis					 
	     EPA Permit Compliance System			 
	     EPA Safe Drinking Water Information		 
	     System						 
                                                                 
	     EPA National Pollutant Discharge			 
	     Elimination System 				 
                                                                 
	     Drinking Water State Revolving Fund		 
	     Clean Water State Revolving Fund			 
	     EPA Drinking Water Infrastructure Needs		 
	     Survey						 
                                                                 
	     EPA Clean Water Needs Survey			 

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GAO-02-764

Report to Congressional Requesters

United States General Accounting Office

GAO

August 2002 WATER INFRASTRUCTURE

Information on Financing, Capital Planning, and Privatization

GAO- 02- 764

Page i GAO- 02- 764 Water Utility Financing and Planning Letter 1

Executive Summary 2 Purpose 2 Background 4 Results in Brief 4 Principal
Findings 6 Agency Comments 9

Chapter 1 Introduction 10 Federal, State, and Local Entities Play
Important Roles in Ensuring

Safe Drinking Water and Effective Wastewater Treatment 11 Addressing
Future Drinking Water and Wastewater Infrastructure

Needs Will Require Major Investments 13 Adequacy of User Charges Is Key
Indicator of Sound Management

at Drinking Water and Wastewater Utilities 15 Utilities Use Approaches
Such as Asset Management and

Privatization to Increase Operational Efficiency 16 Objectives, Scope, and
Methodology 17

Chapter 2 User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service 21

Funds Collected from Local Sources Were Often Less Than Utilities* Cost of
Providing Service 21 Funds from Local Sources Generally Exceeded Operation
and

Maintenance Costs 27 User Charges Represented a Major Source of Local
Funds, but

Were Increased Two Times or Fewer by Half of the Utilities 29

Chapter 3 Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs 32

Many Utilities Lacked Comprehensive Asset Management Plans 32 Despite
Pipelines in Poor Condition, Some Utilities Had Deferred

Maintenance, Capital Improvements, or Both 37 Age and Condition of
Pipelines 39 Rehabilitation and Replacement Activities 41 Contents

Page ii GAO- 02- 764 Water Utility Financing and Planning

Most Utilities Had Capital Improvement Plans, but Many Questioned Adequacy
of Future Funding 46

Chapter 4 Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities 49

Profit Potential Is Key Consideration for Private Companies 49 States*
Policies May Also Influence Companies* Decisions 54

Appendix I Survey of Drinking Water Utilities 57

Appendix II Survey of Wastewater Utilities 67

Appendix III GAO Contacts and Staff Acknowledgments 78

Tables

Table 1: Estimated Percentages of Utilities That Used Each Source of
Funding in Their Most Recently Completed Fiscal Year 23 Table 2:
Relationship between the Frequency of Rate Increases and

Utilities* Ability to Cover Their Cost of Providing Service Using Revenues
from All Local Sources, 1992* 2001 30 Table 3: Frequency of Rate
Increases, 1992 through 2001, by Size of

Population Served 31 Table 4: Extent to Which Utilities* Asset Management
Plans

Covered Assets and Key Elements 35 Table 5: Desired and Actual
Rehabilitation and Replacement Rates

for Pipelines (on average, for fiscal years 1998 through 2000) 43 Table 6:
Relationship between Adequacy of Projected Funding to

Meet Needs Over the Next 5 to 10 Years and Other Key Variables Related to
Funding 48

Figures

Figure 1: Estimated Life of Pipes According to Major Eras of Water Main
Installation 13

Page iii GAO- 02- 764 Water Utility Financing and Planning

Figure 2: Extent to Which Utilities* Actual Rate of Pipeline
Rehabilitation and Replacement Met or Exceeded Their Desired Rate (on
average, fiscal years 1998 through 2000) 42

Abbreviation EPA Environmental Protection Agency

Page 1 GAO- 02- 764 Water Utility Financing and Planning

August 16, 2002 The Honorable Robert Smith Ranking Minority Member
Committee on Environment and Public Works United States Senate

The Honorable Michael Crapo Ranking Minority Member Subcommittee on
Fisheries, Wildlife, and Water Committee on Environment and Public Works
United States Senate

In response to your request, this report provides information on the
financing and planning activities of public and private drinking water and
wastewater utilities, as well as issues related to privatizing these
utility functions.

Unless you publicly announce its contents earlier, we plan no further
distribution of this report until 30 days from the date of this letter. At
that time, we will send copies to appropriate congressional committees,
the Administrator of the Environmental Protection Agency, and the Director
of the Office of Management and Budget. We will also make copies available
to others upon request. In addition, the report will be available at no
charge on the GAO Web site at http:// www. gao. gov.

Please call me at (202) 512- 3841 if you or your staff have any questions.
Major contributors to this report are listed in appendix III.

David G. Wood Director, Natural Resources and Environment

United States General Accounting Office Washington, DC 20548

Executive Summary Page 2 GAO- 02- 764 Water Utility Financing and Planning

According to the Environmental Protection Agency (EPA) and water utility
industry groups, communities will need an estimated $300 billion to $1
trillion over the next 20 years to repair, replace, or upgrade aging
drinking water and wastewater facilities; accommodate a growing
population; and meet new water quality standards. As the agency that
regulates drinking water and surface water quality, EPA provides a
significant amount of financial assistance for these facilities. Other
federal agencies, as well as states, also provide assistance. Given the
magnitude of estimated needs, some industry groups are seeking increased
federal funding, and the Congress is considering several legislative
options.

While drinking water and wastewater utilities use a multitude of funding
sources* including federal and state loans and grants, bonds, and other
debt and equity instruments* they rely primarily on user charges. Indeed,
operating principles established by water utility associations call for
fully supporting the utilities* operating and capital costs through user
and service charges. Utilities that follow these principles derive a *cost
of providing service* to establish their revenue requirements and set
their user rates. Depending on the utility, the cost of service may
include operation and maintenance expenses, taxes (or payments in lieu of
taxes), depreciation, debt service payments, contributions to specified
reserves (for example, putting aside funds for future capital needs),
other capital expenditures, and a rate of return on the value of the
utility*s assets. According to water utility associations, utilities
should manage their capital assets to maximize the useful life of the
assets, control operating costs, and generally enhance the efficiency of
their operations. Utilities can develop asset management plans, which
should contain such key elements as an assessment of the physical
condition of all capital assets, descriptions of the criteria used to
measure and report on the condition of the assets, information on the
condition in which the assets will be maintained, and a comparison of the
planned and actual dollar amounts used to maintain the assets at the
established condition level. To address financial and management
challenges, some publicly owned utilities have entered into public-
private partnerships that use private sector resources in an effort to
upgrade or replace deteriorating infrastructure or to operate more
efficiently.

The respective Ranking Minority Members of the Senate Committee on
Environment and Public Works and its Subcommittee on Fisheries, Wildlife,
and Water, asked GAO to examine several issues relating to the funding
available to help meet the capital investment needs of the nation*s
drinking water and wastewater facilities. Given the broad scope of the
request, GAO agreed to provide the information in two reports. The first
Executive Summary

Purpose

Executive Summary Page 3 GAO- 02- 764 Water Utility Financing and Planning

report, issued in November 2001, addressed the amounts and sources of
federal and state financial assistance for drinking water and wastewater
infrastructure during fiscal years 1991 through 2000. 1

This second report examines (1) how the amount of funds obtained by large
public and private drinking water and wastewater utilities* those serving
populations greater than 10,000* through user charges and other local
funding sources compare with their cost of providing service, (2) how such
utilities manage existing capital assets and plan for needed capital
improvements, and (3) what factors influence private companies* interest
in assuming the operation or ownership of publicly owned drinking water
and wastewater facilities. To address the first and second objectives, GAO
mailed questionnaires to 1,425 public and private drinking water systems
and 2,391 public and private wastewater systems, which it identified using
EPA databases. In the analysis, utilities were weighted to account
statistically for all utilities in the population, including those not
selected in the sample. Overall, GAO received responses from an estimated
77 percent of the drinking water utilities serving more than 10,000 and 73
percent of the wastewater utilities of this size. GAO used the weighted
results to make estimates about the entire population of drinking water
and wastewater utilities serving more than 10, 000. The percentages cited
throughout the report are thus estimates and have 95- percent confidence
intervals of plus or minus 10 percentage points or less. (Copies of the
questionnaires, including a summary of the utilities* responses, are
included as appendixes I and II.) To address the third objective, GAO
obtained information from officials with five private companies that have
significant experience with privatization agreements and are among the
most active participants in this field, either nationally or regionally.
In addition, because company officials identified state requirements and
policies as a significant factor in privatization decisions, GAO contacted
officials in eight states (California, Connecticut, Georgia, Indiana, New
Jersey, Pennsylvania, Texas, and Washington) that the companies, EPA, and
industry associations identified as having requirements or policies that
could affect privatization decisions.

1 See U. S. General Accounting Office, Water Infrastructure: Information
on Federal and State Financial Assistance, GAO- 02- 134 (Washington, D.
C.: Nov. 30, 2001).

Executive Summary Page 4 GAO- 02- 764 Water Utility Financing and Planning

Americans rely on their drinking water and wastewater utilities to provide
clean and safe water for a variety of uses and to protect public health
and the environment. Regulated under the Safe Drinking Water Act and the
Clean Water Act, respectively, community drinking water systems and
wastewater collection and treatment facilities are critical elements in
the nation*s infrastructure. Local drinking water and wastewater
utilities, supported primarily through user charges, have invested
billions of dollars over the past century in the facilities that supply
the nation*s drinking water and treat its wastewater. In many instances,
local communities have received financial assistance from federal and
state programs. However, even with maintenance and repair activities,
infrastructure deteriorates over time and eventually needs replacement and
the estimated needs for upgrading existing facilities and building new
ones are very large, up to $1 trillion.

In response to growing concerns about the condition of the existing water
infrastructure and calls for increased financial assistance, the Congress
is considering a number of infrastructure- related proposals. At the local
level, community leaders are faced with increasing demands for funding all
types of infrastructure and services and must find new ways to control
costs or build public support for necessary expenditures. Water utility
associations, including the Association of Metropolitan Sewerage Agencies,
the Association of Metropolitan Water Agencies, the American Water Works
Association, and the Water Environment Federation, have established
operating principles and guidance for managing utilities* assets and
planning for future capital needs. In addition, public- private
partnerships offer one approach to increasing utilities* operational
efficiency.

According to GAO*s survey, the amount of funds obtained from user charges
and other local sources of revenue was less than the full cost of
providing service* including operation and maintenance, debt service,
depreciation, and taxes* for over a quarter of drinking water utilities
and more than 4 out of 10 wastewater utilities in their most recent fiscal
year. Revenues from user charges and other local sources were adequate to
cover at least operation and maintenance costs for nearly all of the
utilities; however, an estimated 29 percent of the utilities deferred
maintenance because of insufficient funding. Revenues from user charges
accounted for most of utilities* locally generated funds* at least
threequarters of all funds from local sources for at least three- quarters
of utilities. GAO*s survey found that about half of the utilities raised
their user rates two times or less from 1992 to 2001. Background

Results in Brief

Executive Summary Page 5 GAO- 02- 764 Water Utility Financing and Planning

GAO*s survey found that more than a quarter of utilities lacked plans
recommended by utility associations for managing their existing capital
assets, but nearly all had plans that identify future capital improvement
needs. Among the utilities that had plans for managing their existing
assets, more than half did not cover all their assets or omitted key plan
elements, such as an assessment of the assets* physical condition. In
addition, while most utilities had a preventive rehabilitation and
replacement program for their pipelines, for about 60 percent of the
drinking water utilities and 65 percent of the wastewater utilities, the
actual rate of rehabilitation and replacement in recent years was less
than their desired levels, and many had deferred maintenance, capital
expenditures, or both. Almost all utilities reviewed their future capital
improvement needs annually, whether or not a formal plan was in place.
Many utilities also had plans for financing their future capital needs,
but nearly half believed that their projected funding over the next 5 to
10 years would not be sufficient to meet their needs.

A privatization agreement*s potential to generate profits is the key
factor influencing decisions by private companies that enter into such
agreements with publicly owned utilities or the governmental entities they
serve, according to the companies GAO contacted. In assessing profit
potential, the companies cited several specific criteria, such as the
extent of opportunities to enhance operational efficiency, the utility*s
proximity to the companies* existing operations, the potential for system
growth, and the potential need for capital investments. State policies can
also influence privatization agreements. For example, two states that GAO
contacted restrict the use of design- build- operate contracts, which give
a single entity complete control over a project. Other states offer
incentives to encourage the takeover of financially troubled public
utilities.

Executive Summary Page 6 GAO- 02- 764 Water Utility Financing and Planning

GAO found that revenues from user charges exceeded the cost of service at
an estimated 39 percent of the drinking water utilities and 33 percent of
the wastewater utilities. (For the purpose of this analysis, GAO defined a
utility*s cost of service as operation and maintenance expenses, taxes,
depreciation, and debt service.) When revenues from user charges were
combined with funding from other local sources, such as hook- up and
connection fees and sales of services to other utilities, an estimated 71
percent of the drinking water utilities and 59 percent of the wastewater
utilities covered their cost of providing service. For both drinking water
and wastewater utilities, GAO did not find statistically significant
differences between utilities by the size of the populations they serve;
that is, smaller utilities were neither more nor less likely than larger
utilities to have covered their cost of providing service with revenues
from user charges and other local sources. Similarly, GAO did not find
statistically significant differences between drinking water utilities by
public or private ownership. 2

According to GAO*s survey results, about 85 percent of drinking water
utilities and 82 percent of wastewater utilities covered at least the
operation and maintenance portion of the cost of providing service using
revenues from user charges alone. Moreover, adding other locally generated
funds to the user charges, about 93 percent of the utilities covered their
operation and maintenance costs. Operation and maintenance costs are of
particular interest because historically, wastewater utilities* as a
condition of receiving certain grants under the Clean Water Act* generally
were required to cover these costs with user charges. While drinking water
utilities are not subject to a similar requirement, both EPA and water
industry associations consider adequate user charges to be a key indicator
of utilities* financial health. Despite covering operation and maintenance
costs, an estimated 29 percent of the utilities deferred maintenance
because of insufficient funding.

