With your continued interest and help, I know the American Public Power Association, now nearing 10 years of age, will become ever more useful and effective to the public power agencies that constitute its membership, ever mindful that all service must be in the public interest.

THE PLACE OF THE MUNICIPAL UTILITY IN MODERN AMERICA

(A paper presented by Gilmore Tillman, before the California Municipal Utilities Association, at its annual meeting, at Long Beach, Calif., November 8, 1950)

I believe that all of us-as individuals-find it necessary to stop from time to time and take stock of ourselves and our activities; to decide what the purpose of these activities should be; and as against this standard, to make a critical comparison of our actual performance. In my own case I may say I have always found this to be an exceedingly painful process.

It is equally necessary, I think, that every person here who has any part whatever in determining the policies of a municipally owned utility should similarly take stock of the institution which he serves.

What right does the institution have to exist? That is to say, is the service rendered actually valuable and, if so, could it be better rendered by some other agency? In this connection, we must all at cost avoid the illusion that the municipal ownership principle has some virtue which is a matter of faith or dogma. We must not feel that a skeptical inquiry as to the validity of this principle is in some way impious. On the contrary, we should invite skepticism and convince the skeptic. Our adherence to the cause of municipal ownership should be based not on blind faith, or catch phrases, or on slogans, but on reasoned conclusions. If we find that the municipal utility has demonstrated a right to exist, then what are its proper objectives or purposes? That is, against what standard should we judge success or failure?

I am not so bold as to suppose that I have the answers to all of these questions as they may be applied to each of the municipal utilities in California. I only hope that my discussion may in some degree increase your interest and stimulate discussion among you.

Let us consider, first, the fundamental question: Is there any adequate reason for the existence of municipal utilities?

The simplest and most satisfactory answer is, of course, "We do a necessary job better than it would be done by any available alternative agency."

The validity of this answer necessarily depends upon a weighing of the virtues and the defects of the municipal utilities which we serve, as compared with the possible alternatives.

Judged against this standard, the situation most obviously requiring public ownership is that in which private capital has declined to furnish some necessary service.

By the very nature of any system of free private investment, this situation must arise whenever the necessary investment involves a risk which, according to strictly commercial standards, is not justified by the potential return. While this problem has seldom directly arisen in California, yet it is one which may, any day, confront a city experiencing an exceptionally rapid growth.

Anomalous as it may seem, an investment which would not be justified in the case of one whose interest lay solely in the ownership of the utility itself, may on occasion be wholly justified if made by the entire community to be served.

I believe that an excellent illustration of this paradox may be drawn from the experience of my own city. In 1906, the people of Los Angeles, by an overwhelming vote, bonded the community to build an aqueduct from the Owens Valley. The population of the community at that time was approximately 200,000; yet this relatively small community planned, financed, and built an aqueduct which is still sufficient, although the population of the city is now 2,000,000.

From the point of view of a private investor in a water utility, the construction of a water project on such a scale was plainly unwarranted. Why should a public utility investor gamble that a community of 200,000 would in a relatively short space of time grew to 500,000, a million, or 2,000,000?

Yet, in retrospect, it is clear that the entire future of the city was at stake. In cases such as t is the people of the community, if they have faith in their own future, must logically take over the provision of those things which are essential

to their future.

As a personal matter, I should like to add that I have always felt that the courage and self-reliance of this relatively small group of Los Angeles citizens has never received adequate recognition. The bold concept of the project iself and the courage of the community in undertaking the comparatively enormous debt involved is, I think, an example of the finest tradition of the pioneering spirit of the West.

Another situation obviously crying out for municipal operation is that in which the privately owned utility either renders an inadequate service or serves at exorbitant rates.

Examples of these unreasonable rates which so often led to municipal ownership are undoubtedly familiar to you all. The most violent and extreme, as well as the must subtle, examples of the operating practices resulting in these exorbitant rates are to be drawn from the era of the "holding company.' 39 Since many municipal utilities throughout America owe their existence to the abuses perpetrated by the "holding companies," I think that every executive of a municipal utility should have an understanding of this shabby, not to say shameful, period in the history of utility operation.

