Effective Regulation Incentivizes Capital and Accountability for Reliable Water & Wastewater Infrastructure.

June 21, 2022

People often ask if there is a “magic-bullet” technology to solve the world’s growing water problems. Having invested globally for decades, exclusively in companies and assets that improve water quality and water supplies, we have learned that the solution is not a single technology or product. Instead, the key to reliable water is a proper regulatory framework that provides investor-owned water and wastewater utility service providers with fair and transparent pricing arrangements that cover all aspects associated with the costs of delivering reliable water and treating wastewater.

These regulatory regimes already exist around the globe for dozens of water utilities that WAM has profitably invested in where shareholders and paying consumers thrive. Effective water utility regulation has the proven record of attracting hundreds of billions of dollars of private capital to fund the delivery of safe reliable drinking water 24/7/365. Proper regulations incentivize the steady flow of capital that is essential to fund the construction, expansion, and ongoing maintenance essential for reliable water and wastewater services. In addition, this type of regulation also provides effective operator accountability resulting in system outperformance. Moreover, using tiered, volumetric pricing models incentivises conservation while accommodating low-income consumers.

As both drought and flood intensify due to climate change, and as demand for water increases with populations growth, these proven regulatory frameworks must now be adopted in additional geographies around the world to sustain life, economic growth, social stability, and environmental balance.

 Not only is reliable water and sanitation a primary outcome, but this type of regulation also provides the “TLC”, Transparency, Long duration opportunities, and the regulatory Certainty that investors seek. Effective regulation rests firmly on pricing water services appropriately. Full cost pricing incentivizes not only the reliable delivery of clean, safe, reliable water, but also the implementation of innovative technologies people often ask about. These are most effective when coupled with the full specification of rights and full assignment of responsibilities for risk management in a manner consistent with hydrological and biophysical realities.

The following summarizes regulatory practices, core principles, and key objectives of best-in-class regulatory regimes we have experienced. First and foremost, trust-building among stakeholders is an essential characteristic of all effective water regulatory regimes. Decision-making should always be undertaken in a fully transparent manner and ensure that all views and options are considered. The values that flow from the provision of safe, clean, and reliable water should be consciously demonstrated to gain support and alignment from ratepayers, management, investors, environmental stewards, and regulators. Most importantly, to ensure the value of tariffs paid is recognized, regular independent data must be provided to consumers and all other stakeholders as problems are identified and opportunities to improve water quality and service reliability are explored. 

Universal metering is foundational. When utilities don’t measure water use quantities, it can neither be managed properly nor appropriately conserved and priced properly. Since water is the longest of long-term business models (many systems are 100 years old) performance requirements and incentive structures must focus on long term objectives, not short-term gains. Rent-seeking behaviours must be strongly discouraged – especially when they seek to produce incremental short-term returns at the expense of long-term costs. Failure to maintain infrastructure and in particular to fix leaks is a critical example. It is easy to postpone maintenance but almost impossible to catch up once infrastructure decay has become the norm. When it comes to water, the old saying “a stitch in time saves nine” is relevant.

Finally, intelligent, and dynamic tariff structures should fully cover water treatment, transmission, and reliable long-term supplies to create the “perpetual flywheel” necessary to finance ongoing capital investment in water infrastructure. Tiered volumetric pricing systems or better yet arrangements that always ensure full cost recovery through the use of separate mechanisms for the provision of financial assistance to those who cannot afford water to ensure water availability for all while promoting conservation. . In some cases, capacity charges can also be used to smooth certain infrastructure transitions. An additional regulatory “technology” with exciting potential is the pursuit of innovative and more inclusive ownership structures such as partial mutualization which provide long term ownership benefits to rate payers alongside those of institutional investors.

 While WAM’s investment focus is with investor-owned water utility infrastructure, it is the nature of the regulatory regime, even more so than the ownership structure itself (i.e., public vs. private investor owned) that is most important to long-term water utility success. Regardless of ownership, regulation must be structured to engender increased innovation and efficiency to justify a higher return on capital employed and weighted average cost of capital (WACC). Independence from the daily “political” process assures a sound and efficient system over the long term.

There are additional high-level structural attributes that make for particularly robust regulatory regimes. First are rational geographic boundaries. Regulatory jurisdictions should be manageable in size and composition and ideally be geographically aligned with watershed or catchment boundaries. Second is to incentivize outcomes, not outputs. An outcome-focused approach that is method agnostic increases institutional ability to innovate and reduce long-term costs to customers. Third is a regulatory emphasis on efficiently managing total costs, which include both operational costs, and capital costs (sometimes called “TOTEX”) as a key enabler, as this provides operators with flexibility to adjust capex /opex splits over time. Incidentally, an outcome-focused approach will continue to grow in importance as utility operators increasingly shift away from traditional, capex-intensive ‘hard path’ infrastructure and include more nature-based solutions. An example is the UK’s cover crop incentive program for farmers that is designed to encourage them to reduce nitrogen pollution associated with run off that can be much cheaper than water treatment. Results suggest that this approach can lower water treatment costs by 90%.

To the maximum extent possible, the regulatory and budgetary ringfence of operators from political and welfare considerations enables maintenance of operational integrity and focus. Regulatory regimes must be capable of operating independently and transparently, maintaining an arms-length relationship with government. Structural attributes that facilitate successful regulation also include clear statutory duties bestowed upon the regulator. A well-defined regulatory asset base for the operator and the investor is also key. Of course, none of any of this is possible without a clear, well-defined, local rule of law, which stipulates regulatory enforcement and accountability. This is of course paramount and must exist locally and/or be guaranteed by credit worthy counter parties.

Finally, iterative flexibility is key to effective water regulation. Short-dated (2~5 year) periodic regulatory reviews for contractual water utility tariff resets are preferable to longer-dated (~25+ year) programs which tend to fall behind contemporary economic and resource realities, leading to trust and credibility erosion.

 The result of all the above is a prioritization of reliable, high-visibility cashflows that are appropriately redeployed to maintain and expand water infrastructure to the benefit of rate payers, while satisfying shareholders. The foundational responsibility and duty of a regulatory regime is to ensure access to safe and reliable drinking water and sanitation. This need not occur, however, at the expense of future water users. The provision of reliable water access requires substantial capital investment. The regulatory regime must always ensure operation over the long term, and, by long term, we mean forever!