GAO found that more than half of utilities whose revenues from user
charges and other local sources did not cover their cost of providing

2 GAO did not receive enough responses from privately owned wastewater
utilities for a meaningful analysis of ownership types. According to EPA,
most privately owned wastewater systems serve populations of less than
10,000. Principal Findings

User Charges and Other Local Sources of Funds Covered Much, but Not All,
of Utilities* Cost of Providing Service

Executive Summary Page 7 GAO- 02- 764 Water Utility Financing and Planning

service raised their rates two times or less during the 10- year period
from 1992 to 2001. Overall, GAO found no statistically significant
differences in the frequency of rate increases between the utilities that
did not cover their costs and those that did.

According to GAO*s survey, a significant percentage of drinking water and
wastewater utilities* about 27 percent and 31 percent, respectively* did
not have plans for managing their existing capital assets, although some
utilities were in the process of developing such plans. Further, of the
utilities with plans, more than half did not include all of their assets
or omitted one or more key elements recommended by industry associations;
for example, 16 percent of drinking water utilities* plans and 21 percent
of wastewater utilities* plans did not include information on the
condition level at which the utility intends to maintain the assets. GAO
found no statistical differences among utilities of different sizes with
regard to the inclusion or exclusion of any of the key elements in their
asset management plans. However, GAO found that the plans developed by
privately owned drinking water utilities tended to be more comprehensive
than those developed by publicly owned utilities.

According to GAO*s survey results, some utilities had significant portions
of pipelines in poor condition; for example, more than one- third of the
utilities had 20 percent or more of their pipelines nearing the end of
their useful life. Nevertheless, for about 60 percent of drinking water
utilities and 65 percent of wastewater utilities, the actual levels of
pipeline rehabilitation and replacement in recent years were less than the
utilities* desired levels. For example, GAO*s survey indicates that
roughly half of the utilities actually rehabilitated or replaced 1 percent
or less of their pipelines annually, even though an estimated 89 percent
of drinking water utilities and 76 percent of wastewater utilities
believed that a higher level of rehabilitation and replacement should be
occurring. Further, in each of three categories* maintenance, minor
capital improvements, and major capital improvements* about one- third or
so of the utilities had deferred expenditures in their most recent fiscal
years, and 20 percent had deferred expenditures in all three categories.
With one exception, there were no statistically significant differences
among utilities of different sizes; however, GAO found that public
drinking water utilities were more likely than their privately owned
counterparts to defer maintenance and major capital projects. Many
Utilities Lacked

Comprehensive Asset Management Plans and Had Deferred Maintenance or
Capital Improvements, but Most Had Identified Future Capital Needs

Executive Summary Page 8 GAO- 02- 764 Water Utility Financing and Planning

Overall, GAO*s survey results indicate that about 90 percent of drinking
water and wastewater utilities had capital improvement plans to identify
future capital needs, and about 90 percent of utilities reviewed their
needs annually whether or not they had developed formal plans. About 95
percent of the utilities* capital improvement plans covered 5 years or
more* with about 25 percent of drinking water utilities and about 20
percent of wastewater utilities covering 10 years or more. The smallest
systems (those serving 10,001 to 25, 000 people) were slightly less likely
than larger systems to have such plans. Most of the utilities with capital
improvement plans also had plans for financing the projects they
identified; according to GAO*s survey, 86 percent of the utilities had
such financing plans, including virtually all of the largest utilities
(those serving populations of over 100,000). However, about 45 percent of
the drinking water and wastewater utilities anticipated that their
projected funding would not be sufficient to cover future needs over the
next 5 to 10 years. Regarding this outlook, there were no statistically
significant differences among wastewater utilities of different sizes;
however, the largest drinking water utilities were less likely to believe
that their projected revenues would be insufficient to cover anticipated
future needs than their smaller counterparts. Also, public drinking water
utilities were somewhat more likely than privately owned systems to have
concerns about future funding.

Privatization agreements range from contracts to operate and maintain
local drinking water or wastewater facilities to outright ownership by
private entities. Not surprisingly, all five of the companies GAO
contacted evaluate the potential for profits when considering entering
into privatization agreements. Criteria important to assessing the
profitability of a proposed utility privatization agreement include the
potential to improve the efficiency of the utility*s operations; the
proximity to the company*s other utility operations; the potential for
system growth; the terms of a proposed contract; and the potential need
for capital investments. Each of the five companies GAO contacted employs
a somewhat different business strategy in its pursuit of privatization
agreements, such as placing more emphasis on contract operations rather
than assuming ownership of utilities or focusing on utilities of
particular sizes or in particular locations. Differences in the companies*
business strategies had some influence on the relative importance of the
factors to each company. In addition to identifying the site- specific
factors they consider in evaluating privatization opportunities,
representatives from all five companies also provided comments on state
requirements or policies that can facilitate or impede privatization
arrangements. Profit Potential Is Key

Factor in Private Companies* Decisions to Assume Operation or Ownership of
Drinking Water or Wastewater Utilities

Executive Summary Page 9 GAO- 02- 764 Water Utility Financing and Planning

Officials in eight states GAO contacted said their primary interest is the
delivery of adequate service to the public, whether the service is
provided by publicly or privately owned utilities. However, some
requirements and policies can affect companies* privatization decisions.
For example, among the states GAO contacted, state regulators in Indiana
and Pennsylvania have established programs that provide incentives to
acquire or take over troubled utilities. In Indiana, for example, the
acquiring utility is often permitted an *acquisition adjustment,* which
allows the utility to charge customers higher rates. On the other hand,
state policies may have the effect of limiting privatization; two of the
states GAO contacted restrict the use of design- build- operate contracts.
In Texas, for example, the state requires the use of qualification- based
criteria for selection of engineering design services and a bidding
process for construction services, requirements that effectively preclude
combining design, construction, and operating services in a single
procurement.

GAO provided a draft of this report to EPA for its review and comment. GAO
received comments from officials in EPA*s Office of Water, including the
Office of Ground Water and Drinking Water and the Office of Wastewater
Management. EPA agreed with the information presented in the report and
characterized the findings as interesting and informative. EPA officials
also provided several technical comments and clarifications, which GAO
incorporated as appropriate. Agency Comments

Chapter 1: Introduction Page 10 GAO- 02- 764 Water Utility Financing and
Planning

Americans rely on their drinking water and wastewater utilities to provide
clean and safe water for a variety of uses and to protect public health
and the environment. Regulated under the Safe Drinking Water Act and the
Clean Water Act, respectively, community drinking water systems and
wastewater collection and treatment facilities are critical elements in
the nation*s infrastructure. Local drinking water and wastewater
utilities, supported primarily through user charges, have invested
billions of dollars over the past century to create the treatment,
collection, storage, and distribution facilities that supply the nation*s
drinking water and treat its wastewater, in accordance with applicable
federal and state quality standards. In many instances, local communities
have also received financial assistance from federal or state programs to
improve or expand their water infrastructure. Even with maintenance and
repair activities, infrastructure deteriorates over time and eventually
needs replacement. According to recent estimates, the level of investment
that will be required over the next 20 years to repair, replace, or
upgrade aging facilities; accommodate the nation*s growing population; and
meet new quality standards will be very large, up to $1 trillion.
Moreover, following the terrorist attacks of September 11, 2001, both
drinking water and wastewater utilities may have to make additional
investments to increase the security of their operations.

In response to growing concerns about the condition of the existing water
infrastructure and calls for increased financial assistance, the Congress
is considering a number of infrastructure- related proposals. At the local
level, utility managers must find new ways to control costs or build
public support for increasing the rates charged to customers. Among the
options available to help local utilities meet the challenges they face
are ensuring that revenues are adequate to cover costs, finding more cost-
effective ways to manage utility assets, and entering into public- private
partnerships. Chapter 1: Introduction

Chapter 1: Introduction Page 11 GAO- 02- 764 Water Utility Financing and
Planning

The Environmental Protection Agency (EPA) sets standards for the quality
of drinking water and wastewater and issues other regulations and guidance
to implement the requirements of the Safe Drinking Water Act and the Clean
Water Act. Under the Safe Drinking Water Act, EPA is required to establish
(1) standards or treatment techniques for contaminants that could
adversely affect public health and (2) requirements for monitoring the
quality of drinking water and for ensuring the proper operation and
maintenance of water systems. The Clean Water Act*s National Pollutant
Discharge Elimination System program limits the types and amounts of
pollutants that industrial and municipal wastewater treatment facilities
may discharge into the nation*s surface waters. EPA has issued national
guidance and regulations to assist the states in establishing standards to
protect the quality of their waters and in issuing permits to facilities
to limit discharges of pollutants.

Both federal and state agencies also provide a significant amount of
funding for drinking water and wastewater infrastructure through grant and
loan programs. In November 2001, we reported that from fiscal year 1991
through fiscal year 2000, nine federal agencies made available about $44
billion for capital improvements at drinking water and wastewater systems,
and states made available about $25 billion over the same period. 1 EPA
represents the largest source of financial assistance at the federal level
through its Drinking Water and Clean Water State Revolving Funds,
contributing about 56 percent of the total. Under these programs, EPA
provides grants to the states to capitalize revolving loan funds. The
states, which are required to contribute matching funds equal to 20
percent of the EPA grants, make loans to local communities or utilities;
as loans are repaid, the states* revolving loan funds are replenished. In
addition to contributing over $10 billion to match EPA*s capitalization
grants for the Drinking Water and Clean Water State Revolving Funds, the
states made over $9 billion available under state- sponsored grant and
loan programs and provided about $6 billion through general obligation and
revenue bonds and other funding mechanisms.

At the local level, a variety of public and privately owned utilities
operate thousands of systems that supply drinking water and treat
wastewater for millions of Americans. In total, about 55,000 community
drinking water

1 In constant year 2000 dollars. See U. S. General Accounting Office,
Water Infrastructure: Information on Federal and State Financial
Assistance, GAO- 02- 134 (Washington, D. C.: Nov. 30, 2001). Federal,
State, and

Local Entities Play Important Roles in Ensuring Safe Drinking Water and
Effective Wastewater Treatment

Chapter 1: Introduction Page 12 GAO- 02- 764 Water Utility Financing and
Planning

systems and nearly 30,000 wastewater treatment and collection facilities
are subject to numerous treatment, testing, and operational requirements
under the Safe Drinking Water Act and the Clean Water Act, respectively.
Although many of these utilities are quite small, particularly in the case
of drinking water systems, 2 larger utilities serve most of the U. S.
population and account for most of the infrastructure needs identified in
periodic surveys of such needs conducted by EPA. Specifically, according
to EPA*s Safe Drinking Water Information System, as of January 2001, 4,079
utilities, or about 7 percent of all community water systems, each served
more than 10,000 people and accounted for about 65 percent of the
estimated infrastructure needs for drinking water utilities. In the case
of wastewater utilities, about 8,744 treatment and collection facilities,
or about 29 percent of the total, are estimated to serve more than 10,000
people. These facilities account for approximately 89 percent of the
estimated infrastructure needs for wastewater utilities. 3

Publicly owned drinking water and wastewater utilities include systems
owned by municipalities, townships, counties, water and/ or sewer
districts, and water and/ or sewer authorities. Private ownership
encompasses a broad range of owners, from homeowners* associations, mobile
home parks, and other entities whose primary business is unrelated to
water supply or wastewater treatment, to larger, investorowned companies.
About half of the nation*s drinking water systems and an estimated 20
percent of the wastewater systems are privately owned, according to EPA
and industry sources. According to EPA, most of the privately owned
drinking water and wastewater systems serve populations of less than
10,000.

2 For example, nearly 60 percent of the community drinking water systems
serve populations of 500 or fewer. 3 For the purposes of our review, we
focused on wastewater treatment facilities only to avoid double counting
collection facilities that serve multiple treatment plants. According to
an EPA official, wastewater treatment facilities serving 10, 000 or more
people account for approximately 65 percent of the estimated
infrastructure needs for wastewater utilities.

Chapter 1: Introduction Page 13 GAO- 02- 764 Water Utility Financing and
Planning

EPA and a variety of industry groups are predicting that major investments
will be needed to upgrade, repair, or replace existing infrastructure;
meet demands for additional capacity; or comply with new regulatory
requirements. Pipeline rehabilitation and replacement represents a
significant portion of the projected infrastructure needs. According to
EPA estimates, for example, at least half of the drinking water and
wastewater infrastructure need is in the form of pipes buried under
ground. A study sponsored by a major water industry association concluded
that much of the existing pipe network is at or near the end of its
expected lifespan. 4 Using average life estimates for different types of
pipe and counting the years since the lines were originally installed, the
study predicts that drinking water utilities will face significant repair
and replacement costs over the next 3 decades. Other studies make similar
predictions for the pipelines owned by wastewater utilities. 5 Figure 1
shows the estimated life expectancy of the pipelines installed during
major periods of utility growth.

Figure 1: Estimated Life of Pipes According to Major Eras of Water Main
Installation

Source: American Water Works Association Water Industry Technical Action
Fund, Dawn of the Replacement Era: Reinvesting in Drinking Water
Infrastructure (Denver, Colo.: May 2001) pp. 10- 11.

4 American Water Works Association Water Industry Technical Action Fund,
Dawn of the Replacement Era: Reinvesting in Drinking Water Infrastructure
(Denver, Colo.: May 2001).

