Financial Benefit for Restructuring Municipal Water Utilities

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Financial actors could stay in the game and are still relevant actors in the decision-making about Finnish water utilities, while other private corporations have mostly withdrawn after their unsuccessful attempts to promote change. In order to understand why this has happened, it is necessary to analyze the financial benefit of restructuring the water sector, as most managers across different actor groups that were interviewed have argued that the attempts to change the water sector are predominantly about one thing –

‘money’.

One of the major points about the restructuring of water utilities and making them limited companies or merging them with energy companies is that the water utilities’ assets are re-evaluated in such cases, which leads to a higher asset value. The gains in higher asset value are one of the major motivations for municipalities to restructure their utilities, and they allow the municipalities to release capital that otherwise could only be released through selling the utilities – partly or fully – to private investors. A brief analysis of the water utilities’ finances explains in a more practical manner what the benefits of reorganizing the water sector could be for the owner and the water utilities.

In the following paragraphs I present a comparison of the nine largest water and sewerage utilities in Finland, which are all owned by their municipalities and governed as municipal enterprises and hence, not as limited companies. Two of the largest water utilities are therefore excluded, Lahti Water and Hämeenlinna Seudun Water, because although they are municipality-owned, they are limited liability companies. I have excluded them from the analysis because the re-evaluation of assets is a result of changing the legal title of the organization from municipal enterprise to a limited company. The comparison and calculations need to be seen as estimates because the analysis of a water utility’s assets and infrastructure and its value is a rather complex undertaking, and only parts of the necessary data can be retrieved from the water utilities’

annual reports. For example, one of the problems is that the return on the basic capital (in Finnish: Pääoma) does not only come through the annual returns the utility pays to the municipality. In most cases, charging higher interest rates than the usual market rates for loans given by the owner to the water utility allow the owner to receive an additional return from the water utility. This interest-borne return, however, is not included in this calculation because most water utilities do not report on it sufficiently in their annual reports, and neither do the municipal owners (Näsi and Windischhofer, 2005).

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Table 4-4 Comparing Historic and Present Asset Valuation⁷

Asset Value Based on Historic Costs (Method currently in use)

Asset Value Based on Present Costs (Method promoted by Financial Actors and used in the Energy Sector)

Changes in Assets and Returns

Water Utility Basic Capital (based on historic cost system) M EUR Annual Return to Owner % Annual Return to Owner MEUR Basic Capital (based on present costs) Current profits but calculated based on new presentcost system % Rate of annual return on basic capital invested as in electricity sector % New Annual Return based on the 6% as in electricity sector and by using present cost system M EUR Increase or Decrease in annual Return Increase in Owner's asset value

Espoo 67,4 10,0 6,7 202,2 3,3 6,0 12,1 45 134,8

Helsinki 144,3 9,0 13,0 432,9 3,0 6,0 26,0 50 288,6

Jyväskylä 25,2 12,7 3,2 75,6 4,2 6,0 4,5 29 50,4

Kuopio 21,6 5,4 1,2 64,8 1,9 6,0 3,9 69 43,2

Oulu 18,5 18,4 3,4 55,5 6,1 6,0 3,3 -3 37,0

Pori 42,1 4,0 1,7 126,3 1,4 6,0 7,6 77 84,2

Tampere 70,3 14,2 10,0 210,9 4,7 6,0 12,7 21 140,6

Turku 109,4 5,5 6,2 328,2 1,9 6,0 19,7 69 218,8

Vaasa 23,9 8,8 2,1 71,7 2,2 6,0 4,3 51 47,8

Total 522,7 9,8 47,5 1568,1 3,2 6,0 94,1 45 1045,4

As depicted in Table 4-4, the nine largest water and sewerage utilities that are governed as municipal business departments have a combined asset value of EUR 522.7 million, according to their annual reports of 2004. This figure is based on the value of their assets measured according to historic cost, meaning, according to the expense that occurred at the time of constructing the assets. For water service infrastructure, the infrastructure life cycle often goes over decades, or even a century, as some parts of the networks have been constructed a hundred years ago and may still remain intact.

