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PWSA Restructuring Assessment Phase
Task 5 Report: Restructuring Options and Recommendations
November 27, 2017
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Table of Contents I. OVERVIEW 4
II. INTRODUCTION .............................................................................................................................. 72.1. The IMG Team’s Assignment ......................................................................................................... 72.2. Utility Restructuring Principles ........................................................................................................ 92.3. Restructuring Options and Supporting Analyses ............................................................................ 9
III. SUMMARY OF FINDINGS FROM TASKS 1-4 ...................................................................................... 103.1. Governance .................................................................................................................................. 103.2. Resources .................................................................................................................................... 103.3. Recent Improvements .................................................................................................................. 103.4. Finances ....................................................................................................................................... 11
IV. COMMUNITY AND STAKEHOLDER OUTREACH ................................................................................. 124.1. Overview ...................................................................................................................................... 124.2. Community Workshop .................................................................................................................. 134.3. Green Infrastructure ..................................................................................................................... 14
V. THE RESTRUCTURING OPTIONS .................................................................................................... 155.1. Baseline (Status Quo) Path .......................................................................................................... 155.2. Option A: Public Charitable Trust ................................................................................................. 165.3. Option B: Assisted Internal Improvement ..................................................................................... 185.4. Option C: Operations and Maintenance Contract ........................................................................ 215.5. Option D: Infrastructure-Only Lease Concession ......................................................................... 235.6. Option E: Full Service Lease Concession .................................................................................... 265.7. Option F: Transfer to a Regulated Investor-Owned Utility ............................................................ 28
VI. EVALUATION CRITERIA ................................................................................................................. 31
VII.RATEPAYER IMPACT ANALYSIS ..................................................................................................... 347.1. Overview ...................................................................................................................................... 347.2. Restructuring Options Examined .................................................................................................. 347.3. Drivers of Ratepayer Impact ......................................................................................................... 357.4. Methodology ................................................................................................................................. 367.5. Results ......................................................................................................................................... 39
VIII.RECOMMENDATIONS .................................................................................................................... 438.1. Overview ...................................................................................................................................... 438.2. Three Pillars of the Restructuring ................................................................................................. 448.3. Recommendations ....................................................................................................................... 45
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8.4. Conclusions .................................................................................................................................. 50
Table of Figures
Figure 1: Scope of Work ................................................................................................................................... 7
Figure 2: IMG Team Organization and Task Responsibilities .......................................................................... 8
Figure 3: Project Website used for Community Outreach .............................................................................. 12
Figure 4: Community Workshop ..................................................................................................................... 13
Figure 5: Values used in Community Values Exercise ................................................................................... 13
Figure 6: Most important values as defined by community stakeholders ....................................................... 14
Figure 7: Creation of the Public Trust in 5 Steps ............................................................................................ 17
Figure 8: Assisted Internal Improvement scenario ......................................................................................... 20
Figure 9: O&M Contract ................................................................................................................................. 22
Figure 10: Infrastructure-Only Lease Concession .......................................................................................... 24
Figure 11: Full-Service Lease Concession ..................................................................................................... 27
Figure 12: Transfer to a Regulated Investor-Owned Utility ............................................................................ 28
Figure 13: Example Evaluation Criteria .......................................................................................................... 31
Figure 14: Revenue Requirement for Baseline Status Quo scenario ............................................................. 40
Figure 15: Availability-Payment Structure in the Lease Arrangement ............................................................ 46
Figure 16: Proposed Timeline for Restructuring Process ............................................................................... 49
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I. Overview Infrastructure Management Group (IMG) has been tasked by the City to assess PWSA’s performance and organizational issues, evaluate restructuring options, recommend a preferred path, and assist with its implementation. This report summarizes the findings of Task 5 of the Assessment Phase scope of work: evaluation of the options and recommendations for a path forward.
IMG consulted with City officials and Blue Ribbon Panel members to select evaluation criteria for the restructuring options and integrate considerations that are consistent with the citizenry’s hopes for the utility. These include keeping water and sewer rates as low as possible while providing uncompromising assurance that service will be improved and the public’s health protected. These weighed heavily in IMG’s evaluation, along with lessons learned from water utility restructurings across the country. These lessons learned included the following:
1. DURABILITY: Dramatic performance improvement of the type required for PWSA is difficult to guarantee without an enforceable contract mechanism that outlasts the tenure of the governing board members and the executive management. Most utilities threatened by an ambitious restructuring – specifically, one that could replace the personnel at the senior decision-making level – often improve in the short term, but in the years thereafter gradually retreat toward the pre-threat operating norm.
2. INSTITUTIONAL INERTIA: Process automation and information technologies improve the likelihood that performance improvements will be sustained, but other institutional factors (e.g., political pressure to hold down rates below levels required for adequate infrastructure management, lapses in maintaining new business processes, poor inter-agency support services, and outdated hiring practices, among many) tend to undermine even these hard-wired advances.
3. INFRASTRUCTURE RISK: Infrastructure-replacement needs often overwhelm the value of organizational and operating process improvements. In PWSA’s case, that risk is particularly acute for ratepayers, as the enormous cost of capital improvements will be the largest driver of rate increases. Accordingly, advanced infrastructure development, maintenance, and asset-management practices—more so than improved operations—will be needed to keep rates affordable for Pittsburgh’s working families.
4. OVERSIGHT v. DIRECTION: State-oversight bodies can provide a valuable impetus for reform, but their expertise and authority lie in ratemaking, not in operational processes and infrastructure management. While they may be useful political shields for major rate increases, they are not structured to guide failing utilities out of their predicaments.
5. PLANNING AND EXECUTION: Impactful improvement programs – the kind required for a failing utility -- must be all-encompassing and implemented under a comprehensive reform plan; that is, the reforms cannot be made piecemeal if they impose a sustained turnaround in performance, operating culture, and quality of service. Moreover, almost any dramatic improvement plan is certain to interfere with the agendas of those attached to the status quo—whether within the utility’s staff, the City, or the governing board. The inevitable opposition needs to be addressed through larger institutional reform.
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Three Pillars of the Restructuring
The abovementioned considerations highlight why IMG’s recommendation begins with institutional reform and extends through binding operations and infrastructure management. Only this combination will guarantee to Pittsburgh’s citizens and businesses that PWSA’s problems will be rectified, permanently.
The legal and ratepayer-impact assessments conclude that transfer to an existing regulated investor-owned water utility would be the lowest-cost and most durable restructuring solution for Pittsburgh’s household ratepayers—one with widespread support as well as earnest opposition among the city’s diverse stakeholders. Nevertheless, we believe it is possible to structure a powerful reform path that aggressively addresses PWSA’s organizational and infrastructure issues in a contractually-guaranteed fashion, all while preserving public ownership, operations and rate-setting.
This innovative approach consists of three mutually-supporting components:
1. GOVERNANCE: Consistent with the State Auditor General’s findings on PWSA’s problematic governance, IMG recommends that the City’s ownership of the water and sewer infrastructure, along PWSA’s governance and rate-setting responsibilities, be transferred to a newly-created Pittsburgh Public-Infrastructure Trust. The Trust would be governed by a self-perpetuating Board of Trustees and managed by a Board of Directors appointed by the Trustees, not by City officials. This Trust could also serve as the regional foundation for other self-funded capital-intensive public enterprises. It would set water and sewer rates (under the oversight of the Public Utilities Commission, hereafter PUC) and contract with the public operator for operations and customer service and with a private partner for infrastructure management.
2. OPERATIONS: As noted above and throughout this report, major operational improvements are challenging to implement but even harder to sustain for an organization with PWSA’s history. IMG’s recommendation addresses these risks by making operational reform part of a three-way contractual obligation among the Trustees, the public operator (presumably PWSA or an operating component of the Trust) and an infrastructure management partner (see #3 below). Specifically, the public operator would be subject, via contract, to the same stringent performance standards—established by the other two parties of the agreement—as a private contract operator. Failure to consistently abide by those standards would subject the operator to sanctions at the discretion of the Trustees. This operating-performance guarantee is as important to the Trust as ithe success of the infrastructure-management partner.
3. INFRASTRUCTURE: As problematic as PWSA’s operations have been, its enormous infrastructure needs will be the overwhelming driver of water and sewer rates. PWSA’s capital program is nearly on the scale of Boston’s Central Artery/Tunnel Project (“Big Dig”, 1982-2006, initially budgeted at $2.8 billion and eventually completed for $14.8 billion) and Honolulu’s rail transit project (originally budgeted at $4.4 billion in 2010, now expected to exceed $9.5 billion). Large water and sewage treatment plant projects have a better history of being delivered closer to budget. Large underground projects (water and sewer lines, and especially underground stormwater storage facilities) like PWSA’s, however, have a notably
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worse record. In Rockland County New York, for example, a $72 million sewer line project recently escalated to $181 million with a 17-year timetable. Such cost overruns emphasize the need for an alternative that shifts the risk away from the rate-paying public. Accordingly, the third pillar of IMG’s reform recommendation is to execute PWSA’s looming capital improvement and asset management liabilities via a long-term lease arrangement.
Implementation Sequence
The restructuring process would begin with the creation of the Public Trust and appointment of an initial Trustee to oversee the restructuring process. This Trustee would be granted a small temporary staff and broad authority to initiate the restructuring process (e.g., begin the transfer of City-owned water assets into the Public Trust and issue a Request for Expressions of Interest or RfEOI for the infrastructure-lease concession) and address urgent problems until the full Board of Trustees is appointed. The Trustee would also be the primary liaison with the State PUC (assuming PUC oversight begins in April of 2018).
PWSA and its board would continue their current roles under the oversight of the Initial Trustee until: (1) the assets are transferred from City ownership to the Public Trust; (2) PWSA can be converted to an operations-only entity; and (3) the Trustees have completed an agreement with a private partner responsible for the capital-improvement program and asset management (ongoing capital projects would continue with the new partner serving as the program manager).
The Trustees would then appoint a Board of Directors to manage the Public Trust’s day-to-day activities while the Trustee’s role would be reduced to high-level governance, appointing its own members as their terms expire, and other duties similar to the Indianapolis model (discussed further in this report). In addition to being responsible for setting rates, liaising with the PUC, and assuring service quality, the Public Trust would oversee the public operator and private-asset manager under arms-length contracts with high performance standards and sanctions—including the option to terminate for poor performance.
Conclusions
As this report explains, each of the restructuring options has its advantages, and each has its own viable form of public accountability and quality-assurance mechanisms, some stronger than others. However, PWSA’s organizational problems are large and long-standing, and its infrastructure needs threaten to overwhelm the pocketbooks of the city’s water and sewer ratepayers. Business as usual, even along the current improvement path, is simply insufficient against these enormous challenges.
IMG has recommended a combination approach, one that maintains public ownership, operations, and rate-setting while selecting the most beneficial aspects of each restructuring option and forging them into a powerful synthesis, one that relies on politically-independent governance and contract-driven public and private performance. We believe this “best of the best” approach will not only solve PWSA’s persistent organizational and performance problems durably and efficiently but also enhance Pittsburgh’s national reputation as a leader in public-service innovation.
