AKO Without Having To Say Monopoly

To the Residents of Claremont from Andy Winnick                                                                                      September 2014


An Analysis of the Economics of

the Proposal by the City of Claremont to

 Take Over the Local Water System from Golden State Water

and Operate It as a Public Utility,

Using Revenue Bonds described by Measure W


Most of you have seen letters and read press releases written by or citing work done by Dr. Rodney Smith, a former professor of economics at CMC, who has been using his credentials as an economist to give credibility to his comments opposing the City’s purchase of the water system.  In response, I feel it is necessary to establish my own credentials as an economist to lend credibility to my response to Dr. Smith, since I must disagree completely with him and the statements of the No on W campaign. Most of the facts they cite are in actuality false -- they are not facts, but assertions based on flawed and incorrect analysis using misleading assumptions, misstatements of facts, and the decision to ignore concrete evidence that is inconvenient. I will demonstrate this in detail below.

 It must be noted that the work of Dr. Smith and the campaign against Measure W have both been funded by Golden State Water (GSW) as part of their campaign to block the City’s effort.  That is, theirs is not an independent, objective analysis; it is work bought and paid for by GSW to preserve its profits at the expense of the residents of the City of Claremont.

In the interest of establishing my credentials: I am a professor of economics and statistics, still actively teaching both subjects at Cal State L.A.  I have served on the research staff of the President’s Council of Economic Advisors in Washington, D.C. and on the research staff of the Federal Reserve Bank of San Francisco.  I have held tenured positions in economics at three universities, given invited lectures at many universities across the United States and Europe, and have published a book and many articles on a broad range of topics.  I was also involved in a successful effort by another City to take over a utility service and then run it effectively and efficiently for many years now as a public utility.  I have been following this debate in Claremont closely, but until now have not spoken out.  I feel I must do so now. Unlike the work by Dr. Smith that was commissioned and paid for by Golden State Water, the analysis below is at my own initiative and has not been paid for by anyone.

One of the main assertions by Dr. Smith and the No on W campaign is that Measure W and the takeover of the water system from GSW would add more than $100 per month, over $1,200 per year, to your current water bill.  There is no valid analysis that supports such a statement. 

The facts are that your current water bills cover not only the costs of supplying water to Claremont residents, but also generate a profit margin of more than 8%, as allowed for by the unelected California Public Utilities Commission. (A State agency that is far more concerned with protecting the interests of private utility firms, than in protecting the interests of citizens. More evidence of this will be presented below.) This means that after GSW pays for the cost of purchasing and distributing water, and the costs of million dollar salaries to its executives, it is allowed to increase its rates so as to generate more than 8% of the value of its assets in profits. This is done to allow GSW to pay dividends to its stockholders and increase the firm’s accumulated retained earnings. The latter is a pool of cash that the firm can then use for virtually any purpose. In fact, according to Dr. Smith’s own work, commissioned and paid for by GSW, this “allowed return” averaged more than 8.8% of its “rate base” from 2007 to 2011.  The real facts are that the City would not be paying those levels of salary, would not be paying dividends to stockholders, and would not be trying to make a profit. However, the city, as described in the analysis below, does plan to set aside revenue to create a reserve to allow for emergency repairs and for service to newly built homes.

The essential point is that the City would have every incentive to keep costs as low as feasible; whereas, the higher the actual costs that GSW pays, for example to purchase water from outside sources, rather than use water from local wells in Claremont, the higher the rates it can charge and the more profit it makes. That is, GSW is allowed by the PUC to set rates that cover all of their costs, no matter how high a price they pay for the water, and to then also add an amount sufficient to generate the 8.8% profit described just above. As a private firm with a guaranteed profit margin and a guaranteed cost-plus pricing structure, GSW has no incentive to keep costs down.  In fact, they operate like the proverbial defense contractors which consistently experience cost overruns, since they too operate with cost-plus pricing and guaranteed profits. This is part of why La Verne and Upland with their publicly owned and operated water systems pay far less for their water than do the residents of Claremont.

But it is worse than that.  GSW sets its rates for Claremont based upon a far larger service area that includes communities in the high desert that have been expanding.  The PUC then allows GSW to build into the rates it charges Claremont residents the costs of that expansion in distant communities.  Outside experts have determined that this alone results in GSW rates 10% higher than would be needed to provide water just to Claremont. If the City owned and operated its water system, the rates would be set only on the basis of the costs of serving Claremont.

