California possesses broad, flexible P3 legislation in the Infrastructure Finance Act (IFA), which was adopted by Assembly Bill 2660 (Aguiar) in 1996 and may be found at California Gvernment Code §§ 5956 et seq. The IFA authorizes local governmental agencies to enter into contracts with private entities for the implementation of certain infrastructure projects. The broad scope of the statute may be seen in the statement of legislative intent in § 5956.1:

It is the intent of the Legislature that local governmental agencies have the authority and flexibility to utilize private investment capital to study, plan, design, construct, develop, finance, maintain, rebuild, improve, repair, or operate, or any combination thereof, fee-producing infrastructure facilities.

Applicability

The authority created by the IFA extends to all “local governmental agencies,” which include charter and general law cities, charter and general law counties, public districts, school districts, joint powers authorities, transportation commissions or authorities, and “any other public or municipal corporation.” The act does not grant P3 authority to state agencies or for state projects, which include toll roads on state highways, state water projects and state park and recreation projects. State agencies and projects were excluded to convince Professional Engineers in California Government (PECG, a state employees union) to withdraw its opposition to AB 2660.

Eligible projects must be categorized as “fee-producing” infrastructure, which means that operation of the project must be paid for by the persons benefitted by or utilizing the project. Fee-producing infrastructure commonly include utilities, such as water supply and treatment, wastewater collection, treatment and reuse, refuse disposal and energy production, but also includes transportation projects such as harbors, airports, runways, commuter and light rail, highways, bridges and tunnels if the projects are paid for by users. Buildings and structures are also allowed, but the statute contains an express exclusion of structures that will be used primarily for sporting or entertainment events.

Selection of the Private Entity

The IFA establishes an independent legal authority for local governmental agencies and does not require an agency to follow other rules related to public contracting. Specifically, the IFA does not overlap with the traditional design-bid-build procurement process set forth in the California Public Contract Code, and other than prevailing wage requirements, the provisions of that code do not apply to projects completed under the IFA. Instead of the traditional public bidding process, the statute requires “competitive negotiation.” The Legislature did not prescribe that process, but granted substantial discretion to the governing body of the local governmental agency to determine an appropriate process for each project. The Legislature did impose three important requirements on the competitive negotiation process:

1. The primary selection criteria must be demonstrated competence and qualifications of the private entity for the relevant tasks;
2. The selection criteria shall ensure that the facility be operated at fair and reasonable prices to users; and
3. The competitive negotiation process must prohibit illegal practices such as kickbacks and participation in the selection process by government employees who have a relationship with a private entity.

Other than those three requirements, the IFA does not mandate that a local governmental agency use any particular process. Instead, the statute expressly states that the “competitive negotiation process shall not require competitive bidding,” in recognition of the value of flexibility for procurement of P3 projects. In practice, there are likely to be two main ways that a local governmental agency structures the competitive negotiation process.

One, the agency may use a two-step solicitation process, with the first step seeking statements of qualifications from interested firms and selecting a short list of three or four potential bidders, and the second step requesting detailed proposals. Using a qualifications phase is useful to make the process more efficient for both the local governmental agency and interested private entities, and ensures that the best qualified firms submit proposals. A final proposal should be selected based on best overall value for users of the infrastructure facility, rather than lowest bid. A well-executed RFQ/RFP process will include sufficient structure to obtain highly competitive proposals from well qualifed firms, but will leave sufficient flexibility for those firms to use their experience to propose innovative technological and design approaches.

Two, the local governmental agency may receive unsolicited proposals from private entities pursuant to § 5956.5. Unsolicited proposals may come in competition with a design-bid-build procurement process, in which case the local governmental agency may use that process as the comparator to satisfy the requirement of competitive negotiation. In such a scenario, the agency would negotiate the best commercial terms available with the private entity, and then compare the outcome to the lowest bid received under the design-bid-build process.

An unsolicited proposal might also come outside of any prior agency consideration of the infrastructure project, which challenges the agency to devise a process that ensures some level of competition while recognizing the value provided by the private entity making the original unsolicited proposal. This is likely the hardest challenge an agency might face in implementing a P3 project under the IFA.

Terms of the P3 Agreement

Following the competitive negotiation process, the local governmental agency and private entity will execute a comprehensive agreement covering all aspects of the P3 project development. P3 contracts tend to be long and complex, often made up of several integrated agreements. In particular, such contracts must be carefully coordinated with the environmental review process under the California Environmental Quality Act (CEQA), although execution of a P3 agreement itself does not trigger environmental review.

The IFA requires a number of provisions to be included in a comprehensive agreement, including specific identification of the actions to be performed by the private entity. Although proposals are often received from consortia of private entities, there should be a single private entity for contracting. The infrastructure facilities must be owned by the local governmental agency at all times, unless the agency determines in its discretion that there is a good public reason why the private entity should own the facilities. The agency may lease the facilities to the private entity for up to 35 years, but if tax-exempt debt is used to finance the project, a shorter term may be required by IRS rules governing private business use of bond proceeds. At the end of the lease period, all facilities must revert to ownership and possession of the agency at no charge. The P3 contract must provide that the agency may buy out the private entity during the lease period, subject to payment of a break-up fee.

