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“When & How Will Deregulation Come to the

Water Industry?The California Experience”

Henry M. DuqueCommissioner of the California Public Utilities Commission and

Chair of the Water Committee of the National Association of Regulatory Utility Commissions

presented to

The New York Society of Security Analysts

December 10, 1999

New York, New York

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Background on California Water Industry

1998 Sales of Approximately $674 Million.Approximately 5.5 million Californians served by private water companies.Ten largest companies had revenues of $654 and serve over 5.3 million Californians. Approximately 160 companies serve the remaining .2 million.Range of Financial Benchmarks for 1998, 1999, 2000:

Recently adopted ROE’s 9.55-10.35%.Recently adopted ROR’s 8.2 - 9.6%.Embedded Cost of Debt 8.2-8.8%.

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Will Cost-of-Service/Rate-of-Return Regulation Continue for

Water Utilities?

Historically, regulation designed for:

Capital intensive infrastructure.Operations that have large safety or health consequences.Efficient production exploits scale economies and core technology promotes monopoly service provision.

Water industry still has this economic profile:Match between regulation and industry economics continues.

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Will Water Follow the Pattern of Other Utilities, such as Railroads,

towards Deregulation?

Water Industry differs from Railroad Industry:

Loss of coal transport had critical impacts on railroads. Coal would frequently account for almost 30% of rail transport demand, and there were limited transport alternatives (e.g. barges)

Per capita demand for water remains steady or declines moderately; aggregate demand grows with population.

Railroads now compete with trucks to provide generic transport services.

Water industry still lacks competition from any other technology for delivering water.

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Will Water Industry Follow the Telecommunications Industry towards

Deregulation?Water Industry differs from Telecommunications Industry:

In the telecommunications industry, technological change has produced competition in loops and switching:

RBOCs and GTE -- twisted copper/DSLAT&T and Cox -- coaxial cable/Cable ModemsWorldCom (Sprint/MCI) -- radio access/microwave

Water industry has benefited from only modest technological change.

Telecommunications industry faces declining costs -- new investments lower prices. This makes “price cap” regulation an attractive alternative.Water industry faces increasing costs:

EPA estimates that nationally, drinking water treatment and pipe replacement will require $138-$330 billion of new investment in next 20 years. Regulatory scrutiny remains appropriate. In water, “price cap” regulation would create incentive to reduce investment.

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Will the Water Industry Follow the Electric Industry to

Deregulation?Water Industry differs from Electricity Industry:

Wholesale generation of electricity is competitive and accounts for a large portion of service costs (50%).Wholesale supply of water is not competitive, and accounts for smaller percentage of service costs (10-20%).

Where water industry resembles the electric industry, regulation still prevails:Distribution wires of electric industry resemble distribution pipes of water industry in economic characteristics (capital intensive, economies of scale).Electric distribution is a monopoly regulated by traditional cost-of-service/ rate-of-return regulation.

Nevertheless, a wholesale market for water could develop.

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Water Industry Has Had LittleTechnological Change or Competition

Technology has remained stable since Roman times:Gravity is chief obstacle to water delivery and best source of delivery pressure.

Aqueducts carry water from distant sources to population centers.Local distribution occurs through buried pipes.(Caveat: Dropping costs in desalination may affect both supply and transport picture dramatically).

Cost structure precludes competition:Cost of pipe replacement or initial placement is very high and accounts for 80% of the price of water. This prohibits a duplicative system using the same technology.Pipe laid at $2 per linear foot costs $100 to $200 a linear foot to replace depending on urban density. Green field construction is about $60 per linear foot.

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What is Happening in Water Regulation in California?

Many things remain to make California water utilities a strong and stable investment opportunity:

Replacement of aging infrastructure will require new investment and financing.Meeting the treatment requirements of the Safe Drinking Water Act Amendments will require a round of investment.Strong regulatory case law should ensure fair, market-based returns.Rising prices will create new political and regulatory risks for investors and may induce a movement from “district” rates to “regional rates.”

Wholesale Market Developments:Monopolistic pricing of water transport by government agencies controlling key aqueducts is triggering legislative scrutiny.

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What is New in California Water Regulation?

California enacted legislation, effective 1/1/99:Its purpose was to encourage the consolidation of water companies into units capable of addressing the new financial, technical, and managerial challenges facing the industry.Its strategy was to change the standard for the regulatory review of acquisition price from “book value” to “fair market value.” This standard tempered by “public interest” criteria.

Results appear significant:Acquisition prices now a multiple of book value -- small company sales range widely from 2 to 6+ times book. In past, sales were often for $1.About 50 small companies were acquired in last year.Large companies are also consolidating:

Cal Water Service (CWT) is acquiring Dominguez (DOMZ) at 1.6 times book.American Water Works (AWK) is acquiring San Jose Water (SJW) and Citizen’s California operations.Bidding includes foreign firms.

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What Drives the California Water Picture?

Water Law and Water Allotments:Use it or lose it.Agriculture holds and uses about 80% of the water.Water rights not always readily transferable.

Existing Infrastructure:Some aqueducts and river systems are key to California’s water movement:

Sacramento R., California Aqueduct, Federal Aqueduct, Colorado River Aqueduct, and All American Canal.

Other aqueducts lack strategic value:Hetch Hetchy, EBMUD, LA aqueduct.

Geography of mountains, agricultural valleys, deserts and coastal population centers.Rainfall

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California WaterPicture

Water in NorthPeople in SouthSacramento RiverCalifornia AqueductFederal Water Project Colorado River

AqueductLA AqueductAll American CanalPacific Ocean

Desalination

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Potential Developments with Economic Consequences

Federally mandated reductions of California water draws from Colorado River to meet Arizona’s claims spurring a search for new sources.

The “Peripheral Canal” Redux. Environmental constraints on Delta Pumping are under reexamination in the Cal-Fed project.

Shift water from agriculture to urban uses, e.g. Bass brothers/U. S. Filter’s (Vivendi) Imperial Valley play.

Attack water transport monopolies: San Diego’s efforts to gain economic transport on the Colorado River Aqueduct, pending legislation, and the role of the All American Canal.

Looking for opportunities from policies in flux: Azurix investment in water storage fields in Madera County.

Observation: A wholesale water market could develop involving strategic holdings by Azurix or Vivendi.

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Conclusions: Deregulation When and How?

Deregulation will not seriously affect the Private Water Industry soon.Deregulation and “price cap” regulation will not work -- performance contracting possible.Investment Opportunities in Water Will Abound:Many Lower Risk Ventures Continue:

Investments in water utilities and utility bonds should earn market returns based on traditional cost-of-service/rate-of-return regulation.Investment opportunities will arise from infrastructure renewal and EPA mandates water treatment technologies.

Higher Risk Ventures Becoming Possible:Recent California legislation is highly supportive of mergers and consolidations, and its consequences are now being felt.The demographics and geography of California continue to make the combination of water rights and water transport to population centers a highly valuable and strategic asset.