5 For example, see Water Environment Research Foundation, New Pipes for
Old: A Study of Recent Advances in Sewer Pipe Materials and Technology
(2000). Addressing Future

Drinking Water and Wastewater Infrastructure Needs Will Require Major
Investments

Chapter 1: Introduction Page 14 GAO- 02- 764 Water Utility Financing and
Planning

While the size, period covered, and specific assumptions of individual
estimates vary, the amount needed for future capital investments in water
and wastewater infrastructure will be substantial. Several recent studies
project future infrastructure needs over a 20- year period:

 According to EPA*s 1999 survey of drinking water infrastructure needs,
the estimated needs would be at least $150. 9 billion through 2019,
including an estimated $83. 2 billion just for water transmission and
distribution lines. 6

 Similarly, EPA*s 1996 survey of *clean water* needs estimated that total
wastewater infrastructure- related needs will be about $128 billion
through 2016. 7 In a subsequent analysis, EPA estimated that an additional
$56 billion to $87 billion would be needed to correct existing sanitary
sewer overflow problems.

 In April 2000, the Water Infrastructure Network, a consortium of
industry, municipal, state, and nonprofit associations, projected needs of
up to 1 trillion dollars over the next 20 years for drinking water and
wastewater utilities combined, when both the capital investment needs and
the cost of financing are considered. 8

 In May 2002, the Congressional Budget Office estimated that the cost of
drinking water and wastewater infrastructure over the next 20 years would
be $492 billion under a low- cost scenario and $820 billion under a high-
cost scenario, including both the cost of physical capital and interest on
loans and bonds. 9

Whatever the level of investment turns out to be, the needs will be likely
be met by some combination of local, state, and federal funding sources.
As the Congressional Budget Office noted in its recent report, society as
a whole will ultimately foot the bill, whether through the rates charged
to users or through federal, state, or local taxes.

6 U. S. Environmental Protection Agency, Drinking Water Infrastructure
Needs Survey: Second Report to Congress, EPA 816- R- 01- 004 (Washington,
D. C.: February 2001). 7 U. S. Environmental Protection Agency, 1996 Clean
Water Needs Survey Report to Congress, EPA 832- R- 97- 003 (Washington, D.
C.: September 1997). 8 Water Infrastructure Network, Clean & Safe Water
for the 21st Century (April 2000).

9 Congressional Budget Office, Future Investment in Drinking Water and
Wastewater Infrastructure, (Washington, D. C.: May 2002). The report
states that assumptions about the rate at which drinking water pipes are
replaced, the savings associated with improved efficiency, the costs of
controlling combined sewer overflows, and the borrowing term are primarily
responsible for the difference between the low and high estimates.

Chapter 1: Introduction Page 15 GAO- 02- 764 Water Utility Financing and
Planning

Drinking water and wastewater utilities need revenue to maintain current
service levels, meet new demands for service, adequately maintain existing
plant and equipment, and plan for future needs in an orderly manner. To
accomplish these goals, water industry associations generally support the
principle that utilities should generate enough revenue through user rates
and service charges to fully cover the cost of providing service, without
relying on subsidies from other revenue sources. 10 That is, the rates
that utilities charge their customers should be sufficient to finance all
of the utilities* operating and maintenance expenses as well as capital
costs. For example, according to a group of water industry associations
known as the H2O Coalition, water utilities should move toward becoming
selfsustaining by charging their customers rates that reflect the full
cost of service, thus ensuring that utilities will get as much of the
revenues they need as possible from their customers. 11 EPA*s Office of
Water also supports the concept of fiscal sustainability for water
utilities and sees rates that result in revenues sufficient to meet the
cost of service as a measure of the utilities* financial health.

In some instances, drinking water and wastewater utilities may have to
establish user rates that meet certain minimum requirements as a condition
of receiving federal or state financial assistance. For example, the Clean
Water Act requires wastewater utilities that received construction grants
under title II of the act to establish rates that generate enough revenue
to cover operation and maintenance costs. Less specific requirements apply
to wastewater utilities that receive loans under the Clean Water State
Revolving Fund Program. Although the Safe Drinking Water Act does not
contain any explicit requirements for minimum user charges at drinking
water utilities, EPA has addressed the issue indirectly in guidance to the
states. Under the Safe Drinking Water Act Amendments of 1996, states are
required to develop programs to ensure that drinking water systems have
the financial, managerial, and technical capacity to comply with national
drinking water regulations. EPA*s guidance on implementing such programs
suggests that the criteria for assessing the

10 Among the associations that support the principle that utilities should
be self- sustaining are the American Water Works Association, the
Association of Metropolitan Sewerage Agencies, the Association of State
Drinking Water Administrators, the National Association of Water
Companies, the National Council for Public Private Partnerships, and the
Water and Wastewater Equipment Manufacturers.

11 The H2O Coalition includes the National Association of Water Companies,
the National Council for Public- Private Partnerships, the Water and
Wastewater Equipment Manufacturers Association, and the Association of
State Drinking Water Administrators. Adequacy of User

Charges Is Key Indicator of Sound Management at Drinking Water and
Wastewater Utilities

Chapter 1: Introduction Page 16 GAO- 02- 764 Water Utility Financing and
Planning

systems* financial capacity include a determination of whether water rates
and charges are adequate to cover the cost of water. 12

In addition to maintaining adequate user charges, utilities can ensure
that their revenues are sufficient by increasing their operational
efficiency and thus controlling their costs. One approach recommended by
industry experts is *asset management.* The goal of asset management is to
manage infrastructure assets so that the total cost of owning and
operating them is minimized and desired customer service levels are
maintained. The asset management process involves assessing the condition
of a system*s infrastructure assets, estimating the life expectancy of
these assets, and ensuring that sufficient funds are allocated over the
life of the assets to optimize their value.

Asset management is seen as particularly relevant to the water utility
industry because drinking water and wastewater utilities are
capitalintensive and have a sizeable investment in pipes and other assets
with a relatively long service life. According to a comprehensive industry
handbook on managing capital assets, there is a growing awareness among
water utilities that *preserving the life and function of infrastructure
assets will help optimize operations and maintenance and identify needed
capital resources, thereby reducing funding gaps between future capital
needs and available financial resources.* 13 Given the magnitude of the
estimates for future infrastructure needs, it is important for utilities
to adopt a strategy for managing the repair and replacement of key assets
as costeffectively as possible.

In recent years, privatization of public facilities and services,
particularly at drinking water utilities, has been occurring in the United
States at an increasing rate. Some municipal drinking water and wastewater
utilities have explored privatization as another option for increasing
operational efficiency. Privatization is commonly defined as any process
aimed at shifting functions and responsibilities, in whole or in part,
from the municipal government to the private sector. Municipalities may
turn to

12 U. S. Environmental Protection Agency, Guidance on Implementing the
Capacity Development Provisions of the Safe Drinking Water Act Amendments
of 1996, EPA 816- R98- 006 (Washington, D. C.: July 1998).

13 Association of Metropolitan Sewerage Agencies, Managing Public
Infrastructure Assets to Minimize Cost and Maximize Performance, p. 4.
Utilities Use

Approaches Such as Asset Management and Privatization to Increase
Operational Efficiency

Chapter 1: Introduction Page 17 GAO- 02- 764 Water Utility Financing and
Planning

privatization agreements to address issues such as needed infrastructure
improvements, rising costs, or more stringent regulatory requirements.

Privatization can take different forms, ranging from contracting for
specific services to the actual sale of a facility to a private company.
The most common form of privatization is contracting, which typically
entails a competition among private bidders to perform certain activities.
In the case of drinking water and wastewater utilities, such activities
typically include operation and maintenance. When a municipality contracts
with a private company for services, the government remains the financier
and has management and policy control over the quality of services to be
provided. In some instances, privatization involves the transfer of the
ownership of utility assets from a municipality to the private sector.
Once the assets have been sold, the government generally has no role in
their financial support, management, or oversight.

The Ranking Minority Member, Senate Committee on Environment and Public
Works, and the Ranking Minority Member, Subcommittee on Fisheries,
Wildlife, and Water, Senate Committee on Environment and Public Works,
asked us to examine several issues relating to the funding available to
help meet the capital investment needs of the nation*s drinking water and
wastewater facilities. 14 This report provides information on

 how the amount of funds obtained by large public and private drinking
water and wastewater utilities* those serving populations greater than
10,000* through user charges and other local funding sources compare with
the cost of providing service,

 how such utilities manage existing capital assets and plan for needed
capital improvements, and

 what factors influence private companies* interest in assuming the
operation or ownership of publicly owned drinking water and wastewater
facilities.

To address the first two objectives, we obtained information on utility
finances and capital management practices by surveying, using a mailed
questionnaire, drinking water and wastewater utilities that serve

14 As noted earlier, our November 2001 report addressed the amounts and
sources of federal and state financial assistance for drinking water and
wastewater infrastructure during fiscal years 1991 through 2000. See GAO-
02- 134. Objectives, Scope,

and Methodology

Chapter 1: Introduction Page 18 GAO- 02- 764 Water Utility Financing and
Planning

populations greater than 10,000. We developed similar but separate
questionnaires, one for drinking water utilities and one for wastewater
utilities. We focused on utilities serving populations of more than 10,000
because they (1) accounted for a large share of infrastructure needs and
(2) were more likely than their smaller counterparts to have the means to
respond to our survey. A copy of the drinking water utility questionnaire,
with summary response data, is in appendix I, and a copy of the wastewater
utility questionnaire, with summary response data, is in appendix II.

We obtained contact information for the drinking water utilities from
EPA*s Safe Drinking Water Information System database. We mailed
questionnaires to all 480 private drinking water utilities and to a sample
of 945 public drinking water systems, stratified by size of population
served (the size categories appear on the questionnaires), identified in
the database. (Thus, we sent questionnaires to a total of 1,425
utilities.) We obtained contact information for the public and private
wastewater utilities from EPA*s Clean Water Needs Survey database and
EPA*s Permit Compliance System database. 15 EPA does not collect
information specifically on the size of the population served by
wastewater utilities. However, EPA officials estimate that facilities that
process more than 1 million gallons of wastewater per day are roughly
equivalent to facilities that serve populations of more than 10,000
people. Thus, we used EPA*s data on plant capacity to approximate the
sizes of wastewater utilities. We then mailed questionnaires to all 2,391
of the systems estimated on this basis to serve populations greater than
10,000.

We included on the questionnaires a *screening* question to make certain
that the responses we obtained and used were in fact from utilities that
served populations greater than 10, 000. We obtained 821 useable responses
from drinking water utilities and 1,113 useable responses from wastewater
utilities. In the analysis, utilities were weighted to account
statistically for all utilities serving populations greater than 10,000,
including those not selected for our sample. Overall, using response data
from the screening question and from nonrespondent follow- up efforts to
adjust the estimated number of drinking water and wastewater utilities
serving populations greater than 10,000, we estimate that 77 percent of
the

15 We did not send questionnaires to drinking water and wastewater
utilities whose ownership was specified as *federal government,* *state
government,* *native American,* or *not specified.*

Chapter 1: Introduction Page 19 GAO- 02- 764 Water Utility Financing and
Planning

drinking water utilities serving more than 10,000 people and 73 percent of
the wastewater utilities of this size responded to the survey. We used the
weighted results to make estimates about the entire population of such
drinking water and wastewater utilities. Therefore, all utility
percentages cited in the remainder of the report are estimates and have
some sampling error associated with them. All estimates cited have 95-
percent confidence intervals of plus or minus 10 percentage points or
less; that is, we are 95 percent confident that the *actual* population
value is contained in an interval of 10 percentage points above or below
the estimate. We used these sampling errors to assess statistically
significant differences between percentages as well.

In addition to sampling errors, surveys can be subject to other types of
systematic error or bias that can affect the results, commonly referred to
as nonsampling errors. For example, questions may be misinterpreted; the
respondents, as a group, may differ from those who did not respond in ways
that are important; or response data could be erroneously transcribed or
entered into a database. We took several steps in an attempt to reduce
such errors. For example, to minimize the chances of questions being
misinterpreted, we developed our survey questions with the aid of a survey
specialist. We discussed the questionnaire with officials from the EPA*s
Office of Water; the Association of Metropolitan Sewerage Agencies; the
American Water Works Association; the Water Environment Federation; three
consulting firms that specialize in the water utility industry: Beecher
Policy Research, Inc., Hayden Reynolds & Associates, Pty. Ltd., and PA
Consulting Group; and public utility commissions in the states of West
Virginia and Wisconsin. In addition, we pretested the questionnaires with
five drinking water utilities and five wastewater utilities. 16 To
maximize our response rate, we sent reminder postcards and mailed two
follow- up questionnaires to all nonrespondents. All data were double
keyed during data entry, and we verified a sample of the resulting
automated data. We ran various edit checks and other computer analyses to
identify inconsistencies and potential errors in the data, and a technical
specialist independently reviewed all computer programs.

One of our objectives was to compare public and privately owned utilities.
However, we did not receive enough responses from privately owned

16 The five drinking water and five wastewater utilities were chosen to
represent a variety of size categories (based on population served by each
utility) and both public and private ownership.

Chapter 1: Introduction Page 20 GAO- 02- 764 Water Utility Financing and
Planning

wastewater utilities for a meaningful analysis (as noted previously,
according to EPA, most privately owned wastewater systems serve
populations of less than 10,000 people). Therefore, our analyses
concerning utility ownership type were limited to drinking water utilities
only. In comparing utilities according to the size of the population
served, we collapsed the size categories into four: utilities serving
populations of 10,001 to 25,000; 25,001 to 50,000; 50,001 to 100,000; and
over 100,000.

To address the third objective, we interviewed officials from five private
companies that have significant experience with privatization agreements
and are among the most active participants in this field either nationally
or regionally. The companies are American Water Works Service Company,
Inc., United States Filter Corporation, and United Water (companies that
operate nationally in a total of 40 states); ECO Resources, Inc., which
operates principally in the Southwest; and Philadelphia Suburban Water
Company, which focuses its operations in the mid- Atlantic and Midwest. In
addition, because company officials identified state requirements and
policies as a significant factor in their investment decisions, we
interviewed officials from eight states (California, Connecticut, Georgia,
Indiana, New Jersey, Pennsylvania, Texas, and Washington) that the
companies, EPA, or industry officials identified as having requirements or
policies that could affect privatization.

We conducted our work between May 2001 and July 2002 in accordance with
generally accepted government audit standards.