Sources of Financing

One of the primary reasons why a local governmental agency might be interested in pursuing a P3 project is to gain access to new financing sources. Under the IFA, a project may be financed using private capital, reserves or debt from the local governmental agency or federal funds. A project may not be financed using state grant funds.

Ultimately, P3 projects are paid for by users of the infrastructure, normally through some type of user fee. Fees must be set by the local governmental agency, with no delegation of that responsibility to the private entity. Revenues from user fees must be dedicated exclusively to pay for direct and indirect capital and operations costs of the project and cannot be diverted by the local governmental agency for other purposes. The IFA includes extensive provisions regarding public hearings about fees, and the private entity must prepare an annual audit report for the public to increase transparency.

As may be clear from the discussion above, P3 projects are very complex, and the process is unfamiliar to many governmental agencies. There is great value in consulting with experienced project, finance and legal experts for the procurement process and contract structure. The final comprehensive agreement between the parties may provide for reimbursement of such costs incurred by the local governmental agency, but the agency should be prepared to expend the resources necessary to protect and promote the public interest.

Conclusion

The IFA provides a broad, flexible authority for local governmental agencies in California to implement P3 infrastructure projects.  While the statute requires a competitive process and contract terms that protect the public interest, the Legislature has given local agencies substantial discretion on how to create a procurement process and contract that fit the needs of the particular infrastructure project.  As public finances are increasingly challenged at the same time that infrastructure needs are increasing, more agencies are likely to turn to P3s as one tool for project implementation.  P3s allow efficient and cost-effective infrastructure delivery around the world, and California is poised to take advantage of P3 projects to increase the quality of life for its citizens, and improve the environment and economy of the state.

Note: This post was originally published in Watermark, A PERC Water Publication (April 2012). PERC Water is doing some very innovative projects for wastewater treatment these days, from both technical and business perspectives. In the interest of full disclosure, PERC is a current client of my firm.

The new statute departs from existing law in several ways. First, it includes a legislative declaration that “[r]egardless of the form of the organization that operates a public water system, these organizations provide a public service that remains one of the core duties of the people’s government.” Defining the business of a mutual water company as a “public service” is directly counter to a long history of court decisions that recognize the private nature of mutual water companies. It is that purely private nature that allows mutual water companies to remain exempt from regulation by the California Public Utilities Commission (CPUC). The legislative declaration that mutual water companies may be providing a public service is legally questionable, as well as unnecessary for improved oversight of public water systems that happen to be mutual water companies. While Assemblyman Solorio and the Legislature may not have intended to interfere with historical legal doctrines regarding mutual water companies, it is not hard to see some mischief growing out of that declaration in future.

Second, by declaring the distribution of water to be “a public service that remains one of the core duties of the people’s government,” the Legislature has made a bold statement on a question that is widely debated among legal and policy experts. While the 20th Century saw substantial growth in the provision of water services by local governments in California, the same is not true globally or historically, where water service is frequently (and successfully) provided by the private sector subject to public regulation. While there are some civil society activists who argue that water service should be provided exclusively by the government, by no means is that a universal opinion, and the California Legislature’s declaration that water service is a core duty of government appears either ill informed or out of place in a statute that addresses only the relatively tangential matter of mutual water company operations.

Third, AB 54 subjects mutual water companies to a broad range of regulation by the Local Agency Formation Commission (LAFCO) in each county. Traditionally, LAFCOs have provided limited oversight of local government entities that provide water service, while the CPUC has comprehensively regulated the operations of investor-owned utilities.  Mutual water companies have not been regulated by either of those agencies, although they have been subject to regulation by the California Department of Public Health if they operate a public water system, the California Department of Real Estate if they are formed to serve a residential subdivision, and the California State Water Resources Control Board related to water rights.

New Corporations Code § 14301.1 requires that each mutual water company submit to the LAFCO for its county a map showing its service area by December 31, 2012. In addition, a mutual must respond to a request for non-confidential information from a LAFCO in conjunction with that agency’s preparation of a municipal service review or sphere of influence. The statute does not require the mutual to undertake a new study or investigation, but merely turn over information already generated. It also does not require a mutual to disclose information about shareholders, such as their names, addresses or water usage.

New Government Code § 56375(r) grants authority to a LAFCO to approve the annexation of a mutual water company’s service area to a city or special district. This provision does not insulate a city or district from having to pay just compensation for any mutual water company property taken by eminent domain, including, apparently, any compensation due under the Service Duplication Law (Cal. Pub. Util. Code §§ 1501 et seq.).

New Government Code § 56430(c) and (d) allows a LAFCO conducting a municipal service review to investigate whether a mutual water company that operates a public water system is in compliance with the federal and state Safe Drinking Water Acts. This new power overlaps with the existing jurisdiction of the Department of Public Health over public water systems.

Under the new law, Corporations Code § 14300(b) defines a mutual water company as the type of corporation described in § 14300(a), i.e., a “corporation organized for or engaged in the business of selling, distributing, supplying, or delivering water … only to owners of its shares.” Previously, the California statutes did not include a definition of the term ”mutual water company,” although there was a common understanding of what constituted such a company. This is a minor, and possibly helpful, clarification.

