Chapter 3 Water and Wastewater Infrastructure Values

Introduction

This chapter presents an overview of some of the important concepts used in determining value in the water and wastewater infrastructure sectors. The U.S. has a mixed system, part public (85% water—95% wastewater), and part private. In general, public entities are self-regulating with respect to rate-making—while private investor owned utilities have their rates set by commissions. As noted in this chapter, there are exceptions to these generalizations. The mixed nature of ownership and rate-making presents some difficulties in valuation. Price signals can be subject to both judicial and political pressures.

Is there a better system for the U.S.? There is no simple answer to this question. The UK in 1989 voted in privatization. Australia is in the process of privatizing large segments of its public infrastructure, including water. California is restructuring electric utilities, touting this change as a move toward a competitive environment. Numerous other states are considering a like move. France has long had a system of leasing (affermage) its water systems to private companies. To make their system more competitive, the French have implemented a competitive bid process. Developing countries are inviting western companies to bid on water systems, in order to have water available for their emerging economic systems. Yet pivotal to all of these developments remains the problem of resource allocation—or value.

In this chapter, some of the essential determinants in value are reviewed. It is not meant to be a definitive work on the subject of value, but an adjunct chapter to this study that will complement the ongoing monitoring of the dynamics of the water and wastewater industry. Value is derivative of industry structure (open/closed sectors—regulated/non-regulated), the macro-economy, capital markets, complementary infrastructure sectors, regulations, taxing patterns, economic cross-subsidizations, and pricing regimes. In broad scope, this chapter addresses some of these time-derived impacts on value and hence on resource flows.

Rate-making and value are directly related. Government regulation of the price (rate) system affects value. A significant amount of economic activity in the U.S. is subject to economic regulation. Historically, regulation (government intervention) has been used in agriculture, energy, and in all of the traditional public utility sectors. Most constitutional issues raised in regard to government regulation have been resolved in the government’s favor. Economists have generally argued that regulation is only feasible in the presence of a natural monopoly. The concept of natural monopoly appears no longer sacred or well defined—technology has challenged many of the early premises, which made this concept viable. Once regulation of markets is decided on, for whatever reasons, the government must generally engage in rate-making. These fiat rates require that a firm both be efficient and also cover all explicit and implicit costs. This is not an easy task.

Finally, valuation of acquisition, contract operations, and condemnations presents a difficult set of problems. They must be addressed on a case-by-case basis with regard to the economic and social preferences of the micro- and macro-economies in which these facilities operate.

Theory

Capitalized Value

The concept of capitalized value is well illustrated by the British Consul (BC). This financial instrument pays five pounds sterling a year in perpetuity. Each year, the owner of a BC presents it to the Bank of England and receives five-pounds sterling (£). Yet, this financial instrument has a value well in excess of £5 annually. The value of a perpetual series, like a BC, is derived by dividing the coupon value by the discount rate. If the discount rate is 10 percent, then a BC will have a value of £50 (£5/.10). Other net income streams produce capitalized (present worth) values, through a similar, discounting stream, based on their longevity and the discount rate(s) used. To illustrate the discount rate’s importance clearly—a decrease in the discount rate from 10 percent to 5 percent would double the value of the BC to £100 (£5/.05).

In essence, the value of any net income stream producing entity is its present worth. Present worth calculations—by discrete or continuous methods—are well understood. It is not the simplicity of calculation that is the problem, but the method by which income streams are generated. Degrees of competitiveness and government involvement in the income stream process will impact the capital value through changes to both the numerator (net income) and denominator (discount rate). Capital valuation and the projected market environment cannot be separated. To see how this process works, one has no need to look beyond the roller coaster rides of the stock for California investor-owned electric utilities during the debate and implementation of industry restructuring and unbundling (California AB 1890). The speculative buying and selling that accompanied the pre and post (1996-1997) passage of California AB 1890 are atypical for the normally conservative utility (electric) industry.