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 21 GAO- 02- 764 Water Utility Financing and Planning

According to our survey, the amount of funds obtained from user charges
and other local sources of revenue was less than the full cost of
providing service* including operation and maintenance, debt service,
depreciation, and taxes* for an estimated 29 percent of drinking water
utilities and 41 percent of wastewater utilities. (Our survey requested
information on utilities* revenues and costs during their most recently
completed fiscal year.) Revenues from user charges and other local sources
were adequate to cover at least operation and maintenance costs for over
93 percent of the utilities, but about 29 percent of the utilities
deferred maintenance during the same time period because of insufficient
funding. Revenues from user charges usually accounted for most of
utilities* locally generated funds. Our survey found that about half of
the utilities raised their user rates infrequently* once, twice, or not at
all* from 1992 to 2001.

We found that revenues from user charges and other local sources often
fell short of utilities* cost of providing service, as defined below.
According to EPA and major water industry associations, in order to be
selfsustaining, drinking water and wastewater utilities must recover the
full cost of providing service through their user rates and service
charges. Rates that generate sufficient revenue to cover the full cost of
service lessen the need for external assistance, such as federal or state
grants and loans. Determining the cost of service establishes a utility*s
revenue requirements and, accordingly, can serve as a basis for its rate
structure.

According to the National Regulatory Research Institute, *determining

utility revenue requirements involves an examination of aggregate annual
costs, including operating as well as capital costs,* to derive the
utility*s cost of providing service. 1 In a November 1993 report, the
Institute explained that water utilities generally use one of two basic
methods of determining their revenue requirements for the purpose of
setting user rates, largely depending on whether the utility is public or
privately owned: 2

1 The National Regulatory Research Institute was established by the
National Association of Regulatory Utility Commissioners in 1976 at the
Ohio State University and is the official research arm of the association.
The Institute provides research and assistance to state public utility
commissions and other selected national and international clients. See
National Regulatory Research Institute, Meeting Water Utility Revenue
Requirements: Financing and Ratemaking Alternatives (Nov. 1993) p. 63.

2 Meeting Water Utility Revenue Requirements: Financing and Ratemaking
Alternatives,

p. 64. Chapter 2: User Charges and Other Local

Sources of Funds Covered Much, but Not All, of Utilities* Cost of
Providing Service

Funds Collected from Local Sources Were Often Less Than Utilities* Cost of
Providing Service

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 22 GAO- 02- 764 Water Utility Financing and Planning

 Under the *utility* approach, which is typically used by investor or
privately owned utilities, the total cost of service includes operation
and maintenance expenses, taxes, depreciation, and a rate of return on the
value of the utilities* assets less accumulated depreciation.

 Under the *cash needs* approach, used by many public utilities, the
total cost of service includes operation and maintenance expenses, tax
equivalents (e. g., payments in lieu of taxes), debt service payments
(including both interest charges and repayment of principal),
contributions to specified reserves, and capital expenditures not financed
by either debt or contributions.

To determine whether revenues from user charges and other local sources
were large enough to cover the cost of providing service among the
utilities covered by our survey, we adapted the utility approach. We
developed a modified utility method because it allowed us to (1) adopt a
standard approach to deriving the *cost of providing service* for both
public and privately owned utilities, thereby enabling more meaningful
summaries and comparisons among all of the utilities and (2) make the most
effective use of the categories of cost data we collected. Specifically,
to calculate the cost of service, we included the amounts reported for
operation and maintenance expenses, taxes, and depreciation. 3 We also
included the amounts reported as debt service (including interest charges
and repayment of principal) as a surrogate for rate of return, a category
for which our survey did not request information. 4 Because of the
approach we used, we may have overstated some utilities* costs and thus
the number of utilities that did not cover their costs. The reason is that
for some utilities the portion of debt service attributable to repayment
of principal may have been covered, in part, by the inclusion of
depreciation in computing the cost of service.

3 Our survey allowed utilities to report miscellaneous costs under an
*Other* category, and some utilities did so. When appropriate, we
recategorized these costs. For example, some public systems reported
transfers to other city departments in the Other category; when the survey
document indicated that the transfer was for administrative services, such
as accounting or legal services, we included the amount in the *Operations
and Maintenance* category. When it was not possible to discern a more
appropriate category for particular costs, we included them in the
calculation of cost of service as other costs.

4 We considered using the cash needs approach to calculate the cost of
service because most of our respondents were public utilities and, as
such, were more likely to use the applicable cost categories. However,
while our survey requested information on the amount of utilities* capital
expenditures during their most recently completed fiscal year, the survey
did not specifically request information on *capital expenditures not
financed by either debt capital or contributions.*

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 23 GAO- 02- 764 Water Utility Financing and Planning

Our survey showed that virtually all utilities obtained revenues from user
charges during their most recently completed fiscal year. Other common
funding sources included hook- up and connection fees and interest
earnings, used by an estimated 80 to 90 percent of utilities. Table 1
summarizes the types of funding used by drinking water and wastewater
utilities during their most recently completed fiscal year, according to
our survey.

Table 1: Estimated Percentages of Utilities That Used Each Source of
Funding in Their Most Recently Completed Fiscal Year

Funding source Estimated percentage of utilities using funding source a
Drinking water Wastewater

User charges 98 97

Other local revenues

Property taxes 8 10 Sales to other utilities 42 32 Product sales b 12
Special operating cost levies 3 39 Interest earned 77 78 Assessments 14 21
Permit and inspection fees 41 50 Hook- up, connection, or tap fees 89 78
Reserves 35 37 Other 51 29

Grants

Federal grants 16 18 State grants 21 31 Other grants 4 4

Debt and equity

Federal loans 12 8 State loans 25 40 Commercial loans 9 6 Revenue bonds 36
36 General obligation bonds 19 23 Private activity bonds 2 <1 Sale of
stock 2 0 Other short- term debt 8 5 Other long- term debt 7 3 Other debt
and equity instruments 2 1

Other 7 7

User Charges Represent One of Many Sources of Funding Used by Utilities

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 24 GAO- 02- 764 Water Utility Financing and Planning

a Our survey did not collect information on the dollar amount of funding
generated by nonlocal sources. b Our survey also did not collect
information on whether drinking water utilities obtained revenues from

product sales. This may account for the large percentage of such utilities
that used the Other category under the Other local revenues category (51
percent compared to 29 percent of wastewater utilities).

Source: GAO*s analysis of survey data.

Using the modified utility approach described earlier, we analyzed our
survey data to compare utilities* costs and revenues. Among other things,
we found that for many utilities, revenues from user charges alone were
not enough to cover the cost of service in their most recently completed
fiscal year. Specifically, we found that revenues from user charges
exceeded the cost of service at an estimated 39 percent of the drinking
water utilities and 33 percent of the wastewater utilities. However,
combining revenues from user charges with funding from other local
sources, such as hook- up and connection fees and sales of services to
other utilities, we found that more utilities were able to cover their
cost of providing service. Specifically, for an estimated 71 percent of
the drinking water utilities and 59 percent of the wastewater utilities,
user charges plus other local revenues exceeded the cost of providing
service.

We analyzed our survey data to determine if there were any statistically
significant relationships between certain utility characteristics and the
utilities* ability to cover costs with user charges and/ or other local
revenues. First, we examined these relationships for both (1) the size of
the population served by the utilities and (2) the type of ownership
(public or private). We found the following:

 For both drinking water and wastewater utilities, there were no
statistically significant differences between utilities based on the size
of the populations they served; that is, smaller utilities were neither
more nor less likely than larger utilities to have covered their cost of
providing service, whether we looked at revenues from user charges alone
or revenues from all local sources.

 Among drinking water utilities, ownership type did make a difference
when comparing the cost of providing service with revenue from user
charges alone. We found that 62 percent of public drinking water utilities
did not cover their cost of service with user charges alone, compared with
44 percent of privately owned systems. However, when we included revenues
from other local sources in the analysis, we found no statistical
difference between public and privately owned drinking water utilities.
User Charges and Other

Local Revenues Were Less Than Many Utilities* Cost of Providing Service

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 25 GAO- 02- 764 Water Utility Financing and Planning

EPA has reached similar conclusions about the ability of some utilities to
cover their costs. For example, in a July 1999 report on the
characteristics of small drinking water systems, defined as those serving
less than 10,000 people, EPA compared such systems to larger ones serving
more than 10,000 people* the same group included in our study. EPA
reported that an estimated 20 percent of the larger systems did not have
sufficient revenues to cover their debt service costs after paying
operating expenses. 5 In the case of wastewater utilities, a September
1990 study on user fees reported that when total wastewater revenues were
compared to total wastewater treatment costs, a significant percentage of
the utilities included in the study* 31 percent of those serving
populations of 10,000 to 100,000 and 26 percent of those serving over
100,000 people* were operating with a revenue shortfall. 6 As defined in
the study, total treatment costs consisted of debt repayment costs plus
operation, maintenance, and equipment replacement costs.

We next analyzed our survey data to determine if there were any
statistically significant relationships between utilities* ability to
cover costs with user charges and/ or other local revenues and other
characteristics. Overall, we found few significant differences; that is,
for the most part, utilities that covered their cost of providing service
with revenues from user charges and/ or other local sources did not
differ* on the basis of characteristics we examined* from those that did
not. More specifically, we found the following regarding utilities*
ability to cover their cost of providing service with user charges and
other local revenues and the following characteristics:

 Use of federal or state grants or loans. An estimated 24 percent of the
drinking water utilities and 36 percent of the wastewater utilities that
did not cover their costs obtained federal and/ or state grants during
their most recently completed fiscal year. These utilities obtained grants
at about the same rate as the drinking water and wastewater utilities that
did cover

5 U. S Environmental Protection Agency, National Characteristics of
Drinking Water Systems Serving Populations Under 10, 000, EPA 816- R- 99-
010 (Washington, D. C.: July 1999). Among other things, the report
compares the financial characteristics of several different subsets of
small systems serving less than 10, 000 people to the systems that serve
more than 10, 000 people in a number of ways, including the ratio of
annual debt service payments to net available revenue (i. e., total
revenues minus operating and maintenance expenses).

6 U. S. Environmental Protection Agency, National Wastewater User Fee
Study of the Construction Grants Program, EPA 430/ 09- 90- 011
(Washington, D. C.: September 1990).

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 26 GAO- 02- 764 Water Utility Financing and Planning

their costs. Similarly, when we included utilities that received federal
or state loans in our analysis* in addition to the utilities that received
assistance from grants* we found that an estimated 43 percent of the
drinking water utilities and 60 percent of the wastewater utilities that
did not cover their costs used some form of federal or state grant or
loan. These utilities received assistance at about the same rate as
utilities that did cover their costs.

 Dedication of rate revenues for specific purposes. We found no
statistical differences regarding the extent to which utilities* rates
included amounts to cover the cost of preventive rehabilitation and
replacement programs for pipelines. Based on our survey, an estimated 85
percent of the utilities* rates included such amounts, whether or not the
utilities covered their cost of providing service. Similarly, both
drinking water and wastewater utilities that covered their cost of service
were no more likely than those that did not to dedicate a portion of
revenues from user charges specifically to future capital needs. Overall,
according to our survey, about 70 percent of drinking water and wastewater
utilities dedicated a portion of their user charges to future capital
needs in developing their rates.

 Existence of rate relief or other subsidy for lower- income customers.

About the same percentage of utilities offered some type of subsidy to
lower- income customers* about 14 percent of the drinking water utilities
and about 13 percent of the wastewater utilities* whether or not the
utilities covered their cost of service.

More comprehensive information might have allowed us to draw some clearer
distinctions between utilities that did and did not cover their costs.
However, to limit the burden on our survey respondents, we did not ask
utilities to report the amount of any assistance they received, and we
requested data on only the most recently completed fiscal year.

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 27 GAO- 02- 764 Water Utility Financing and Planning

Annual operation and maintenance costs are those associated with operating
and maintaining a utility* including the costs of labor, energy,
chemicals, and accounting services. Operation and maintenance costs are of
particular interest because of certain requirements imposed on many
wastewater utilities as a condition of receiving construction grants under
the Clean Water Act. Specifically, the wastewater utilities are required
to generate sufficient revenues through user charges to cover operation
and maintenance costs. 7 According to EPA*s 1990 report on wastewater user
fees, all wastewater utilities serving more than 10,000 people at that
time received such grants. 8 While drinking water utilities are not
subject to a similar requirement, both EPA and key water industry
associations consider adequate user charges to be a key indicator of
utilities* financial health.

According to our survey results, an estimated 85 percent of drinking water
utilities and 82 percent of wastewater utilities were able to cover their
operation and maintenance costs using revenues from user charges alone.
Moreover, adding other locally generated funds to the user charges, we
estimated that over 93 percent of the utilities were able to cover their
operation and maintenance costs. With one exception, we also found that a
utility*s size or type of ownership did not influence its ability to cover
operation and maintenance costs. However, privately owned drinking water
utilities were somewhat more likely to have sufficient revenues from user
charges to cover their operation and maintenance costs than public
utilities (the estimates were 91 percent compared to 85 percent).

Our findings are consistent with EPA*s July 1999 report on the
characteristics of small drinking water systems, which compared systems
serving less than 10,000 people to systems serving more than 10,000
people. EPA reported that 13 percent of the larger systems (those serving
populations of more than 10,000) had operation and maintenance

7 The user charge requirement applies to construction grants awarded under
title II of the Clean Water Act. According to EPA, although most of these
grants were expended long ago, the user charge requirement applies *in
perpetuity,* as long as the facilities for which the grants were used
remain in operation.