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II. Introduction 2.1. The IMG Team’s Assignment
The IMG Team was selected from among 18 proposers responding to a Request for Proposal (RFP) issued by the City of Pittsburgh. The RFP asked the selected consultant to (among other services) do the following:
• “understand, and communicate all legal, financial, operational and other related issues in designing and implementing alternate provision of water and sewer services,”
• “[evaluate] value propositions of various operating scenarios,”
• “[develop and implement] an appropriate public engagement process to ascertain the public's concerns, and provide information to the public,” and
• [identify] “an organizational structure capable of moving a restructuring project forward to conclusion.”
In the succeeding weeks after selecting the IMG Team, the City and IMG negotiated a scope of work that included the tasks shown in the diagram below.
Figure 1: Scope of Work
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The IMG Team began its work in mid-July by holding a lengthy meeting with the senior management of PWSA and several of its board members. This was followed by additional information meetings with individual PWSA managers, administrative staff, PWSA plant and field managers, and City of Pittsburgh officials, as well as the following task execution processes:
• Task 1 included a Briefing Book on the restructuring options, a presentation to the Blue Ribbon Panel on the IMG Team’s initial impressions of PWSA, and several community outreach initiatives including the publicly-available project website where constituents could ask questions, post comments, follow the progress of the assessment and view project reports and presentations, as well as a series of outreach meetings to PWSA’s community stakeholders.
• Task 2 included the analysis of legal and contractual issues affecting both PWSA and the restructuring options.
• Task 3 included the operations and asset management assessment.
• Task 4 included high-level reviews of PWSA’s capital improvement programming, comparative finances, internal controls and information technology.
• Task 5, of which this document constitutes the full report, included an evaluation of the restructuring options and IMG’s recommendations.
The diagram below shows how the tasks were managed among the various IMG Team members.
Figure 2: IMG Team Organization and Task Responsibilities
IMGTeamOrganizationandTaskDeliverablesRestructuring
EngagementManagerSteveSteckler,IMG
FinancialAnalysisAssistantEngagementManager
SashaPage,IMG
TechnicalServicesAssistantEngagementManagerfor
JeffGeorge,IMG
LegalandContractualAssistantEngagementManager
TenoWest,WestGroup
AssetMgmt.TacomaZach,UberlyDcs
Opera?onsP.Roux&R.JonesWoodward&Curran
Accoun?ng&AuditAnthonyHernandezGrantThornton
StakeholderOutreachChrisDneMondor
EvolveEA
CapitalProgramsJonathanShimko
TetraTech
TaskIIIOpera?onsAssessment
Report
TaskIIICapital
InvestmentProgramming
Report
TaskIIIMaintenance&
AssetManagementAssessmentReport
TaskIVFinancialMgmt.
InternalControls&DataManagementAssessmentReport
TaskICommunity,Labor&EnvironmentalGroupMtgsandPublicWorkshop
TaskVRatepayerImpact
Analysis&RestructuringOp?onsReport
TaskIILegalandContractualAnalysis
TaskVPanelDelibera?onandPublicQ&A
Support
PublicEduca?onMaryKiernanActualSize
TaskIWebsite,Business
CommunityOutreach&ProjectCommunica?on
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2.2. Utility Restructuring Principles
IMG has spearheaded restructurings for a variety of water and sewer utilities, as well as other public infrastructure agencies in the US and around the world. This experience has yielded several common principles for understanding an agency’s performance issues and the appropriate restructuring options for improving that performance. These principles include the following:
• Strong, Consistent Governance and Leadership • Clear and Meaningful Agency Mission and Goals • Enforceable Performance Drivers • Up-to-Date Performance Tools • A Cohesive and Widely-Shared Performance Culture • Expert and Responsive Management at All Levels • High-Functioning Human Resources, Training and Career Advancement • Streamlined and Well-Documented Business Processes • Solid Finances and Financial Management Practices
These were the IMG Team’s focal points for assessing PWSA’s organizational capability and thereby its greatest needs from a restructuring. Equally important, the Team considered the City’s concerns. As the owner of the assets, the City has the responsibility to select a proper long-term steward of the assets and structure under which water and sewer services will be provided. Finally, the Team considered the often-divergent views of PWSA’s stakeholders, which included water and sewer customers, the community at large, the environmental and labor communities, special interest groups, the business community and regional government partners.
2.3. Restructuring Options and Supporting Analyses
Consistent with the direction of City officials, IMG evaluated the following restructuring options: • Governance Change • Assisted Internal Improvement • Operations and Maintenance Contract • Infrastructure-Only Lease Concession • Full Service Lease Concession • Transfer to a Regulated Pennsylvania Investor-Owned Utility
Over the duration of the assessment phase, each of these restructuring options was detailed and tailored to better suit PWSA’s circumstances. The Blue Ribbon Panel was briefed on the options as the assessment progressed. In the final November 8th public presentation, the IMG Team presented the results of its evaluation and its recommendations. These recommendations were supported by various quantitative and qualitative analyses that are summarized in this report.
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III. Summary of Findings from Tasks 1-4 3.1. Governance
IMG agrees with the Pennsylvania Auditor General’s report that PWSA’s governance suffers from a lack of public credibility and political independence. The newly appointed board has several City employees as well as a City Council member, an unusual composition for the board of a large American water authority. IMG understands that the board was appointed earlier this year to act upon PWSA’s immediate issues. The restructuring assessment, however, is focused on the utility’s long-term needs. Three decades of damaging experience with political influence and patronage forewarn of the utility’s continuing vulnerability to its old ways under future mayors and city councils. This persistent threat demands a bold, permanent, structural change.
3.2. Resources
IMG found PWSA’s staff to be an inefficient mix of dedicated and capable employees and an unacceptably large number of under-qualified, unmotivated and poorly trained employees. Together they work in an environment with rudimentary maintenance and operating systems, and without an effective asset management strategy or detailed strategic business plan. Simply funneling more money into such a damaged organization is not likely to change this operating paradigm: it requires a structural shift that makes operational excellence something akin to contractual obligation.
The absence of an overall asset management strategy and adequate operating systems, as well as the lack of staff skills to utilize them, presents an insurmountable challenge for a utility that needs to spend nearly $4 billion over the next 25 years to address its failing infrastructure. PWSA needs new leaders and positive thinking throughout the organization, not just at the top where recent improvements have been notable. Yet it is handicapped in achieving sustained improvement by a crippled culture, below-market compensation for expert staff, city residency requirement and a wholesale lack of experience with contemporary operations and maintenance systems.
3.3. Recent Improvements
To some extent the newly appointed board is doing what was asked of it: address the utility’s most pressing problems. Recently the PWSA board approved a larger-than-usual 5-year Capital Improvement Program (CIP) which has effectively empowered the acting director to launch an internal operations and maintenance improvement program that includes (1) possible outsourcing of not just billing, but also of all of customer service; (2) asking one of its contractors to conduct a better inventory of its assets and begin a rudimentary asset management system; and (3) initiating planning for a low-level Computerized Maintenance Management System (CMMS) to improve its maintenance quality.
Notwithstanding these recent improvements, the United States Environmental Protection Agency (USEPA) and the Pennsylvania Department of Environmental Protection (DEP) appear to have little faith in the potential accomplishments of a temporary director and a closely-held board within a flawed organization. They appear especially concerned over its organizational disfunction and the
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imminent danger of critical system failures. It is possible that they will soon call for some type of dramatic action, or otherwise remove the utility from the City’s and the Board’s control. Legislation was recently introduced to place PWSA under state receivership, and a bill to place PWSA under the Pennsylvania Public Utility Commission (PUC)’s regulatory authority seems likely to pass before year’s end. These three looming sanctions suggest that at least at the state level, the recent board actions are considered insufficient.
3.4. Finances
The IMG Team found that PWSA’s finances are constrained by its relatively large per-customer debt load and its enormous capital improvement needs. Although water and sewer rates will be rising sharply over the next three years, they will need to rise much more quickly to fund the utility’s full capital needs and comply with CSO-related mandates.
Almost every US municipal utility is faced with enormous capital investment needs that will require large rate increases, but PWSA’s infrastructure and organizational problems are unusually challenging for the size of its customer base. Asking 83,000 water customers and 110,000 sewer customers to shoulder $4 billion in investment over the next 25 years requires more than just verbal assurances that the investments will be done efficiently. It is likely that by 2043, water and sewer rates (including stormwater fees) could be as much as four times higher than they are today.
Much of the rate increase will be used to catch up on the deferred repairs and upgrades required to assure clean water and compliance with environmental mandates; the remainder will be to address the City’s stormwater-driven Combined Sewer Overflow (CSO) problem. EPA and DEP will likely force PWSA to make those costly improvements if it does not do so on its own.
Operations and maintenance costs are additional drivers behind higher rates: higher per-employee compensation will be needed to attract and retain high-skilled labor and bring in seasoned middle management from outside. New IT are needed along with additional staff to manage them.
The lack of performance information makes it much harder for PWSA to spend its money efficiently, as does the absence of a broader strategy for asset management. PWSA’s assets have fallen into disrepair because the utility lacked the systems, staff, resources and insightful plans to maintain them properly. This cannot happen to the expensive new capital investments. This represents the greatest long-term threat to the organization’s success. IMG’s recommendations flow directly from these three major assessment findings:
• PWSA’s governance needs to become more independent and professional before other improvements are embarked upon;
• PWSA’s operations and administration need to be reformed through much higher levels of technical expertise, including new management information systems, operating procedures and planning protocols; and
• PWSA’s infrastructure needs are so large relative to its customer base, and the threat of investment mismanagement and cost escalation is so consequential for water and sewer rates, that “business as usual” is inadequate to the task.
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IV. Community and Stakeholder Outreach 4.1. Overview
The IMG Team used several avenues for community and stakeholder outreach and education:
• A project website where those interested in the restructuring could register their questions and comments and download information and Team reports on a real-time basis. The site also posted announcements for public meetings and invited readers to register.
• one-on-one meetings with a wide variety of stakeholder groups
• a three-hour public workshop attended by approximately 200 people
• public meetings and presentations before the Mayor’s Blue Ribbon Panel
The home page of the website is shown in Figure 3.
Through these multiple channels the Team obtained a wide range of public input. While these views diverged, almost none of the participants felt that the status quo path was adequate to meet the challenges faced by PWSA.
Figure 3: Project Website used for Community Outreach
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4.2. Community Workshop
The IMG Team organized a community workshop held on the evening November 2nd. Over 200 attendees participated in (1) the pre-workshop values exercise, (2) an opening briefing on the restructuring options and (3) the breakout session where they were asked to connect the values they selected in the pre-workshop “sticker board” exercise with the restructuring options. Figure 4: Community Workshop
In the pre-workshop exercise, participants were asked to place stickers next to the values that were most important to them. These values are shown below:
Figure 5: Values used in Community Values Exercise
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The results (see the numbers to the immediate right of the value titles shown in Figure 6) showed that “accountability” was the most important, follow by cost and green infrastructure. While these results may or may not be representative of the larger community’s sentiments, it is clear that a large constituency wants the stewards of their water and sewer services to be held accountable for their success or failure to perform; i.e., that guarantees and consequences for failure be a significant part of the restructured utility, and that cost be an important part of the promise.
Figure 6: Most important values as defined by community stakeholders
4.3. Green Infrastructure
As the stakeholder interviews, public meetings and community workshop progressed, it became clear that Pittsburgh citizens value green infrastructure very highly, both as an environmentally-friendly alternative to “gray” concrete infrastructure and as a cost-saving measure for complying with sewer and stormwater mandates.