In addition, the PUC allows GSW to punish Claremont residents for daring to reduce their water use.  Under PUC rules, GSW is allowed to add on to the rates it charges, a fee to cover the lost revenue that results from Claremont residents conserving and using less water.  If the City sets the rates, instead of adding these special fees to the water rates, the City would pass on any savings due to reduced water usage directly to the residents, unless the drop in revenue impacted the ability to repay the bonds. In that case, during the life of the bonds, the City might have to raise rates to the extent it could not find other savings, for example by buying less water, to sustain the revenue at a level sufficient to pay the bonds.  Later, it would simply pass on all savings to the residents.

Moreover, as a private firm, GSW must pay taxes on its net revenue.  The City as a not-for-profit entity would not pay any taxes.  So while GSW must set its rates high enough to insure a reserve large enough to pay taxes, the City would not need to do this.

For these reasons, if the City kept water rates for Claremont residents at their current levels, this would generate more than $8 million dollars per year above the costs of distributing water, even allowing for the establishment of a planned reserve to pay for unanticipated repairs and the providing of water services to new homes.  This money, that GSW uses to pay million dollar salaries, generate profits to pay dividends, provide services outside of Claremont, and pay taxes, would be sufficient for the City to pay the annual costs on about $80 million dollars in revenue bonds to purchase the system from GSW.  That is, the City could afford to pay up to about $80 million for the water system without needing to raise rates at all.  The City does not anticipate that it will need to pay $80 million, as will be explained just below.  This is simply the amount it could afford to pay without raising water rates. Dr. Smith and the No on W campaign amazingly have the gall to simply ignore all of these facts.

But what would it actually cost the City to acquire its water system?  Dr. Smith and the No on W campaign have stated in their written material:

“Government [presumably they mean City] officials have consistently raised their estimated cost to purchase the water system.  First it was $54 million, then $55 million, then $80 million, and now $135 million.”

This statement, as will be explained just below, is either an intentional lie or it shows a complete and total misunderstanding of the situation.  Either way, the statement is false. 

Then, in early published statements, Dr. Smith talks about the court setting a price of as much as $100 million.  Then, in a recent letter, he states that the cost of taking over the water system is “likely to exceed $200 million.”   The hard fact is that there is no valid basis for that number. 

One has to ask why Dr. Smith and the No on W campaign; that is, why Golden State Water, thinks that they can get away with such blatantly false and misleading statements.  Do they really think the residents of Claremont are so stupid as to accept their figures without proper analysis?  I am insulted by having to read such material, and so should you be.

Here is the factually accurate and honest description of the situation:

The cost to purchase the water system from GSW will be determined by a court which is required by law to set the price at a “fair market value.” The City hired outside, independent, expert appraisers to estimate the fair market value and they, not City officials, determined initially that it is about $54 million; but then in their final report adjusted that a bit to $55 million. No higher appraised value has been suggested by the outside appraisers or by the City. The facts are that even if GSW claims a value far above the $55 million appraisal, the court will determine the actual price and the court must, by law, at least take into account the appraisal by the independent experts hired by the City.  Even if the court were to allow a price of as much as $80 million, which would be 48% above the appraised value, as the earlier analysis showed this could be paid for with no increase in water rates at all.  That is, the City and the outside independent experts it hired have determined NOT that the price would be $80 million, but instead determined that even if the court were to set such a high price, that amount could be paid with revenue bonds financed from the current water prices.  No increase in rates would be required whatsoever.

But the City decided to be very cautious and to allow for even a worse possible situation. In setting the amount of Measure W at $135 million, the City decided to allow for the highly unlikely possibility of the court setting a price more than twice as high as the appraisal. In fact, it allowed for the remote possibility of the court setting a price 145% above the appraised value.  In all likelihood, the court-determined price will be far lower.  But if this worst case occurred, the City could afford to pay for the costs of the first $80 million in revenue bonds without raising water rates at all, and would need to raise the rates only enough to cover any amount above $80 million.  So, in the worst case, it would need to cover additional revenue bonds of $135 - $80 million or $55 million.  Outside legal and financial experts advise that, despite Dr. Smith’s wild conjectures, there is almost no chance that the price set by the court would be more than 145% above the appraised value. Note – the figure of $135 million is NOT the City’s estimate of the price the court is likely to set. Quite the contrary, it is instead an exceptionally cautious provision for a worst case situation.  Anyone who bothered to read the publicly available documents can see this.  The question again is:  Why would Dr. Smith and the No on W campaign so misrepresent the actual facts?

Further, this worst case possibility is the basis for the City’s estimate of the remote possibility that in this situation it might need to increase, on average, the water rates by less than $30 per month per household. In laying out this information, the City is bending over backwards to be open and honest with residents of Claremont about the worst case outcome of the effort to take control of the water system.  On the other hand,  Dr. Smith’s wild assertion that the water rates “are likely” to increase by more than $100 per month is simply false and misleading --and one has to think intentionally so.

