Special District Privatization

A Report Prepared for the
Association of California Water Agencies



by Stephen P. Morgan, M.P.A.
Research Associate, School of Public Administration
Sacramento Center, University of Southern California

and

Jeffrey I. Chapman, Ph.D.
Professor, School of Public Administration
Sacramento Center, University of Southern California

July 1, 1995

This report was funded under Contract
with the University of Southern California

Executive Summary

There is currently a proposal before the Orange County Local Agency Formation Commission to replace the Santa Margarita Water District, an independent enterprise special district, with the California-American Water Company, a subsidiary of American Water Works Company, Inc. This report is a discussion of some of the governance and economic issues raised by that proposal. In addition, because two recent studies on the topic of privatization have become part of the debate over this issue, the draft report of the Rose Institute on Orange County government and the 1992 Reason Foundation Report on privatization will also be considered as they relate to the Santa Margarita question.

It is crucial to understand from the outset that this is not a debate over the relative merits of the private sector or the public sector. The theoretical efficiencies of the private sector are achieved through competition in an open marketplace. However, water distribution, like many other public services, does not lend itself to a competitive market. Water is considered a natural monopoly, "an industry in which the economies of scale...are continuous up to the point that one company supplies the entire demand".

Although the marketplace can sometimes be simulated in cases where a government accepts bids for contracts or franchises, the California-American plan envisions no competitive environment. Instead, California-American proposes that a single public sector producer be replaced with a single private sector producer. Because of the monopolistic nature of water service, some oversight is necessary to ensure that the citizens' interests are protected. Therefore, the proposal also suggests that the current system of oversight by local citizens, in the form of elections of the Santa Margarita board of directors, be replaced with oversight in the form of the California Public Utilities Commission.

Therefore, the key issue in the Santa Margarita water district case is not whether the private sector or the public sector can do a better job of providing water service. Rather, the key issue is whether the citizens's interests are best protected by local voters or by a state appointed commission.

Governance and Economic Issues

In recent years, a body of scholarly literature has developed which makes a distinction between provision and production in government. Provision decisions are defined as choices, made by government, about how money will be collected from the community and how it will be spent. Production is the actual delivery of goods or services. The public sector has a wide variety of options available when considering how to allocate a community's resources.

If the production of a particular service is to remain a fully public sector activity, a government can simply choose to produce the service in-house with its own equipment and personnel. It can also choose to work with other governments and create a combined production unit such as a joint powers authority. A third option is to pay another government to produce the service.

On the other hand, a government may establish an agreement with a private sector organization to deliver the good or service. This range of options tends to fall under the umbrella term "privatization". Perhaps the most popular form of privatization in this country is a contract between a government and a business. A similar option is a franchise arrangement under which companies bid for the right to provide a specific public service for a specific period of time. In the case of either the contract or franchise, the right to produce is granted by a government and a company's performance is monitored by that government. Another privatization alternative is a voucher system, where citizens are allotted funds from a government and it is they who choose among private sector producers for a good or service.

The California-American proposal deals with a natural monopoly. It would replace a single public sector producer with a single private sector producer. The discipline of a competitive market is missing in this situation and some other form of oversight must be substituted to protect the consumer's interests. Since most voters are not stockholders and the Santa Margarita government would be gone, the State of California through the California Public Utilities Commission would be charged with monitoring the activities of California-American on behalf of southern Orange County water and sanitation customers.

Existing literature comparing the relative efficiencies of public and private producers of water and electrical service has produced mixed results. According to John D. Donahue of the Kennedy School of Government at Harvard University, of seven studies which compared public and private water companies, one found the private company more efficient, two favored the public sector and four found no significant difference. Of six studies that examined public and private electric service, none found the private more efficient, three found the public more efficient and three reported no significant difference.

Santa Margarita Water District

The Santa Margarita Water District, established in 1964, provides water and wastewater services to approximately 75,000 residents, by its own estimate, in southern Orange County. In 1992 certain individuals were found to have engaged in unethical practices with District contractors. At the same time, the District was accused of serious financial mismanagement. Since that time, the upper management and the entire board of directors have been replaced, a strict code of ethics has been adopted, and a more conservative fiscal policy has been implemented.

The Draft Rose Institute Report

In recent weeks a partial copy of a draft report on Orange County government, written by the Rose Institute, has been circulating in Southern California. Although it is premature to evaluate the report itself based upon preliminary, fragmentary excerpts, the ideas contained in the draft report have become part of the debate concerning the California-American proposal. An examination of those ideas merits some discussion.

Although it acknowledges that such measures are seriously flawed, the draft report recommends that special district leaders be held accountable for variations in the per capita costs of providing services. Since everything from voter preferences to the availability of water resources can influence per capita costs, caution in applying such measures is certainly advisable. Furthermore, in the specific case of special districts, accurate population data is not readily available. Moreover, the use of annual data, when considering a capital-intensive service, is not nearly as informative as long range figures. Finally, the economic literature on pricing efficiency suggests that cost per unit of output rather than cost per capita, is the appropriate unit of measure in this case.

