American Waterworks Association: Interview with Prof. Steve Hanke

Reprinted from Journal AWWA Vol. 75 No. 5 (May 1983), by permission. Copyright © 1983, American Water Works Association.

The debate on privatization of public water supplies is an ongoing one. In this 1983 interview, Prof. Steve Hanke discuses his views, many of which are still relevant today.

David B. Preston, executive director of AWWA, interviewed Steve Hanke on March 2, 1983, in Washington, D.C. Hanke was an economist on President Reagan’s Council of Economic Advisors during 1981 and 1982, when he was one of the authors of the President’s privatization policies. He is now a Professor of Applied Economics and Co-Director of the Institute for Applied Economics and the Study of Business Enterprise at The Johns Hopkins University in Baltimore; a Senior Fellow at the Cato Institute in Washington, D.C.

David B. Preston: I would like you to describe your career to Journal readers, emphasizing your work on public water supply.

Steve Hanke: I originally became interested in public water supply when I conducted research for my PhD dissertation at the University of Colorado in Boulder. In that study, I isolated the effects of meter installation on water consumption.

Preston: Was that part of F. Pierce Linaweaver’s study done in the 1960’s?

Hanke: It was a follow-up to the Linaweaver study. Linaweaver did a cross-sectional analysis of water demand and attempted to estimate statistically what influence various factors had on water use. His data were taken from communities throughout the country at a specific time. My objective was to analyze consumption in one location over a period of time. I selected Boulder and analyzed consumption patterns prior to meter installation. Then I analyzed the effect of meter installation on consumption.

Preston: What are some of the highlights of your career in the field of public water supply?

Hanke: The first phase was analyzing water demand. After that, I spent a number of years analyzing rate structures and the effect rate structures have on water use. Then I analyzed water utility costs and conducted benefit-cost analyses of various measures taken to promote conservation of water, including changing rate structures, installing meters, restricting water use, and detecting and controlling leaks. The most recent phase of my career has been directed toward the investigation of alternative means of financing and organizing water supply systems. This is what has led me to the conclusion that to improve the efficiency with which water is supplied, alternative means of financing and organizing must be found. Because there are inherent cost advantages associated with doing this privately rather than publicly, the concept of privatization for water supply and wastewater systems is very attractive. That rounds out the sequence of my career to date. I started by dealing with some rather small technical matters, then expanded into the larger issues. Along the way, I have done work on water supply policies in Australia and France and also some in Sweden and Austria.

Preston: The Heritage Foundation is a private foundation?

Hanke: It’s a private “think tank.” As you might know, it has had and still has some links with the Reagan administration. In fact, during the early months of the administration, those at the foundation were referred to as the “court philosophers.”

Preston: Would you comment about rumors that a large municipal water system in the East is for sale? For what reasons would such action be considered?

Hanke: I don’t know the particulars of the rumor you refer to, but in general, I anticipate that within the next 10 to 15 years many municipal systems will be put up for sale, either in whole or in part. Municipal systems are faced with a financing situation that has resulted in considerable deterioration of their systems. One reason for this is the costs mandated by the federal government. Another is the relatively high cost level associated with public supply. In addition, there are price controls on municipal systems in one form or another. Faced with this situation, cities are beginning to explore cost-effective private alternatives, including the sale of their systems. There is a financial gap that water systems have not been able to fill.

Preston: Aren’t the water rates charged by many municipally owned systems really low — $100 or even $50 a year for a family of three — compared with rates charged by other utilities? Why is there such reluctance to increase water rates to solve some of these problems?

Hanke: The relationship of water utility charges to other utility charges is an inappropriate comparison. The key question is: what is the real cost of supplying water? I think, if I may modify your statement slightly, the water rates now charged are far below the real cost of supplying water. The question is why are they so low? I think one factor is that water utilities aren’t very glamorous. Water is a forgotten industry in a sense, the last one noticed by local politicians or utility rate commissions. They consider the big-ticket items first-electricity, gas, and telephone service. If any time is left, they might deal with water. I might add that private, deregulated supply systems, such as they have in France, would correct this situation.

Preston: There are many examples of successful public water systems that charge sufficiently to operate as self-sustaining enterprises. We could list them.

Hanke: I suggest that it is a rather short list.

Preston: Would you comment on the trend toward contracting with consulting engineering firms to manage municipally owned systems. Is this the same thing as full privatization?

Hanke: In a way, it is. The only difference is that the assets of a public water system are retained by the municipality, but a consulting engineering firm manages the system. The only way the engineering firm can make money is by operating the system efficiently, so there are strong incentives for good operation and maintenance. Also, there are economies-of-scale associated with this type of management. For example, if there are many small systems in an area, it might be wise to use a private circuit rider and have the private firm take responsibility for operation and maintenance, laboratory work, and so on to gain economies. This has been done in Europe, particularly in France, for more than 100 years. Virtually all the systems in France have at least a minimum of this component. They call it affermage, or farming out operations and maintenance.