The City is committed to protecting its clean water resources by reducing combined sewer overflow frequency and volume through green infrastructure. It is an important part of an affordable strategy to reduce CSOs, flooding, and restore ecological systems through investment in communities, workforce development, adaptive management and integrated sewer-shed planning. Moreover, the City and PWSA are committed partners in the regional resiliency strategy. The IMG Team is equally committed to making green infrastructure a major contractually-binding commitment as part of its recommended restructuring strategy.
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V. The Restructuring Options 5.1. Baseline (Status Quo) Path
IMG assumes that without restructuring PWSA will continue to make some of the material improvements initiated under its acting director, including its recently approved capital program (and accompanying rate increases). It also assumes that (1) more staff will be hired (within the limits of its existing pay structure and residency requirements); (2) more data will be collected and refined on asset conditions; and (3) that basic capital programming and operating protocols will be improved.
The Baseline scenario examined as part of this analysis assumes that PWSA’s considerable organizational flaws and staffing limitations will be addressed only slowly compared to other restructuring options. It also assumes that problematic governance will continue, and that PWSA will continue its reliance on contractors for capital programming and asset management.
For the ratepayer-impact analysis, the Baseline assumes that capital investments will continue to lag the demonstrated need. It also assumes that asset management will continue to be hindered by staff capabilities, underinvestment in technologies, and lack of insightful strategy. Due to deferral and under-management of investments, along with suboptimal operations and maintenance, the asset base will continue to deteriorate faster than it is repaired, resulting in higher long-term costs.
Textbox 1: The Importance of Baseline Rate Forecasts
THE IMPORTANCE OF BASELINE RATE FORECASTS Critics of major governance changes, expensive improvement investments, public-private partnerships (P3s) or ownership transfers often point towards the negative ratepayer impacts or rate increases that have often accompanied such changes. However, these concerns typically overlook the reasons for restructuring: a looming physical and operational crisis brought on by years of inadequate revenue (i.e., too-low rates) and misdirected spending under the municipality’s previous operations. These deferred-but-impending costs are often exacerbated by new regulatory requirements, sometimes forcing new billion-dollar expenditures for CSO abatement with significant new rate increases. Rectifying those problems under a status quo approach usually requires much larger rate increases than under a reform initiative. The picture is worsened when the city takes millions from the transaction (as Pittsburgh once did) for non-water uses. Accordingly, it is very important that any reform process be preceded by a “baseline” forecast of what rates would have been had the municipality tried to solve the problem on its own.
The following sections explain each of the six additional reform options that the IMG Team was asked to explore as part of the restructuring’s assessment phase. After the option summaries, the report reviews possible evaluation criteria for selection of a preferred restructuring option, including a quantitative analysis that attempts to compare the options against the Baseline (or status quo path, and against each other) in terms of how much new revenue will be required from ratepayers. The report concludes with IMG’s recommendations and an implementation path.
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5.2. Option A: Public Charitable Trust Textbox 2: Auditor's Report of Oct 2017 identifies governance as key issue
FROM THE AUDITOR GENERAL’S REPORT, OCTOBER 30, 2017 Finding 1 – PWSA’s aging and deteriorating infrastructure issues and financial and operational long-term viability issues result from years of mismanagement and conflicted leadership causing a crisis in the authority’s governance. The citizens of Pittsburgh have been plagued for the past few years by the dysfunctional operations of the PWSA, including a heavy debt load, deteriorating infrastructure, constant operational problems, lack of leadership, and frequent senior-level management turnover. These issues are evidence of a governance crisis that must be addressed as soon as possible [italics added]
The Auditor General’s report identified PWSA’s governance as the root cause of its long-standing problems. It recommended that governance reform be the priority of any improvement initiative, to achieve independence from partisan politics and a long-term, strategic organizational focus.
In 2010, Indianapolis chose to transfer its water and sewer utility to an existing self-perpetuating public non-profit charitable trust overseen by an independent Board of Trustees and managed by a Board of Directors appointed by the Trustees.
For the September 12th meeting of the Blue Ribbon Panel, IMG invited the President of the Citizens Energy Board of Trustees (the overseer of Indianapolis’s multi-utility Public Charitable Trust), Daniel Evans, to explain to the Trust’s history and how it meets the best interests of Indianapolis’s water and sewer customers. Mr. Evans explained why the City of Indianapolis transferred its system to the Trust, and that its rates and charges were now regulated by the Indiana counterpart of the Pennsylvania PUC. Until that time, Indianapolis’s water and sewer system had been operated and maintained by a private contractor. Almost all of the contractor’s employees and managers were transferred to the Trust along with the utility’s assets.
Panel members and PWSA stakeholders expressed interest in the Indianapolis model. After reviewing the Indianapolis experience and considering the Pennsylvania Auditor General’s recommendation, IMG believes that an independent non-profit trust could be an ideal answer to the Auditor General’s imperative. Accordingly, IMG recommends that any restructuring selected by the City include the following:
• The City would establish a non-profit public trust based on the Indianapolis model, but with a charter tailored to Pittsburgh’s specific values and circumstances;
• The City would appoint high-profile Trustees to govern the Trust, who would appoint a managing Board of Directors;
• PWSA’s assets and operations would be transferred in a manner that removes assets and operations from political influence; and
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• As in Indianapolis, rate setting would be regulated by the PUC.
The diagram below shows how the Public Trust would be created in a stepwise process, beginning with the creation of the shell entity and the appointment of the initial Trustees.
• In Step 1, the City creates a Trust shell with no assets, operations or revenues. • In Step 2, the initial Trustee (or Trustees) is appointed, with duties that may include
coordinating with the PWSA board while the Trust’s operating procedures are created. • In Step 3, PWSA’s asset and liabilities are transferred into the Trust. Because the assets
are encumbered by a variety of indentures, this could take six months or longer. Meanwhile, PWSA continues to operate the assets under a temporary agreement. During this time, additional Trustees are appointed.
• In Step 4, the operations are transferred to the Trust. All employees are transferred along with the operations under the preexisting employment and compensation terms; collective bargaining agreements are transferred as well. Since the Trust is a public entity, pension obligations should be transferred without immediate modifications.
• In Step 5, the Board of Trustees appoints a Board of Directors who will directly oversee the management of the utility and be responsible for all strategic financial, operational, planning and investment decisions.
Figure 7: Creation of the Public Trust in 5 Steps
After the Trust is created, empowered and staffed, rate and service quality regulation would become the responsibility of the Pennsylvania PUC, regardless of which restructuring option was chosen to supplement the governance improvement.
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5.3. Option B: Assisted Internal Improvement
COMPONENTS: The Assisted Internal Improvement scenario assumes that comprehensive changes are undertaken under the auspices of special City-driven Trustee with sufficient powers and outside resources to make significant progress over an 18-month period. The activities of the Trustee are guided by a long-term business plan that integrates all organizational and system improvements. The business plan includes the following actions:
• Reengineering major processes and rapidly upgrading employee skillsets; • Installing new operating, maintenance and performance information systems; • Developing new capital programming protocols based on criticality; and • Developing a new asset management strategy based on real risk, and asset failure modes.
The Assisted Internal Improvement scenario is “shock therapy” applied to a poorly-performing organization. It is rarely achieved by existing management. However, experience shows that the durability of the change is a persistent challenge.
CRASH COURSE: Many utilities faced with the threat of privatization have embarked on crash-improvement programs driven by the desire of existing management to retain their positions, along with a conviction that they can be as efficient and productive as the private operators. Some have even submitted staff proposals under the privatization RFP process, which sometimes were successful (although in nearly every case the losing private operators criticized the winning staff proposals for being financially non-binding, short-term and poorly accounting for overhead costs). IMG believes that such “managed competitions” are inappropriate for PWSA’s circumstances, since an already fragile organization is unlikely to be able to make a credible proposal, let alone one that could financially commit to the improvements.
DURABILITY: The bigger issue is ensuring the durability of improvements. With the threat of privatization gone and the status-quo governance and management still in place, most utilities gradually retreat toward their previous performance level. Contract water and sewer operation is a highly competitive business with thin margins and an intense day-to-day focus on performance, cost and regulatory compliance. Internal-improvement initiatives that were accompanied by robust new performance-management tools (computerized maintenance-management systems, new operating systems and, most importantly, integrated performance-information reporting) tend to be more successful at maintaining new performance levels. However, experience shows that few were able to maintain the enormous organizational energy required to operate at 20-30 percent below their previous operating expenditure levels and still meet the quality-of-service standards embodied in public-to-private operating contracts.
Lessons learned from failed and successful internal improvement initiatives include the following: • ORGANIZATIONAL CHANGES: Becoming contractor-competitive requires major cultural
changes at the governing board, management and staff levels, not to mention painful choices about staffing, work rules, organization structure and training budgets (most private operators spend several times the level of public systems on training).
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• A GREATER BUSINESS PLAN: The changes cannot be done piecemeal; they must be part of a business plan that encompasses all facets of the utility’s operations, maintenance, capital programming and asset management. A gap assessment is essential, but simply knowing the gaps does little to motivate the entire organization to make the often-drastic changes—and sacrifices—required.
• QUANTIFIED PERFORMANCE STANDARDS AND MILESTONES: The new performance standards and progress goals need to be clear and quantifiable (an essential feature for enforceability), and they must be backed up by realistic benchmarks from top-performing public and private utility operations around the country. These measures, goals, and milestones must be derived directly from – or incorporated into – the utility’s long-term strategic business plan with annual progress assessments.
• ENFORCEABILITY: The improvements must be enforceable, ideally binding by contract, with personal and/or institutional consequences for failure to meet milestones. The most common way for cities to bind their utilities in a performance compact is through an agreement between the asset owner (typically the city or county government) and its operator (often an authority). The asset owner should have the right to terminate the operator in its entirety -- or at least its board and executive management -- if the standards are not met. For Pittsburgh, the City-to-PWSA asset lease instrument is a convenient vehicle upon which to piggyback an enforceable performance contract.
• TIME AND COST: It takes many years to implement a major internal improvement initiative. This is especially the case for PWSA, because the organizational challenges are so great and the assets have been so long-neglected. While organizational charts and procedures can be codified in a matter of months, it takes much longer to install new systems and protocols and train staff to use them, even more so if the utility is starting from scratch (as is PWSA) in assembling operating and asset condition data. This up-front investment also takes lots of money: Tulsa’s Metropolitan Utility Authority needed over $14 million (all outside costs, and not including staff time, new hires or capital investment) over a 6-year period to improve a similarly-sized organization which was in a far better condition than PWSA.
Notwithstanding these cautionary lessons, IMG envisions an Assisted Internal Improvement scenario that would include the elements shown in the diagram below.
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Figure 8: Assisted Internal Improvement scenario
STRATEGY AND PERFORMANCE COMPACT: The program begins with a binding Strategic Business Plan (Item #1 above) that includes goals, milestones, quantified performance measures and time-relevant action items. These long-term goals (5-10 years) are reflected in an Annual Utility Performance Agreement (Item #2 above) between the owner of the assets (usually a city or county government) and the public operator. This Performance Agreement is akin to an annual contract where the asset owner is able to sanction the executive management and governors for under-performance, or even cancel if the performance shortfall is egregious and inexcusable.
SUPPORT SERVICES: The utility uses its budgeting and Human Resources tools to meet the standards in the Annual-Performance Agreement. If the city/county government supplies Support Services (Item #3 in the chart) to the utility, such as accounting, procurement, legal, IT, etc., then those services are part of a separate contract (or incorporated into the Annual-Performance Agreement between the city/county and utility). In this case, the city/county would face consequences for failure to provide the support services required for the utility to achieve its annual performance goals.