Claremont residents need to understand that once the bonds are paid off, this differential, if it exists at all, would disappear. That is, if the price is set by the court at $80 million or less, there would be no increase in water rates needed at all.  If the court set a price of between $80 million and $135 million, then some modest increase in rates would be needed, but only for the duration of the bonds.  

Moreover, during the life of the bonds and thereafter, the City’s water rates would continue to be based only upon the cost of actually providing water to just Claremont, would not be based on the payment of million dollar salaries, would not provide for the 8.8% return on assets to pay dividends, would not add a cushion to pay taxes, and would not include fees to make up for lost revenue due to lower water usage (except possibly while paying off the bonds, but only if other savings due to reduced purchases of water by the city were not sufficient to maintain revenues at a level sufficient to pay for the bonds).  Hence, over the years, as the cost of water to everyone in California goes up due to droughts and other statewide and regional issues, the rates that would be charged by the City of Claremont to its residents would go up less than those charged by a private for-profit firm like GSW. This means that even if the City has to pay something in excess of $80 million for the water system, the rates paid by Claremont residents over the years ahead are virtually certain to be lower than they would pay if GSW continued to own and operate the system.

A couple of other points need to be made. Dr. Smith in his GSW paid-for scare letters talks about the fact that Measure W does not include funds to pay for future repairs to the water system and then cites what recently happened in L.A., even though what happened there was to systems decades older that most houses in Claremont.  Beyond that, he fails to mention that whatever repairs and improvements needed to be made to the water system in Claremont would have to be done by either GSW or the City.  And GSW will not be doing those for free.  In fact, any improvement to the system that GSW makes that increases their net asset value, would result in an increase in rates equal not just to the cost of the improvements, but an increase in rates that also allowed for an additional 8.8% in profits (judging by recent years and the PUC allowed profit margin).  That is, any increase in rates due to improvements or repairs would be higher under GSW than the City.

Dr. Smith also makes a point that there are fees involved in selling revenue bonds. That is certainly true.  But he fails to mention that the City already understood that and allowed for these fees in its estimate of the costs of the revenue bonds. Why would Dr. Smith and the No on W campaign not understand that?

Another issue: In his writings, Dr. Smith talks about the costs of the expanded size of the Claremont City government that would be required if it acquired and then operated the water system.  The fact is that the City does not intend to reinvent the wheel. It is already in negotiations with nearby municipalities that already own and operate their water systems quite successfully (and charge rates far lower than those GSW charges in Claremont).  It is planned to hire one of these to actually operate the Claremont public water utility.  The estimated costs of such an administrative arrangement have already been factored into the figures discussed above and would be far lower that the administrative costs of GSW with its million dollar salaries.

Finally, any economist should be able to distinguish between a tax and a user’s fee. Dr. Smith and the No on W campaign keep referring to the water rates that would be charged by the city as a “tax,” whereas they choose to refer to the water rates charged by GSW as “prices.” This is simply another attempt to use a word, “taxes,” that they hope will scare people.  As Dr. Smith must know a “tax” generates money to a governmental entity which is then free to use that money for any purpose.  A “user’s fee” is based upon the actual amount of the service or product that is used by the payer, and the government agency that collects it is typically bound by law to use those funds only for specific purposes.  For example, the Federal user’s fee applied to every gallon of gas you buy goes into the Highway Trust Fund and must be used to maintain and upgrade roadways in America.  Similarly, the rates that would be charged by the City for water would be based on the amount used and all of those funds would be restricted to be employed to pay back the revenue bonds needed to buy the water system and for the operation, maintenance and upgrading of the water system.

As important as they are, beyond all of these financial issues is the fundamental matter of whether the citizens of Claremont want to control their own access to water and what they pay for it – or whether they wish to leave this critical matter in the hands of a private, for-profit company that has been charging us far more for years than the publicly owned utilities in nearby cities like La Verne and Upland have charged their residents.  Indeed, if we leave our future access to water in the hands of this private for-profit firm, we have no guarantee whatsoever that it will not someday be sold, perhaps to a foreign firm tied to a foreign government, like that of China.  We must keep in mind that water is not like other commodities, the price and availability of which we can leave to the private market – it is a fundamental necessity of life itself and should be in the hands of the people who are reliant on it to live.

For all of these reasons, I urge the residents of Claremont to support their City Council (which consists of people from different political parties) by voting yes on Measure W, in order to support the City’s acquisition of the water system.

Andy Winnick

Professor of Economics and Statistic

Claremont resident since 1996

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