Preston: When either the purchase of a utility or a contract for total management of a utility takes place, isn’t it inevitable that charges for water increase?

Hanke: I think user charges in any case will increase enough to cover the real cost of providing service. The level of deterioration in service in many systems simply will not be tolerated in the future. But I think the real cost of investor-owned service is lower than the real cost of public service. The problem is that public rates have been so low compared with the real public costs of providing the service that customers believe privately owned utilities have higher costs than publicly owned utilities. The thing the customer forgets is that many public systems have used up all their capital stock, are in disrepair, are not operating properly, and will require very large investment and financing in the near future. Given this situation, privatization is an option that is being seriously considered.

Preston: Would you comment on overseas companies buying into investor-owned water utilities in the United States? Is this a trend?

Hanke: This fits into the context of the question you asked earlier about the trend toward private ownership of water and wastewater systems in the United States. I think the answer should be yes.

Preston: But these are already private systems?

Hanke: That’s right, but there must be a place to start, and one way to start is to acquire an established private system. The most exciting thing that’s happened this year, and that might prove to be the most exciting thing of the decade, is the purchase of 51 percent of a large investor-owned system in the United States by a large European water company. If this trend continues and is viable for the long term, new ideas as well as new capital will be injected into the industry. This company and others like it have experience with farming-out contracts and with ownership of water systems and laboratories. They manufacture equipment and are vendors of equipment. They have a full package of services for which we have no counterpart in the United States. They are very advanced technologically, and they have the financing skills and capabilities one expects from large private-sector firms.

Preston: I notice that investor-owned water systems listed on the New York Stock Exchange did rather well last year compared with previous years.

Hanke: I think if you look closely, you will see there have been buyers, foreign buyers, nibbling around the edges of investment opportunities in the United States. After all, the stock market reflects expectations, so investors are bullish, or becoming bullish, about water companies. This is consistent with my views on privatization.

Preston: I would like you to comment on an issue currently before Congress, the so-called infrastructure issue — replacement or rehabilitation of obsolete or worn-out public facilities.

Hanke: This issue is why I was recently asked to prepare the study for HUD on privatizing infrastructure. I’d like to point out that the so-called needs projected for infrastructure are no more than wish lists for everything under the sun people think they might want to build. If all these things are added up, the sums are very large.

When I was on President Reagan’s Council of Economic Advisors, the idea of supply-side economics was to cut government grants for infrastructure projects. We looked at the failure of past policies that led to deterioration of the infrastructure even though construction of public projects had been subsidized. In addition, we succeeded in changing the tax laws in 1981 to encourage private capital investment in infrastructure through investment tax credits and accelerated depreciation, thus giving private investors a tax benefit. The objective of these two changes was to encourage privatization and to capture the inherent cost advantages of doing things privately. I think privatization of infrastructure is the cutting edge of a new movement in the United States.

Scare stories about the infrastructure crisis are designed to retain government subsidies and obtain increased subsidies. I ask why is there such a big crisis, since all these subsidies have existed in the past? It’s time to do something differently. My position is that virtually all these so-called public works should be privatized. I believe the cost of delivering these services privately is less than the cost of delivering them publicly.

Preston: Would you comment on the Edgar bill that will be introduced in Congress? This bill would provide loans either to investor-owned or municipally owned utilities for replacement or rehabilitation of obsolete or aging systems. Let’s assume that the loans would be made on the basis of need and were predicated on a self-sustaining enterprise. Would this be another way of solving the problem?

Hanke: I don’t think so. It is very difficult to make government more efficient. In general, the only way to correct the situation is to remove the function from the public sector and put it in the private sector.

Preston: Would you like to summarize your comments?

Hanke: I think the next 10 years in the water supply field will be the most exciting and revolutionary in the United States since the turn of the century. I believe we will witness a radical restructuring of the water industry, with heavy emphasis on privatization and innovation. Let me give an example. Many systems might continue to be publicly owned in the following sense. The public portion would be the distribution systems, but virtually all of the treatment plants would be owned and operated privately. In effect, water would be wholesaled from privately owned treatment plants into a public grid. And this grid, although publicly owned, would be operated and maintained by a private company. That’s one scenario in which the public system doesn’t sell all its capital. It keeps the distribution network and sells, or maybe sells and leases back, the treatment plants.

This is a radical departure from the past. The public survivors will be only the outstanding public water supply systems in the United States. In more marginal situations, the local politicians, local taxpayers, and local users of these systems will simply demand more than the public sector can produce. The solution is privatization. Innovation in the field of water supply and management might come from foreign water companies, for instance. Some have been in this business for a long time and are very sophisticated. Clear evidence of the intent of overseas water companies to put money where they have experience is a French company’s purchase in late 1982 of 51 percent of a large investor-owned U.S. water utility.

Steve H. Hanke is a CEPA Advisory Board member and a Professor of Applied Economics and Co-Director of the Institute for Applied Economics and the Study of Business Enterprise at The Johns Hopkins University in Baltimore.