Monopoly

Theory

The Dictionary of Economics and Business defines monopoly as “[i]n a general sense, the market situation in which one person or a group has such control of the supply of a commodity to be able to regulate its price.” Alchian and Allen, University Economics, see monopolists as price searchers. They note: “Reducing the number of sellers down to one gives us a ‘monopoly’.” They see two types of price seekers (monopolists) as those who face competition in open markets (open monopolists) and those who operate behind fiat created barriers to entry (closed monopolists). Milton Friedman suggests that open monopolies do not deny society its productive optimum in resource exchange. However, he sees closed monopolies as producing less than maximum resource exchanges. In other words, society is less well off because of the barriers to entry.

Natural Monopoly

Strickland, in Government Regulation and Business, defines a natural monopoly as follows: “A monopoly is considered to be ‘natural’ when it is the inevitable end result of the market process. Competition eliminates all the firms in the market except one, the natural monopolists.” Strickland also points out that the “…traditional argument for economic regulation is the presence of a ‘natural’ monopoly.” Strickland believes that for a natural single monopoly to exist, average cost must decline with each increase in output. He summarizes the impact on society of a natural monopoly: “Although society thus benefits from the single producer, economic regulation is necessary if the monopolist is to be prevented from exploiting its unique position.”

Relevance of Natural Monopoly Concept in Regulations in the New Millennium

Infrastructure companies (gas, electricity, water, sewerage, communications) have traditionally fallen under the umbrella of the natural monopoly concept. However, recent changes in electric markets (e.g. Australia and California) suggest that this definition might require revisiting (narrowing) in the context of lower information and transaction costs that have derived from the technological revolution. While many U.S. states are considering electricity restructuring on the California and Australian type electric industry models, as noted in Chapter 2, water restructuring does not appear imminent or at least as fundamental in its potential.

Advances in water and wastewater metering and point of entry/point of use technologies may erode the traditional “natural utility” model as applied to water. The availability of competitively priced substitutes—bottled water, filtration/cleansing units, etc.—could well impact the water industry so that a more market driven pricing regime as in electricity will be implemented. This pricing structure could meter, via a less regulated environment—the societal value that is placed on certain marginal supplies.

Rate-making

Rate-making is the administrative process by which prices are established in regulated industries. Rates are predicated on a firm’s ability to generate a sufficient level of revenues to cover allowable (as defined by the regulators) explicit and implicit costs. The allowable costs are the regulated firm’s rate base. Over-valuation of this base causes a wealth transfer from the consumers to the utility. Under-valuation is akin to a confiscation of the firm’s assets.

Market Rate

Alchian and Allen note in University Economics, “An equilibrium (market clearing) price in the market is one at which all possible mutually beneficial exchanges can occur.” They suggest that so-called “administered prices,” as set by large firms operating in an open market, are basically search points, as the firm tries to maximize profits/wealth. Regulatory agencies, setting administered prices (rates), are also cognizant of the impact on demand and therefore on rate base and investor returns, although the response is not as quickly transmitted as via the market process. Markets and regulators both search for those prices (exchange ratios) that maximize their objectives. Entities search for prices that maximize wealth and/or net discounted “accounting profits” over time. Regulators, as noted in Chapter 2, often try to maximize a number of financial and community objectives within the constraints of their rate-making activities. However, private or public, a business entity maximizes according to its objective function as it defines such.

Elasticities

Elasticity is an important concept in rate-making (e.g. price searching), in that it refers to sensitivity to price changes. Supply and demand are price sensitive and/or have an elasticity measure. Specifically, to quote from M.I. Friedman¹: “…elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price that is responsible for this change in quantity demanded when ‘other things’ are given and the change in price approaches zero.” Friedman goes on to add: “One of the most important reasons for employing the elasticity concept when dealing with demand curves is that it provides a very convenient way of indicating the behavior of total receipts.” These relationships are summarized in Table 3-1.