PERFORMANCE SYSTEMS: A robust Performance Management System (PMS, Item #4) is the most essential part of an internal improvement initiative. It incorporates performance information from all the utility’s departments and systems and reports it in a manner that can be understood by all staff and can be used as the basis for determining compliance or non-compliance with the Annual-Performance Agreement. The PMS is also critical to optimizing both operations and maintenance protocols and the capital-improvement program. A Process Optimization Strategy (Item # 5) should be explicit about how the organization will respond to new performance information.
ASSET MANAGEMENT: Asset management encompasses both capital improvements and maintenance. Most utilities consider them separate activities, however, placing capital
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improvements above maintenance in the organizational hierarchy. Advanced utilities almost flip the equation, with capital programming and maintenance managers reporting to the same individual or joint committee. All relevant information is organized via a Strategic Asset Management System (SAMS, Item # 6 above). Tulsa, for example, subordinated its previously-dominant Engineering Department to an Asset-Management Committee composed of both maintenance and engineering managers and overseen by an independent technical manager reporting directly to the executive director. This ensures that capital programming is informed by the maintenance and operating needs of existing and future infrastructure.
GOVERNANCE: One of the biggest challenges for a governing board is being sufficiently informed to make tactical decisions (e.g., annual plan approval, construction contract approval, annual budget, etc.) in the context of a long-term business strategy. This is especially challenging for an unpaid, part-time, non-expert board meeting only a few hours a month. It is even more challenging when the board is trying to oversee a major performance-improvement initiative. New Governance Information Tools (Item # 7) are essential to this effort. These tools include understandable outputs from the Performance-Management System, such as dashboards and checkpoint statistics, as well as highlighted action items displayed in the context of the Annual-Performance Agreement and the Strategic Business Plan. Ideally, information for the board meeting should be summarized in a 3 to 5-page document not including appended reports and contracts.
BOARD MANGEMENT: To be truly effective in managing a major internal-improvement initiative, the board needs a full-time Board Coordinator (Item #8) dedicated to the board’s performance information needs. This is especially true for a “managing board”—one that meets more frequently than monthly and is directly involved in performance-related decisions. The information demands of active management are too extensive for a part-time administrator; this analyst position needs to report directly to the board chairman and not to the executive director. IMG’s experience is that utility staff with other responsibilities will find themselves distracted by those duties, leaving their board support duties unfulfilled.
ASSISTANCE: This scenario is labeled “assisted” improvement because outside expertise will be required for quantitative business planning, proper asset registry and hierarchy, asset management planning, maintenance systems design and implementation, project optimization, business process reengineering and governance changes. Should the City decide to appoint a Trustee to oversee the improvements, this assistance should be provided under their direction.
5.4. Option C: Operations and Maintenance Contract
Overview
Operations and maintenance (O&M) contracts are the most common form of P3s in the US water and sewer industry. More than 2,000 municipal entities contract out their water and/or sewer operations. Together with private water companies (those that both own and operate their water infrastructure), O&M contractors provide nearly one-third of Americans with water or sewer services.
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Figure 9: O&M Contract
The largest US water or wastewater utility to contract out its operations is in Milwaukee, beginning in 1997. Thirty years later it remains the largest outsourced sewer system, having renewed its contracts with various providers three times. It has also been among the most successful in reducing costs to customers: not long after the outsourcing, the Milwaukee Metropolitan Sewerage District reduced its household rates by nearly 15 percent. Such rate reductions are exceedingly rare in the US, as many large cities have seen their sewer rates skyrocket over time.
INGREDIENTS FOR A SMOOTH TRANSITION: In Milwaukee—as in almost all private takeovers of municipal water/sewer operations since 1990—the existing collective bargaining units are recognized; there are no involuntary layoffs as part of the transition; there is no diminution of pay and benefits; and managers and staff are almost entirely local. To reduce costs while simultaneously improving service quality and environmental compliance, private operators tend to install advanced O&M systems, reengineer business and operating process, implement new O&M protocols, and significantly increase staff training hours. When disputes arise, they often involve disagreements over pre-existing and unknown conditions of the underground infrastructure and responsibility for paying for repairs—rather than over service quality or responsiveness.
Contract Specifications
TERMS AND RATESETTING: O&M contracts are typically 5 to 10 years in length, with longer contracts becoming the norm over the last decades. Recent IRS rulings have made it practical to execute longer O&M contracts, in which cases the contractor can be given greater responsibility for major repairs and capital-improvement planning. As a consequence, the line between O&M contracting and full-service lease concessions (see below) is becoming increasingly blurred. However, O&M contractors do not set rates; they are compensated by a fixed annual fee, often with
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incentives for exceptional performance and penalties for underperformance. Full service lease concessions, by contrast, allocate the full responsibility for revenues and expenditures to the concessionaire (within proscribed limits), with rates being set according to a mutually-agreed schedule or formula.
OVERSIGHT: Figure 9 shows how the PWSA board would oversee the O&M contractor. We have assumed that a contract would be between 10 and 20 years in length, and that the contractor (and the City of Pittsburgh, as the asset owner) would be granted some influence over capital improvements and asset management. Accordingly, we have included a joint public-private “Asset-Management Committee” in the contract structure.
SERVICE STANDARDS: Detailed performance standards would be included in the O&M contract, and the contractor would be required to file monthly performance and operations reports with the Contract Oversight Office. The contractor would be expected to make monthly (or more frequent) presentations to the PWSA board, similar to current PWSA management reports. In addition, the Contract Oversight Office would have one or more staff who would communicate daily with the contractor and have complete freedom to conduct spot inspections and request additional information or reports.
5.5. Option D: Infrastructure-Only Lease Concession
Overview
WHY JUST INFRASTRUCTURE? The IMG Team offers the infrastructure-only lease concession as a nod to PWSA’s uniquely-large capital improvement and asset management needs. While PWSA’s operating and organizational problems might be adequately addressed over a few years by new governance and assisted internal improvements, its vast infrastructure needs will take decades to resolve. In the meantime, ratepayers would be exposed to the all-too-typical roster of cost-escalation risks, asset-strategy shifts, system-failure risk and inadequate maintenance that often plague long-term capital programs. An infrastructure-only lease concession can manage these risks in a highly-predictable package with known costs and performance standards.
CHANGING INVESTOR PERSPECTIVE: Infrastructure-only leases are not the most common forms of P3s for water and sewer; they are more common for airport runways, passenger terminals (including a $1.4 billion terminal in New York), and roads and bridges, where development and asset management can be easily separated from operating functions. Some large US courthouses and municipal-government centers also use the infrastructure-only lease model. Most infrastructure-only projects are outside of the US, but interest is increasing as private investors—particularly pension funds—become less interested in the operating economics of a facility and more interested in the low-but-consistent returns of the infrastructure side.
In Figure 10, the gray-shaded area represents the limits of the concessionaire’s authority. The remainder is fully public, including ownership of the assets.
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Figure 10: Infrastructure-Only Lease Concession
How It Works
WATER VERSUS SEWER: Most client cities and concessionaires couple operations with infrastructure and asset management, especially for the development of new treatment facilities (e.g., water or wastewater treatment plants). For existing assets like PWSA’s, the question is both political and practical: water operations are a sensitive area of public policy, probably more so than any other public service. While sewer operations are rarely a public concern, drinking water seems different. Accordingly, the larger US utility P3s tend to be for sewer rather than potable water.
SEPARABILITY OF INFRASTRUCTURE AND OPERATIONS: This leaves the practical side: Are water and sewer operations sufficiently separable from their infrastructure (and asset management) such that an infrastructure concession is efficient? The answer may already lie in the Pittsburgh region, where PWSA builds and manages the sewage-collection infrastructure while ALCOSAN, a separate organization, is responsible for wastewater treatment operations. This seems to work well enough. Differences between water and sewer operations vis-à-vis their relationship to infrastructure do not appear to be significant enough that they cannot be dealt with through proper coordination and a joint asset management committee.
ASSET MANGEMENT: Of course, maintenance responsibilities need to be considered, including their allocation. Cities that contract out their water or sewer O&M distinguish sharply between major maintenance and repairs (those costing many thousands of dollars) and minor repairs and routine maintenance. The former typically remains the responsibility of the municipality, while the latter is entirely the contractor’s responsibility. This division of labor has worked quite well over the past forty
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years. Other maintenance responsibilities, such as those related to customer service (responding to emergencies, line breaks, residential lead-line replacement, etc.) can be assigned to either party upfront, in the lease agreement. Additional questions can be resolved via a joint asset-management committee.
COMPENSATION STRUCTURE: The infrastructure-only concessionaire would be compensated via an “availability payment” (AP) structure. This payment, made annually or quarterly, is separate from the public ratemaking process; it is simply an input into the public utility’s cost structure, much like energy, chemicals or other supplies. The public owner continues to set rates. The concessionaire bears the risk of the payment being insufficient to cover its costs to provide the infrastructure. For the public utility, an availability payment makes service planning and rate-setting simpler and more predictable.
The AP name describes the conditional contractual relationship: the concessionaire is paid only if it makes the infrastructure available to its public client on-time, as specified, in good operating condition and able to perform (now and in the future) according to the standards specified in the agreement. Incentives for exceptional performance and penalties for underperformance are built into the payment structure. An increasing number of US infrastructure projects—from toll roads to courthouses and municipal office buildings—are being provided under this structure. In Europe, the AP structure is the most common form of P3. IMG and its Dutch sister company, Rebel Group, have extensive global experience crafting and negotiating AP structures.
The Concessionaire’s Responsibility
RESPONSIBILITY: An infrastructure-only concession works like a full-service concession (with which Pennsylvania already has experience) in terms of how the long-term capital improvement program is defined initially and refined over time, but the concessionaire’s footprint would be much smaller. IMG Team member Tetra Tech has significant experience defining long-term water utility CIPs. Other, much larger examples of full-service concessions (including multi-billion-dollar ones for water) can be found outside of the US.
PROPOSAL SPECIFICATIONS: The public-private collaboration process works as follows: PWSA would issue a Request for Proposals (RFP) that includes as much detail as possible about the repairs, replacements, and upgrades required of its underground systems and above-ground treatment facilities, as well as its expectations for asset management. Prior to submitting their proposals, prospective concessionaires would be invited to comment on those plans, offering possible refinements and requesting greater project definition where necessary to make a responsive proposal. They would also submit an asset-management approach for ensuring that the improvements, once made, remain durable, functional and in good condition. These types of contract parameters have been successfully used in dozens of large systems around the world.
EVALUATION: Proposals would be evaluated according to a combination of price, performance commitments, and the credibility of the plans. The balance among these criteria will be determined by the public officials in charge, but there is plenty of experience to support their choices. The resulting long-term lease agreement would codify the price, plans and commitments—along with
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appropriate incentives and penalties—into a contract document of sufficient strength and detail that works as well in Year One as in Year Fifty.
Public Operator Obligations and Three-Party Contract
The public-private collaboration mechanism in an infrastructure-only lease (e.g., the Asset-Management Committee) was described above, but one other contractual instrument is also required: an operations contract that ensures that the public partner fulfills its side of the agreement, particularly for operating functions affecting the condition of the assets and the concessionaire’s ability to meet performance obligations.