The draft report suggests that the use of property taxes by enterprise districts masks the true price of water service from the consumer and distorts consumer behavior. Since Proposition 13 eliminated local government control over property tax rates, it is certainly possible that some price distortion of public services is taking place. At the same time, it is also true that there are at least three important reasons for including some level of property tax with enterprise special district funding.

First, the presence of a well-maintained water system adds both property value and fire protection to a community for both water customers and non-customers. This positive externality is partially captured by property taxes. Second, since water is a public necessity, there is an argument to be made that water should be as affordable as possible, and property tax helps meet this equity issue. Finally, due to the special case of a natural monopoly, economically efficient pricing would not necessarily be profitable. Property taxes help offset the pricing problems created in the environment of a natural monopoly.

The draft Rose report names six liabilities associated with water and wastewater service in Orange County. The price distortion problem has already been addressed. The assertion that property taxes should be diverted from special districts to schools fails to recognize the externality, equity, and efficiency function of the tax for enterprise districts. It also makes a value judgment about the allocation of public resources that is more appropriately left to elected officials. Evidence for charges that districts are "unnecessarily expensive", are "poor stewards of public funds", and make "imprudent, and perhaps illegal, expenditures" is not provided in the available section of the draft report. Furthermore, such sweeping generalizations could be applied to many public and private sector organizations. The suggestion that general purpose governments are a more appropriate forum for land use decisions has some legal merit. At the same time, recent court decisions have criticized cities and counties that have failed to consider the capacity limitations of special districts when making planning and zoning decisions.

The draft report from the Rose Institute offers five recommendations. The argument that the District Securities Division might have prevented special district losses in the collapse of the Orange County investment pool is unclear. The collapse of the pool caught both the voters and many investment experts by surprise. There is no evidence that the Division, if it still existed, would possess a special wisdom that could have clearly foreseen the emergency. The suggestion that water and sanitation districts be subject to PUC regulation questions the ability of citizens to "meaningfully" control their government. Furthermore, there is no argument in the draft report supporting privatization so the reasoning behind the recommendation cannot be evaluated. The draft report's criticism of municipal debt seems to be applied very selectively to water districts although it is widely used by local governments throughout California. To the degree that the draft report's call for the elimination of "California Water Districts" in Orange County really means ending "landowner voting" for water districts, that recommendation has been implemented. The final recommendation for the privatization of water and sanitation districts fails to define the form of privatization advocated. As has been noted, there is nothing in the partial draft report that supports privatization. The sweeping assertion that "All the inefficiencies and waste associated with the current arrangement can be eliminated by privatization"" would require extensive substantiation and analysis.

The 1992 Reason Foundation Report

Reason Foundation Report of 1992 does not address the form of privatization proposed by the California-American change of organization plan. It does argue that current U. S. tax, debt, and regulatory laws make it impossible for Americans to take full advantage of the benefits of some forms of privatization enjoyed by citizens of other nations.

The report is particularly impressed with the form of competition for franchises which is traditional in France. Although governments own the pipelines, pumps, and treatment facilities, they award management franchises to private companies to actually run their water systems. In Great Britain, the government's "privatization" philosophy was recently extended to water service which is government regulated. The Foundation favors the incentives provided by Britain's price-cap form of regulation which the report believes are missing in the U. S. rate-of-return regulatory system.

The examples of successful American privatization efforts offered by the report were actually projections of savings that might be realized by various cities that were embarking upon short-term management contracts with private businesses. The report concludes that, under current U. S. tax, debt, and regulatory law, private sector service producers cannot successfully compete with public sector organizations. Tax and debt laws create unfair advantages for government, and American rate-of-return regulatory policies fail to provide adequate incentives for private sector firms. It should be noted that the report's criticism of the commingling of resources and funds in municipal water agencies is addressed by limited purpose governments such as the Santa Margarita Water District.

Conclusions

In conclusion, because water distribution has the attributes of a natural monopoly, the key issue raised by the California-American proposal to replace the Santa Margarita Water District is not whether the public or private sector is better suited to produce water and wastewater service for the citizens of southern Orange County. The issue is whether the voters of southern Orange County or the California Public Utilities Commission is better suited to oversee the monopoly.

The fragmentary draft of the Rose Institute Report offers little guidance in this area since conclusions are reached but little useful evidence is provided. On the other hand, the Reason Foundation Report persuasively argues that current tax and debt law place the private sector at a competitive disadvantage with government and that current regulatory practices offer inadequate incentives for private utilities to cut costs.

Thus we find no compelling arguments in any current literature for the type of change of organization proposed in the California-American Water Company plan.