8 National Wastewater User Fee Study of the Construction Grants Program,
p. 2. The last year for which the Congress authorized funding for
construction grants was 1990. Funds from Local

Sources Generally Exceeded Operation and Maintenance Costs

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 28 GAO- 02- 764 Water Utility Financing and Planning

expenses that exceeded their operating revenues. 9 For the purposes of its
study, EPA defined operating revenues as the sum of water sales and the
following water- related revenues: connection fees, inspection fees,
developer fees, usage fees, other fees, and general fund revenues.
Interest earned, primary business revenues, fines or penalties, and other
water related revenues were not included. Although our results indicate
that a smaller percentage of utilities were not covering their costs than
EPA*s study concluded, we defined local sources of revenue more broadly
than EPA and included some categories, such as interest earnings and
reserve payments, that were used by large percentages of utilities. EPA
has not done a similar analysis of wastewater utilities.

While our survey shows that, for an overwhelming majority of utilities,
locally generated funds met or exceeded their operation and maintenance
costs, it provides some indications that utilities* costs may be lower
than they should be to adequately maintain facilities and equipment.
Specifically, we looked at the extent to which utilities that were
covering their operation and maintenance costs also deferred maintenance

*because available funding was not sufficient.* We found that for both
drinking water and wastewater utilities, an estimated 29 percent of the
utilities that covered their costs also deferred maintenance in their most
recently completed fiscal year. However, there was no statistical
difference in the extent to which the utilities deferred maintenance,
whether they covered their operation and maintenance costs or not.

The fact that utilities were deferring maintenance suggests that either
unanticipated expenses forced the utilities to reschedule planned
maintenance or their budgets were never sufficient to cover the needed
expenses in the first place. According to EPA and water industry experts,
deferring maintenance beyond the optimal point for system repair and
renewal can lead to earlier capital replacement needs and increases in the
cost of providing service.

9 National Characteristics of Drinking Water Systems Serving Populations
Under 10, 000,

p. 4- 1. EPA compared the financial characteristics of small systems and
larger ones, in this instance, by dividing operating revenues by operation
and maintenance expenses and deriving an *operating ratio* as a measure of
financial health. Generally, an operating ratio below 1 is considered to
be an indicator of weak financial health.

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 29 GAO- 02- 764 Water Utility Financing and Planning

User charges represent a major source of locally generated funding at both
drinking water and wastewater utilities. According to our survey, for
about half of the utilities, user charges accounted for at least 90
percent of their local funds in their most recently completed fiscal year.
10 User charges accounted for at least three- quarters of the funds from
local sources at an estimated 80 percent of the drinking water utilities
and about 75 percent of the wastewater utilities.

We analyzed the data on utilities* user charges to determine if the
utilities* ability to cover their cost of providing service was related to
the frequency of their rate increases. As noted earlier, our survey- based
estimates are that 29 percent of drinking water utilities and 41 percent
of wastewater utilities had revenues from user charges and other local
sources that were less than their cost of providing service. As table 2
shows, we found that more than half of these utilities reported raising
their rates infrequently* once, twice, or not at all* during the 10- year
period from 1992 to 2001. However, overall we found no statistically
significant differences in the frequency of rate increases between the
utilities that did not cover their costs and those that did.

We did not ask utilities to provide information on the magnitude of their
rate increases. Some utilities may have a strategy of seeking fewer but
larger rate increases. This strategy could enable them to cover more of
their costs if the rate increases, though infrequent, are sufficiently
large.

10 About 21 percent of the drinking water utilities and 23 percent of the
wastewater utilities indicated that they had local sources of funding in
addition to user charges, but they did not report an amount. We have no
way of knowing whether the amounts these utilities reported as user
charges actually represented revenues from all local sources or from user
charges alone. We excluded these utilities when we calculated the
percentage of locally generated funding represented by user charges. User
Charges

Represented a Major Source of Local Funds, but Were Increased Two Times or
Fewer by Half of the Utilities

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 30 GAO- 02- 764 Water Utility Financing and Planning

Table 2: Relationship between the Frequency of Rate Increases and
Utilities* Ability to Cover Their Cost of Providing Service Using Revenues
from All Local Sources, 1992* 2001

Estimated percentage of utilities that increased rates, by frequency of
increase Drinking water Wastewater

Number of rate increases

Did not cover cost of providing

service Covered cost

of providing service

Did not cover cost of providing

service Covered cost

of providing service

0 11 7 15 13 1- 2 41 44 37 38 3- 4 21 22 23 19 5- 7 19 17 17 18 8- 10 9 9
8 11

Source: GAO*s analysis of survey data.

Other studies provide some data on the magnitude and frequency of rate
increases by water utilities. In its July 1999 report on the
characteristics of small drinking water systems, EPA examined the
frequency and magnitude of rate increases and found that for larger
systems (those serving more than 10,000 people), about 2- 1/2 years had
elapsed, on average, since the last increase. 11 In addition, EPA reported
that the average size of the increase was 14 percent. Similarly, data
collected by the Association of Metropolitan Sewerage Agencies for its
1999 financial survey indicated that the current rates had been in effect
for an average of about 2- 1/2 years. This survey also found that the
sewer rates had increased 9 percent annually, on average, between 1996 and
1999. 12

We further analyzed our survey data to determine if the frequency of rate
increases varied depending on the utilities* size. We found that larger
utilities, particularly those serving more than 100,000 people, were more
likely to have had 5 to 10 rate increases from 1992 to 2001 than smaller

11 National Characteristics of Drinking Water Systems Serving Populations
Under 10,000, p. 4- 8. 12 Association of Metropolitan Sewerage Agencies,
AMSA 1999 Financial Survey: A National Survey of Municipal Wastewater
Management Financing Trends (1999), pp. 13, 65. The survey included 119
utilities serving populations greater than 21, 000. Of the 93 utilities
that provided information on how long current rates had been in effect, 45
reported that their rates had been in effect for less than 1 year prior to
the survey; the longest period of time that a rate was unchanged was 17
years.

Chapter 2: User Charges and Other Local Sources of Funds Covered Much, but
Not All, of Utilities* Cost of Providing Service

Page 31 GAO- 02- 764 Water Utility Financing and Planning

utilities. Conversely, smaller utilities were more likely than larger ones
to have increased their rates infrequently during the 10- year period.
Table 3 summarizes the results of our analysis.

Table 3: Frequency of Rate Increases, 1992 through 2001, by Size of
Population Served

Estimated percentage of utilities that increased rates, by frequency
Frequency of rate increases, by population served Drinking water utilities
Wastewater utilities No increases

10,001- 25,000 8 15 25,001- 50,000 12 14 50,001- 100,000 7 17 Over 100,000
6 13

1- 2 increases

10,001- 25,000 51 41 25,001- 50,000 44 44 50,001- 100,000 36 32 Over
100,000 27 23

3- 4 increases

10,001- 25,000 19 22 25,001- 50,000 24 21 50,001- 100,000 25 21 Over
100,000 23 17

5- 7 increases

10,001- 25,000 16 16 25,001- 50,000 14 13 50,001- 100,000 22 18 Over
100,000 24 29

8- 10 increases

10,001- 25,000 6 7 25,001- 50,000 6 9 50,001- 100,000 10 11 Over 100,000
21 18

Source: GAO*s analysis of survey data.

When we analyzed the data according to the utilities* ownership type, we
found no statistical differences in the frequency of rate increases at
drinking water utilities, whether they were public or privately owned.

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 32 GAO- 02- 764 Water Utility Financing and Planning

According to our survey, more than one out of four utilities lacked plans
recommended by utility associations for managing their existing capital
assets. Further, over half of the utilities with plans did not cover all
their assets or omitted key plan elements, such as an assessment of the
assets* physical condition. In addition, while most utilities had a
preventive rehabilitation and replacement program, for about 60 percent of
the drinking water utilities and 65 percent of the wastewater utilities,
the actual rate of pipeline rehabilitation and replacement in recent years
was less than their desired levels. Further, in their most recent fiscal
year, an estimated one- third of the utilities deferred maintenance; one-
third deferred major capital improvements; and one- third deferred minor
capital improvements.

Our survey indicates that about 90 percent of the utilities had capital
improvement plans that identify future needs and that about the same
percentage of utilities reviewed their capital improvement needs annually
whether or not a formal plan was in place. Utilities* capital improvement
plans generally had a long- term focus* the large majority covered 5 years
or more* as recommended by industry associations. Most utilities also had
plans for financing their future capital needs, but an estimated 45
percent believed that their projected funding over the next 5 to 10 years
would not be sufficient to meet the needs.

According to our survey, more than 25 percent of drinking water and
wastewater utilities lacked asset management plans, although some were in
the process of developing such plans. Of the utilities with plans, more
than half did not include all of their assets or omitted key plan
elements.

Drinking water and wastewater utilities manage their existing capital
assets to maximize the useful life of the assets, control operating costs,
and generally enhance the efficiency of their operations. According to a
comprehensive industry handbook, published in 2001, the term *asset

management* means managing infrastructure- related assets, such as
pipelines and equipment, to minimize the total cost of owning and
operating them while maintaining adequate service to customers. 1 The

1 The Association of Metropolitan Sewerage Agencies developed the
handbook, Managing Public Infrastructure Assets to Minimize Cost and
Maximize Performance, in partnership with the Association of Metropolitan
Water Agencies, the American Water Works Association, and the Water
Environment Federation, to help water and wastewater utilities adopt
advanced management methods that can reduce long- term costs and improve
service to customers. Chapter 3: Many Utilities Lacked

Comprehensive Asset Management Plans, but Most Had Identified Future
Capital Needs

Many Utilities Lacked Comprehensive Asset Management Plans

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 33 GAO- 02- 764 Water Utility Financing and Planning

handbook states that asset management allows an organization to
characterize the condition of capital assets and quantify an ongoing
renewal program to maximize their reliability. The handbook further
provides that a goal of an asset management system should be *the ability
to merge what is known about an organization*s capital assets with
rehabilitation standards and costs and with risk assessments of asset
failures to identify critical assets.* 2

For the purposes of our survey, we focused on four areas identified as key
elements of good asset management systems: an inventory of the assets,
assessment criteria, the assets* condition, and the planned and actual
expenditures to maintain the assets. 3 More specifically, we asked
drinking water and wastewater utilities (1) if they had plans for managing
their existing capital assets and (2) if so, whether these plans included
a complete assessment of the physical condition of all capital assets,
descriptions of the criteria used to measure and report on the condition
of the assets, the condition level at which the assets will be maintained,
and a comparison of the planned and actual dollar amounts used to maintain
the assets at the established condition level. For each of the key
elements, we also asked if the plans covered all or some capital assets or
did not address the element at all.

Based on the results of our survey, a significant percentage of drinking
water and wastewater utilities* an estimated 27 percent and 31 percent,
respectively* did not have plans for managing their existing capital
assets. However, 40 percent of the drinking water utilities and about 50
percent of the wastewater utilities were developing such plans at the time
of our survey.

2 Managing Public Infrastructure Assets to Minimize Cost and Maximize
Performance,

p. 154. 3 We focused on elements of an asset management system identified
by the Governmental Accounting Standards Board in a June 30, 1999,
statement that made comprehensive changes in state and local governments*
financial reporting. Among other things, it requires, for the first time,
the governments to report information about public infrastructure assets,
including their drinking water and wastewater facilities. Specifically,
the governments must begin reporting depreciation of their capital assets
or implement an asset management system. See Governmental Accounting
Standards Board Statement No. 34, Basic Financial Statements* and
Management*s Discussion and Analysis* for State and Local Governments.

Some Utilities Did Not Have Plans

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 34 GAO- 02- 764 Water Utility Financing and Planning

When we looked at the characteristics of the utilities without asset
management plans, for the most part, we found no statistical differences
between utilities of different sizes for either drinking water or
wastewater utilities, with one exception: about twice as many of the
smallest drinking water utilities* those serving populations of 10,001 to
25,000* lacked plans compared with the largest ones, serving populations
of over 100,000 (the estimates were 34 percent and 17 percent,
respectively). We also found that public drinking water utilities were
somewhat more likely than their privately owned counterparts not to have
plans for managing their existing capital assets (an estimated 29 percent
compared with 11 percent).

According to our survey, more than two- thirds of the utilities had asset
management plans* an estimated 69 percent of the drinking water utilities
and 65 percent of the wastewater utilities* but many of the plans did not
cover all of the utilities* assets or did not contain one or more key
elements. 4 Table 4 summarizes the extent of coverage of utilities* assets
and the four key elements in utilities* asset management plans.

4 Three percent of drinking water utilities and 4 percent of wastewater
utilities did not indicate that they did or did not have a plan. Many
Utilities* Plans Did

Not Cover All Assets or Lacked Key Elements

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 35 GAO- 02- 764 Water Utility Financing and Planning

Table 4: Extent to Which Utilities* Asset Management Plans Covered Assets
and Key Elements

Estimated percentage of plan coverage Plan element Drinking water

utilities Wastewater utilities

All assets 41 All assets 38 Some assets 53 Some assets 54 Complete

assessment of the physical condition of the utility*s capital assets

Not addressed in plan 6 Not addressed in

plan 7 All assets 30 All assets 26 Some assets 53 Some assets 51
Descriptions of

the criteria used to measure and report the assets* condition

Not addressed in plan 17 Not addressed in

plan 23 All assets 34 All assets 25 Some assets 50 Some assets 54
Condition level

at which utility intends to maintain the assets

Not addressed in plan 16 Not addressed in

plan 21 All assets 28 All assets 22 Some assets 40 Some assets 41
Comparison of

the planned and actual dollar amounts used to maintain the assets at the
condition level established by the utility

Not addressed in plan 32 Not addressed in

plan 36 Note: Numbers are estimated percentages of all utilities that have
plans. Source: GAO*s analysis based on survey data.

Significantly, our survey results indicate that over 50 percent of
utilities* asset management plans did not cover all assets. Industry
associations for both drinking water and wastewater utilities advocate the
inclusion of all capital assets in such plans. They also believe that good
asset management planning starts with a comprehensive inventory of
existing assets and encompasses other elements addressed in our survey as
well. In fact, the comprehensive industry handbook cited earlier indicates
that an integrated asset management system includes, among other things, a
maintenance management system as well as components designed to

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 36 GAO- 02- 764 Water Utility Financing and Planning

inventory and analyze the condition of a utility*s assets. 5 Using this
information, utilities can optimize decisions on what system components
require maintenance or need to be rehabilitated or replaced, when these
actions need to occur, and what they will cost.

