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Dry Hole: Great Expectations For Private Water Fail to Pan Out --- Under Fire, Germany's RWE Plans to Exit U.S. Market; Global Ambitions Thwarted --- An Uprising in California Town
Wall Street Journal, June 26, 2006, Page A1
By Mike Esterl

FELTON, Calif. -- To RWE AG, Germany's biggest electric company, the water business a few years ago seemed to promise a gusher of profits. Governments in the U.S. and around the globe were eager to privatize their water systems. RWE was already experienced in delivering electricity and gas to millions of homes.

But dreams of heady profits evaporated amid heated opposition in places like this town of 6,500 people, in California's coastal redwood forests. Today, RWE is in the midst of dismantling an international water empire that cost more than $10 billion to assemble and spanned more than 40 countries at its height.

Water turns out to be less like electricity than RWE hoped. It's heavy and hard to transport, making it difficult for a big company to build economies of scale. Regulation is never predictable. In the U.S., RWE found itself fighting in town referendums and state legislatures across the country, winning many battles but losing the war.

"It's a very local business," says Harry Roels, RWE's chief executive, adding that a global water company "just doesn't have outstanding advantages."

RWE is planning to divest its American Water subsidiary, the largest water company in the U.S., in an initial public offering. It is also preparing an IPO or sale of Thames Water, the largest water company in Britain, which it bought in 2000.

Other Europe-based global water companies are treading more carefully. France's Suez SA has scaled back its exposure to developing countries, and its 20-year contract to run Atlanta's water supply ended after just four years amid mutual unhappiness. Veolia Environnement SA of France, formerly part of Vivendi SA, continues to expand abroad but sold many of its U.S. businesses in recent years and still generates the lion's share of its revenue in Europe. Only about 5% of water services world-wide are estimated to be in the hands of the private sector today, unchanged from when RWE made its big moves.

The retrenchment illustrates how foreign investment can often founder on inadequate understanding of local conditions. In the U.S., for example, although some communities have long had private suppliers of water, public entities dominate. Many people see clean water as a basic right and balk when their bills go up, especially because municipally run systems often keep prices low through tax benefits and subsidies.

"People are just kind of weird with water," says Catherine Bowie, a community-relations manager for RWE's subsidiary in California.

RWE began a little more than 100 years ago as an electricity provider in Germany's Rhineland region. It grew quickly in the early 20th century by snapping up power plants and connecting them to its grid. More recently it has built up its gas business to become Germany's second-largest distributor. Based in Essen, the company has annual revenue of around $50 billion and 86,000 employees.

By the late 1990s, water was becoming a hot business around the world. Enron Corp. was among the companies that jumped in. Many cash-strapped U.S. municipalities and other governments were looking to sell assets or farm out services, and some hoped that private enterprise could do a better job upgrading old facilities and managing operations.

RWE became the world's third-largest water player -- behind the two French companies -- when it bought Thames and American Water. In its 2001 annual report, RWE hailed water as "blue gold" and called the U.S. "the world's most attractive water market." RWE paid $4.6 billion for Voorhees, N.J.-based American Water -- a 36.5% premium over the company's average stock price in the 30 trading days prior to the deal -- and assumed about $3 billion in debt.

Trouble quickly emerged. The acquisition of American Water required approvals from more than a dozen states. It took 16 months -- until January 2003 -- for RWE to gain control. Regulators then moved slowly to approve water price increases. And rebellious territories furnished endless headaches for management.

In Felton, south of San Francisco, RWE became embroiled in a battle with a group called FLOW, or Friends of Locally Owned Water. American Water secured ownership of Felton's water system in January 2002 when it bought the water holdings of a Connecticut company that had long controlled the asset. Eight months later, American Water, in the process of being acquired by RWE, asked the California Public Utilities Commission for approval to raise rates in Felton by 74% over three years. It noted that rates hadn't been raised since 1998 and cited the cost of infrastructure repairs.

Soon after, FLOW was formed. Members handed out literature at shops, knocked on neighbors' doors and lobbied county politicians to stir opposition to RWE. "I've had no vacation in three years. It's all I've done," says 85-year-old Frank Adamson, a retiree and FLOW member.

