Act 12, explained: Customers more likely to see rates rise with Pa.’s new water privatization process

Pennsylvania is already known among water companies and their shareholders as being a good state for doing business.

And now, it’s even better.

That was the conclusion of a report out this week from Moody’s Investor’s Service.

The change is Act 12, a law that offers a different way to privatize water systems in Pennsylvania.

It stemmed in part from concerns about municipalities leaving money on the table, according to the Pennsylvania Economy League’s Central Office Executive Director Gerry Cross, as struggling communities increasingly consider unloading their public water systems to generate some cash. Financially stable municipalities might consider it, too, if running the systems no longer seems worthwhile.

In its recent report, Moody’s contends Act 12 benefits both municipalities looking to sell their water systems and utilities looking to buy.

Some argue the analysis was premature: just one transaction has gone through the process since the law took effect.

Others say no matter what, it’s customers who bear the most risk.

What’s Act 12?

Act 12 sets up a negotiating framework in which the seller and prospective buyer each pick an independent consultant from a group vetted by the state Public Utility Commission.Each consultant has six months to calculate an estimated value of the water system pending sale. This figure takes into account many factors including the value of the infrastructure itself, the system’s anticipated revenue and foreseeable costs such as repairs, maintenance or improvements required by law.

The acquisition price is the average of the two consultants’ estimates – unless the parties agree on a lower one.

Act 12’s valuation process basically guarantees higher figures. There are a couple reasons why.

First, Act 12 does away with a deduction that’s long been standard in these types of transactions, as explained in plain terms in this release from engineering firm HRG.

Before, if a municipality ever used grant money to build, expand or improve the infrastructure, that money would be deducted from the system’s assessed value.

Under Act 12, there’s no deduction of grants or other subsidies used over the years.

Act 12 also allows income to be considered in a systems’ value, which wasn’t the case previously.

That means municipalities are poised to get more cash for their assets.

And the higher prices are more palatable for utilities than one might expect due to other components of Act 12.

Previously, utilities could expect to recover acquisition costs through PUC-approved rate increases only when buying systems that were small (3,300 or fewer customers), distressed or in violation of federal law. Otherwise, they utility didn’t know for sure until after the sale how much PUC would allow rates to go up to cover transaction costs.

With Act 12, PUC is essentially giving preapproval as part of the process regardless of a water system’s financial status.

Consumer concerns

Act 12 is voluntary. Municipalities and utilities are free to do these deals as if the law doesn’t exist. While municpailties can get more money for their assets through Act 12, the new process is prolonged enough right now to discourage some communities from going that route, according to Adrienne Vicari, who heads HRG’s financial services practice area.

Pennsylvania’s Acting Consumer Advocate Tanya McCloskey says she has concerns based on the first few Act 12 cases (Limerick Township, Montgomery County, and the distressed city of McKeesport are engaged, but not yet through, the process; New Garden Township is done with it).

Higher value estimates and sale prices were anticipated under Act 12 because they reflect considerations absent appraisals before Act 12, Vicari says.

But for McCloskey, the figures so far have exceed even those expectations, prompting concerns that customers might end up overpaying.

“Our experts found [the appraisals] were overstated,” she says. “So we have concerns [about] acquisitions at these purchase prices.”

It’s also important to note that in some cases, rates charged by municipally-operated systems might be artificially depressed. Often rooted in politics, this tendency can lead to other problems such as poorly maintained infrastructure (a struggle even for better-resourced systems). 

Municipal systems, however, don’t have to answer to shareholders expecting returns. Regulators limit the extent to which customers can contribute to those profits. But Pennsylvania’s cap is more generous than in most other states.

PUC oversight and approval of rate increases is also intended to prevent rate spikes. Utilities’ ability to spread increases over larger customer bases mitigates this effect as well — but in theory, this tempering effect could be negated if enough systems are privatized.

And even Moody’s acknowledges in its report that rate increases could, at a certain point, drive regulatory reform brought on by political pressure from consumers.

Editor’s note: This post has been updated to add information provided by Adrienne Vicari of HRG.