To minimize the reporting burden on utilities, we did not ask the surveyed
utilities to be more explicit about the types of assets that were or were
not covered by the plans. However, some evidence suggests that utilities
might not be developing comprehensive plans for the management of their
pipelines, a potentially critical omission considering that pipelines
account for about 75 percent of the nation*s investment in drinking water
and wastewater infrastructure. A study sponsored by the American Water
Works Association Research Foundation concluded that effective planning
for pipeline rehabilitation and replacement falls into three categories:
(1) developing asset inventory data on pipe condition by segment, (2)
developing priorities for annual replacement plans, and (3) developing
long- term plans to optimize the rate of replacement. 6 However, the
report states that 15 of the 18 utilities reviewed for the study had not
developed comprehensive information projecting their pipeline replacement
needs based on when the pipes were installed and how long they are
expected to last.

5 Managing Public Infrastructure Assets to Minimize Cost and Maximize
Performance,

pp. 156- 157. 6 American Water Works Association Research Foundation,
Financial and Economic Optimization of Water Main Replacement Programs
(Denver, Colo.: 2001). This study included 18 utilities* 13 in the United
States, 2 in Canada, and 3 in Australia. The objective of the study was to
identify and document best practices in planning for the rehabilitation
and replacement of aging, deteriorated water main piping.

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 37 GAO- 02- 764 Water Utility Financing and Planning

For utilities with plans, we analyzed our survey data according to the
size of the utility. We found no statistical differences among utilities
of different sizes with regard to the inclusion or exclusion of any of the
four key elements in their asset management plans. However, when we
similarly analyzed the data according to the type of utility ownership, we
found that the asset management plans developed by privately owned
drinking water utilities tended to be more comprehensive than those
developed by publicly owned utilities. For example, we found that an
estimated

 55 percent of private utilities* plans covered all capital assets,
compared with 40 percent of public utilities;

 46 percent of private utilities* plans included criteria for all assets,
compared with 28 percent for public utilities;

 43 percent of private utilities* plans included the condition level at
which the assets would be maintained, compared with 33 percent for public
utilities; and

 40 percent of private utilities* plans included a comparison of the
planned and actual expenditures for maintaining the assets, compared with
26 percent for public utilities.

According to our survey results, some utilities had significant portions
of pipelines in poor condition; for example, more than one- third of
utilities had 20 percent or more of their pipelines nearing the end of
their useful life. We also found that for an estimated 60 percent of
drinking water utilities and 65 percent of wastewater utilities, the
actual levels of pipeline rehabilitation and replacement in recent years
were less than the utilities* desired levels. Further, in each of three
categories* maintenance, minor capital improvements, and major capital
improvements* an estimated one- third or so of utilities had deferred
expenditures in their most recent fiscal year, and 20 percent had deferred
expenditures in all three categories.

Drinking water and wastewater utilities carry out various activities to
ensure efficient and cost- effective operations and plan for needed
improvements. According to the industry handbook, for example, utilities
carry out planned maintenance of plant, equipment, and pipes to prevent,
minimize, or delay failures or shutdowns that result in unplanned Despite
Pipelines in

Poor Condition, Some Utilities Had Deferred Maintenance, Capital
Improvements, or Both

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 38 GAO- 02- 764 Water Utility Financing and Planning

maintenance activities and increased costs. 7 Utility officials told us
that they also rehabilitate existing assets, such as pipelines, to extend
their useful life. Both regular maintenance and rehabilitation of key
assets help utilities keep their operating costs as low as possible. When
maintenance and asset rehabilitation are no longer cost- effective options
and capital assets reach the end of their useful life, they must be
replaced, often requiring large investments. Despite their needs,
utilities may have to postpone capital improvements because revenues are
not sufficient to finance the costs or more immediate needs divert
resources away from the planned improvements. However, deferring major or
minor capital improvements can ultimately result in higher costs to the
utilities. For example, additional costs may be incurred to repair damage
associated with the failure of a major asset that was not replaced when
planned.

In looking at how utilities were managing their existing capital assets,
we decided to focus on utilities* pipelines for several reasons. First, as
noted earlier, EPA estimates that underground pipelines account for about
75 percent of the nation*s existing capital investment in drinking water
and wastewater infrastructure. Moreover, aging pipelines* including the
water supply, transmission, and distribution lines at drinking water
utilities and the sanitary sewer lines and other underground systems at
wastewater utilities* represent a significant share of the estimated
future capital investment needs. In May 2001, the American Water Works
Association, citing a *huge wave of aging pipe infrastructure,* predicted
significant increases in pipe break rates and repair costs over the next
30 years* even if utilities increase their investment in pipe replacement
by several times over today*s levels. 8 According to EPA*s 1999 Drinking
Water Infrastructure Needs Survey, the largest category of need is the
installation and rehabilitation of transmission and distribution systems*
accounting for $83.2 billion, or 55 percent of the needs projected through
2019. For wastewater systems, EPA*s 1996 Clean Water Needs Survey
projected infrastructure- related needs for wastewater systems of $128
billion through 2016. However, according to an EPA official, the needs
survey estimate substantially underestimates the needs associated with the
rehabilitation and replacement of the underground infrastructure because
these needs are frequently not detected and therefore tend not to be

7 Managing Public Infrastructure Assets to Minimize Cost and Maximize
Performance,

p. 80. 8 Dawn of the Replacement Era: Reinvesting in Drinking Water
Infrastructure,

p. 13. Some Utilities Had

Pipelines in Poor Condition and Rehabilitation and Replacement Rates That
Were Less Than Desired

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 39 GAO- 02- 764 Water Utility Financing and Planning

included in long- range capital plans. As a result, the national survey
tends not to include these costs. However, EPA has developed a more
comprehensive estimate that does include such needs. Although the new
estimate has not yet been released, the official confirmed that at least
half of the projected capital need for wastewater systems will be
associated with the rehabilitation and replacement of the underground
infrastructure.

Given the projected needs for rehabilitating and replacing drinking water
and wastewater pipelines, we asked for more detailed information on their
age and condition. Among other things, this enabled us to explore the
relationship between the age and condition of utilities* pipelines and
their rehabilitation/ replacement activities. 9

For our survey, we asked the utilities to estimate the percentage of their
pipelines that were installed during each 25- year period between 1900 and
2000, as well as prior to 1900 and from 2000 to the present. Our results
indicate that, in general, for about a third of utilities, a significant
portion of their pipelines is relatively new* 50 percent or more was built
since 1975. At the other end of the spectrum, for an estimated 5 percent
of the utilities, a significant portion of their pipelines is quite old:
50 percent or more was built before 1925.

Also, according to our survey, significant portions of pipelines are in
poor condition at some utilities. Specifically, we estimate that for more
than one- third of utilities, 20 percent or more of their pipelines were
nearing the end of their useful life; and for 1 in 10 utilities, 50
percent or more of their pipelines were nearing the end of their useful
life.

By size and type of utility, our survey results indicate the following:

 Utilities with 20 percent or more of their pipelines in poor condition
tended to be smaller. In the case of drinking water utilities, an
estimated 35 percent of the systems serving 10,001 to 25,000 people and 41
percent of the systems serving 25,001 to 50,000 people fell into this
category, compared with 24 percent of the largest systems (those serving
over

9 For wastewater utilities, the information on the condition of pipeline,
and its rehabilitation and replacement, represents what the utilities
reported for their sanitary sewer lines. Our survey also requested
information on combined storm/ sanitary sewer lines, but because only
about 20 percent of the utilities reported having such lines, we did not
include the information in our analysis. Age and Condition of

Pipelines

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 40 GAO- 02- 764 Water Utility Financing and Planning

100,000 people). Among wastewater utilities, the survey data indicate that
42 percent of the smallest (serving 10,001 to 25,000 people) have at least
20 percent of their pipelines in poor condition, compared with 24 percent
of the largest systems. We found no statistically significant differences
between utilities in other size categories.

 Wastewater utilities with 50 percent or more of their pipelines in poor
condition also tended to be smaller. A somewhat larger percentage of the
systems serving populations of 10,001 to 25,000 and 25,001 to 50,000 fell
into this category than systems serving more than 100,000 people (an
estimated 14 and 13 percent, respectively, compared with 3 percent). We
found no statistical differences among the population size categories for
drinking water utilities.

 There was no statistical difference between public and privately owned
drinking water utilities in terms of the percentage of pipelines reported
to be nearing the end of their useful life.

In exploring the relationship between age and condition of the pipelines,
we found some indication that utilities with a preponderance of *newer*

pipelines were less likely to have pipelines in poor condition. For
example, according to our survey, among drinking water utilities that had
built three- quarters or more of their pipelines since 1950, an estimated
47 percent of the utilities reported having 20 percent or more of their
pipelines nearing the end of its useful life. In contrast, an estimated 72
percent of the utilities that reported having less than 20 percent of
their pipelines in poor condition had a preponderance of newer pipelines.
Our findings were similar with regard to wastewater utilities.

However, the relationship between pipeline age and condition was not
consistent. Indeed, industry studies have found that older pipe typically
has a longer life expectancy than pipe of more recent vintage because of
the type of material used, manufacturing techniques, and other factors. In
addition, technological advances in pipeline rehabilitation allow drinking
water and wastewater utilities to extend the useful life of existing
pipelines by installing special liners, injecting grout or epoxy, or using
other techniques.

Finally, we found little or no relationship between the condition of
utilities* pipelines and the frequency with which the utilities had raised
their user rates during the 10- year period from 1992 to 2001. Utilities
with higher percentages of pipelines nearing the end of their useful life
did not increase rates with any greater or lesser frequency than utilities
with smaller percentages of such pipelines.

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 41 GAO- 02- 764 Water Utility Financing and Planning

While no industry benchmark exists for the optimal pace of pipeline
rehabilitation and replacement that is applicable to all utilities, our
survey shows that nearly two- thirds of utilities have fallen short of
their desired pace of rehabilitation and replacement.

Little consensus exists among industry experts regarding what the
appropriate rate of pipeline rehabilitation and replacement is for the
average utility. Some experts have expressed concern that even though
utilities may have kept up with the workload so far, the pace of pipeline
upgrades will have to increase significantly because much of the existing
pipeline is nearing the end of its useful life. For example, according to
the industry report, Dawn of the Replacement Era, the United States is not
so much faced with making up for an historical gap in the level of
replacement funding, but it now has a compelling need to increase spending
on pipeline replacement to prevent a serious funding gap from developing.
10 The report also points out that as pipes age, they tend to break more
frequently, and utilities will be experiencing an estimated three- fold
increase in pipeline repair costs at the same time replacement costs are
rising. On the other hand, some experts believe that utilities are already
facing a backlog of work. As the Water Environment Research Foundation
reported in 2000, *years of reactive maintenance and minimal expenditures
on sewers have left a huge backlog of repair and renewal work.* 11

While we could not compare our data to an industry benchmark because the
optimal pace of pipeline rehabilitation and replacement is best determined
on a utility- by- utility basis, we did examine the extent to which
utilities were achieving what they had determined to be appropriate for
their own circumstances. We found that many of them were falling short of
their goals. As shown in figure 2, for many drinking water and wastewater
utilities, a significant disparity exists between utilities* actual
rehabilitation and replacement of pipelines and the rate at which they
believe it should be occurring.

10 Dawn of the Replacement Era: Reinvesting in Drinking Water
Infrastructure, pp. 13- 14. 11 Water Environment Research Foundation, New
Pipes for Old: A Study of Recent Advances in Sewer Pipe Materials and
Technology (2000), p. 4- 1. Rehabilitation and

Replacement Activities

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 42 GAO- 02- 764 Water Utility Financing and Planning

Figure 2: Extent to Which Utilities* Actual Rate of Pipeline
Rehabilitation and Replacement Met or Exceeded Their Desired Rate (on
average, fiscal years 1998 through 2000)

Source: GAO*s analysis of survey data.

Our survey indicates that roughly half of the utilities actually
rehabilitated or replaced 1 percent or less of their pipelines annually,
even though an estimated 89 percent of drinking water utilities and 76
percent of wastewater utilities believed that a higher level of
rehabilitation and replacement should be occurring. More specifically,
about 35 percent of drinking water utilities and 42 percent wastewater
utilities believed that they should be annually rehabilitating or
replacing more than 4 percent of their pipelines; yet, only an estimated
18 percent of these utilities were actually doing so. Table 5 shows in
more detail how utilities* desired rates of rehabilitation and replacement
compared with their average actual rates during recent fiscal years (1998
through 2000).

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 43 GAO- 02- 764 Water Utility Financing and Planning

Table 5: Desired and Actual Rehabilitation and Replacement Rates for
Pipelines (on average, for fiscal years 1998 through 2000)

Desired rate Rate at which rehabilitation/ replacement actually occurred 0
to 1 percent >1 to 2

percent >2 to 3 percent >3 to 4

percent > 4 percent Total Drinking water utilities

0 to 1 percent 87 8 2 1 2 100

>1 to 2 percent 64 23 5 1 6 100

>2 to 3 percent 42 33 17 1 8 100

>3 to 4 percent 32 45 4 14 6 100

>4 percent 35 14 5 5 41 100 Wastewater utilities

0 to 1 percent 85 8 1 1 4 100

>1 to 2 percent 47 40 7 4 3 100

>2 to 3 percent 51 23 18 2 6 100

>3 to 4 percent 35 39 10 4 12 100

>4 percent 28 23 7 6 36 100

Notes: In seeking information on utilities* desired and actual
rehabilitation and replacement rates, we asked the survey respondents to
provide separate answers for the percentage of pipeline subject to
rehabilitation and the percentage subject to replacement, to the extent
possible. For the purposes of this analysis, we added the percentages
together to get combined rehabilitation and replacement rates. Totals may
not add to 100 due to rounding.