Table 3-1. Elasticities

During the period of the Civil Aviation Board (CAB), 1938-1978, Brian Browne postulated that major interstate carrier demand functions were elastic, and that traffic flows could benefit from decreases in prices. Under the formula driven CAB rate-making procedures (see below—Revenue Requirements), a more innovative pricing regime was not possible. However, the California Public Utilities Commission (CPUC) implemented a more creative pricing structure (off-peak/on-peak—generally lower passenger yield rates) with regard to their large intrastate airline, PSA. As a result, PSA, with its highly traveled city-pair route, San Francisco-Los Angeles (SFO-LAX), had load factors in excess of CAB regulated routes. Browne also advised the Australian government (Two Airline Policy) that his empirical testing showed that their airlines were operating in the elastic section of their demand curves. He recommended more competition and a more creative pricing regime. The elasticity statistic is an excellent decision tool for pricing decisions.

Since the dismantling of the CAB, U.S. airlines and regulated utilities, especially electric utilities, have used multipart or discriminatory pricing. Multipart pricing is a strategy to maximize wealth by pricing different amounts at different prices—e.g. off-peak/on-peak. Multipart pricing, although simple in concept, is difficult to achieve in open markets. To achieve multipart pricing, buyers must be prevented from reselling to each other. It will be interesting to see how the California and the Australian electric restructuring impact multipart pricing. This is not a trivial question in the framework of evaluating asset value based on net income streams. Airlines in the U.S. (and worldwide) perform multipart pricing by a complex array of demand variables, such as time of booking, directness of route, age, season, etc.—a far cry from the formula driven CAB rate-making days.

Seasonal water rates and peak and off-peak electric pricing are examples of multipart pricing. Airlines, after the demise of rate regulation, have raised multipart pricing to an art.

Supply (marginal cost) elasticities are important also. The static elasticity measure (as in the demand computation) assumes a cetebus paribus approach to planning horizons (time), rate, and volume. Changes in any of these parameters will impact the elasticity—volume changes are positive in the first instance and negative in the second. That is, costs increase, but at a decreasing rate. Rate of production change is positive in the first- and second-instance; costs increase at an increasing rate. Production costs (as reflected in changing supply elasticities) can also impact valuation.

An understanding of the integral role of elasticities is important for decision-makers, planners, and regulators. All these participants are in essence price seekers trying to maximize a set of goals. Hearings before regulatory entities represent the search process in a judicial climate. Price changes by private entrepreneurs represent the same search process. “Errors” in pricing (responsiveness/demand metering, etc.) and the period that such errors remain in place do impact the value of an enterprise and ultimately the entire community.

Revenue Requirements

U.S. Regulatory Approach

Janis Beecher in her “Survey on Commission Ratemaking Practices for Water Utilities” (1992), estimates that approximately two-thirds of state public utility commissions regulating water utilities require cost-of-service studies. (See Chapter 2, above.) As noted above, revenues must cover cost. The determination of allowable costs is integral to rate-making. The concept, as applied, varies from state to state. The consensus appears to be to that society will have a resource use equal to what would be achieved in alternative economic pursuits.

Without perfect information and in a world of positive transaction costs, reaching this “optimal” goal is difficult, if not impossible. The cost of contaminated water (see Chapter 1) can be incredibly high from a societal viewpoint. Moreover, the cost of perfectly pristine water for all uses could imply resource transfers from more productive alternative uses. Commissions in rate-making appear to play a balancing act.