IMG and its legal advisor Team member West Group envision a three-party contract involving the public infrastructure owner, the public operator, and the concessionaire. The contract would have many similarities to the public-private O&M contract described in Chapter 5.4, with the public operator held to the same operating standards as a private contractor. Likewise, the infrastructure-lease agreement would include infrastructure-availability specifications to ensure that the public operator provides water and sewer services that meet the public’s expectations.
The Low-Income Assistance Trust
An infrastructure-only lease (as well as a full-service concession) can include an up-front payment from the successful proposer. In Pittsburgh’s case, the payment can be as high as $100 million or more—which is not really that large considering the size of the infrastructure program that the concessionaire will embark upon. Similar up-front payments have been part of most US water/sewer lease concessions, although in Pittsburgh’s case the payment would NOT be used to cover a deficit in the city’s general fund or to address an unfunded pension liability. Instead, the payment would be placed into a perpetual trust for assisting the city’s low-income households with their water and sewer bills. This is no small program considering the expected increases in PWSA’s water and sewer bills over the next two decades, and it should far exceed the benefit of the 15 percent assistance built into PWSA’s recent rate increase. Both the up-front payment and the Low-Income Household Trust Fund are shown in Figure 10.
5.6. Option E: Full Service Lease Concession
How It Works
RATE SETTING: The full-service lease is similar to the infrastructure-only lease except that the former includes operations and administration as well as responsibility for financing, constructing, and maintaining the infrastructure. Under a full-service lease, the concessionaire takes full revenue responsibility, although rate-setting is generally done via a pre-agreed formula or schedule of rates. For example, rates may only be allowed to rise by a (lower) fixed percentage every year rather than the larger double-digit rate increases every few years under public operation.
EFFICIENCY: O&M efficiency gains are similar under a full-service lease and an O&M contract, however there are additional savings from more efficient construction and improved asset management. Full-service leases are therefore well-suited to systems with both large operating
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problems and large infrastructure investment needs. Figure 11 shows the private partner’s areas of control (shaded gray), which are much broader than under an infrastructure-only concession. This model can also render an up-front payment that can be used for a Low-Income Household Assistance Trust Fund.
Figure 11: Full-Service Lease Concession
Ratepayer Impacts
Critics of lease concessions often point to rate increases as evidence of a P3’s negative impact. However, these concerns usually overlook the reasons why the municipality opted for the concession in the first place: a looming physical and operational crisis brought on by years of inadequate revenue and misdirected spending under municipality control. Rectifying those past problems and future problems (e.g., CSO rule compliance costs) under status-quo management usually requires much larger rate increases than those scheduled under a concessionaire’s management of the system.
Rate impacts are exacerbated when a city uses ratepayer funds for its general fund (as Pittsburgh once did) or to address other needs. Accordingly, it is very important that any P3 or sale agreement be preceded by a “baseline” forecast of what rates would be if the city tried to solve the problem on its own, not to mention siphoning water revenue for non-water uses. The City of Pittsburgh has made it clear, however, that it will not do so.
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5.7. Option F: Transfer to a Regulated Investor-Owned Utility
Overview
POLARIZED STAKEHOLDER VIEWS: When IMG interviewed stakeholders in the Greater Pittsburgh region, a surprising number were in favor of transferring PWSA’s assets to an existing regulated investor-owned utility. Many viewed this as the simplest and most-likely to succeed approach in which PWSA’s organization would be professionalized, important investments would be made, operating synergies and efficiencies would be realized, and public oversight would be exercised through the PUC.
These views contrasted with more vocal statements by some community groups who felt that such a transfer would jeopardize water quality, lead to underinvestment in infrastructure (especially green infrastructure), lack of environmental oversight, and result in rate increases that would far exceed those of a PWSA addressing the same infrastructure and service needs.
Figure 12: Transfer to a Regulated Investor-Owned Utility
ADMINISTRATIVE AND CUSTOMER SERVICE ECONOMIES: Proponents of transferring PWSA to an existing regulated utility cite obvious economies in combining PWSA’s administrative, financial management, billing, meter reading, and other customer services with that of the larger utility company. This would be particularly true for gas and water companies. While these economies are significant (probably on the order of 30-40 percent on a per-PWSA customer cost basis), and customer service is one of PWSA’s greatest and most noticeable shortcomings (enough that PWSA
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is considering outsourcing its entire customer-service function), in the larger financial scheme the savings are likely to be drowned out by PWSA’s capital improvement needs.
UNDERGROUND MAINTENANCE ECONOMIES: Additional economies are likely for combining PWSA’s maintenance activities for underground infrastructure with those for gas, including street repair. These savings are harder to quantify, but they are also likely to be significant. The same type of maintenance economies would apply underground power distribution, although to a lesser extent.
Rate Impacts
CUSTOMER BASE: While gas and electric companies share the same customers with PWSA, and administrative, customer service, and some maintenance economies are likely to lower PWSA’s total revenue requirement (and perhaps improve service), the direct cost of water and sewer operations and capital improvements will still fall upon water and sewer customers if PWSA’s functions are transferred to a gas or water company. However, transferring them—or at least the drinking water portion of PWSA—to a regulated Pennsylvania water company might be a very different matter. Those companies have very large existing water customer bases, several times that of PWSA. Spreading future capital-improvement costs over a larger base of customers could have a significant impact on water-rate increase for PWSA’s customers ten and twenty years from now.
THE PUC’S APPROACH: When Pennsylvania American and Aqua America have acquired other municipal water systems, the PUC has allowed—if not required—the company to charge their new and old customers the same water rates; i.e., a single state-wide rate structure. PWSA’s rates are currently below the water companies’ respective statewide rates, and it is likely that were they to acquire PWSA today, rates would rise only gradually to the statewide level. However, over time those statewide rates are likely to be notably lower than they would have been under continued PWSA ownership because of PWSA’s large and imminent capital improvement spending compared to the companies’ systems.
Moreover, Pennsylvania American and Aqua America’s systems are generally newer and in better condition than PWSA’s and have much lower capital-improvement needs per household. The result is that PWSA customers could probably expect notably lower water rates in the future under a statewide rate structure than if the capital-improvement costs were spread only over Pittsburgh’s water customers. (See Chapter VII of this report for more detail on the rate-impact analysis.)
It is important to note that the transfer of such a large, needy, and expensive system into an existing water company’s customer rate base would be unprecedented for the PUC. It appears from a quick review of state laws, regulations, and precedents that passing Pittsburgh-specific costs onto non-Pittsburgh customers is allowable, if not required. However, it is still unprecedented, and the companies’ existing customers may decide to challenge the PUC on the matter.
LOW-INCOME HOUSEHOLDS: Transfer to a regulated investor-owned utility can yield sales proceeds that the City could use to establish a low-income household assistance Trust identical to that created under a lease concession structure. However, unlike some other cities that have sold their water systems to Pennsylvania American or Aqua America, the City of Pittsburgh does not plan
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to use the proceeds for any other purpose, and so the sale price is likely to be much smaller on a per-customer basis compared to the other sales (e.g., Scranton). Under this restructuring scenario, the Low-Income Household Assistance Trust Fund would presumably be operated by a City-appointed trustee and work in cooperation with the utility company.
ACCOUNTABILITY AND RATE SETTING: All service accountability and rate setting would be governed by the state PUC, as is the case for all of the major gas, electric, and water companies in the state (and soon for PWSA). Water and sewer services would have separate “rate bases,” so Pittsburgh’s future sewer and stormwater projects will not increase rates for statewide water customers (although Pittsburgh’s water system improvement costs will).
SEPARATING WATER AND SEWER?: PWSA’s water assets need not be transferred along with it sewer assets (Pennsylvania American’s and Aqua America’s sewer customers are a negligible part of their overall customer base). In fact, it is possible that PWSA’s sewer assets could be retained and later transferred to a new city or regional stormwater authority. However, it is almost certain that the City of Pittsburgh would insist that that the companies take the sewer system – including its considerable debt and future liabilities -- along with the water system, not wishing to be stranded with either burden. Moreover, ALCOSAN and its regional partners have shown little interest in taking on PWSA’s enormous sewer and (impending) stormwater liabilities.
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VI. Evaluation Criteria
At the first meeting of the Mayor’s Blue Ribbon Panel, IMG offered some suggestions for criteria they might wish to use to select a preferred restructuring option. These included the criteria shown in the table below (not in any order of priority).
Figure 13: Example Evaluation Criteria
These potential criteria are elaborated below:
• RATEPAYER IMPACT refers to how the restructuring will affect future household water and sewer rates, including additional fees needed to deal with CSO issues over the next 25 to 30 years. Most of the rate increases will be needed to pay for the roughly $4 billion in repairs, replacement and system upgrades over the period, as well as new construction for stormwater management. Additional expense growth will come from upgrading staff, systems and operating processes. No matter what scenario is chosen – either staying with the existing performance path or adopting one of the restructuring options – PWSA’s rates are going to increase dramatically, as much as four times higher, over the coming years. In other words, ratepayers will be paying a much higher percentage of their take-home pay for water and sewer services. In addition to solving PWSA’s immediate problems, this restructuring process is a search for innovative, outside-the-box solutions to reduce those painful rate increases as much as possible.
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• PUBLIC HEALTH & SAFETY AND PUBLIC ACCOUNTABILITY: All the restructuring options are intended to improve public health and safety compared to the status quo path, either through improved operations, upgraded infrastructure or both. The managing institutions resulting from all the restructuring options would be overseen by the Pennsylvania DEP and the USEPA. They would also maintain or provide for laboratory testing of water and effluent quality testing according to DEP standards, and regularly report their results in order maintain their operating permits. In addition to these considerable assurance mechanisms, it is safe to assume that all of the restructuring options would increase investments in infrastructure, operating systems and staff training in a manner that would reduce public health and safety risks compared to PWSA’s status quo. Ratemaking and service accountability would be provided through the state PUC under a restructuring option carried out alongside the independent Public Trust. Under the O&M Contract and Infrastructure-Only Lease, ratemaking and service-quality accountability would remain with PWSA or the City.
• PERFORMANCE IMPROVEMENT GUARANTEE: Performance improvement is somewhat different from public health and safety assurance because it includes all measures from customer service and responsiveness to maintenance standards to operational and capital improvement efficiency. Moreover, “commitment” is not the same as “guarantee.” A commitment can be a policy or an initiative, either personal or institutional. A guarantee implies that the commitment is contractual and is accompanied with consequences (financial, termination or others) if the commitment is not kept.
• ENVIRONMENTAL PROTECTION AND COMPLIANCE is a regulatory commitment reflected in the infrequency of permit violations and in the satisfaction of non-regulatory commitments, such as improving the larger environment, enhancing water resources, substituting green infrastructure for gray infrastructure (where their performance is equivalent), minimizing water transmission and wastewater collection leakage and infiltration, respectively, and enhancing conditions around the utility’s above-ground facilities.
• LABOR AND BARGAINING UNIT PROTECTION refers to the specific treatment of labor and its representatives, including their compensation, work rules and career advancement. All the restructuring options are fairly equivalent on this measure, and the City of Pittsburgh can – as part of its restructuring implementation -- ensure that this remains the case if there are any doubts.
• GREEN INFRASTRUCTURE GUARANTEE: As with performance, a policy or personal commitment is not as strong as a contractual guarantee. For example, the two concession options can readily be configured with highly specific contractual commitments to green infrastructure percentage-of-mitigation basis, a total dollar basis, or a specific list of projects as part of the larger infrastructure investment plan.