Legend: Numbers are percentage of utilities within each category of
desired rehabilitation/ replacement rate. Shaded areas denote cases in
which utilities* actual rehabilitation and replacement of pipelines was
less than the utilities* desired rate.

Source: GAO*s analysis of survey data.

For replacement rates alone, we found that about 60 percent of the
drinking water utilities and 77 percent of the wastewater utilities
replaced 1 percent or less of their pipelines annually, on average, from
fiscal years 1998 through 2000. 12 At these rates, the utilities would
need at least 100 years to replace their entire inventory of pipelines.
These results are consistent with a 2001 study by the American Water Works
Association Research Foundation, which reported that at least 9 of the 15
North American utilities examined in the study replaced their water mains
at an annual rate ranging from 0. 1 percent to 1 percent. 13 According to
a

12 As noted earlier, for wastewater utilities, the information on pipeline
rehabilitation and replacement represents the information they reported
for the sanitary sewer lines. 13 American Water Works Association Research
Foundation, Financial and Economic Optimization of Water Main Replacement
Programs (Denver, Colo.: 2001), pp. 63* 81. For some utilities, the actual
replacement rate was unknown or not reported.

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 44 GAO- 02- 764 Water Utility Financing and Planning

1994 Research Foundation study, an estimated 4,400 miles of pipeline, or
0.5 percent of the estimated 880,000 miles of existing pipeline, were
being replaced annually. 14 The study concluded that utilities would
replace any given pipe only once every 200 years at the estimated
replacement rate and noted that no pipe has a 200- year life expectancy.

We also took a closer look at utilities with large percentages of
pipelines nearing the end of their useful life. Specifically, we examined
whether these utilities were any more or less likely than utilities with
small percentages of pipelines nearing the end of their useful life to (1)
have a preventive rehabilitation and replacement program or (2) achieve
their desired rehabilitation and replacement rate for their pipelines. We
found the following:

 Utilities with a large percentage of pipelines nearing the end of their
useful life were no more likely to have a preventive rehabilitation and
replacement program than utilities with a small percentage of pipelines
nearing the end of their useful life.

 Utilities with larger percentages of pipelines nearing the end of their
useful life were somewhat less likely to have achieved their desired
rehabilitation and replacement rate. More specifically, a larger
proportion of utilities with 20 percent or more of their pipelines nearing
the end of their useful life did not achieve their desired rates than
those with less than 20 percent of pipelines nearing the end of their
useful life (the estimates were about 80 percent and about 50 percent of
utilities, respectively). When we compared those having 50 percent or more
of their pipelines nearing the end of their useful life with those having
less than 50 percent nearing the end of their useful life, we found a
similar difference.

We asked the surveyed utilities whether, in their most recent fiscal year,
they had deferred maintenance, minor capital improvements, and/ or major
capital improvements as a result of insufficient funding. We found that
about one- third of the utilities deferred maintenance expenditures and
similar percentages of utilities deferred expenditures in the other
categories.

14 American Water Works Association Research Foundation, An Assessment of
Water Distribution Systems and Associated Research Needs (Denver, Colo.:
1994), p. xv. Many Utilities Deferred

Maintenance, Capital Improvements, or Both

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 45 GAO- 02- 764 Water Utility Financing and Planning

By size and type of ownership, we found the following:

 With one exception, there were no statistically significant differences
among utilities of different sizes. However, the smallest drinking water
utilities (serving populations of 10,001 to 25,000) were more likely to
defer maintenance and major capital projects than utilities serving
populations of 25,001 to 50, 000* an estimated 35 percent compared with 24
percent for maintenance and an estimated 47 percent compared with 33
percent for major capital projects.

 Public drinking water utilities were more likely than their privately
owned counterparts to defer maintenance (an estimated 31 percent compared
with 12 percent) and major capital projects (42 percent compared with 26
percent).

About 20 percent of utilities had deferred expenditures in all three
categories. Although we found no statistical differences among these
utilities based on population size, we found that public drinking water
utilities were more likely to defer all three than privately owned
drinking water utilities (an estimated 21 percent compared with 7
percent).

Utilities that deferred expenditures in all three categories because
available funding was not sufficient might also be expected to have other
indications of financial problems. However, we found no statistically
significant differences in the percentage of utilities that were unable to
cover their cost of providing service through local sources of revenue,
whether or not they deferred maintenance and capital improvements.
Similarly, we found only one significant difference when we compared the
frequency of rate increases among the utilities that deferred
expenditures: wastewater utilities that had deferred expenditures in all
three categories were somewhat more likely to have had frequent rate
increases (8 to 10 rate increases from 1992 to 2001) than no increases
during this period (an estimated 25 percent were in the first category,
compared with 11 percent in the latter). 15

15 For the latter two analyses, we also compared utilities that deferred
expenditures in all three areas with the utilities that had not deferred
expenditures in any of the categories. We found no statistical differences
in their ability to cover their cost of providing service or the frequency
of their rate increases.

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 46 GAO- 02- 764 Water Utility Financing and Planning

According to our survey, the large majority* about 90 percent* of
utilities had capital improvement plans to identify future capital needs,
and most also had plans for financing the projects identified. However,
almost half of the utilities anticipated that their projected funding
would not be sufficient to cover future needs over the next 5 to 10 years.

Utilities prepare capital improvement plans to identify future needs for
plant and equipment as a result of the rehabilitation and replacement of
existing infrastructure, compliance with regulatory requirements, and
growth. According to EPA and industry sources, such plans should contain
detailed information on all needed capital projects, the reasons for each
project, and their estimated cost, for a specified period of time. Experts
also agree that capital improvement plans should be updated on a regular
basis to reflect changes in existing circumstances. The projected
financing for needed capital projects should be identified and detailed in
the utility*s capital improvement plan, a separate financing plan, or some
other document, and ideally, should reflect several alternative scenarios
and their impact on user rates.

Overall, our survey results indicate that about 90 percent of drinking
water and wastewater utilities had capital improvement plans to identify
future capital needs. The smallest systems, serving 10,001 to 25,000
people, were slightly less likely than larger systems to have had such
plans (an estimated 86 percent for drinking water utilities and 81 percent
for wastewater utilities). Also, the survey results show that about 90
percent of utilities reviewed their needs annually* whether or not they
had developed formal plans.

Experts familiar with capital planning in the utility industry recommend
that capital improvement plans have a longer- term focus and cover a 5- to
10- year period, at a minimum. The industry handbook developed by the
Association of Metropolitan Sewerage Agencies recommends that utilities
also forecast system replacement and expansion needs for a much longer
period of time* even 50 to 100 years, if possible. 16 Our survey results
indicate that about 95 percent of the utilities* capital improvement plans
covered 5 years or more* with about 25 percent of drinking water

16 Managing Public Infrastructure Assets to Minimize Cost and Maximize
Performance,

pp. 133- 134. Most Utilities Had

Capital Improvement Plans, but Many Questioned Adequacy of Future Funding

Most Utilities Had Capital Improvement Plans

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 47 GAO- 02- 764 Water Utility Financing and Planning

utilities and about 20 percent of wastewater utilities covering 10 years
or more. The remaining utilities had plans covering 4 years or less.

Most of the drinking water and wastewater utilities with capital
improvement plans also had plans for financing the projects identified in
their plans. According to our survey, 86 percent of the utilities had such
plans, including virtually all of the largest utilities (those serving
populations of over 100,000). Utilities with financing plans were somewhat
more likely to dedicate a portion of their income to future capital needs.
Specifically, our survey results indicate that about 73 percent of the
drinking water utilities with plans considered future capital needs when
developing their user rates by dedicating a portion of their income to
future needs, while about 59 percent of the utilities without plans did
so. In the case of wastewater utilities, an estimated 78 percent of the
utilities with plans dedicated a portion of their income to future needs,
while about 48 percent of those without plans did so.

According to our survey results, about 45 percent of the drinking water
and wastewater utilities anticipated that their projected funding would
not be sufficient to cover future needs over the next 5 to 10 years. The
comprehensive industry handbook developed by the Association of
Metropolitan Sewerage Agencies recommends that drinking water and
wastewater utilities use a detailed financial planning window of at least
5 to 10 years to provide for future capital needs. However, the handbook
notes that some utilities have a very narrow time line for financial
planning; while such utilities may identify their future capital needs
over a 5- to 10- year period, they only address detailed financial
forecasting as part of their annual budget development process.

By utility size and type of ownership, we found the following:

 Drinking water utilities serving populations of 10,001 to 25, 000 and
50,001 to 100,000 were more likely to believe that their projected
revenues will be insufficient to cover anticipated future needs than the
utilities serving over 100,000 people (an estimated 47 percent for the
smaller population groups compared with 35 percent for the largest
population group).

 There were no statistically significant differences among wastewater
utilities of different sizes.

 Public drinking water utilities were somewhat more likely than privately
owned systems to have concerns about future funding (an estimated 44
percent compared with 33 percent). Most Utilities Had Plans

for Financing Capital Needs, but Many Questioned Whether Funds Would Be
Adequate

Chapter 3: Many Utilities Lacked Comprehensive Asset Management Plans, but
Most Had Identified Future Capital Needs

Page 48 GAO- 02- 764 Water Utility Financing and Planning

We also looked at the relationship between the extent to which utilities
anticipated that their projected funding will be adequate to meet future
needs and a number of other key variables related to funding. As table 6
shows, we found that both drinking water and wastewater utilities that
anticipated that future funding will be inadequate were significantly more
likely to have deferred maintenance, minor capital expenditures, or major
capital expenditures in recent years compared with utilities that
anticipated adequate future funding.

Table 6: Relationship between Adequacy of Projected Funding to Meet Needs
Over the Next 5 to 10 Years and Other Key Variables Related to Funding

Drinking water utilities Wastewater utilities Key variables (percentage of
utilities reporting in each category)

Anticipated funding would

not be adequate to

meet future needs

Anticipated funding would be adequate to

meet future needs

Anticipated funding would

not be adequate to

meet future needs

Anticipated funding would be adequate to

meet future needs

Deferred maintenance in most recently completed fiscal year

49 15 47 14 Deferred minor capital improvements in most recently completed
fiscal year

53 20 50 20 Deferred major capital improvements in most recently completed
fiscal year

63 24 57 20 Increased rates 1- 2 times or not at all from1992 to 2001

53 51 54 50 Dedicated portion of income from user charges to future
capital needs

66 71 65 76 Note: Numbers are estimated percentages of utilities that meet
both row and column criteria. Source: GAO*s analysis of survey data.

Chapter 4: Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities

Page 49 GAO- 02- 764 Water Utility Financing and Planning

In making decisions to enter into privatization agreements with publicly
owned utilities or the governmental entities they serve, the private
companies we contacted primarily focus on a venture*s potential to
generate profits for the company. In assessing profit potential, the
companies cited several specific criteria, such as the extent of
opportunities to enhance operational efficiency, the utility*s proximity
to the companies* existing operations, and the potential for system
growth. They also noted that state policies can influence privatization
agreements. For example, two states that we contacted restrict the use of
design- buildoperate contracts, which give a single entity complete
control over a project. Other states offer incentives to encourage the
takeover of financially troubled public utilities.

Privatization agreements range from contracts to operate and maintain
drinking water or wastewater facilities to outright ownership by private
entities. Regardless of the specific type of agreement, the companies we
contacted all evaluate the potential for profits when considering entering
into privatization agreements. Each of the five companies employs a
somewhat different business strategy in its pursuit of privatization
agreements, such as placing more emphasis on contract operations rather
than on ownership of utilities or focusing on utilities of particular
sizes or in particular locations. While none of the companies would
consider entering into a privatization agreement without the potential to
make a profit, differences in the companies* business strategies had some
influence on the relative importance of the factors company officials
cited as affecting profit potential.

Privatization can take different forms, ranging from contracting for
specific services to selling the facilities to a private company. The most
common form of privatization is contracting, which typically entails a
competition among private bidders to perform certain activities. In the
case of drinking water and wastewater utilities, such activities typically
include operation and maintenance for a set period of time. When a
municipality contracts with a private company for services, the government
or public entity remains the financier and has management and policy
control over the quality of services to be provided. According to an
official at one of the largest companies we contacted, the most common
type of public- private partnership in the field of drinking water and
wastewater utilities has historically been operations and maintenance
contracts covering from 1- to 5- year periods. Chapter 4: Profit Potential
Is Key Factor

in Private Companies* Decisions to Assume Operation or Ownership of
Utilities

Profit Potential Is Key Consideration for Private Companies

Companies Engage in Different Types of Privatization Arrangements

Chapter 4: Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities

Page 50 GAO- 02- 764 Water Utility Financing and Planning

A variation of this type of contractual arrangement is called *design-
buildoperate,* in which a private company (or a team of companies)
designs, builds, and operates a facility under one agreement. Under this
model, the local government retains ownership of the utility once it has
been constructed and the contractor is responsible for operation and
maintenance over the life of the contract, often a long- term agreement of
10 to 20 years.

In some instances, privatization involves transferring the ownership of
utility assets from a municipality to the private sector. Once the assets
have been sold, the municipality generally has no role in their financial
support, management, or oversight. Collectively, the companies we
contacted are involved in all of these types of privatization agreements.

According to officials of the five companies, criteria important to
assessing the profitability of a proposed agreement to privatize a utility
include the potential to improve the efficiency of the utility*s
operations; the proximity to the company*s other utility operations; the
potential for system growth; the terms of a proposed contract; and the
potential need for capital investments. The relative importance of the
factors varies, depending on the companies* business strategies.

All five of the companies saw the opportunity to improve the efficiency of
a utility*s operations as a key factor in evaluating candidates for
privatization because of its potential impact on the companies* ability to
make a profit. For example, in two cases, company officials said that
operating efficiency can be improved by either reworking resources already
in place (e. g., training workers or correcting inefficient practices) or
investing in cost- effective improvements (e. g., computerizing operations
or installing energy- efficient equipment). Officials in two other
companies commented that the potential for correcting operational
inefficiencies exists because public utilities often lack the financial or
technical capabilities of companies that are in the business of assuming
the operation or ownership of drinking water and wastewater utilities.