The basic revenue requirements, American Water Works Association, Revenue Requirements (1991), establish the following algebraic relationships for basic revenue requirements (after Beecher/AWWA):

R = O + D + T + rB

Where:

B = Rate base (V - d)
V = Rate base valuation
d = Accumulated depreciation
R = Revenue requirements”
O = Operations and maintenance expenses
D = Annual depreciation charges
T = Taxes
r = Permitted rate of return (cost of capital)

The permitted rate-of-return “r” equals the weighted sum of the cost of debt capital and cost of equity capital:

r = k(E/C) + i(I/C)

Where:

k = Cost of equity capital
E = Total equity capital
i = Cost of debt capital (a weighted average)
I = Total debt capital
C = Total equity and debt capital

Beecher/AWWA notes that the structure for self-regulating publicly owned utilities is:

R = O + T + D + C

Where:

R = Revenue requirements
O = Operations and maintenance expenses
T = Tax equivalents
D = Debt-service payments (interest charges and principal)
C = Capital expenditures not financed by debt

The rates needed to generate R must be designed so that the sum revenues from all customer classes (household, commercial, and industrial) equal the cost components. As noted in The Reason—ACWA discussion (cf. Chapter 1, above), rate-making and economic cost allocation (alternatives foregone), in a world of subsidies and varying social objectives, is no easy target. Changes in macro-economic variables, subsidies, taxes, environmental rules, and technologies all impact the rate-making process.

Price Cap Rates

Price capping is another way to regulate natural monopolies. Price capping is achieved by taking some escalation factor (CPI/GDPD/PPI/etc.) and applying this increase to an existing rate structure. This is done in the UK (England and Wales—Scottish systems are still public), but their status is being reviewed. The utility must then operate within the escalated revenue generated by the allowable price increases. The U.S. experimented with a similar system during the 1970s and 1980s—with oil and gas. The results from the U.S. consumers’ perspective were less than satisfactory.

Theoretically, revenue requirements and price cap systems use a similar calculus. Under the revenue requirements method, the rates are set to cover the (allowable) costs. The idea of “allowable” assumes that all economic costs are subsumed in the cost assignment. This approach is consistent with attracting competitive resources to that industry. In setting a simple escalation factor for rates, the administrative process is decreased, and it is up to the regulated utility to achieve efficiencies commensurate with allowable rates.

Since 1989 privatization, England and Wales have used a price cap system for water. Rate changes are set and administered by OFWAT (Office of Water Services), which also regulates other “…unfair industry practices.” However, it should be noted that only 8 percent of households in England and Wales have meters. Which?, a trade magazine of the UK Consumers Association, notes that two-thirds of UK water companies favor implementing a metering system. Interestingly enough, Which? opposes meters on the following basis: “The cost of water does not reflect the true cost of the system—most goes to maintenance or improvements. And metering is expensive.” Which? adds “…in most regions, you have to pay for the first water meter.” Which? estimates that metering would cost consumers £263 million a year (approximately 0.5 billion $U.S. (7/04/96)²).

Under OFWAT, according to Which?, average-metered prices have fallen by 2 percent in constant dollars since 1989, but non-metered water rates have increased by 39 percent. The Consumers Association opposes additional metering, stating: “Water metering is likely to encourage those on low incomes to use less water. People should not be encouraged to get by without water—the health hazards are too great.”

It is interesting to compare (contrast) this statement with the definition of a market clearing price as defined by Alchian and Allen. “An equilibrium (market clearing) price in the market is one at which all possible mutually beneficial exchanges can occur.” To Alchian and Allen—and to most economists—a metering system would be pivotal for market signal transmissions from the producer to the consumer and back. However, the surfacing of such concerns as health hazards underscores the entire discussion on what objectives infrastructure investments should achieve and in essence, who should pay and how much?

Price Cap in a Long-Term (20 year) Contract

North West Water Australia was recently awarded a contract by the South Australian government to build and operate 10 private wholesale water plants along the Murray River in South Australia. These plants will supply water to 100 communities. One major term in the contract is that North West Water guarantee a fixed contractual price throughout the entire contract period. North West Water developed a pricing forecast model to ensure that guaranteed price. That model, according to discussions with North West Water officials, appears to be a level annualized capital model with labor, power, and replacement expenditures (timing) and inflationary assumptions factored in.

