By Jason Mumm
Utility systems work better at scale. George Westinghouse demonstrated it to the world in 1896 when his company harnessed hydroelectric generating stations at Niagara Falls to power the entire city of Buffalo with alternating current. Compared to Thomas Edison’s direct current, Westinghouse’s system required far less investment per customer served: one generating station vs. Edison’s dozens. In economics, what Westinghouse accomplished, much more than Edison’s DC power monopoly (to its demise), is called “economies of scale.” Economies of scale exist when the average cost per unit of output is less when more units are produced.
You will find economies of scale in many industrial settings, but utilities benefit more than most others due to the tremendous costs involved in constructing the infrastructure needed to provide even one unit of output. Utilities that maximize the output of their infrastructure will be able to produce at the lowest possible unit cost and may therefore charge the lowest possible rates.
The allure of economies of scale for municipal water utilities is obvious. After all, lower costs and lower rates are desirable on every level. As affordability concerns continue to loom over many of the country’s water systems, consolidation of adjacent providers to attain those alluring economies of scale continues to be of high interest to governing bodies, managers, and the general public. However, with about 60,000 drinking water utilities operating in the United States, it would seem that consolidation is not easy and, quite possibly, not as attractive of an option as one might think. What are those challenges, and how can one navigate them successfully to find the elusive win-win scenarios and all the potential benefits?
Challenge no. 1: Scale Isn’t a Given
To capture the benefits of economies of scale, a merger of utility systems will either need to increase output across existing capacity or produce efficiencies that reduce overall costs, preferably both. In both cases, the costs of consolidating must be lower than any benefit produced, or the business case for consolidation will implode on itself. Consider the following figure: it shows two average cost curves. TAC(1) is the one a utility may currently have, and TAC(2) is one that might exist in a post-merger operation. The difference between TAC(1) and TAC(2) is due to cost efficiencies: the combined operations simply cost less due to whatever efficiencies exist from merging. There are also two output levels, D(1) and D(2). Even without the cost efficiencies described above, we still see a small decrease in the average cost per unit marked by P(1) and P(2). Once we also add the savings from efficiencies, we could get to P(3) for the big win! This is an example of a merger producing both an increase in production across an existing system capacity and generating cost efficiencies.
But things are rarely so obvious. Once utilities start investigating consolidation, they often find that they can expect a host of new, unplanned costs necessary to combine the systems physically and legally. If they exist, these costs may be large enough to wipe out the immediate gains because they shift the scale altogether. Put another way; these costs cause the average cost per unit to be higher for one or more of the merger partners; think of it as TAC(1) shifting upward rather than downward to TAC(2). However, those costs may still be manageable if the output is large enough to counterbalance the upward shift in costs. In Figure 2 below, we see an upward shift in TAC that may still yield a lower cost per unit indicated by P(2). Had the upward shift been any higher, though, the cost at P(2) may have been higher than the current cost at P(1), and the merger may have looked less desirable.
Challenge no. 2: Benefits Are Often Long-Term Rather Than Short-Term
More often than not, mergers of municipal water utilities will produce a mix of so-called wins and losses: those who benefit immediately vs. those who don’t. In many cases, the presence of “losers” will shut down the merger talk, maybe permanently. It’s short-sighted to do so, however.
It is a rare case when consolidation, even among neighboring utilities, would immediately result in reduced costs for the customers of both systems. That kind of win-win scenario requires a true marriage of equals, neither requiring significant upgrades to make it work, and both willing to eliminate duplicated costs and share in the governance. More common is a situation where one of the partners benefits almost immediately, and the other benefits somewhere down the road as the inherent efficiencies in the consolidation play out. Unfortunately, it is not easy to convince the key decision makers in a municipal water utility merger that they should go forward if only for the potential for future cost efficiencies. Quick wins are what everyone wants to see, but the reality mostly begs for patience.
There are also cases where the consolidation never works for one or more participants, and it’s as important to identify those situations as the wins because avoiding a structurally bad consolidation is perhaps even more important than finding viable ones. If there is no point in the reasonable future where all the partners can expect lower average costs per unit, it’s probably safe to say the merger isn’t a win-win. It’s best to avoid those.
Challenge no. 3: Control Matters More Than You Think
Assuming you make it past the first two challenges, the merger will still need to deal with the significant weight that most municipal bodies place on autonomy. The ability to control the policies and key decisions for the water utility is a power that nobody wants to give up lightly. It’s a power that has intrinsic value and needs to be recognized at the outset of any discussions about a merger. If you don’t deal with it early, it will certainly be back later to stand in the way of claiming those elusive cost savings.
In any merger situation, one party will either lose or gain some level of control. Those losing control tend to want something in exchange, whether financial considerations or otherwise. What’s important for the success of the merger is that you recognize that control has value and that losing or diluting it is something that must be addressed as part of the plan. How it is addressed will come down to negotiation, but those negotiations can’t go anywhere if there is not an up-front acknowledgment.
Consolidation is one way for communities to work towards the goal of lower unit costs for water service and, therefore, lower rates for residents and businesses. We’ve explored three key challenges for making a consolidation work, but certainly not all of them. Keep in mind that utilities can find economies of scale together through multiple different arrangements, consolidation being only one. Still, of all the forms of regional cooperation out there, consolidation offers the highest potential to achieve both economies of scale and the kinds of efficiencies that can change the game for years to come. It also happens to be the most difficult to pull off, which is perhaps why we still see 60,000 water utilities 180 years after the first major waterworks started operating in the country.
Jason Mumm is principal at FCS GROUP, Inc. He has more than 20 years of financial and economic experience for water, wastewater and stormwater utilities. He is a nationally recognized expert in utility rates, fees and charges and has helped author significant portions of the American Water Works Association’s guidelines for water utility rates.