• LOW-INCOME HOUSEHOLD PROTECTION: This refers mostly to protecting poorer households from the impact of the large water and sewer rate increases expected over the next twenty years, but it also can refer to helping them with more immediate problems such as service shutoff abatements and residential lead-line replacements. This is one of the
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most challenging issues faced by water utilities across the US as long-deferred infrastructure needs must now be paid for. PWSA’s board recently approved a large rate increase but offered low-income households a 15 percent discount. Such two-rate-class subsidy programs have proven challenging to implement and sustain, and in some instances voided by rate regulatory commissions. Emergency funds and deferred payment programs are more common, including among investor-owned utilities. The two concession options offer the prospect of a permanent fund from which periodic and continuing subsidies can be drawn, potentially larger than PWSA’s pending 15 percent.
• LEGAL AND FINANCIAL FEASIBILITY: The legal and legislative analysis conducted by the IMG Team’s legal advisor concluded that both the Public Trust and public-private restructuring options are available in Pennsylvania without a change of law. Financial feasibility is more a matter of ratepayer impact than actual project financing. Based upon its experience and the preliminary interest of pension funds and private investors in PWSA’s restructuring, financial feasibility – or rather, the ability to attract bond buyers or investors to PWSA’s needed infrastructure improvements -- is not likely to not to differ greatly among the restructuring options so long as those improvements are prudently selected, well-planned, efficiently implemented and well-maintained over their useful lives. The latter four factors, however, may differ among the restructuring options.
• EASE AND SPEED OF IMPLEMENTATION: The Assisted Internal Improvement scenario will take longer to implement and become effective than the other restructuring options. Transfer to an existing regulated utility would be the swiftest and simplest option. The other options – O&M Contract, Infrastructure-Only Concession, and Full Service Concession -- would likely take between 9 and 14 months to implement.
• DURABILITY OF CHANGE: The report noted earlier that performance improvements made via the Assisted Internal Improvement option tend to be less durable than those made under contract where the operator faces financial consequences for lower-than-desired performance. This is a significant concern where the most impactful improvements – infrastructure in Pittsburgh’s case – will take place over decades.
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VII. Ratepayer Impact Analysis
7.1. Overview
The IMG Team analyzed cost and efficiency factors associated with each restructuring model that would affect PWSA’s total “revenue requirement”—the total amount of money needed from its customers each year—and therefore the total ratepayer impact. The Team found that the key drivers of ratepayer impact are private capital and management costs (which result in rate increases) and capital and operating efficiencies (which result in rate decreases).
While Restructuring Option E, Transfer to a Regulated Investor-Owned (Water) Utility, appears to have the best ratepayer outcome, this conclusion may not be a true ‘apples-to-apples’ comparison with other options because the PUC may approach the acquisition of PWSA’s larger system with larger per-customer liabilities than it has with smaller systems.
7.2. Restructuring Options Examined
The options evaluated were consistent with those described in the previous chapters of the report, with some slight modifications to allow for sensitivity analysis and structural variations on the base models. The options examined are summarized below. Options B through F are assumed to include a new governance structure (Option A).
• Status Quo Baseline Performance Path: The Baseline Path model, as described earlier in this report, includes maintaining the status quo and a ‘do minimum’ scenario for implementation of the CIP and O&M reforms.
• Assisted Internal Improvement (Option B): The Assisted Internal Improvement option utilizes outside assistance and internal reforms as part of a larger program for implementation of O&M and CIP management reforms.
• O&M Contract (Option C): The O&M Contract is a 10-20-year contract with a private contractor for operating and managing the utility. Under this scenario, implementation of the CIP remains the responsibility of PWSA and its staff.
• Infrastructure-Only Lease Concession (Option D): The Infrastructure-Only Lease Concession (or, the ‘hybrid’ model), transfers responsibility for implementing the CIP program and major asset-management functions to a private partner under a long-term lease. Ownership of the assets, operations, administration, and rate-setting remain in public hands, and is governed in part by a three-party agreement between the governing body, the public operator, and the private partner.
• Full-Service Lease Concession (Option E): The Full-Service Lease Concession assumes public ownership of the assets and rate-setting, via a formula or schedule determined by the public governing body. A private entity assumes responsibility for operations, maintenance,
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and all capital improvements (as agreed to by the public governing body) for approximately fifty years, long enough to be responsible for their completion and their continued maintenance in high-performance condition.
• Transfer to a Regulated Investor-Owned Utility (Option F): The Transfer to a Regulated Investor-Owned Utility (either a non-water or a water utility investor) model assumes full control of the utility for the length for the operations period, typically 30 years.
The analysis shows that the ‘Transfer to Pennsylvania Regulated Investor-Owned (Water) Utility offers by far the lowest cost to Pittsburgh’s water ratepayers. However, this mostly due to spreading the cost of PWSA’s massive water (not sewer or stormwater) capital-improvement program over all water-company ratepayers across the state. The analysis assumes that this will be permitted as it has been in other municipal transfer cases in Pennsylvania, but it is not certain.
The analysis presents the rate impact of each option as a range rather than as a single number. It does so because the outcome changes depending upon which assumptions are used for capital program and operating efficiencies, which vary by option. The range of assumptions used is informed by extensive research and Team members’ experience reforming other water systems.
7.3. Drivers of Ratepayer Impact
Factors that may improve rates for PWSA customers include:
• Increasing the efficiency of operations: Different models are assumed to have different levels of operational efficiency. Typical vectors of operational efficiency include:
o Implementing professional management and systems; o Improving staffing efficiency, for example eliminating the residency for staff enabling
a wider and more flexible talent pool; and o Economies of scale in purchasing (i.e. chemicals, consulting services, etc.).
• Increasing the efficiency of maintenance: o Implementing state-of-the-art maintenance protocols through targeted maintenance
upgrades based upon asset criticality and failure modes; o Advanced maintenance practices leading to lower whole-of-life cost for replacement
and maintenance; o Economies of scale in purchasing maintenance assets; and o Economies of scale in purchasing and service deployment, which results in lower
average costs for certain asset classes.
• Increasing efficiency of CIP implementation: o Implementing advanced, system-wide risk- and criticality-based capital expenditure
(capex) planning principles;
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o Applying superior expertise in identifying required asset interventions; o Flexible and competitive procurement for new assets; and o Full accountability and contractor risk-sharing for time and cost overruns.
• Spreading costs over a wider number of users: As already noted, some reform options lower the long-run costs to PWSA’s current customers by spreading the costs of the CIP across a wider number of users.
Factors that may increase rates for customers include:
• Up-front investment: As with the “Assisted Internal Improvement” option, there are initial costs related to investing in the systems and consultants needed to realize O&M improvements. Unlike with the private options, these costs are realized up-front rather than amortized over the course of an O&M or concession contract.
• Private sector equity return requirement: A private investor entering into any investment will demand a return on that investment equivalent to what they would be able to realize with the next best alternative investment. This is referred to as the equity internal rate of return (IRR) or, “expected return.” In our analysis, we assume private investors would demand a 10-15% return, which adds costs and decreases the attractiveness of private options.
• Higher private sector cost of debt: Whereas PWSA currently enjoys access to the tax-free municipal finance market, we assume that under private control, new investors will borrow funds in private markets, rather than municipal markets. We assume this adds at least 100 basis points to the cost of borrowing.
• Costs of debt defeasance: Options which involve a substantial change in ownership will require the existing PWSA revenue bonds to be defeased. Funds must be set aside either to call the existing bonds or to cover the debt service on bonds that cannot be called. A major component of this cost would be the $90 million spent to unwind swaps on the existing debt.
7.4. Methodology
Overview
The ratepayer impact analysis used assumptions derived from IMG’s water industry performance improvement engagements and public-private partnership experience; financial industry benchmarks; the experience of its operating subcontractors; and research on water utility restructuring and performance improvement examples in the industry. Because the results of the analysis are highly sensitive to these assumptions, IMG chose to be conservative whenever there was uncertainty—particularly regarding the operating and capital program efficiency metrics (i.e., how much more efficient the restructuring option would be than the Baseline Status Quo Path) and for the “risk transfer” assumption.
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Risk Transfer and CapEx Efficiency
Risk transfer is a very important concept in these types of Value-For-Money (VfM) analyses. It refers to the value to the public of sharing or fully shifting (to a private party) the risk that a capital improvement program or operations will be costlier than the baseline forecast. For example, if a project has an estimated cost of $1 billion, with a 30 percent chance that the actual cost will rise to $2 billion by the time the project is completed (a too-common occurrence for large underground infrastructure projects), then the value of the risk transfer to the public is $1 billion x 30% = $300 million.
Efficient risk allocation exists when risks are assumed the party with the authority and the capability/expertise to best manage a particular risk. For example, under the O&M Contract Option, the contractor is not in control of CIP implementation, so allocating the risk of cost overruns on major repairs and replacements to the private contractor would be considered inefficient, as the contractor does not have capabilities to manage neither the occurrence or cost of this risk.
There is a large body of evidence showing that private infrastructure entities have a more advanced toolbox for reducing project-delivery costs and improving delivery times compared to the procurement and management practices of traditional public-sector organizations. These tools include (but are not limited to) design-build construction; sharing the risks of cost overruns among subcontractors; and end-to-end control and integration of every element of the delivery and maintenance process. Moreover, private-infrastructure entities function under the watchful eyes of their investment partners (such as pension funds) and lenders.
Studies from the US and globally show that private-infrastructure firms have a much better record of on-budget performance for both construction and asset management compared to their government counterparts. Most of these superior “capex” performances have been accompanied by the full roster of labor-protection requirements to which any private partner would be held in Pittsburgh, such as union subcontractors, local sourcing, and project-labor agreements.
Valuing Risk Transfer
There are several ways to value risk transfer. The most common is to build the risk into the cost-of-capital assumption, similar to a bank adding a risk premium onto its lending rate. In this case, the interest rate on debt is increased above the nominal level (about 3 percent in PWSA’s case) to a level that roughly reflects the risk of cost overruns to ratepayers. This “assigned risk premium” can vary from a fraction of a percent to two or three full percentage points.1
Having previously noted the risks associated with PWSA’s $4 billion CIP implementation, IMG assigned a 100 basis point (1 percentage point) risk premium to the utility’s future cost of borrowing,
1 in the case of Boston’s Big Dig, Honolulu’s rail system and Rockland County’s sewer improvements, for example, even three percentage points would not have been nearly enough.
2 Banks do not invest, but rather lend with the full expectation of being paid back.
3 PWSA’s capital program is nearly on the scale of Boston’s Central Artery/Tunnel Project (“Big Dig”, 1982-2006, initially budgeted at
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which we believe to be conservative in trying to achieve an “apples-to-apples” rate impact comparison.
CapEx and OpEx Efficiency Gains
For all of the restructuring options, IMG has assumed there will be some percentage reduction from Baseline Status Quo Path cost estimates for operations and capital improvement costs (OpEx and CapEx, respectively). For example, if the Baseline estimate for operating costs is $200 million per year and a restructuring option can reduce that to $150 million, then the option is said to have an OpEx Efficiency Gain of 25 percent. Similarly, if annual Baseline CIP costs are $200 million and a restructuring option can reduces costs to $170 million, that option is said to have a CapEx Efficiency Gain of 15 percent. This efficiency gain is separate from the value of the risk transfer.