Forecast models using level annualized initial capital charges and escalated operation and maintenance charges are fundamental to regulatory/contractual rate-making—whether ex ante (as in the U.S.) or ex post (as in the UK—OFWAT approach). The success or failure of a contract, which must be internalized by either the ratepayers or stockholders, depends upon the accuracy and timing of capital charges, interest rates, tax structures, regulatory changes, inflation, elasticities, and so on.

The mathematics for computing revenues/rates is straight-forward. It is the independent, future variables that significantly impact outcomes. The alternative is to let the markets prevail as being planned in California and as happening in Australia. There, spot and derivative markets will bear the risk and ensure the outcomes for both the present and future. Many believe that the water and wastewater industry is not a likely candidate for such a solution. The future will tell.

Acquisition/Contract Valuation

How does a government entity value a public resource when privatizing? How does a government entity reimburse a private entity for condemnation purposes? As noted above, the simple method would be to take the net income flow, plus the present worth of salvage value. However, economists and their theories and the judicial process do not always mirror each other. Some valuation methods are suggested below.

Historical Costs/Replacement Costs

One method would be to take the actual historical costs and sell/condemn at that price. However, that approach might overstate or understate the value based on numerous factors including methods of acquisition (eminent domain), tax subsidies, government subsidies (especially water and wastewater), technologies (obsolescence), and so forth. For example, old railroad tracks no longer serving any purpose due to changing demands and alternate technologies caused the Interstate Commerce Commission (ICC) serious concerns in terms of valuation. The basic value of such facilities was only the right-of-way value. The track was often an impediment to future use.

Condemnation hearings present a similar situation. For example, some water systems in Florida subject to condemnation have been paid multiples up to 3 times based on book value.

Accounting Principles

Regulatory acceptable accounting practices (RAAP) and generally acceptable accounting practices (GAAP) may lead to different asset valuations. Moreover, accountants, following established formulas, have problems identifying the allocation of costs. Economists see a joint-product with common costs, e.g. a sheep which produces both mutton and wool, as having output maximized when the marginal cost of maintaining the sheep is equal to the marginal revenue from the sale of its wool or the sale of mutton. Accountants have long agonized over how to allocate a sheep’s cost between mutton and wool production. Likewise, applying the various accounting procedures to asset valuation can cloud the issue and cause either over- or under- valuation. Certainly, commingling both economic and accounting principles will lead to a more accurate evaluative process.

Asset Sale—Victorian Model (electricity)

The Victorian model in Australia was basically an auction. In Victoria, the assets initially belonged to the government. Under the 1995 National Competition Policy and Related Reforms Act the neutrality section pertaining to government ownership catalyzed the sale. The generating plants were acquired by a mixture of local, U.S., and UK companies. In the U.S., the process, as noted by the various regulatory responses in Chapter 2, would require a multi-governmental level review. The Australian states and territories, in conjunction with the federal government, passed similar legislation relating to restructuring and asset sales. This joint action permitted restructuring and therefore avoided the peril of a high court challenges under the constitution.

In July 1997, the Australian Labor Party (ALP), formed a committee to evaluate the sale of the state’s electricity, subject to Labor Party criteria, which included impact on jobs, prices, and the environment. It is estimated that an outright sale of these facilities—which include three generation companies, six distribution companies, the high-voltage Transgrid network and the state’s 58 percent share of the Snowy Mountains hydroelectric scheme—would produce a sale price of $U.S. 17 ($A22) billion. Interestingly enough, the amount of $17 billion was arrived at by the merchant bank Deutsche Morgan Grenfell.

Critics in New South Wales (NSW) say that this amount will not offset “…the subsequent social and economic distress” that will follow, as it did, according to these critics, in Victoria. On the other hand, if the state does not privatize, proponents of privatization note that the state’s budget sector debt ($A13.4 billion) will remain a burden, industry in NSW will be at a pricing disadvantage regarding electricity purchases, and other vital state capital works projects will not be served.