New Corporations Code § 14301.3(a) requires that all improvements to a public water system owned by a mutual water company be designed and constructed in accordance with the California Waterworks standards found in Chapter 16 of Title 22, California Code of Regulations. New Corporations Code § 14301.3(b) requires that a mutual water company maintain financial reserves at a level sufficient to repair and replace its facilities in compliance with the federal and state Safe Drinking Water Acts (42 U.S.C. §§ 300f et seq.; Cal. Health & Safety Code §§ 116270 et seq.). These are helpful changes in the law and directly support the provision of high quality water supplies without challenging the nature of mutual water companies.

Lastly, new Health and Safety Code § 116755 requires that each board member of a mutual water company complete a two-hour training course within six months of joining the board, or by December 31, 2012 if already serving on the board as of the effective date of AB 54. The course must cover the duties of board members, including: the fiduciary duty of a corporate director; avoiding conflicts of interest; the duty of a public water system to provide clean drinking water; and long-term management of a public water system. A qualified trainer may include a California attorney, a person accredited under ANSI/IACET 1-2007, or a program sponsored by the Rural Community Assistance Corporation or California Rural Water Association.

During 2012, I will be offering the required training to mutual water company board members in several cities. Please contact me at wstrickland@bhfs.com if you are interested in participating in one of those sessions, or to schedule a training course for your board as a group. That training will include all required topics, as well as an overview of the laws related to mutual water companies, water rights and water quality. I look forward to seeing many of you during this year.

Del Norte Water Company (DNWC) was founded in 1910 as a mutual water company with a service area located in the Somis area of Ventura County. It provides water to its shareholders for both domestic and irrigation uses, although unlike some mutual water companies serving both purposes, there is a single class of shares. Shares of the company are not appurtenant to specific lands, but are freely transferable to support water use within the company’s service area. The DNWC articles and bylaws provide that the primary purpose of the company is to supply domestic water, and a shareholder may only request irrigation water if he or she owns more than a threshold number of shares, which is set at 1 share for every 3 acres north of a defined grant line, or 1 share for every 5 acres south of the grant line. In the event of a water shortage, irrigation water is allocated in proportion to the number of shares that each shareholder holds above the threshold requirement. Thus, if a shareholder desires more water, he or she may purchase additional shares above the domestic threshold.

Plaintiff De Boni Corporation is a shareholder in DNWC, and the De Boni family have been shareholders since 1913.  During the recent dry period from 2007 through 2009, De Boni filed a complaint for declaratory relief, claiming that the DNWC water allocation scheme violated California Corporations Code § 400, which provides that a corporation may not discriminate between shares of the same class. De Boni argued that the allocation scheme creates a de facto classification of shares as either domestic or irrigation in a manner not authorized in the articles of incorporation.

The trial court held, and the appellate court affirmed, that the plaintiff’s argument failed for two reasons. First, the DNWC was formed prior to the adoption of § 400, so that provision does not apply to the company. Former California Civil Code § 290, the statute that was in effect at the time of incorporation, allowed for the classification of capital stock, consistent with a company’s articles of incorporation. The DNWC articles provide the basis for the company’s water allocation scheme and include the critical element of dividing water supplies proportionally based on the number of shares held by each shareholder in excess of those required for domestic water service. Second, the court noted that the water allocation scheme treats every share and every shareholder equally, in that all are subject to the same threshold system. That conclusion would seem to apply to a mutual water company formed after the effective date of § 400 (January 1, 1977), as well as one formed under former § 290. (The plaintiff did not argue, and the court did not address, the differential treatment of properties north and south of the grant line.)

This case is interesting as an example of how one mutual water company allocates its water supplies in times of shortage, and how that allocation scheme fared in response to challenge by a shareholder. Of course, another mutual does not need to use the DNWC water allocation scheme, and may establish its own allocation method through its articles, bylaws and rules and regulations. Mutuals are generally free to determine the rules by which they will operate internally, and the courts will not interfere. As the court pointed out in this case, mutual water company articles and bylaws may be characterized as a contract between and among the corporation and its shareholders. A court cannot change a water allocation scheme to benefit one shareholder without adversely affecting other shareholders. Courts are generally reticent to interfere in the internal operations of a company, as long as the company exercises its discretion in a fair and reasonable manner. A well-run mutual need not be overly concerned about judicial modification of its water allocation scheme.

In order to understand the new legislation, it is necessary to know the broader context. The Central Valley Project (CVP) is the largest water development project in the United States and is owned and operated by the Bureau of Reclamation (USBR), part of the United States Department of the Interior (DOI). It includes 20 dams and reservoirs, 11 power generating stations and over 500 miles of canals and pipelines for the development and distribution of water supplies for agricultural irrigation and municipal uses. The CVP largely controls the flows of the Sacramento and San Joaquin Rivers and their tributaries, which together drain a significant portion of California. The amount of water captured and delivered varies annually based on hydrologic conditions and operational constraints, but is approximately 7 million acre-feet (MAF) per year, of which about 5 MAF is delivered for agricultural irrigation purposes.

The CVP was largely constructed between 1937 and the 1970s, and its capacity was increased incrementally with each new component up to its current state of development. Project construction was financed by the federal government, with repayment obligations assumed by the beneficiaries through long-term service contracts. Federal reclamation law provided for interest-free financing and other financial benefits, so that the contractors will not bear the full cost of the CVP and project water supplies will always be subsidized at some level. Congress expressly intended these subsidies in order to gain the broad national benefits of food security and economic stimulus that the CVP provides.