Weighted Average Cost of Capital (WACC)
A key assumption for all scenarios is the cost of capital. For a municipal utility, the cost of capital is the interest rate on its revenue bonds. This rate is low compared to private entities for several reasons: (1) the Federal government provides an interest-rate subsidy to state and local government debt equal to the marginal income tax rates for the bond buyers; and (2) bond buyers know that the government can (and indeed, is usually required to) raise taxes or user-fee rates to guarantee sufficient revenue to repay the debt and interest owed.
For a private entity, the cost of capital includes the weighted average of its cost of equity (that is, the expected-but-not-guaranteed return to equity investors for having risked their money in a project) and the cost of debt (the interest rate charged by banks and bond buyers). The equity serves as a buffer to assure lenders that they will be repaid first if revenues are less than expected or costs are higher than expected.2 For example, a financing with 80 percent debt at a 4.5 percent rate and 20 percent equity with a (hoped for) 9 percent return would have a WACC of (4.5% x 80%) + (9.0 x 20%) = 5.4%.
For each restructuring scenario, IMG assigned a specific and most-appropriate WACC. For restructuring options in which the public sector shifts the CapEx risk to a private partner, the analysis adds a conservative value-of-risk-transferred premium of 100 basis points (1 percentage point) to the public-side WACC.
PWSA Capital Improvement Program Cost and Schedule
The analysis used several simplifying approaches to craft a manageable ratepayer impact model. First, it developed a Baseline Status Quo Path scenario. This scenario uses the average of PWSA’s last two (FY 2015 and 2016) audited capital program spending to create projections for future capital spending. We assumed that modest capital spending would persist for several years but that most CIP needs would be deferred until a later date. That is, the Baseline scenario assumes that PWSA
2 Banks do not invest, but rather lend with the full expectation of being paid back.
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continues its historical practice of keeping rates low by deferring expensive improvements, but that the utility (and ratepayers) eventually suffer the consequences of that deferral through sharp increases in costs in later years. The purpose of modeling this scenario was to establish a baseline against which to compare the reform options.
For each of the reform options (in contrast to the Baseline), the analysis assumed that the CIP would be implemented on a simplified 2017 to 2030 spending schedule developed by Tetra Tech from its consultations with PWSA. We further assumed (to simplify the analysis) that annual CIP spending would be constant at Year 2030 and beyond. For O&M costs, the analysis used the latest audited PWSA budget approval, adjusting for efficiency (OpEx Efficiency Gain) and/or additional option-specific costs.
Under assumptions for WACC, O&M, and other major cost categories, the financial model calculated the total cost of each restructuring option, which yields an annual and total “revenue requirement”— the amount of revenue required to fully fund the utility’s functions. The analysis then estimated a rate (per gallon of water billed) that would satisfy the revenue requirement and the demand of water in a given year.
The outputs of the financial model include:
• NPV of Revenue Requirement: The net-present value (NPV) of the revenue requirement is the most straightforward means of comparing the public cost of the various restructuring options. This metric gives the total cost to the public over the 30-year period of comparison.
• Difference to Baseline: This metric describes, percentage-wise, how a given option differs from the Status Quo Baseline Path case. Since most of the reform options we identified involve a lower total cost than the Baseline, this is reported as a negative percentage (in other words, how much less expensive the given option is compared to the Baseline).
• Average Bill: IMG developed a metric for evaluating the “annual average bill” in constant 2017 dollars. However, this estimate does not immediately translate into the bill that an average household customer might receive, but rather to the average for all billed connections including major commercial connections. To arrive at that average, IMG took the revenue requirement in each year and divided it by the total number of billed connections. This yielded an estimate for the per-connection revenue requirement, which approximated the average bill.
7.5. Results
The Status Quo Baseline Scenario
The Status Quo Baseline scenario assumes that only the most critical and dangerous flaws are fixed in the near term while other problems linger. To capture this scenario in the model, we assumed that only 50 percent of the CIP is implemented from years 5 to 15, with the balance of the CIP deferred beyond ten years. Shifting out the CIP and the resulting compounding problems of deferred maintenance result in much higher O&M and capital expenditure costs in the years when they are
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incurred due to more rapid degradation of the assets and asset-price escalation. The annual revenue requirements for the Baseline Scenario are shown in the graph below.
Figure 14 shows the revenue requirement for the Baseline Status Quo scenario.
Key WACC and Performance Assumptions
The analysis relies on several important assumptions, including WACC and Debt/Equity Ratio, CapEx Efficiency Gain, OpEx Efficiency Gain and Transaction Cost. These are listed below for each scenario:
• BASELINE: 4% risk-adjusted WACC (includes 1.0% Retained Liability Factor); 0% CapEx Efficiency Gain and 0% OpEx Efficiency Gain.
• ASSISTED INTERNAL IMPROVEMENT: 4% risk-adjusted WACC; 5% CapEx and OpEx Efficiency Gain; $10 million transaction cost (for assistance and new systems deployment); CIP executed on schedule.
• O&M CONTRACT: 4% risk-adjusted WACC; 22.5% OpEx Efficiency Gain; 5% CapEx Efficiency Gain; $2 million transaction cost.
• INFRASTRUCTURE-ONLY LEASE plus O&M Contract with Public Operator (Taxable Financing Scenario): 80-20 Debt-to-Equity Financing Structure with 5.1% WACC; 20% CapEx Efficiency Gain and 20% OpEx Efficiency Gain; $3 million transaction cost.
• INFRASTRUCTURE-ONLY LEASE plus O&M Contract with Public Operator (Tax-Exempt Financing Scenario): 85-15 Senior Tax-Exempt Debt to Subordinate Tax-Exempt
Figure 14: Revenue Requirement for Baseline Status Quo scenario
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Debt Ratio with 4.3% WACC; CapEx Efficiency and 20% OpEx Efficiency Gain; $5 million transaction cost for tax-exempt financing scenario (includes cost of financial restructuring).
• FULL SERVICE LEASE: 75-25 Debt-to-Equity Ratio with 6.25% WACC; 20% CapEx Efficiency Gain and 25% OpEx Efficiency Gain; $3 million transaction cost.
• TRANSFER TO REGULATED NON-WATER UTILITY: 6.5% WACC; 5% CapEx Efficiency Gain and 10% OPEX Efficiency Gain; $5 million transaction cost.
• TRANSFER TO REGULATED WATER UTILITY: 6.5% WACC; 10% CapEx Efficiency Gain and 15% OpEx Efficiency Gain; $5 million transaction cost.
Summary of Results
The results of the ratepayer-impact analysis are summarized in the table below:
Baseline Status Quo Path
Assisted Internal
Improve-ment
O&M Contract
Infrastruc-ture - Only
Lease
Full Service Lease
Regulated Non-Water
Utility
Regulated Water Utility
Average Monthly Bill Over 30 Yrs.
$659 $479 $456 $417 to $435 $438 $540 $229*
Monthly Savings
from Baseline
$0 $180 $203 $242 to $204 $221 $119 $430*
* Results for the Transfer to a Regulated Water Utility scenario are quite dependent upon three variables: (1) the assumed WACC, (2) the size of PWSA’s projected water CIP versus the CIPs for sewer and stormwater (the cost of those CIPs cannot be shared with the utility company’s other state-wide water customers), and (3) the willingness of the PUC to allow the utility company to share all of PWSA’s water CIP costs among its other state-wide customers.
Interpretation of Results
It is worth emphasizing again that the results are highly sensitive to the assumptions, particularly the WACC and the value of the risk transfer, for which a 1 percent premium on the WACC is very conservative. IMG chose these assumptions based upon its experience with other utility restructurings, available information on the cost of capital (WACC) for each option, and research on CapEx and OpEx efficiencies in the US and globally.
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Some caveats are in order. First, several simplifying assumptions were made with regard to the schedule for CIP spending, as well as on the level of O&M spending that would be required if PWSA were to be fully functional (IMG assumes that current O&M spending is below what a typical municipal utility of the same size would spend). Second, it is important to note that PWSA’s actual experience will certainly differ from both the assumptions and the record of other reform efforts since the utility’s O&M deficiencies are only partially quantified, and the reliability of its infrastructure-spending forecasts is unknown.
That said, this ratepayer impact analysis is useful as a directional guide to how the utility might perform under the restructuring options, especially in relation to each other. It should be used carefully alongside all the other evaluation criteria suggested in Chapter VI.
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VIII. Recommendations 8.1. Overview
IMG was tasked by the City to assess PWSA’s performance and organizational issues, evaluate restructuring options, recommend a preferred path, and assist with its implementation. As explained in Chapter 2.1, this report was intended to evaluate different options and recommend a path forward.
As shown in Chapter IV, City officials and Blue Ribbon Panel members were consulted in the selection of evaluation criteria and in the development of considerations consistent with the citizenry’s hopes for the utility. These included keeping water and sewer rates as low as possible, while guaranteeing improvements in service and protection of the public’s health. These factors weighed heavily in IMG’s evaluation.
IMG’s recommendations also derive from lessons learned from water-utility restructurings around the country, including:
• DURABILITY: Dramatic performance improvements can only be guaranteed with an enforceable contract mechanism that outlasts the tenure of the governing board members and the executive management. Most utilities threatened by an ambitious restructuring—especially one that could replace senior decision-making personnel—improve in the short term, but later gradually retreat toward the pre-threat operating norm.
• INSTITUTIONAL INERTIA: Process automation and information technologies improve the likelihood of sustained performance improvements. However, institutional factors—including political pressure to keep rates below the levels required for adequate infrastructure management; lapses in maintaining new business processes; poor inter-agency support services; and outdated hiring practices—can easily undermine such advances.
• INFRASTRUCTURE RISK: Infrastructure-replacement needs often overwhelm the value of organizational and operating process improvements. In PWSA’s case, the cost of capital improvements will be the largest driver of rate increases. Accordingly, advanced infrastructure development, maintenance, and asset management practices—more so than improved operations—will be needed to keep rates affordable for Pittsburgh’s working families.
• OVERSIGHT v. DIRECTION: State-oversight bodies can provide a valuable impetus for reform, but their expertise and authority lie in ratemaking, not in operational processes and infrastructure management. While they may be useful political shields for major rate increases, they are not structured to guide failing utilities out of their predicaments. PLANNING AND EXECUTION: Impactful improvements must be implemented under a comprehensive reform plan—piecemeal reforms will not be able to achieve a sustained turnaround in performance, operating culture, and quality of service. Almost any dramatic improvement plan, however, is certain to interfere with the agendas of those attached to the status quo. This inevitable opposition needs to be addressed through larger institutional reform.
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8.2. Three Pillars of the Restructuring
IMG’s recommendation begins with institutional reform and extends through binding operations and infrastructure management. We recommend a powerful reform path that aggressively addresses PWSA’s organizational and infrastructure issues in a contractually-guaranteed manner, while preserving public ownership, operations, and rate-setting.
This innovative approach consists of three mutually-supporting pillars:
• GOVERNANCE: IMG recommends that the City’s ownership of the water and sewer infrastructure, along PWSA’s governance and rate-setting responsibilities, be transferred to a newly-created Pittsburgh Public Infrastructure Trust. The Trust would be governed by a self-perpetuating Board of Trustees and managed by a Board of Directors appointed by the Trustees—not by City officials. This Trust could also serve as the regional foundation for other self-funded capital-intensive public enterprises. It would set water and sewer rates (under PUC oversight) and contract with the public operator for operations and customer service and with a private partner for infrastructure management.