The current ongoing debate in NSW mirrors privatization debates around the world. However, this debate, unlike California’s electricity restructuring debate, involves the sale of an entire public asset. It has brought into clear focus the social and economic issues that characterize these situations. Dr. Peter Botsman, who wrote Labor’s submission to the Hogg Inquiry (privatization of the state’s electricity), noted (Sydney Morning Herald—August 25, 1997): “…perhaps the most important debate in the postwar history of the party. If we don’t win this debate, then we will spend the next 10 ALP (Australian Labor Party) conferences fighting the privatization of health, fighting the privatization of law and order, fighting the privatization of everything that in a decent society is owned by the people and managed on their behalf.”

Contract Operations—Ownership Format

Contract operations are purchased, as are assets acquisitions, based on projected net income streams. Ownership type and format is irrelevant in the context of resources being rewarded at their market rate. If economic efficiency is pursued and factors are paid according to their highest alternative use, the legal nuances of ownership disappear from a social wealth maximizing perspective.

Planning Discount Rates—Allocating a Resource Over Time

Each entity has a unique subjective discount rate appropriate to its project. This rate, in tandem with net income, determines the value of the project to a company and or public entity. Each project is unique and the discount rates are highly subjective and biased by the assumed risk. A project in a developing country would not produce the same valuation as a similar project with the same income stream in the U.S., because of the need to imbed a risk premium in the discount factor and hence decrease the capitalized value derived from that income stream.

Writing in 1967, in regard to California’s immense Feather River Project, Alchian and Allen wrote: “….For example, advocates of the California Feather River Project water project, an immense state-financed endeavor to supply additional water to Southern California, held it to be an excellent investment—as it may be at interest rates of about 2 percent. But if the rate of interest is higher, as it is, the resources would be more valuable if used for other things…” The project was built. The relationship between capitalized (present worth) value, planning, and societal outcomes cannot be separated from the mechanism by which society allocates resources over time. Alchian and Allen believed that this water project should have been deferred for at least 20 years.

Valuation Issues in U.S. Water and Wastewater Privatization Transactions KPMG³

At the 1996 EPRI conference on Water and Wastewater Privatization, held in San Francisco, California, Messrs. Michael Graham and Michael Blum, two senior KPMG consultants, presented an operational approach to valuation. Blum and Graham identified types of privatizing transactions:

• Re-municipalizing

• “Managed Competition”

• Operating Contracts

• Concessions

• New Facility BOOTs/BOTs

• Asset Sales

• Mergers and Competition
  
  
  

In this valuation search process they clearly identified the need for both seller and buyer data:

Table 3-2. Uses for Valuation Data

The key valuation issue from the seller’s perspective was identification of market value. This element equals fair market value of contract offered and fair market value of hard assets. The former attribute was further broken down into (a) current cash to operate with, (b) current operating cash revenue, and (c) hidden costs. The realization of value, as defined by Blum and Graham, was assessed by looking at (a) cash flow comparison to alternatives, (b) understanding buyer’s valuation criteria, and (c) fair market rate of return. The value of deal required is defined in terms of (a) market valuations and fair market rate of return, (b) understanding seller’s valuation criteria, and (c) sensitivity analysis.

These two consultants defined the market approach to value as follows: “The market approach involves valuing a company based on the market valuations of similar publicly held companies.” Their approach to valuation was summarized by acknowledging the cost element, the comparable (opportunity cost—alternative foregone) element, what the market has paid, and finally the value of the projected income stream. Both consultants recognized that market valuations are driven by the discount rates and the overriding idea that sunk costs are irrelevant costs—it’s what values the market assigns. The market, according to the consultants, is the final arbiter of value.

From a buyer’s perspective, Graham and Blum dichotomized the key valuation issues into (1) value of deal offered and (2) value of deal required. They noted that the value of the deal offered had three component parts: (a) fair market value of hard asset (purchase of acquisition), (b) fair market value of contract offered (budgeting) and (c) opportunities for cost savings/synergies.

Table 3-3, as presented by Messrs. Blum and Graham, summarizes their “Market Approach to Value.”