In an operation geared to collect tribute on everything that moved, the extortion commenced at the drawing board before the operating property was built. The operating company, with no volition of its own, and controlled by the voting stock of the parent company, was required to pay tribute in the form of fees for engineering services on new construction. Normally these fees were paid under a continuing contract, as a percentage on all new construction, and a fee of as much as 71⁄2 percent might be exacted. The cost to the parent company of rendering these engineering services might range from 10 to 50 percent of the fees collected from the subordinate operating utilities. When we consider that the asset value of the operating subsidiaries in each of the many chains ranged from one to four billion dollars, the possibilities inherent in these engineering fees are obvious. I want to emphasize that almost without exception the engineering services rendered were first-rate in character. Their cost to the holding company simply bore no reasonable relation to the fees charged to the operating utilities.

Once the engineering plans were complete, another device entered the picture. A "construction" company, owned by the parent, would handle, on a cost-plus basis, the major construction work of all subsidiaries. The nature of these "construction" contracts is well illustrated by the practice of one of the largest and most respectable of the holding companies, a company which controlled operating subsidiaries with assets in excess of 31⁄2 billion dollars.

This holding company was sole owner of a subordinate "construction" company, consisting of nothing but a corporate charter and a name. The construction company had outstanding 20 shares of stock with a total par value of $2,000, all owned by the holding company. It operated with no funds of its own, no construction equipment, and no employees.

Oddly enough, this corporation certainly unlikely to appeal to the ordinary utility management was able, over a period of more than 25 years, to secure contracts for the major construction work of its affiliated operating companies. These contracts were carried out in a very simple fashion. The operating company simply transferred men and equipment to the construction job, completed the project, paid the bills, and then paid an override of 3 percent to the "construction" company. The receipt of this check was the "construction" company's only actual contact with the job and the check was, of course, 100 percent net profit, gained with no risk and no work.

To a group of utility executives I am sure that I need not labor the point that the total sum involved in a 3 percent override on the major construction projects of a 31⁄2 billion dollar chain of operating utilities was very substantial indeed.

Excessive charges for engineering services and construction contracts, had, of course, a dual effect. First, they enabled the holding company to make direct profits which were literally astronomical. Second, since they were added to the costs of the operating property, the rate payer was bound to pay a "fair return" on these charges during the life of the property.

At this point, with the plant thus engineered and constructed, there enters perhaps the most effective device of all-the management contract. A fair example of such a contract would call for the payment to the holding company of 21⁄2 percent of the gross receipts of the operating utility in return for advisory services to the management.

Here, again, so far as I know, the personnel employed to render these services was in all cases first-rate. The vice of the transaction lay in the simple fact that the cost of rendering the services bore no reasonable relation whatever to the enormous fees charged to the operating subsidiaries.

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When you consider that there were many holding company chains and that the cross receipts of the operating companies of a relatively small chain exceeded $200,000,000 per year, you can readily see that these percentage fee management contracts constituted loot on a grand sacle. All these fees were, of course, added to operating expenses of the subsidiary companies and exacted from the public

in rates.

Another practice, obviously not in the best interests of either the operating utility or the public, was what became known as the "up-stream loan." Under this system, all funds of the operating subsidiaries, except bare-bones operating cash, were transferred on "loan" to the parent company. Under the best practice, the money thus "borrowed" was loaned by the parent, at a profit, to some other operating company in the chain. Thus money might be "borrowed" by the parent from one subsidiary at 1 percent and loaned to another at 6 percent. In the worst instances, the funds of the operating company were simply used by the parent in speculative ventures for its own account, either in the acquisition of new utilities or in playing the stock market. Whenever these speculative ventures caused the parent company to be pressed for cash, the operating subsidiaries could readily be required to defer necessary improvement and maintenance work.

While I have not by any means cited all of the devices used by the holding companies to extort money from the American public, I have labored the subject long enough. In passing, I should like to point out that the rather unpleasant history of the utility holding companies has in it a philosophical lesson for everyone; the lesson that excellent principles can be perverted to the achievement of very bad ends.