Starting in the 1980s, it became clear that while the CVP had achieved fantastic success in developing water supplies and controlling floods for the benefit of the Central Valley and the United States as a whole, it also was causing the deterioration of the natural environment, including habitat for fish species such as salmon and steelhead trout. Additionally, operation by the USBR was considered by many to be excessively rigid, resulting in the loss of available water supplies during certain conditions. In order to increase the flexibility of CVP operations for the benefit of both project contractors and the environment, Congress passed the Reclamation Projects Authorization and Adjustment Act of 1992, commonly known as the Central Valley Project Improvement Act (CVPIA).

While the shifting of water supplies between CVP contractors was widely discussed as one method of achieving flexibility in project operations, it was not expressly authorized by federal law until the CVPIA. Section 3405(a) of that act provided express authorization for CVP contractors to transfer their water supplies to other users, in accordance with California state law, which had been modified in the 1980s to expressly encourage water transfers as a means of increasing flexibility of the state water management system. Both the CVPIA and state law impose restrictions on water transfers, which have been responsible for largely stifling the water market in California other than a few highly publicized transactions. Water transfers can be accomplished in California, and I have been personally involved in a number of successful transactions for either the seller or buyer, but there are significant transaction costs and delays associated with regulatory approvals and environmental review that decrease the likelihood of transfers being undertaken. As a result, there are many circumstances where water that is not needed in one location cannot be put to use elsewhere in the state because of legal difficulties, for an overall societal loss.

One of the complaints regarding transfer restrictions within the CVP is that the CVPIA limits transfers of contract water to: (1) the average deliveries to the seller over the three years of normal water delivery prior to enactment of the CVPIA (which were 1986, 1987 and 1989) in Section 3405(a)(1)(A); and (2) the amount of water that would have been consumptively used during the year or years of the transfer in Section 3405(a)(1)(I). While both of these restrictions are part of state law for the protection of third-party water rights holders under the No Injury Rule, critics argue that they do not make sense within the CVP, which is a single project operating under integrated water rights. They would argue that the restriction is like imposing a tax on an individual shifting money from one back account to another. Imagine if you had to pay income tax on money that you shifted from your checking account to a savings account, or vice versa! Similarly, those sections of the CVPIA require a transfer to take a “haircut” even when the water is shifted from one CVP contractor to another within the project.

This limited problem is the first part of what Sen. Feinstein’s language addresses. Section 207(a) of Division B, Title II of H.R. 2055 (found on page 81) provides in its entirety that:

Subject to compliance with all applicable Federal and State laws, a transfer of irrigation water among Central Valley Project contractors, from the Friant, San Felipe, West San Joaquin, and Delta divisions, and a transfer from a long-term Friant Division water service or repayment contractor to a temporary or prior temporary service contractors within the place of use in existence on the date of the transfer, as identified in the Bureau of Reclamation water rights permits for the Friant Division, shall be considered to meet the conditions described in subparagraphs (A) and (I) of section 3405(a)(1) of the Reclamation Projects Authorization and Adjustment Act of 1992 (Public Law 102-575; 106 Stat. 4709).

This language is noteworthy not only for what it does, but for what it does not do. For example, Ms. Schifferle criticizes the measure as allowing a small group of landowners to make significant profits from selling water, and specifically calls out Westlands Water District and Stewart Resnick. Her concerns are misplaced, as Section 207(a) only removes restrictions on transfers of irrigation water within the CVP. That inherently limits both the market and the price for water supplies. It does not remove any restrictions currently in place on transfers outside the CVP or for municipal purposes. Transfers between agricultural users within the CVP do not command high prices, and would only be expected on a short-term basis to improve flexibility of CVP operations. The transfers that Ms. Schifferle cites in her parade of horribles would not be affected by Section 207(a). For example, contrary to Ms. Schifferle’s suggestion, the 2009 transfer from Paramount Farms that has become a favorite target of the Progressive Left was not of CVP water, but of water rights formed under state law without any federal or state subsidy. In addition, the holders of most CVP water contracts that would be either sellers or buyers are public agencies, subject to state laws regarding open, transparent public decision-making. This includes Westlands Water District, which is generally not a seller, but a buyer in the water markets.

The second problem addressed by Sen. Feinstein’s legislation is that of costs and delays that are imposed on transfers, particularly for the most common transfers that are only in effect for one irrigation season from April through October. The cost and time consumed in seeking regulatory approvals and environmental review often leads to parties not trying to consummate a transfer that would increase water availability and promote system efficiencies. In the drought year of 2009, this led the California Department of Water Resources (DWR) to coordinate a one-year Drought Water Bank to streamline the process. That effort was followed by a joint USBR-DWR program in effect for the two years of 2010 and 2011. Currently, the USBR is pursuing environmental review for a 10-year transfer program within the CVP, and Sen. Feinstein’s legislation simply encourages that effort (which has stalled), without changing any federal or state substantive restrictions on transfers. Section 207(b) states that:

The Secretary of the Interior, acting through the Director of the United States Fish and Wildlife Service and the Commissioner of the Bureau of Reclamation shall initiate and complete, on the most expedited basis practicable, programmatic environmental compliance so as to facilitate voluntary water transfers within the Central Valley Project, consistent with all applicable Federal and State law.

