The job of CFO at a public utility might appear on the surface to be rather bland, compared with finance chief roles in many other industries.
After all, strict regulations dictate many of utilities’ actions. Utilities don’t set their own prices for their services. They are much better able to forecast revenue than are most businesses. Their capital structure is established by state regulatory commissions, which also dictate a return-on-equity ceiling for their capital investments.
Don’t try to tell Linda Sullivan that utilities are bland, though.
The finance chief of American Water Works started handling a public utility account almost 30 years ago during her early-career days at a public accounting firm. That led to a 22-year stretch with electric utility Edison International, where Sullivan rose to the CFO role. In 2014 she moved to American Water, the biggest player in the highly fragmented U.S. water-utility industry.
“A lot of people outside the utility industry think it’s stodgy, but it’s anything but that,” she says. “It’s very interesting, very exciting, and serves the public. I love it.”
The heart of the job involves balancing a need for significant ongoing capital investments with the mission of achieving efficiencies that serve to keep customers’ rates as low as possible. That balancing act breaks down into four key issues.
Most important among them is the supply of water. There is a finite amount of fresh water in the world, Sullivan notes. It comes from four primary sources: ground water; surface sources such as rivers and lakes; desalination of saltwater; and recycling and re-use.
But supply is tight in portions of the United States, especially areas afflicted by near-chronic drought conditions.
“We need to make sure we’re taking a long-term view of water supply and understand the risks — relating to water storage and water stress — in each of our locations, so that we can mitigate those risks,” says Sullivan, noting that American Water has coverage territories in 16 states.
Such mitigation requires investment. For example, the company is building a desalination plant on California’s Monterey Peninsula, “because there’s really no other solutions in that area,” the CFO says.
American Water also works to establish interconnections with other utilities neighboring drought-prone areas like New Jersey. And it recycles more than 2 billion gallons of water annually to offset irrigation and industrial demand.
The second key issue is aging infrastructure. As is the case for most other U.S. water systems, the pipes and other infrastructure American Water uses were installed well more than 100 years ago and need to be repaired or replaced.
“Every year U.S. water systems lose about 20% of already-treated water, or about 2 trillion gallons,” Sullivan says. “We’ve gone to the expense of getting that water, treating it, and putting it in the pipes. But we lose 20% of it due to leaks and main breaks. It’s very expensive.”
Here too, the challenge before Sullivan is making the right investments while keeping an eye on customer affordability. But in general, infrastructure upgrades tend to be good investments.
“The way our rates are designed, if we spend a dollar of operating cost, our customers pay for that, dollar for dollar, every year,” she says. “But if we invest in our system, then our customers pay for that over the life of the system, which is generally 40 years or more. So, we know that for every dollar we can save in operating expense, we can invest $8 in capital infrastructure and have the same impact on customers’ bills.”
To prioritize pipe repair and replacement, the company takes into account the age of sections of pipe, the surrounding soil conditions, and “the replacement cycle we think is appropriate so that we’re running almost to the failure point, but getting as predictive as we can about replacing the pipe before we have a large, costly main break.”
The third big issue is water quality, which has been in the spotlight in recent years because of the polluted-water situation in Flint, Mich., and algae blooms in Lake Erie and the Ohio River.
The American Chemical Society has registered 145 million chemicals, 120 million of them just since 2005. There are also 1,300 types of bacterial microbes that can diminish water quality.
Sullivan’s challenge is making the correct investments in smart technologies that allow water quality to be measured at the source and that issue alerts when “something foreign comes into our water,” she says.
The fourth key issue, which the company calls customer connectedness, is interesting because the company operates as a monopoly in its coverage territories. However, “the way we look at our customers is that if they were given a choice, we’d want there to be no question in their mind that they would choose us,” Sullivan says.
That involves providing customers with information they need to better manage their water and become more aware of the quality and other issues associated with water.
Lower Usage, Greater Earnings
In making decisions on all types of capital investments, American Water must take into account that household water usage is declining in the United States, slowly but steadily, at a rate of about 1% to 2% annually. It results from the increasing prevalence of low-flow toilets, more-efficient washing machines, and the like, as well as a growing “conservation mindset,” Sullivan says.
The trend is expected to continue for the next 15 years or more years, she notes. That’s good news, in light of the water-management challenges some areas face.
“However, reduced usage and the resulting reduction in revenues can have significant adverse financial impact on water utilities,” Sullivan adds. “We must adapt our systems and rate structures to reduced consumption trends in order to cover fixed costs and maintain reliable service, while a number of fixed costs continue to rise.”
Such fixed costs range from capital needs to operating costs such as plant maintenance, customer service needs, IT support, and security. “The challenge is to work with regulators to be progressive in establishing rate structures that support appropriate levels of ongoing investment in the pipes and plants that ensure reliable service,” Sullivan notes.
Utilities regularly file “rate cases” with state regulators, detailing their operations and costs. The regulators make the final pricing decisions. Utilities are allowed to recover their costs and earn a specified return on their investments, based on an authorized capital structure.
Generally, Sullivan says, the capital structure is about 50% debt, the costs of which the utility recovers by passing them through to customers, and 50% equity. In the states where American Water operates, the weighted average authorized return on equity is 9.8%.
Regardless of all the challenges, American Water is actually growing and projects a compound annual earnings growth rate of 7% to 10% through 2022. The bulk of that growth will flow from the efficiency-minded capital investments already made and those still to be made over that time period.
The company also buys, each year, 15 to 20 of the 50,000-plus water systems in the United States, typically ones operated by troubled municipalities.
Deciding which ones to acquire involves answering two “sophisticated” questions, Sullivan says.
“One is, where is the ‘stupid line’? At what price are we happy to walk away? If someone else is willing to pay that price, we can be happy for them.”
The second question is, “In 5 or 10 years, are people going to look back and believe we made a good decision? Or are they going to say, ‘What were they thinking?’ I think that’s really important for the utility industry, because we’re in the business for the long term.”
In addition to its core water business, American Water operates a much smaller but growing wastewater management business, which is regulated to the same degree.
The company also has a handful of unregulated businesses. One provides water and treats wastewater for U.S. military sites around the country. A second provides warranty services to homeowners and small businesses, protecting against the cost of repairs. And a third is a water-logistics service provider to the oil and gas industry, which primarily operates in Pennsylvania, Ohio, and Virginia.