What Is Fair Return to Water Companies?
Subject Considered in Its Relation to the Financing of Extensions to Water Works Systems and Question of Adequate Water Rates—Proper Rate of Return on the Investment
THE vexing question of adequate return on investmeat for the private water company, involving, as it does, the mutter of equitable water rates, which is always a troublesome problem and one which is productive of much friction, is treated in the following article. Mr. Coulter is a clear thinker, and his conclusions on the subject which he handles are based on long experience.
In a rate case with which the writer was connected some time ago, some of the water company’s witnesses claimed that a fair return meant a return large enough to yield a surplus from which extensions to the system might be financed.
It is now generally conceded that, other things being equal, a water utility is fairly entitled to reimbursement for all its operating expenses; to an additional amount sufficient to keep its investment unimpaired from losses arising from the deterioration of age and wear and tear—that is, depreciation; and. further, to a fair percentage of return on the investment. If the return or interest rate on investment is not greater than that which may be secured, say, from conservative, long-term industrial bonds or a similar safe, non-speculative investment, it is clear that there is no incentive for anyone to bother with the difficulties involved in the construction and operation of a water utility.
Reimbursement and Payment for Depreciation
Reimbursement for operating expenses returns to the utility only what it has paid out. Payment for depreciation offsets ageing and wear and tear; its purpose is to prevent the loss of the investment. For instance, if one were to buy 20-year bonds, he would have at the end of 20 years the face value of his bonds, and would have received during the interim certain interest payments. Should he undertake with the same investment to construct and operate a water utility, he would, at the end of 20 years, have lost a considerable part of his initial investment through the wearing out of his pipes, valves, meters, pumps, buildings, standpipes, etc., etc., unless he received payments to make good such losses.
It is evident then, that payments for operating expenses and depreciation represent no net income to a water utility, but it. is as though the utility were to take a given amount from its corporate righthand trousers pocket and transfer it t.o the left.
Rate of Return on Investment
As to the rate of return on investment, the owner of the utility could receive from five to six percentum. say, by investing in safe, non-speculative bonds, without worry, labor or difficulty beyond that involved in clipping his coupons. As matters stand then, if the owner of a water utility is receiving only his operating expenses, depreciation and not over 51/2 percertum return on his investment, he would be better off out of the water works business. To make it worth while he should receive substantially more than 51/2 percentum.
“Reimbursement for operating expenses returns to the utility only what it has paid out. Payment for depreciation offsets ageing and wear and tear; its purpose is to prevent the loss of the investment.”
Entitled to Payment for Service
Although the degree of risk or hazard from competition or displacement is ordinarily not so great in the case of a public utility as in that of a competitive business, it is clear that the utility is entitled to some return over and above that which it could Secure without difficulty, merely by buying conservative bonds. That is, the utility is entitled to some additional payment for conducting a water works business, for serving the public. This additional payment may be called the profit increment, or payment for service.
I have been at some pains to make this clear, because it is not generally understood. If the public and its representatives had acted with a knowledge of these simple facts in time past, the railroads would not be in their present unsatisfactory condition.
What the Profit Increment Is
The profit increment referred to above may be expressed as an increase of the rate base, or investment value, to which the rate of say 51/2 percentum is applied; or as an increased percentage of return on the unenlarged rate base. For instance, let us assume a rate base of $5,000,000 and an interest rate of 51/2 percentum, the latter including no profit increment. We may now take a profit increment of 33 1-3 percentum of the rate base (1-3 of $5,000,000), making a total of $6,666,667. and apply to this the rate of 51/2 percentum. We thus secure a return of $366,666.68 instead of $275,000 (51/2 per cent, of $5,000,000). That is, the additional return for conducting the enterprise and serving the public is $01, 667 a year.
Or, instead, we may add one-third of 51/2 per centum to the interest rate, making the latter 7 1-3 percentum. Seven and one-third per cent, of $5000.000 equals $366,667. as before, leaving $91,607 annual profit increment. The foregoing figures and percentages are simply assumed for purposes of illustration and are not to be considered as fixed.
Now, the witnesses referred to in the opening paragraph of this article, held that in addition to the elements of return we have discussed, the company was entitled to a further payment to provide a fund from which extensions to the system might be financed.