In addition, Section 207(c) requires USBR to make a report to Congress once every four years about the status of efforts to facilitate and improve water transfers within the CVP.

In all, Sen. Feinstein’s legislation provides a very small, incremental improvement in the way that water transfers are handled within the CVP. It does not fundamentally change any of the existing federal and state laws that have restricted water markets in California, and certainly does not facilitate any private party making untoward profits by selling water in a manner that harms the public. Any resulting transactions will be between willing sellers and buyers, with generally positive effects for the CVP, California and United States as a whole. Negative externalities, including environmental protection, are well prevented by existing federal and state laws.

If anything, federal and state laws should be modified to incrementally reduce the transaction costs and barriers for transfers, so that the waters of the state may be put to the greatest, and most valuable, uses possible, including environmental resource protection and enhancement. Many environmental organizations, such as the Natural Resources Defense Council, Environmental Defense and The Nature Conservancy, recognize the value of water transfers and markets for improving water management. As we enter a new era of seeking true environmental and economic sustainability for the next century, water transfers will need to play a critical role in reallocating water from lower to higher value uses, while providing funding for water conservation improvements and economic enrichment of areas of origin.

For the majority of my readers who are based in the US, some background may be helpful. The UK water utility industry was reorganized in 1989 with the privatization–or, as they would say, privatisation–of all retail water and sewerage services. Water and sewerage services are divided among 34 private companies, each of which has a monopoly within its own service area. Environmental and water resource regulations are overseen by the Environment Agency, while the Water Services Regulation Agency (Ofwat) governs economic issues such as capital investments, customer fees and competition. Despite the fears of many in the US regarding water services privatization, the UK experiment has largely been successful.

In order to address identified challenges, Defra proposes a number of water resource reforms, which would be implemented through new legislation and regulatory agency action. Large-scale goals include protecting and restoring the environment, increasing resiliency of the water utility sector through efficiency and innovation, ensuring that water is affordable to all citizens and appropriately valued, and enabling economic growth.

Regarding over-abstraction from water sources, the government proposes to modify the existing system of abstraction licenses created in the 1960s to create greater certainty in light of future changes to water resource availability, protect in-stream flows and incentivize efficient water use. Examples of specific policy reforms include:

• Varying water abstractions based on the volume available at the given time rather than a fixed volume;
• Issuing abstraction licenses to approximately 30,000 currently exempt abstractors;
• Holding reverse auctions to buy back licenses in over-subscribed catchments;
• Invoking a power in the Water Act 2003 to limit abstractions that cause serious damage to rivers without compensation;
• Improving connections between water systems;
• Removing barriers to bulk water transfers;
• Increasing abstraction charges to better reflect scarcity of water resources;
• Better connecting water resource planning and Ofwat economic regulation, including price review; and
• Requiring water companies and businesses that rely on water abstractions to better manage risks of reduced water availability with a long-term perspective.

These actions will be undertaken at the catchment level, and specific solutions will be based in part on experience gained through pilot projects in the Restoring Sustainable Abstraction (RSA) program administered by the Environment Agency.

Of particular interest to me, having just come from a December 12-13, 2011 meeting of the Western Governors’ Association and Western States Water Council on innovative water transfers, is the proposal to increase use of water markets for bulk water transfers. The UK government noted the advantages of markets to coordinate supply deficit solutions across basins, allow businesses to obtain new or expanded water supplies without the issuance of new abstraction licenses, promote efficient use of water and encourage abstractors to invest for climate change adaptation sooner rather than later. The initial stage of water transfers will be limited due to the perception of relatively high expense and carbon emissions to transport water over long distances, but may be expanded in future as envisioned in the Assessment of regulatory barriers and constraints to effective interconnectivity of water supplies (Defra, 2010) and Exploring views on the potential for more active water rights trading (Synovate UK, 2008). Defra plans to work with Ofwat, the Environment Agency and water companies to remove barriers to water transfers, particularly through the use of economic incentives. The Environment Agency started these efforts by publishing new rules for water rights trading in October 2011.

Regarding water use efficiency, Defra proposed to encourage household water use reduction measures, such as use of rain barrels, efficient appliances and leak reduction. Water companies will be required to conduct a thorough review of water use efficiency improvements as part of their water resource management plans every six years. Interestingly, Defra does not support blanket use of water meters at the individual customer level, instead looking to regional differences as to whether metering is appropriate. In England and Wales, only 37 percent of households pay for water according to usage; the remainder pay for water and sewerage services based on the value of their homes. Use of meters is increasing, particularly in water-stressed South East England, and Ofwat has established a Smart Metering Advisory Group. Defra is looking at additional ways of conserving water by non-water companies, especially in energy generation, agriculture and the public sector.

Defra noted that water companies have an important, but not singular, role to play in resource management. Responsibilities also lie with government agencies, businesses and individual citizens. The government expressed concern about the impact of proposed reforms on affordability of water and sewerage fees, especially for low-income customers. The water companies will be encouraged to develop “social tariffs” targeted at vulnerable customers, and Defra proposed national-level subsidies to South West Water to deal with uniquely high rates facing customers of that company based on need to develop infrastructure more fully in recent years.