The present cost value, however, means valuating these assets according to the expense that would occur if one had to construct this infrastructure today and with present technology and according to present standards in quality and safety. According to financial actors and engineering consulting firms, the present cost value of a Finnish water utility represents on average the threefold to fourfold of the historic cost value.

This results in an increase of asset value from EUR 522.7 million to EUR 1.57 billion in case of a threefold increase or to EUR 2.1 billion in case of a fourfold increase.

7 These calculations are based on information received during interviews and conversations with several experts from the water, finance, and municipal sector on the methodology of these calculations and by using financial data from the water utilities’ annual reports.

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In order to maintain a conservative estimate of the potential transaction volume for the selected water utilities, I decided to use a threefold increase of asset value, which results in EUR 1,568.1 million (Table 4-4 on previous page).

“Our logic is based on the regulatory side, which is applied in the energy market and which the energy market authority applies, so we applied the same principle to the water sector. The energy market authority uses the replacement value as the basis of where the return should be calculated because it cannot be calculated on the basis for how much you would buy that water utility, for example including the goodwill, or that much, it can’t be the book value because you have assets of varying ages, you can have new assets, you can have old assets, you always have a mixture of those.”

(Investment Banker)

“The financial statements of these companies do not have a relation to the reality of what the real value of the assets is. The real value of the assets is three or four times bigger than the book values.” (Investment Banker)

Because the municipal owner can borrow against the assets of the water utility at the financial markets and the value of assets increases three times, the municipalities of these nine cities would be able to take loans for approximately EUR 1 billion, which represents the lump sum payment, as financial consultants often call it. In other terms, the increase in water utilities’ assets is used by the municipal owner as collateral against which capital can be borrowed from financial markets.

In addition to this lump sum, the continuous revenue flow would increase if the same methodology as in the energy sector is applied to the water sector (the financial actors assume that it would be the case). For the energy sector and electricity utilities in particular, the return of investment is connected to the present cost value of the transmission network, which is on average six percent as permitted by the regulative authority for the energy sector.

Concerning the profitability and annual return on basic capital the return for the water utilities in the larger Finnish cities has often been higher than the six percent in the energy sector. This has been the case for examples in cities such as Oulu, Tampere and Helsinki. Based on the historic value of their utilities’ assets, the return on capital for the year 2004 was within a range of 4 to 18.4 percent, with an average of 9.8 percent.

However, the present return on capital in relation to the present value of assets is significantly lower than 6 percent. In fact, on average, the return on capital invested based on a conservative threefold increase in asset value ranges between 1.4 and 6.1 percent, on average 3.2 percent. Switching to a similar methodology of regulating the return on capital as it exists for the Finnish electricity utilities, the owners of these nine Finnish water utilities could increase their returns from 3.2 to 6 percent, a growth by 47 percent.

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Under such a new regime, with re-evaluated assets and a regulation allowing 6 percent return on these assets would allow the nine owners to increase their combined annual revenue flow from their water and sewerage utilities from EUR 47.5 million by fifty percent to EUR 94.1 million, if the conservative threefold asset value increase is applied.

From the investment banker’s perspective, the fees that could be earned from the transactions in this sector are rather substantial as the approximate total asset value of only these nine utilities is EUR 1.5 billion (if considering a threefold increase in assets).

Basically, transactions of any kind provide the financial actors with income and in this case without even privatizing any of the public assets but just transferring them within the public organization.

The impact of these changes in valuation of assets and return on capital on water tariffs—

and therefore on the consumers—is not included in this analysis. However, a rise in prices for consumers seems inevitable in my opinion if the water sector is to renovate its infrastructure according to sufficient quality standards. This rise in water tariffs may be even greater when municipalities continue receiving profits from the water utilities at current levels or try to increase them.