See Nothing Inequitable in Arrangement
Some prominent engineers see nothing inequitable in such an arrangement. It is certainly done by large private corporations engaged in the oil. coal, steel and other industries. But the water company is a public utility; it performs a public function, a function which has come to be generally recognized as governmental, left in private hands from motives of expediency, and herein, to my mind, lies an essential difference between it, and wholly private corporations, upon which are imposed no limitations as to the amount of money they are entitled to earn if they can get it; no limitation outside of the charter fixing the lines of business in which the corporation may engage.
“It is unquestionable, however, that water utilities experience great difficulty in securing capital for extensions. They should be assisted by public utility boards in their financing operations, in every legitimate way.”
Should consumers pay a water company an increased rate of return especially to enable the com pany to finance extensions from earnings, consumers would later on pay interest, profit increment and what may be termed an extension increment, upon these same extensions built with the consumers’ money. Payments by consumers on such extensions would not represent payments for the use of and service from the owner’s stored-up labor in t.he form of capital, but for the use of and service from their own stored-up labor transferred to the company without, a corresponding return in service. Any service later rendered by extensions so financed would be paid for by consumers quite as if the capital had been provided by the owner.
In the case of a rapidly growing utility, such an arrangement would create a veritable mint for the owner, with the bullion and stamping machines presented to him free of charge.
The private corporation is, in many cases, controlled by competition and is not able to finance any large extensions from earnings. The formation of public utility boards and commissions was instigated largely by a desire to control just such operations of public utilities, which are more or less monopolistic in character. To ask these same boards to place their official seals of approval on practices they were originally formed to stop, is a little unreasonable.
Should be Assisted in Financing Operations
It is unquestionable, however, that water utilities experience great difficulty in securing capital for extensions. They should be assisted by public utility boards in their financing operations, in every legitimate way. The suggestion that consumers pay increased water rates to finance extensions is not at all unfair, in my opinion, if interest on the funds so accruing were to be returned to the fund or applied to reduce the water rates and if, after the extensions were made, no interest charges were to be paid thereon by consumers. Profit increment, operating expenses and depreciation should, of course, be paid on such extensions by consumers.
The water company being paid the usual profit increment on the extensions for its services in operating the same, it would receive the same net profit as if it had sold bonds to finance the extensions. The consumers would pay the charges of operation and depreciation, as they would do in any case, but would be relieved from interest charges which they would otherwise pay.
Effect Would be to Lower Water Rates
As the effect of such operation of the extensions would be felt by the system as a whole, the result would be to eventually lower the water rates to a point below that prevailing before the increase to finance extensions—that is. assuming no disturbing influences, such as the recent war. In short, the water utility would thus become something of a co-operative enterprise, the owner holding unimpaired and receiving the usual return on the investment actually made by him, and holding the extensions in trust for the consumers as a body, while receiving a profit increment for their management.
Such an arrangement could possibly be worked out to the satisfaction of public utility boards. If so, an unfailing source of funds for financing extensions would be available to such companies as cared to adopt the arrangement. Supervision by the public utility boards would protect both the public and the utility.
Serious Objections to the Scheme
Serious objections to such a scheme present themselves. It would entail a large amount of additional accounting, and the company could fairly claim additional compensation for such work. Uncertainties would be introduced. A miscellaneous distribution of extensions and changes in the character and direction of service, might prevent, the identification of the physical features carried on the public account in the books, after the lapse of considerable time and the blurring of the intermixed features. The sale of the system in whole or in part, or the withdrawal of one of several municipalities in the company’s system, would bring up the matter of the restitution of payments contributed by its citizens. In case of the withdrawal of a town, the amount could perhaps be paid into the town’s treasury but, in fairness to the water company, the necessary money should come from the other municipalities, who would thus acquire the withdrawer’s public interest. Other difficulties will suggest themselves.
“Although the degree of risk or hazard from competition or displacement is ordinarily not so great in the case of a public utility as in that of a competitive business, it is clear that the utility is entitled to some return over and above that which it could secure without difficulty, merely by buying conservative bonds.”
(Continued on page 418)
What Is Fair Return to Water Companies?
(Continued from page 400)
Finally, and most important, it is probable that the act would be ultra vires, and an amendment of the charter required to cure the defect or, failing provision for amendment, the enactment of special legislation. If, however, the legal obstacles could be overcome, the remaining difficulties should not prove insurmountable.
In the case referred to, the body before which the hearings were held, rendered no specific decision in the matter of an extension increment, which was not mentioned in the brief of the water company’s attorney.