Finally, Defra plans to look at ways to increase competition between retail water companies for non-household customers. Current rules limit the market to a few large customers, which has resulted in few market entrants in England. This is in contrast to the situation in Scotland, where an alternative regulatory regime has led to 42 percent of eligible customers switching or renegotiating their water supplies, with significant attendant cost savings. This proposal follows the recommendation of the Cave Review released earlier this month and, as might be expected, is very controversial among the water companies and business customers. It will be interesting to see if the UK can experiment with retail water competition in a way that provides lessons (or warnings) for other jurisdictions.

Specific reform proposals from Water for Life will be developed with consideration of linked policy objectives such as food security, energy security, climate change mitigation and international competitiveness. Defra has promised a public process, including formation of a national advisory group of key stakeholder representatives in 2012. New legislation is scheduled to be introduced in 2013, with many reforms being implemented on a river basin level, starting with those under the most stress and finishing by the mid to late 2020s.

The Defra report proposes many policy reforms in the right direction, but as with many reforms, there can be a significant distinction between the direction and magnitude of the reform vector. I am struck by the significant gap between Defra’s aggressive policy goals and the list of specific actions that will be taken to achieve them. As seen in the 1989 reforms and more recent austerity actions, however, the UK seems politically willing to make needed reforms. That is one way in which the UK is ahead of the US, which seems to be stuck with little will to respond to our water resource, infrastructure and economic challenges.

While this law is undoubtedly a step in the right direction, it’s a very, very modest step. Couldn’t we ask a little more from the Legislature to promote efficient water use?

Related to this blog, P3s may be used to procure water and wastewater infrastructure projects, particularly those that require innovative technology or are outside the expertise of the sponsoring agency. Such projects often include water treatment plants, wastewater treatment plants, water recycling facilities, brackish groundwater or seawater desalination plants, long-distance water pipelines, remote groundwater well fields, groundwater storage banks and new surface water reservoirs. Water and wastewater projects fit well into the P3 model, because water and wastewater rates provide a steady revenue stream for repayment of private financing.

As the current and foreseeable future status of federal, state and local government budgets make significant infrastructure investments difficult, private financing can provide a valuable replacement or supplement. Unfortunately, federal and state laws often make P3s difficult to accomplish in the most effective and efficient manner, if at all. As much as the President and Congress have spoken about infrastructure and its potential for jobs creation over the past five years, they have done very little to actually encourage infrastructure projects for the long-term. A directed effort by the Super Committee to remove legal and regulatory barriers for P3s would be welcome for the furtherance of infrastructure projects across the United States.

Government agency procurement laws are typically legislated at the state level, although some local home-rule jurisdictions have also adopted their own rules. In California, there are a number of statutes authorizing P3s for various types of infrastructure projects. This post concerns one of those statutes, the California Infrastructure Finance Act (IFA), codified at Government Code §§ 5956 et seq. That act provides one of the most broad and flexible authorizations for P3s in the state, although there are limitations on its applicability as well. The IFA is particularly useful for water and wastewater infrastructure projects, which are the focus of this blog.

The IFA was adopted by the California Legislature in 1996 to authorize the use of private financing for government infrastructure projects. The statute does not require the use of private financing, however, and allows the private entity or entities in a P3 to “study, plan, design, construct, develop, finance, maintain, rebuild, improve, repair or operate” the project. The main limitations are that the infrastructure project must be fee-producing (not a hard requirement for most water or wastewater projects to meet), that the project may not include any state funds, and that the length of the P3 contract may not exceed 35 years. Overall, the IFA is a very useful statute for implementing P3s. Perhaps the greatest limitation of the IFA is that so few local government agencies are aware of or understand it.

For more information on the IFA, please see the slideshow below that I presented at a meeting of the National Council for Public-Private Partnerships (NCPPP) last week. If you have specific questions about the IFA, please comment below or contact me directly.

As described in my earlier posts here and here, mutual water companies are corporate organizations that have a primary purpose of delivering water to their shareholders. Private water companies have been formed throughout the history of the state, but many were formed in the early years of the 20th Century to meet the water demands of growing urban and agricultural areas. In 1911, the California Legislature responded by forming the Railroad Commission (now the California Public Utilities Commission) with jurisdiction over the terms of service and rates charged by private water companies. A distinction was recognized early on between private water companies that are owned by developers or investors for the purpose of earning a return on investment, and mutual water companies that are owned and governed by water users themselves. Section 2705 contains the codification of the legal distinction between the two types of private water company. Any interpretation of § 2705 must take into account the purpose and function of the provision, which is to protect water end users (or “customers”) from the monopoly power enjoyed by retail water suppliers. Customers of an investor-owned utility are entitled to regulation by the CPUC for their protection, while it is assumed that customers of a mutual water company do not need such protection, since they control the company through shareholder voting. This is the same reason that government-owned utilities are not regulated by the CPUC, since they are controlled by a customer-elected board or city council.

Consistent with the public policies described above, § 2705 states that “[a]ny corporation or association that is organized for the purposes of delivering water to its stockholders and members at cost … is not a public utility, and is not subject to the jurisdiction, control or regulation of the commission.” The term “at cost” is defined to mean “without profit.” Section 2705 goes on to provide that, “[h]owever, a mutual water company may perform the following acts without becoming a public utility and becoming subject to the jurisdiction, control or regulation of the commission: … (c) May transfer water or water rights to, or exchange water or water rights with, another entity pursuant to state or federal law, or both.”