Table 3-3. The Market Approach to Value

The income approach to value used by Blum and Graham is consistent with that discussed above having either continuous or discrete discounting. They present two balanced definitions:

• “The fair market value of an ongoing business is the present worth of its expected cash flows.”

• “The value of an asset is the expected present value of the expected returns from an asset during the holding period.”

To augment this definition, the following equations (based on the Capital Asset Pricing Model (CAPM)¹) are presented to show the derivation Cost of Equity (COE) and Weighted Average Cost of Capital (WACC) factors.

Cost of Equity Calculation

Cost of Equity Capital = Rf_c + Beta  (Rm – Rf) + Rs₁ + Rs₂

Where:

Beta = 0.48
Current Risk Free Return (Rf)_c = 8.00%²
Long Horizon Equity Risk Premium (Rm – Rf) = 7.40%³
Company Specific Premium (Rs)₂ = 0.00%⁴
Cost of Equity = 11.58%

Weighted Average Cost of Capital (WACC) Calculation

WACC = Cost of Debt  Amount of Debt + Cost of Equity  Amount of Equity

Where:

Selected Debt to Equity Ratio = 101.00%
% Debt = 50.25%
% Equity = 49.75%
Cost of Debt (BBB Bond Yield) = 10.33%⁴
After Tax Cost of Debt = 6.24%
Cost of Equity = 11.58%
WACC = 8.90%

Using the above calculations, as shown in Table 3-4, KPMG calculates the present worth of the debt free cash flows as follows:

Table 3-4. The Income Approach to Value

The final step in the derivation of value, using the net income approach, is illustrated by Table 3-5 (from the KPMG presentation).

Table 3-5. Derivation of Value

Notes and Relevant Data Sources

Armen A. Alchian and William R. Allen, University Economics, Second Edition, 1964-67, Wadsworth Press, Belmont California.

Armen A. Alchian and William R. Allen, Exchange & Production, Competition, Coordination, & Control, Third Edition, Wadsworth Press, Belmont, California 1977.

American Telephone and Telegraph Company, Engineering Economy, Third Edition, McGraw-Hill Book Company, 1977.

Brian Browne, Various Academic and Consulting Studies.

Milton I. Friedman, A Preliminary Price Theory Text—University of Chicago Press.

The National Regulatory Research Institute, “Meeting Water Utility Revenue Requirements: Financing and Ratemaking Alternatives,” November 1993.

Proceedings: Water and Wastewater Privatization, MWW, EPRI Water and Wastewater Program, Report CR-107892, October 1996.

Allyn D. Strickland, Government Regulation and Business, Houghton Mifflin Company, Boston, MA. 1980.

Figure 3-1. Economics of Pollution, Clean Water, and Industrial Output (Steel)

Figure 3-1 (above) diagrams the economics of pollution, clean water, and industrial output (steel) as postulated by Armen Alchian and William Allen. It is reproduced from the Alchian and Allen text (Chapter 5, pages 93-95—Figure 5-1 [page 94])—Exchange & Production, Competition, Coordination, & Control, Third Edition, Wadsworth Press, Belmont, California 1977.

Alchian and Allen use two demand curves—one for steel—decreasing from the left vertical axis and one for water—decreasing from the right vertical axis—to explain how possible misallocation (under or over pricing) in water use can impact other outputs.

The authors note: “The total use value to consumers of the steel is indicated by the area under the whole demand curve for steel DD, out to whatever is the amount being produced, whereas, the total use value to consumers of cleaner water is the area under the demand curve for water, WW, reading from right to left.” They define the point where the marginal value of steel is equal to the marginal value of water as the point where society maximizes total output value (“X”) at that trade-off ratio. They argue that if for some reason (e.g. government intervention) water prices are too high, less steel will be produced and visa versa (pricing errors). A productive optimum for society will not be achieved. Friedman in his earlier text “A Provisional Price Theory” makes the same assertion, however, as discussed in the above text, he puts it in the context of society being taken off its production possibility curve.