Infrastructure Replacement Surcharges and Other Investment Recovery Mechanisms

1. Infrastructure Replacement Surcharges and Other Investment Recovery Mechanisms Frank Kartmann President Missouri American Water Texas American Water MARC 2010 June 7, 2010

2. What Are Infrastructure Surcharges? • Mechanisms to pass through to customers the return on (rate of return) and return of (depreciation expense) the capital needed to replace water or wastewater company infrastructure on a periodic basis without filing a full rate case

3. Challenge − The Infrastructure Gap • EPA says the nation’s water utilities will need to invest an additional $335 billion over the next 20 years • Wastewater utilities will need to invest from $300 - $400 billion over the next 20 years (USEPA 2007 Drinking Water Infrastructure Needs Survey and Assessment) • More than $7 billion needed in Missouri to close this water utility funding gap

4. The Need for Infrastructure Replacement Programs • Cost of $1 to install 1 foot of main in 1900 can exceed $150 / foot today • Regulatory lag acts as a disincentive to necessary infrastructure replacement investment • Non-recognition of infrastructure replacement investment between and during the pendency of general rate proceedings can delay earning a return of or on infrastructure investment for years, permanently impairing the ability to earn fair or allowed returns.

5. Negative Impact of Regulatory Lag and Potential Impact on Cost of Capital for Capital Intensive Regulated Industries “Primarily because of regulatory lag and increased financing expenses that cause balance sheet strain and execution risks, utilities suffer sub par returns during periods of heavy capital investment.” Source: Lehman Brothers; Power and Utilities: Regulated Utilities; Global Equity Research, North America, May 22, 2007) Infrastructure Replacement Surcharge Programs Permit Utilities to Better Manage Cash Flows and Capitol Programs in Times of Extreme Financial /Market Volatility “Firms can also reallocate capital to projects with more timely return periods and take advantage of regulatory mechanisms that recover investment more quickly. Pennsylvania’s distribution system infrastructure charge (DSIC), which allows a monthly customer surcharge for pipe repair costs, is an example of this.” (Source: Janney Montgomery Scott, LLC; Water Industry Report; October 30, 2008)

6. State Utility Commissions that have Approved Infrastructure Replacement Surcharges

7. Examples of American Water Utilities Infrastructure Replacement Programs

8. Ratepayers Protection • Surcharges are limited to a maximum, relatively small, percentage of revenues (5% - 10%), with small impact on customer bills • Surcharges are reset to zero at the time of a general rate case • Surcharges are limited to specific non additional revenue producing infrastructure replacement • Depending on the state, other provisions may apply, such as customer notice requirements, limitations to plant actually in service, etc. Very few customer complaints or inquiries have been received in any state where an American Water subsidiary has utilized such programs. This includes inquiries from customers who may be confused or simply have questions about the program.

9. Potential Benefits of a DSIC Program • Mitigates rate shock • Reduces rate case expense • Reduces frequency of base rate proceedings • Promotes the acquisition of small and non-viable water systems consistent with Commission policy • Allows for cost benefits associated with infrastructure replacement • Positive impact on capital attraction and cost of capital • Accelerates the replacement of aging infrastructure

10. Endorsement of DSIC-Like Infrastructure Replacement Programs • As early as February, 1999, NARUC, through a resolution, endorsed DSIC as “…an example of an innovative regulatory tool that other Public Utility Commissions may consider to solve infrastructure remediation challenges in their states.” • Resolution adopted February 24, 1999 • NARUC recognized DSIC-like programs as a “Best Practice.” • Resolution adopted July 27, 2005 • DSIC-like programs included as model legislation by Council of State Governments in 1999, Publications of Suggested State Legislation

11. Missouri American Water Example • Total ISRS investment since inception in 2004: • $213m • Average frequency of rate case proceedings pre ISRS: • Annually • Average frequency of rate case proceedings post ISRS: • Biannually • Infrastructure replacement pre and post ISRS: • Pre-ISRS annual average from 1996 through mid 2003 was approximately $11.2 million • Post-ISRS annual average from mid 2003 though 2009 was approximately $32.7 million

12. ISRS – Accelerated System Upgrades 2003 ISRS Legislation passed

13. DSIC Charges – Approximate Impact on Typical Customer Bill

14. Safe Drinking Water Act Regulatory Update – A Moving Target • Number of potential contaminants currently requiring monitoring and/or treatment: Inorganic chemicals 16 Organic Chemicals 53 Microbiological 9 Disinfection by-products 14 Radionuclides 6 Total 98 • USEPA has recently issued a list of 105 new contaminants from which candidates for new monitoring and/or treatment regulations may be developed (contains one pharmaceutical)

15. Other Solutions To Improved Capital Attraction Policies That Incent Investment • Timely Recovery of Invested Capital • Prospectively relevant test years • Streamlined rate case process (national average is 8.5 months) • Step increases • Distribution System Improvement Charge (DSIC) • Surcharges for extraordinary environmental compliance costs (e.g., arsenic) • Fair and Reasonable Returns • Facilitation of Growth, Consolidation, Economies of Scale • Acquisition adjustment for proven benefits • Single tariff pricing

16. The Challenge of Customer Communication: Unique Factors Source: AUS Utility Reports – 2008 (1) Source: 2004 Bureau of Labor Statistics (assumes four person household)(2) Source: United States Department of Labor – Consumer Expenditures Survey, 2004-2005 (assumes four person household)

17. More Challenges • Declining Water Use • Active conservation where water is short • Passive elsewhere like the Midwest • Replacement water fixtures, appliances • Housing turnover • Results in a one to two percent per year decline • Revenue based on usage is declining at a time when infrastructure investment needs are increasing

18. Ultimate Need • Replacement of drinking water and wastewater systems will require an increase in the investment per customer. • Water and wastewater rates will increase at a rate greater than inflation. • All the more need for a Distribution System Infrastructure Charge (DSIC), which adjusts rates in small and predictable increments better enabling household budget adjustments

20. MWI Partnership’s Mission • The Metro Water Infrastructure Partnership is a 501(c)6 organization dedicated to advancing community conversations about the value of our region’s water and wastewater infrastructure and the importance to responsibly invest in that infrastructure to preserve and protect: • Our environment; • Public health and safety; • Local economic vitality; • Water and wastewater service for future generations.

21. MWI Partnership Members City of Kirkwood (MO) Water Department City of St. Louis (MO) Water Division Illinois American Water Metropolitan St. Louis Sewer District Missouri American Water American Society of Civil Engineers St. Louis Section Associated General Contractors of St. Louis Missouri & Illinois Chapters of the American Water Works Association Missouri Water Environment Association

22. Contact Information MWI Partnership: www.mwipartnership.org eMINTs Course (Water 9-1-1: Inquiry in the Science Classroom): www.elearningmo.org ASCE 2009 Report Card: www.infrastructurereportcard.org Liquid Assets Documentary: www.liquidassets.psu.edu 22