It is clear from the language of § 2705 that while the central purpose of the statute is to describe the general circumstances under which a mutual water company is exempt from CPUC regulation, there are also special actions that a mutual may undertake without becoming subject to regulation. One of those is the implementation of water transfers or exchanges, in subsection (c). I have heard the argument that the phrase “at cost” in the main text of § 2705 should apply to each of the five subsections (a) through (e), but that argument fails as a matter of statutory interpretation because three of the subsections – (a), (b) and (d) – repeat the phrase “at cost,” which would be redundant if that concept applied to all the subsections based on the main text. Rules of statutory interpretation require that all language of the provision be given effect to the extent possible, and for § 2705 that means not applying the phrase “at cost” to those subsections – (c) and (e) – that do not expressly include it. It is best to conclude that the Legislature intended to apply the “at cost” limitation only to those subsections in which the language appears.

This interpretation of § 2705 is consistent with the historical acceptance by the courts of water transfers at the wholesale level that do not trigger CPUC regulation. Examples of such cases include Garrison v. North Pasadena Land & Water Company, 163 Cal. 235 (1912) (sale from a mutual to an investor-owned water utility), Marin Water & Power Company v. Town of Sausalito, 168 Cal. 587 (1914), and City of San Diego v. La Mesa, Lemon Grove and Spring Valley Irrigation District, 109 Cal.App. 280 (1930). Those courts concluded that bulk water transfers do not fall within the jurisdiction of the CPUC because the private water companies at issue did not offer water for sale to the public, but only sold water to other entities that could be assumed to have the commercial sophistication to represent their own interests. A buyer in a water transfer is not like a utility customer who is subject to the utility’s monopoly power; such a buyer may seek a water transfer with a number of potential sellers and may negotiate the terms and price of the transaction. Those cases are consistent with the fact that in addition to satisfying the requirements of § 2705, a private water company is regulated by the CPUC only if the company has dedicated its assets, including water supplies, to public use. That common law test has been in place for a century now, and has been reviewed and accepted by the California Legislature and courts as high as the United States Supreme Court.

California law supports the ability of water rights holders to engage in water transfers. The California Constitution, Article X, § 2 mandates the greatest use of water resources of the state, and effective and efficient reallocation between water users is a necessary component of achieving that fundamental state policy. The California Water Code expressly authorizes water transfers in a number of ways, including but not limited to:

• State policy to facilitate the voluntary transfer of water and water rights (§ 109);
• Transfers by public agencies (§§ 380-387);
• State assistance for water transfers (§§ 470-484);
• Transfer of water made available by conservation or use of recycled or desalinated water (§§ 1010, 1011);
• Water leases (§§ 1020-1031);
• Temporary transfers (§§ 1725-1732);
• Long-term transfers (§§ 1735-1737);
• Transfer of decreed water rights (§ 1740);
• Transfers by water suppliers (§§ 1745-1745.11);
• Use of water conveyance facilities to implement water transfers (§§ 1810-1814);
• State policy supporting water transfers within integrated regional water management plans (§§ 10531, 10537(c)).

None of these provisions states or implies that mutual water companies are not able to engage in water transfers or that such transfers should be conducted without financial compensation to the seller. The essence of a water transfer is a voluntary transaction between a willing seller and buyer, and almost always the consideration for a seller to enter into such a transaction is monetary. Thus, California law generally supports the right of any water rights holder, including a mutual water company, to sell water for financial remuneration.

I think what this argument shows is that opponents of market mechanisms and private sector participation in water are increasingly looking for legal grounds by which to challenge transactions they would disfavor. Every water rights holder, whether it is a mutual water company, private investor or even a public agency, should be aware that opponents are likely to challenge any attempted water transfer, but it should also be aware that the law and good public policy are on its side.

On August 25, 2011, the Second District Court of Appeal published its decision in the Palmdale case. While the decision had been rendered earlier in the month, the court decided to publish its opinion on the 25th, meaning that the decision now has precedential effect in the courts. Given the outcome described below, there is a good chance Palmdale Water District will appeal the decision to the California Supreme Court, with continued amicus support from the Association of California Water Agencies (ACWA).

The Palmdale Water District, located in the Antelope Valley area of Los Angeles County, sought to raise its revenue in 2008 due to rising expenses and decreased revenues from its then-current rates. The board of directors hired a financial consultant and considered several options for rate design, eventually deciding to proceed with a “Fixed/Variable Cost Allocation” (FV) method. The FV rate design was established to recover 60 percent of revenues through fixed monthly service charges and 40 percent through commodity rates. The commodity rates were divided into five tiers, with higher prices for each progressive tier, and the tiers defined by percentages of a water budget set for each customer. The budget was determined for residential customers based on indoor and outdoor use allocations, commercial customers based on a three-year previous use average, and irrigation customers based on an outdoor allocation only. In addition, the speed at which each customer type moved up the tiers was different, as shown in the figure below. As is apparent, the FV method increased rates for irrigation customers more rapidly than for residential or commercial customers.
The district’s financial consultant also provided the board of directors with a second rate design option, ominously called “Cost of Service,” which collected a lower proportion of the district’s costs through fixed service fees. That option was expected to further incentivize efficient use of water based on higher commodity rates, but would have caused greater volatility in district revenues. This dilemma has been faced by many water utilities over the past few years, as there has been a push to drive water efficiency through customer incentives rather than specific directives (which approach, in my opinion, is well justified in a liberal society). I have written about the dilemma of conservation and utility revenues in a prior post.

