This page describes valuation practice and the text of one state’s acquisition statute. It is not legal advice and it is not an appraisal. A transaction needs a licensed appraiser and the utility’s own counsel; what follows is what a board should understand before it commissions either.
Start with why the balance sheet is wrong
The audited statements carry the utility’s capital assets at original cost less accumulated depreciation. That figure is correct for the purpose it exists for, and it is close to useless as an indication of what a system is worth.
Depreciation schedules are conventions. A cast iron main laid in 1955 on a fifty-year schedule has a book value of zero, delivers water every day, and would cost several hundred dollars a foot to put back. The error runs one way and it grows with the age of the system, so the systems most likely to be approached by a buyer are exactly the ones whose book value understates them most.
A board that opens a negotiation from net book value has opened it from a number produced by its own depreciation policy.
The three approaches
Appraisal practice recognises three, and a competent valuation runs all three and reconciles them rather than picking one.
Reproduction cost new less depreciation. What it would cost to build the system again today, less an allowance for the physical, functional and economic depreciation actually observed. The strength of this approach is that it starts from the physical asset and does not inherit an accounting convention. Its weakness is the depreciation estimate, which is a judgement about remaining service life on assets nobody has dug up.
Discounted cash flow, or income approach. The present value of the net cash the system will produce, under an assumed rate path, over a forecast period. This one is honest about the fact that the system is worth what it can earn, and it is extremely sensitive to the assumed rate path. A valuation that assumes rates rise faster than the community will tolerate is a valuation of a system that does not exist.
Comparable transactions. What buyers have paid for similar systems recently, normalised by connections, by revenue, or by a multiple of book. It is grounded in actual transactions and constrained by how few of them there are and how badly matched the comparables usually are.
The spread between the three is itself information. A wide spread means the answer depends heavily on an assumption somebody has to own.
What a fair market value statute changes
Under traditional ratemaking, an investor-owned acquirer could include in rate base only the depreciated original cost of the plant it bought. A well-depreciated municipal system was therefore worth very little to a buyer, and very few sales happened.
Several states have changed that. Pennsylvania’s is the clearest worked example. 66 Pa.C.S. section 1329, added by Act 12 of 2016, allows a buyer acquiring a municipal water or wastewater system to have the acquisition valued at fair market value. Two utility valuation experts each produce an appraisal; fair market value is defined as the average of the two. The lesser of the negotiated purchase price and that fair market value becomes the rate base for the acquired assets in the buyer’s next base rate case.
The stated purposes of the section are to give certainty about the value of acquired property, remove regulatory barriers to sale, protect a seller from having to sell public assets below market, and let a buyer recover a market-based investment through regulated rates.
The part the seller has to model
That last purpose is the mechanism, and it is the one a board should follow through to the end.
The premium above depreciated original cost enters rate base. The buyer earns its authorised return on rate base and recovers depreciation on it. Both are collected from customers. In a state where the buyer’s rates are consolidated across its whole service territory, some of that cost is spread across other communities and some of the acquiring utility’s existing costs are spread onto the acquired one. In a state where they are not, the acquired community carries it alone.
So the sale price the city receives and the bills its residents pay afterwards are two ends of the same arithmetic. A valuation that produces the first number and not the second has answered half the question the board asked.
What a board should have in front of it
- The value under each of the three approaches, with the assumptions that drive each one stated separately.
- The projected bill path under a sale, over enough years to include the first base rate case after the acquisition.
- The same bill path under remaining independent, funding the capital plan from rates and debt.
- The same again under merging with a neighbouring system, where one exists.
- What each option does to service, to staff, to local control of capital decisions, and to the obligations already on the utility’s own bonds.
Three of those five are financial and can be calculated. Two are not, and a study that pretends otherwise is selling a decision rather than informing one.
Sources
Pennsylvania Public Utility Code, 66 Pa.C.S. section 1329, added by Act 12 of 2016; Pennsylvania Public Utility Commission, Section 1329 application materials. Governmental Accounting Standards Board, Statement No. 34, on capital asset reporting in proprietary funds. American Water Works Association, Principles of Water Rates, Fees, and Charges, Manual M1, 7th ed. (2017), on the utility basis and rate base.
Fair market value statutes differ substantially between states, and several states have none. If a figure or a citation here is wrong, email [email protected] with the point; we correct the page and note what changed and when.