People in Felton complained that response times to broken water mains and the like slowed as RWE centralized operations. Accident reports from Felton were routed to a call center in Alton, Ill. Daniel Kelleher, senior vice president at American Water, says the national call center is aimed at boosting service. "It became a much more difficult project than we anticipated, and it's still a work in progress," he says. While state regulators didn't grant the entire rate increase, they decided after more than a year that American Water could raise rates 44% in Felton. Momentum grew in the community to try to take over the Felton water system and return it to public control.

Seeing its operations under attack, RWE became embroiled in Santa Cruz County politics. Mark Stone, a county supervisor, says officials from American Water's local subsidiary told him they would torpedo his election bid in 2004 if he supported a public takeover. A spokesman for the local unit says no threat was issued but acknowledges the company sent mailings to people urging them to avoid candidates who would raise taxes to fund a takeover by the government.

Mr. Stone won the election. By then, the Board of Supervisors had set in motion a referendum calling for Felton's water system to be purchased by the community after FLOW delivered a petition with 1,300 signatures.

RWE enlisted a public-relations firm to send letters and make telephone calls against the ballot initiative. Its Californian subsidiary acknowledges giving tens of thousands of dollars to a local property owners' association that filed a legal challenge against the referendum. The association distributed a flier that depicted a burning $100 bill, arguing that a public-sector takeover would cost some Felton taxpayers more than $1,000 a year for the next 30 years. FLOW disputed that, saying water bills were cheaper in neighboring towns with public control.

At Felton's 2005 Memorial Day parade, Mr. Adamson was wheeled through town in a bathtub, throwing candy to people and accompanied by a sign: "Local Water, Local Control."

Some opponents made hay out of the fact that RWE is German. A year before the referendum, a local newspaper published a cartoon imagining what Felton would be like if RWE also owned rights to the air. "Yoo Hoo! Gootentag! Felton! Ve cut off'n your air because you didn't pay der bill!" a local worker in lederhosen announces to a room full of slumped-over and gasping inhabitants.

Mr. Adamson, a World War II veteran, says it's not about Germany. "I don't hold any grudges, but I don't want some foreign corporation controlling our water. I don't even want a large U.S. corporation controlling our water," he says.

Last July, 75% of voters in Felton favored Measure W, which proposed that the town raise $11 million in bonds to buy its water system. RWE's chief executive, Mr. Roels, says the system isn't for sale. RWE is preparing to list its entire U.S. unit, which generates more than $2 billion in annual revenue, on a U.S. stock exchange. "If people are interested in buying into their water supply, they can buy shares in American Water after the IPO," says Mr. Roels.

RWE has conducted surveys indicating that more than 90% of its U.S. customers are satisfied with the quality of service, according to Mr. Roels, who calls Felton "an exception."

Still, the company has faced similar skirmishes across the U.S. In Monterey, about an hour's drive south of Felton, RWE spent more than $300,000 to defeat a measure proposing a study of whether to buy back the water system. In Chattanooga, Tenn., where water has been in private hands since the Civil War, Mayor Ron Littlefield has approached RWE's local unit about a municipal buyout. He thinks the city can save money by combining water with municipally owned power and sewer utilities. Chattanooga's water, he says, is a "private island in the middle of a sea of public utilities."

Laurel Prussing, the mayor of Urbana, Ill., became interested in a municipal buyout after a growing number of "boil orders," when people are told they must boil their water to make it safe to drink. When she tried to investigate a boil order in February, she says she was put on hold for 25 minutes before being connected to a call center in another city. An American Water spokesman disputed that boil orders have risen in Urbana and said the company distributes special telephone numbers that municipal officials can call in an emergency.

Voters in Lexington, Ky., will weigh this fall whether to try to seize RWE's unit there by eminent domain -- an idea that some in Felton are discussing too.

Private-sector ownership of water in the U.S. remains stuck at 15% to 20%. Some industry participants believe momentum will pick up as municipalities face pressure to upgrade long-neglected infrastructure. Still, "the market has grown more slowly than any of us thought possible," says Peter Cook, executive director of the National Association of Water Companies in Washington.