Getting the Lead Out

EPA’s issued its most consequential regulation in decades and few are noticing

Lead is on the mind of the US Environmental Protection Agency these days. But it has nothing to do with the short-lived lead-encased telecom cables hysteria, unleashed by over-eager Wall Street Journal reporters and editors over the summer.

Rather, it’s a proposed rule by the EPA to require water systems across the country to replace all of their lead service lines within 10 years. Announced on November 30, the proposal is projected to require ripping out some 9 million pipes, for the purpose of eliminating lead-based neurotoxins from drinking water.

The proposed rule also has an incremental requirement for systems to replace at least 10 percent of their lead pipe every year. And there are restrictions on utilities’ long-standing practice of only replacing the pipe they technically own, mandating instead removal of pipe on customers’ land as well.

Getting the lead out of the water pipeline business is obviously a worthy goal. But understandably, there’s massive disagreement regarding who will pay for such a massive effort.

The EPA itself estimates a cost of about $45 billion to do the job. Industry projects an all-in price tag of around $60 billion. And both estimates leave a massive funding gap from the $15 billion allocated for the purpose in the bipartisan 2021 infrastructure law.

The Association of Metropolitan Water Agencies—which represents the giant municipally owned systems that dominate the US water and wastewater business—has called the proposed rule “a massive unfunded mandate.” And it’s already warning the EPA that its members will “likely have to turn to increased customer water rates.”

The proposed rule still has to go through a public comment period. And it’s not expected to be fully finalized until sometime next year. But given the Trump Administration also ramped up lead pipe rules during its tenure, toughening looks like a fully bipartisan goal. And at a time when both Republicans and Democrats are battling over record federal budget deficits, the sector can’t count on further funding beyond the $15 billion already allocated.

To be sure, there are success stories. According to an article in the Washington Post—so far the only major media outlet I’m aware of that’s covering the story—water systems in Newark (NJ), Green Bay (Wisc) and Benton Harbor (MI have replaced all of lead pipe. But most large cities are struggling including New York, which the Post reports has the most lead pipes of any major city in the US.

So who is to pay? Unfortunately, a $30 to $45 billion shortfall looks like a bridge too far for most municipal systems, which continue to provide upwards of 80 percent of Americans’ drinking water. Not only are many of these systems a relic of the early 20^th century industrial era, New York and Chicago being good examples. But according to many observers, the money once set aside as depreciation for existing systems has long been appropriated for other purposes.

In contrast to publicly traded companies, municipal utilities don’t operate under the aegis of state regulators. And in places where tax bases have long since eroded, there’s often no alternative to kicking the can down the road on maintenance measures, even when there are considerable hazards to public health.

In recent years, the weakness of municipal systems has induced state officials including Pennsylvania and New Jersey to enact legislation easing acquisitions by investor owned utilities. Companies like American Water Works (NYSE: AWK), Essential Utilities (NYSE: WTRG), Middlesex Water (NSDQ: MSEX) and SJW Group (NYSE: SJW) have long been the one segment of the water and wastewater sector able to fund needed environmental upgrades without bankrupting customers.

Unlike municipal systems, publicly traded companies must file financial documents quarterly with the SEC, and more often if there are significant events affecting their health. State regulators have oversight of operations to ensure performance. And they can raise equity capital at a low cost thanks to historical premium valuations, which reduces reliance on debt to fund projects. American Water Works, for example, recently sold for almost 28 times trailing 12 months earnings, versus just 22 times for the S&P 500.

Companies like American and Essential Utilities have a long history of successfully acquiring struggling neighboring systems and integrating them, vastly improving performance with the advantages of scale while increasing earnings along the way. But recently, the pace of those acquisitions has slowed.

Essential Utilities, for example, reports just $45 million of deals closed year-to-date. That’s well below the $200 million management targets each year. And the company has turned to other areas of investment to spur growth, such as replacing water and natural gas pipelines.

A new EPA rule on lead that has teeth could shift that in a hurry. Of course, no should underestimate the tenacity of “public water” advocates, who generally view investor takeovers of systems as anathema. They’ve worked hard to block deals around the country, as well as to force investor owned companies to divest systems.

Essential Utilities, for example, has been unable to close the still pending acquisition of the DELCORA municipal system despite its bankruptcy and inability to provide safe service. And the Pennsylvania Consumer Advocate convinced the state Commonwealth Court to overturn state regulators’ order approving its takeover of the bankrupt East Whiteland Wastewater system. That’s forced the company and the Public Utilities Commission to appeal the decision to the state Supreme Court, though Essential continues to operate the system.

A $30 to $45 billion funding gap for lead pipe removal, however, has the potential to change the game considerably. For investor owned water utilities, it’s a major opportunity to step up their pace of acquisitions, with increasing scale setting the stage for being able to do even larger and more profitable deals. That means faster earnings and dividend growth and fatter returns for investors.

Municipalities that see the merit in a 21^st century water utility system will benefit from such deals with more stable rates and better service. And they’ll avoid what could be a hammer blow to systems that are already pressured to comply with current clean water regulation.

For the strapped systems that insist on remaining municipally owned, there are basically three choices. And none will be particularly pleasant for preferable for anyone living within their jurisdictions.

They can issue a big chunk of municipal debt, which is tax advantaged but will add to government deficits and eventually come out of taxpayers’ pockets. They can jack up customers’ rates as the president of their leading trade group has threatened, and hope few enough people notice to avoid a full-on ratepayer revolt. Or they can do nothing, absorb what are likely to be substantial fines and accept the risks to residents’ health.

For disclosure, I’m happy to live in an area served by American Water Works.