The City of Palmdale challenged the district’s FV rate design based on the different commodity rate tiers imposed on irrigation customers, as opposed to residential or commercial customers. The city is an irrigation customer based on its maintenance of parks, playing fields and playgrounds. According to the city’s argument, the district violated Proposition 218 by treating irrigation customers differently without a cost-of-service justification, i.e., because it costs the district no more to provide irrigation water than it does residential or commercial water. In addition, the city argued that the fixed service fee for each water meter, the commodity rate tiers and the water budget allocation to each customer were not proportional to the cost of providing service.

Proposition 218, also known as the Right to Vote on Taxes Act, was adopted by California voters in November 1996. Codified at Articles XIIIC and XIIID of the California Constitution, Proposition 218 places both procedural and substantive limitations on property-related fees or charges, including water utility rates. Procedurally, a government-owned utility must adopt rates through a public hearing process and give voters the opportunity to protest. Substantively, utility rates must be set so that revenues do not exceed the funds required to provide the service, and the fee or charge imposed on any ratepayer must not exceed the proportional cost of the service attributable to that ratepayer.

The district first defended its rates by claiming the establishment of commodity rate tiers is not subject to the requirements of Proposition 218. The court rejected this argument, citing Bighorn-Desert View Water Agency v. Verjil, 39 Cal.4th 205 (2006), the seminal case holding that water rates are property-related fees subject to Proposition 218. In Bighorn, the California Supreme Court held that “all charges for water delivery are charges for a property-related service, whether the charge is calculated on the basis of consumption or is imposed as a fixed monthly fee,” and the Palmdale court concluded that such language applies not only to water rates as a whole but also to each constituent part.

The district then argued that its commodity rate tiers were set appropriately to incentivize the efficient use of water pursuant to the California Constitution, Article X, § 2. The district specifically cited Water Code § 372, which authorizes water utilities to adopt conservation rates that rely on allocation budgets. The court sidestepped the issue of potential conflicts between Proposition 218 and Article X, § 2, holding that conservation rates are not at odds with Proposition 218 as long as such rates are set in a proportional manner. The court noted that § 372 provides only general authority for conservation rates and does not mention inequality of tiers between different types of customers. As stated in § 372(a)(4):

A conservation charge shall be imposed on all increments of water use in excess of the basic use allocation. The increments may be fixed or may be determined on a percentage or any other basis, without limitation on the number of increments, or any requirement that the increments or conservation charges be sized, or ascend uniformly, or in a specified relationship. The volumetric prices for the lowest through the highest priced increments shall be established in an ascending relationship that is economically structured to encourage conservation and reduce the inefficient use of water, consistent with Section 2 of Article X of the California Constitution.

The court held that the district’s rates violated Proposition 218 because they treated irrigation customers differently than residential and commercial customers with no cost-of-service justification. Although the district argued that the rates were designed to disincentivize use of urban water for irrigation, the court noted that both residential and commercial customers may use water for irrigation, but it was only those customers in the “irrigation only” category that paid higher rates. In addition, the record was clear that the Cost of Service rate design provided greater incentives for water efficiency than the FV design, and the district seemed to choose the latter over the former based solely on concerns about its own revenue stability.

Although the city argued that the fixed service fee, commodity rate tiers and water budget allocations of the FV rate design also violated Proposition 218, the court did not reach those issues. Thus, the court did not resolve many of the difficult questions that exist at the intersection of conservation rates and Proposition 218. While conservation water rates are commonly seen as good public policy, and there is express statutory authority for their adoption, there are serious questions about their viability in light of the California constitution. It seems likely that future cases will force the courts to address the issues head-on.

One approach that may satisfy the twin goals of promoting water efficiency and complying with Proposition 218 is the adoption of water rates based on the marginal cost of supplies. Under this approach, a water utility would create commodity rate tiers based on each of its water supplies, with the lowest-cost supply for the first tier, and higher-cost supplies for the following tiers. Some water professionals have suggested setting the highest rate tier at the cost of developing new, currently undeveloped supplies, and that fits well with a marginal cost approach. This would appear to be defensible under Proposition 218 because it expressly connects each rate tier to the cost of service, and good policy because it effectively communicates the cost of developing new water supplies to ratepayers. Such an approach might be difficult to implement because water supply costs are often fixed regardless of utilization and could not be entirely dependent on customer usage. Very few, if any, public agencies have sought to adopt rates based on a marginal cost approach.

While we wait for the Palmdale case to be resolved by the California Supreme Court and for a future court to address the issues left unanswered by the Court of Appeal’s decision, water utilities will need to proceed with caution, knowing there is a fog of uncertainty about what lies ahead. If the courts were to resolve future disputes about the intersection between conservation water rates and Proposition 218 without a clear understanding of the significant policy questions implicated, there is the possibility of a major collision that will snarl progress on water resources management for many years to come.