Officials of one company said that they focus on three major cost areas in
looking for ways to increase efficiency: employees, energy, and chemicals.
The officials acknowledged that dealing with employees can be sensitive
because of concerns about potential job losses; thus, the savings in this
area typically come about as a result of attrition or retraining. Energy
consumption is a target of operational improvements because it accounts
for about one- third of the average utility*s operating costs. Because
Companies Cite Several

Criteria for Evaluating Ventures* Profit Potential

Chapter 4: Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities

Page 51 GAO- 02- 764 Water Utility Financing and Planning

chemicals are also a major cost element, utilities can achieve significant
savings through bulk purchases.

At drinking water utilities, another area with significant potential for
cost savings is the reduction of *unaccounted for* water. This water
represents the difference between the volume of water that leaves the
treatment works and the volume that is *metered* (that is, used by
customers according to their water meters). For example, utilities may
experience leaks in their water distribution systems. According to an
official of one of the largest companies we contacted, it is not uncommon
for many communities to be unable to account for 25 percent or more of the
water they produce.

The companies provided examples of the types of operational improvements
that have resulted in cost savings or increased revenues:

 At a California drinking water utility, a company worked with state
regulatory authorities to reduce the utility*s requirements to monitor
water quality, thus achieving over $200,000 savings in annual laboratory
costs.

 At another utility, also in California, the company introduced
improvements that reduced energy consumption by 13 percent and certain
treatment costs by 22 percent.

 At a Georgia utility, the same company implemented a leak detection
program that reduced unaccounted for water from 60 percent to 30 percent.

 Another company helped a Massachusetts wastewater utility to improve the
treatment process and modify the utility*s incinerator, which reduced
incineration costs by about 75 percent.

 At a Texas drinking water utility, a meter replacement program is
projected to increase water revenues by $1 million over 10 years.

Other criteria cited by the companies for evaluating profit potential of
privatization opportunities include the following:

 Proximity to the companies* existing operations. Four of the five
companies we contacted consider the utilities* proximity to their other
operations when they decide whether or not to pursue a public- private
partnership. In one case, company officials told us that their preference
is to add new business in close proximity to existing operations because,
among other things, the company*s technical experts can make site visits
at a reasonable cost. Officials from the other companies indicated that
proximity to existing operations allows them to take advantage of
economies of scale. For example, certain commonly used products and

Chapter 4: Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities

Page 52 GAO- 02- 764 Water Utility Financing and Planning

equipment such as chemicals, pipe, and meters can be purchased in bulk at
lower costs and, with an expanded service area and customer base, the
companies can spread the costs over more customers. An official from one
of the companies commented that proximity is more of a consideration in
the case of smaller utilities because they get more of a benefit than
larger systems from sharing staff and other resources.

Increasing efficiency through economies of scale may be more difficult,
however, in the case of relatively small and isolated utilities. According
to an official of the National Association of Water Companies, a plan to
consolidate several small, remote utilities probably would not be
costeffective where miles of pipelines were needed, for example, to
connect the remote utilities. On the other hand, he noted that there are
ways that privatization agreements with such utilities can be profitable.
For example, private companies can bring in professional management
expertise to oversee multiple utilities, use a limited number of system
operators to run several small utilities that do not require full- time
operators, and consolidate purchases of equipment and chemicals to get
better prices.

 Potential for system growth. The projected growth in the population
served by a utility* its customer base* was also mentioned as a factor by
several companies. Officials from one company told us that projected
population growth allows the company to increase its customer base and
thus be assured of additional revenues. According to officials of another
company, a utility*s growth potential is more of a consideration when the
privatization opportunity involves a smaller utility. The officials
indicated that they examine this factor more closely at smaller utilities
because these utilities may have to grow before they become profitable.
According to an official of the National Rural Water Association, private
companies generally consider public water systems serving rural, low-
density populations an unattractive investment. Further, according to an
official of the Kansas Rural Water Association, small towns often have
relatively high water and sewer rates as well as a greater proportion of
households with lower median incomes. 1

1 Testimony of Elmer Ronnebaum, General Manager of the Kansas Rural Water
Association, before the Subcommittee on Fisheries, Wildlife, and Water,
Senate Committee on Environment and Public Works, February 28, 2002.

Chapter 4: Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities

Page 53 GAO- 02- 764 Water Utility Financing and Planning

 Terms of operation and maintenance contracts. Three of the companies
told us that, in the case of operation and maintenance agreements, the
length of time covered by a proposed contract is a key factor in their
decisions. Generally, the longer the time period covered by the contract,
the more time the company has to recoup its investment. According to an
official at one of the largest companies we contacted, over the past 2
years the number of longer- term contracts has increased markedly, partly
because of the increased use of design- build- operate contracts. The
official also cited two examples of restrictive contract provisions that
his company views as deal breakers. First, he said that some communities
insist on unlimited liability guarantees from companies that bid on
privatization contracts; however, responsible companies have to limit
their liability. Second, restrictive maintenance provisions can impose a
ceiling* typically $10,000* on a contractor*s responsibility for
maintenance items. According to the company official, this kind of
restriction limits a company*s ability to offer comprehensive solutions,
which could be more cost- effective over the long term.

 The potential need for capital investment. The extent to which companies
foresee a need to invest their funds to repair, replace, or upgrade
utilities* plant and equipment can affect whether they enter into an
agreement or what type of agreement they enter. Officials from several
companies indicated that the condition of a utility*s infrastructure is
not a deterrent as long as the amount and nature of any investment needs
are accurately reflected in the contract and the company is fairly
compensated. One official commented that it is difficult to operate a
utility as a contractor when the company has no control over the level of
capital investment* and the level has not been adequate. In these
situations, his company has tried to become more involved in developing
capital improvement plans for the utilities they manage and to assume more
responsibility for capital investments in general. The same official also
commented that even if the condition of a utility*s infrastructure is
adequate, company officials may determine that a substantial investment
will be required just to make the utility more efficient.

 Other factors. For drinking water utilities, officials of two companies
noted the importance of a reliable water source. For example, according to
one of the companies, an unreliable source limits profit potential because
it can be costly to purchase water from other systems or develop a new
source. For wastewater utilities, two companies pointed out that the
presence of large quantities of industrial waste in the influent (the
water flowing into the treatment facilities) can be a deterrent to an
agreement. For example, one company official noted that industrial waste
can

Chapter 4: Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities

Page 54 GAO- 02- 764 Water Utility Financing and Planning

increase treatment costs as well as pose a potential liability issue for
the facility owner or operator.

In addition to identifying the site- specific factors they consider in
evaluating privatization opportunities, representatives from all five of
the companies we contacted also commented on state requirements or
policies that can facilitate or impede privatization arrangements. We
contacted officials of eight states identified by the five companies, EPA,
and industry officials as having particular requirements or policies that
affect privatization, either positively or negatively. Our contacts
included representatives from the state agencies that oversee the drinking
water and wastewater management programs and the public utility
commissions, which regulate the rates and other activities of privately
owned (and, in some cases, publicly owned) utilities. The state officials
told us that their agencies are primarily interested in the delivery of
adequate service to the public, whether the service is provided by
publicly or privately owned utilities. However, the states have some
requirements and policies that can affect companies* privatization
decisions, including laws that address the acquisition of *troubled*
utilities 2 and the use of design- build- operate contracts.

State regulators in Indiana and Pennsylvania have established programs
that provide utilities in good standing with incentives to acquire or take
over troubled utilities. For example, under Indiana*s program, the
acquiring utility is permitted to add an *acquisition adjustment* to its
user rates as an incentive for taking over a troubled utility. Similarly,
Pennsylvania*s incentive program allows, under certain circumstances, the
acquiring utility to increase the rate of return on its investment and
thus, accelerate the recovery of costs incurred for needed system
improvements. This program targets small utilities that lack the
financial, managerial, and/ or technical capacity to comply with
applicable regulatory requirements. To encourage faster replacement of
aging water distribution systems, Pennsylvania also established a special
pipe surcharge program* the Distribution System Improvement Charge
Program* in which companies make improvements to utilities* distribution
systems. In return, the companies are allowed to raise rates by up to 5
percent without going through a formal hearing process.

2 Under some state laws, either public or privately owned utilities may be
the *acquiring

utility; in other cases, state law specifies that the acquiring utility
must be privately owned.* States* Policies May

Also Influence Companies* Decisions

Chapter 4: Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities

Page 55 GAO- 02- 764 Water Utility Financing and Planning

In addition to the incentive programs, four of the eight states we
contacted* Connecticut, Indiana, New Jersey, and Pennsylvania* have
enacted laws that give state regulators the authority to provide for
qualified utilities to acquire or take over certain *troubled* utilities
to resolve specific problems. For example, in New Jersey, the state may
order the acquisition of small drinking water or wastewater utilities
(with less than 1,000 connections) by a suitable public utility or a
privately owned company if the small utilities fail to comply with an
enforcement order. In New Jersey and the other states, the orders are
directed at serious violations involving, for example, the availability,
potability, or provision of water at adequate volume or pressure or the
failure to remedy

*severe deficiencies.* While these laws could affect companies*
privatization decisions by compelling the takeover of particular
utilities, state officials indicated that the laws are rarely used.

Other state requirements or policies can affect the use of design-
buildoperate contracts, which couple the design and construction of new,
expanded, or upgraded facilities with comprehensive agreements to operate
and maintain the facilities. For example, Texas officials told us that
professional services such as engineering design must be procured using a
qualification- based selection while construction services must be
procured using a bidding process. As a result, the design, construction,
and operating services cannot be combined in a single procurement. The
situation in Pennsylvania was similar; a state official told us that the
state*s procurement regulations have not been updated to allow the kind of
combined procurement contemplated in a design- build- operate contract. In
other instances, state laws can also facilitate the use of design-
buildoperate contracts. For example, Georgia amended its official code in
2000 to specifically authorize local governments to enter into contracts
with private entities *for the design, construction, repair,
reconditioning, replacement, maintenance, and operation of the system, or
any combination of such services* at drinking water or wastewater systems.

We also identified certain requirements that could affect companies*
privatization decisions and are specific to individual states. For
example, New Jersey law requires that privatization proposals be approved
by the applicable state agency. Among other things, state regulators
assess the financial and technical capacity of the private company; the
reasonableness of the contract terms; the extent to which the interests of
utility customers are protected; and whether the particular contract
terms, such as user charges and the status of current utility employees,
are clearly spelled out. In addition, under California law, sales

Chapter 4: Profit Potential Is Key Factor in Private Companies* Decisions
to Assume Operation or Ownership of Utilities

Page 56 GAO- 02- 764 Water Utility Financing and Planning

of drinking water and wastewater systems must be approved by voters in the
affected community.

Appendix I: Survey of Drinking Water Utilities

Page 57 GAO- 02- 764 Water Utility Financing and Planning

Appendix I: Survey of Drinking Water Utilities

Appendix I: Survey of Drinking Water Utilities

Page 58 GAO- 02- 764 Water Utility Financing and Planning

Appendix I: Survey of Drinking Water Utilities

Page 59 GAO- 02- 764 Water Utility Financing and Planning

Appendix I: Survey of Drinking Water Utilities

Page 60 GAO- 02- 764 Water Utility Financing and Planning

Appendix I: Survey of Drinking Water Utilities

Page 61 GAO- 02- 764 Water Utility Financing and Planning

Appendix I: Survey of Drinking Water Utilities

Page 62 GAO- 02- 764 Water Utility Financing and Planning

Appendix I: Survey of Drinking Water Utilities

Page 63 GAO- 02- 764 Water Utility Financing and Planning

Appendix I: Survey of Drinking Water Utilities

Page 64 GAO- 02- 764 Water Utility Financing and Planning

Appendix I: Survey of Drinking Water Utilities

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Appendix I: Survey of Drinking Water Utilities

Page 66 GAO- 02- 764 Water Utility Financing and Planning

Appendix II: Survey of Wastewater Utilities Page 67 GAO- 02- 764 Water
Utility Financing and Planning

Appendix II: Survey of Wastewater Utilities

Appendix II: Survey of Wastewater Utilities Page 68 GAO- 02- 764 Water
Utility Financing and Planning

Appendix II: Survey of Wastewater Utilities Page 69 GAO- 02- 764 Water
Utility Financing and Planning

Appendix II: Survey of Wastewater Utilities Page 70 GAO- 02- 764 Water
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Appendix II: Survey of Wastewater Utilities Page 71 GAO- 02- 764 Water
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Appendix II: Survey of Wastewater Utilities Page 72 GAO- 02- 764 Water
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Appendix II: Survey of Wastewater Utilities Page 73 GAO- 02- 764 Water
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Appendix II: Survey of Wastewater Utilities Page 74 GAO- 02- 764 Water
Utility Financing and Planning

Appendix II: Survey of Wastewater Utilities Page 75 GAO- 02- 764 Water
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Appendix II: Survey of Wastewater Utilities Page 76 GAO- 02- 764 Water
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Appendix II: Survey of Wastewater Utilities Page 77 GAO- 02- 764 Water
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Appendix III: GAO Contacts and Staff Acknowledgments

Page 78 GAO- 02- 764 Water Utility Financing and Planning

Ellen Crocker, (617) 565- 7469 Lisa Turner, (202) 512- 6559

In addition to the individuals named above, Wendy Ahmed, Mark Connolly,
Teresa Dee, Laura Greene, Jerry Laudermilk, Grant Mallie, and Laura
Shumway made key contributions to this report. Important contributions
were also made by Ulana Bihun, Stuart Kaufman, Karen Keegan, Jonathan
McMurray, Mehrzad Nadji, Carol Herrnstadt Shulman, and the staff in GAO*s
Shared Services Center. Appendix III: GAO Contacts and Staff

Acknowledgments GAO Contacts Acknowledgments

(360152)

The General Accounting Office, the investigative arm of Congress, exists
to support Congress in meeting its constitutional responsibilities and to
help improve the performance and accountability of the federal government
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