• OPERATIONS: As noted, major operational improvements are challenging to implement but even harder to sustain. IMG’s recommendation includes making operational reform part of a three-way contractual obligation among the Trustees, the public operator (presumably PWSA or an operating component of the Trust) and an infrastructure management partner (see #3 below). The public operator would be subject (via contract) to the same stringent performance standards as a private operator. Failure to abide by those standards would subject the operator to sanctions at the discretion of the Trustees. This operating-performance guarantee is as important to the Trust as the success of the infrastructure management partner.
• INFRASTRUCTURE: PWSA’s infrastructure needs will be the overwhelming driver of water and sewer rates.3 Whereas large water and sewage treatment plant projects have a better history of being delivered closer to budget, large underground projects—water and sewer lines, and especially underground stormwater storage facilities like PWSA’s—have a worse record. In Rockland County New York, for example, a $72 million sewer line project recently escalated to $181 million with a 17-year timetable. Such cost overruns highlight the importance of a reform option that shifts risks away from the rate-paying public. The third pillar of IMG’s reform recommendation is therefore to execute PWSA’s capital improvements via a long-term asset management lease arrangement with a private partner.
3 PWSA’s capital program is nearly on the scale of Boston’s Central Artery/Tunnel Project (“Big Dig”, 1982-2006, initially budgeted at $2.8 billion and eventually completed for $14.8 billion) and Honolulu’s rail transit project (originally budgeted at $4.4 billion in 2010, now expected to exceed $9.5 billion).
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8.3. Detail of the Recommendations
The recommendations are detailed in the narrative below.
Governance
As noted above, IMG recommends that PWSA’s assets and operations be transferred to a newly-created Independent Non-Profit Public Trust governed by a self-perpetuating Board of Trustees, initially appointed by the City but eventually self-appointing for terms proscribed under the bylaws of the Trust. The trustees would appoint a Board of Directors to oversee the management utility on a monthly or semi-monthly basis. The Trust would be modeled after Citizens Energy Group in Indianapolis, but with accountability mechanisms, policies, and powers tailored to Pittsburgh’s values and needs.
Ownership
IMG recommends that ownership of the utility and its assets remain public. No assets should be sold to a non-governmental party. The Trust would exercise control over all activities, develop long-term business strategies, manage finances, and establish water and sewer rates under the auspices of the Pennsylvania PUC.
Operations and Administration
As with ownership, IMG recommends that operations and administration continue to be provided through a public entity, either directly by the Trust or under an operating-performance contract with a reconstituted PWSA (reconstituted as an operations-only entity).
Rate-Setting and Financial Management
IMG recommends that rates be established under the oversight of the Pennsylvania PUC. Revenue collection, management, budgeting, and disbursement should be the sole responsibility of the Trust’s Board of Directors and its public-operations entity (internal or external).
Infrastructure Capital Improvements and Asset Management
IMG recommends that all capital improvements—ongoing, awarded, planned and projected—be implemented under an infrastructure-only lease concession model outlined in Chapter 5.5. For awarded and ongoing CIP projects, the concessionaire would take over program management responsibilities. For planned and projected projects, the concessionaire would be responsible for carrying out the CIP program as per their initial proposal and agreed to by the Trust’s Board of Directors.
The concessionaire would be responsible for financing the capital improvements and all additional expenditures associated with their long-term condition. IMG concludes that tax-exempt financing may still be available and that PWSA’s existing debt may not have to be defeased (i.e., replaced with taxable financing). During the implementation phase, IMG will provide additional analysis on the
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most efficient financing. In all cases, the concessionaire would remain responsible for the long-term performance of the assets they install.
Asset-management duties, including but not limited to repairs and replacement of assets, along with contractual assurance of assets’ performance according to standards established by the Board of Directors, would be the responsibility of the concessionaire.
Availability Payment Structure
The infrastructure concessionaire would have no rights to establish rates or charges. It would be paid for the delivery and management of the utility’s infrastructure under an ‘availability payment’ mechanism. The concessionaire would only be paid if it delivered the agreed-upon capital projects on-schedule and of satisfactory function. Additional responsibilities tied to the payment would include asset management, repairs, replacement, and other major maintenance activities. The availability payments would vary within a specified range according to the quality and condition of the assets and asset management services.
As noted in Chapter 5.5, the AP structure is increasingly common in the US for the provision of public assets with relatively low variable annual costs. It is already one of the most common infrastructure-financing instruments for public works outside of the US, with a well-established body of experience. The diagram below shows how the AP structure would work in the lease arrangement.
Figure 15: Availability-Payment Structure in the Lease Arrangement
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Multi-Party Public Contract for Operations
As aforementioned, the public operator would be party to a performance agreement among the Trust and the infrastructure concessionaire. This contract would be similar to a performance agreement that a private O&M contractor would sign with a municipal utility’s public owner. The public operator would commit to operate the utility according to standards established jointly by the Trustees and the concessionaire, with consequences for failure to meet those standards. This is important because even though operations can be readily separated from infrastructure management, the concessionaire’s ability to fully satisfy its performance obligations to the Trust will partially depend on the performance of the public operator.
An additional part of this operator-asset manager relationship is the Joint Asset Management Committee, which will serve as the key coordinating body between the operations and the infrastructure sides of the utility’s services. The committee would ensure that mutual performance expectations are well understood, operations and maintenance plans are well-aligned, and that both parties are adequately informed about the other’s activities. The committee would be chaired by a member or representative of the Board of Directors, and would also serve as a vehicle for mediating any misunderstandings or disputes between the operator and concessionaire. Similar joint asset-management committees exist in several public-water utilities in the US to coordinate the activities of various operations, capital programming, and maintenance departments within the utility.
Low-Income Household Trust Fund
IMG recommends that the infrastructure-only lease concession be used as an opportunity to create a permanent, self-perpetuating trust fund to assist low-income Pittsburgh households with water and sewer rates that are expected to grow dramatically over the next 20 years. The upfront payment would be much like the often-large upfront lease payments from full service concessionaires (see Restructuring Option E). In this regard, the infrastructure-only concession is a unique opportunity to permanently and generously address the impending and ever-increasing needs of low-income water ratepayers.
Unlike rate-discount programs and assistance vehicles funded by voluntary donations from other water ratepayers, the Assistance Trust fund could be quite large—$50 to $100 million—and it would be permanent and self-perpetuating (expenditures from the fund would be derived from earnings on the trust). It would provide continuing subsidies, one-time subsidies, loans, or grants for household water needs (e.g., residential lead-line replacement) and all other needs-based activities otherwise covered in less generous form by uncoordinated assistance programs.
Timeline
OVERVIEW: The restructuring process would begin with the creation of the Public Trust and appointment of an initial Trustee to oversee the restructuring process. This Trustee would be granted a small temporary staff and broad authority to initiate the restructuring process (e.g., begin the transfer of City-owned water assets into the Public Trust, issue a Request for Expressions of Interest or RfEOI for the infrastructure-lease concession) and address urgent problems at PWSA
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until the full Board of Trustees is appointed. The Trustee would also be the primary liaison with the State PUC (assuming PUC oversight begins in April 2018).
PWSA and its board would continue their current roles under the oversight of the Initial Trustee until: (1) the assets are transferred from City ownership to the Public Trust, (2) PWSA can be converted to an operations-only entity, and (3) the Trustees have completed an agreement with a private partner responsible for the capital-improvement program and asset management (ongoing capital projects would continue with the new partner serving as the program manager).
The Trustees would then appoint a Board of Directors to manage the Public Trust’s day-to-day activities while the Trustees role would be reduced to high-level governance, appointing its own members as their terms expire, and other duties in a manner similar to the Indianapolis model. In addition to being responsible for setting rates, liaising with the PUC, and assuring service quality, the Public Trust would oversee the public operator and private-asset manager under arms-length contracts with high performance standards and sanctions—including the option to terminate for poor performance.
INITIAL TRUSTEE: IMG recommends that the restructuring process begin immediately with the governance change, starting with the creation of the Trust shell entity (into which assets and operations will eventually be transferred) and the appointment of an Initial Trustee to assume executive control of—or merely coordinate with—the PWSA board. The Initial Trustee would have a small implementation staff that would later serve the Board of Trustees and the Board of Directors. This appointment would be followed by the appointment of additional trustees selected by the Mayor and City Council for their profile and executive expertise in overseeing large corporate or non-profit organizations. Since the Board of Trustees will be a higher-level body—and in short order will appoint the Board of Directors with more responsibility and to handle day-to-day matters for the utility—the trustees can include high-profile individuals who have shown great interest in permanently resolving Pittsburgh’s persistent water and sewer crises.
TRANSFER CONDITIONS: During the early months of the Trust, the trustees would work with the City (the current owner of PWSA’s assets) to establish the condition under which the utility’s assets would be transferred into the Trust. At around the same time, the Trust—again, in cooperation with the City—would issue an Request for Proposal (perhaps preceded by a Request for Interest and a Request for Qualifications) seeking an entity to carry out a long-term (40+ years) capital-improvement program for water, sewer and stormwater, and assume responsibility for their long-term condition and performance.
OPERATIONS: As noted previously, there are two alternatives to ensuring public operations for the utility. The first is to fully transfer PWSA’s operations and staff responsibilities into the body of the Trust, or at least its operating arm. However, this would jeopardize the arms-length relationship required to enforce the standards of an O&M Contract. The better alternative might be to maintain PWSA as a smaller operations-only public entity to which the Trust can source its operations. The latter allows the Trust to enforce performance guarantees and impose consequences for inadequate performance, including (as a last resort) termination of its contract.
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ASSET MANAGEMENT LEASE PROPOSALS: Once the water and sewer assets have been transferred from the City into the Trust (8 to 12 months after starting the process), the prospective infrastructure managers will have had time to conduct their due diligence and submit their capital program and asset management proposals. The Trust—through either the Board of Trustees or the Board of Directors—would evaluate and compare the proposals.
IMG recommends that the proposals be evaluated according to proposer qualifications, total life-cycle price (for projects within the known parameters of the 40-year CIP), credibility of the plan and budget, and proposed availability payment. IMG further recommends that the proposals be evaluated not just against each other but against a “public sector comparator” that incorporates the most appropriate all-inclusive cost estimate and the value of known risks. If the comparison indicates that none of the proposals are demonstrably superior to the hypothetical public baseline, then the Trust would follow through with a capital improvement and asset management approach of its own design and executed by Trust staff.
Figure 16: Proposed Timeline for Restructuring Process
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8.4. Conclusions
As this report explains, each of the restructuring options has its advantages, and each has its own viable form of public accountability and quality assurance mechanism, some stronger than others. However, PWSA’s organizational problems are large and long-standing, and its infrastructure needs threaten to overwhelm the pocketbooks of the city’s water and sewer ratepayers. Business as usual, even along the current improvement path, is simply insufficient to overcome these enormous challenges.
IMG has recommended a combination approach, one that maintains public ownership, operations, and rate-setting, while selecting the greatest advantages of each restructuring option and forging them into a powerful synthesis—one that relies on politically-independent governance and contract-driven public and private performance. We believe this “best of the best” approach will not only solve PWSA’s persistent organizational and performance problems, durably and efficiently, but also enhance Pittsburgh’s national reputation as a leader in public-service innovation.
END OF DOCUMENT