The holding companies and their engineering and management affiliates were founded on two perfectly sound principles. First, that small utilities, particularly in the early days of the industry, needed advice in the fields of engineering, utility law, purchasing, accounting, and other fields of management, and that these services could most efficiently be furnished if the small utilities were banded together in a group with a centralized agency available to serve each utility when needed.

The second principle involved financing. Small individual utilities in the early days found it difficult, if not impossible, to attract capital at any reasonable figure. It was believed, correctly enough, that a large corporation, backed by the assets of a large group of small operating companies, could procure the needed funds with more facility and on better terms than would be possible for the operating companies each standing alone.

Twisted indeed were these principles by the time of the enactment of the Public Utility Holding Company Act of 1935, commonly known as the "death sentence" law. In the case of the management services, while valuable services were still being rendered, the emphasis had completely shifted. From the original ideal of service to the operating companies, the relationship had degenerated into a device for transferring money from the operating company to the parent. The helpful financing services wound up as the "up-stream" loan, with money needed by the operating companies for betterments and for maintenance loaned instead to the parent company for speculation.

In conclusion upon this question, I feel perfectly safe in saying that any municipality in America which was served by one of the subsidiaries of the major utility holding companies would have improved its lot by embarking upon municipal ownership.

The vast majority of these abuses have been stamped out through the Holding Company Act, but I assume there are still in America some mismanaged public utilities where municipal ownership is, on that ground alone, clearly justified. I have discussed, probably at undue length, the obvious usefulness of municipal ownership in cases where privately owned utilities fail to serve or render an obviously unsatisfactory service. But what of the case of the well regulated, well managed private utility rendering a proper standard of service at rates which are no more than sufficient to attract the necessary capital? Does the municipally owned utility offer any advantages as compared with such an operation?

I believe that it does. There are many reasons for this belief. For illustration, I think that there are many indirect and imponderable benefits to the community. These are as unmeasurable, but as real, as the many intangible advantages which I think weigh so heavily in favor of private enterprise, as against governmental operation, in those fields adapted to free competition.

Within the time available, it would be obviously futile to attempt any discussion of these imponderables. I shall stick to a discussion of a single advantage

which is purely economic, relatively simple, and subject to a fair degree of measurement; that is, the overwhelming advantage available to the municipal utility in the matter of cost of money.

Every utility, private or municipal, to be healthy and render satisfactory service, must be able to attract adequate capital. As you probably know, the cost of this capital—that is, bond interest or dividends—is vastly more important in determining the price of the commodity sold by public utilities than is true in any other large industry. The tremendous importance of this factor is one of the peculiarities of the utility industry and is not too well understood by the public generally.

In order to understand the measure and magnitude of the advantage available to the municipal utility in this field it is necessary first to understand clearly the basic feature which distinguishes the economics of public utilities from other large industries in America-that is, the ratio between invested capital and gross annual revenues.

In the over-all utility industry of the United States I am confident that not less than $4 of net assets (by net assets, in this discussion, I refer to gross assets less depreciation reserve) are needed to produce $1 of gross annual revenue.

This ratio of net assets to gross revenue varies, of course, between the various classes of utilities-water, electric, gas, telephone, and others. In California I think it would be found that in the electric utilities closer to $5 of net assets were needed to produce $1 of gross revenue annually. On the other hand, a water system having a gravity supply, with capital invested in water-bearing lands, dams, reservoirs and aqueducts, may range as high as $9 of net assets for $1 of gross annual revenue.

Again, the ratio of net assets to gross annual revenue may vary widely as between equally efficient and equally profitable utilities in the same industry, depending upon such factors, for illustration, as the proportion of investment in hydroelectric properties, the amount of electricity purchased from others and thus involving no capital investment. Differences in the rates charged by two similar properties will also, of course, produce widely differing ratios. In any event, the pattern is clear; in the utility industry it requires several dollars of investment to produce $1 of gross revenue. As I said before, I am confident that a ratio of $4 of net assets to $1 of gross annual revenue is conservative. This pattern is the reverse of the norm of American industries.

In order to gain a perspective, I cite the extreme example of Safeway Stores, Inc. During fiscal year 1948-49, with net assets of $180,000,000, Safeway had sales of $1,200,000,000. Thus, a dollar of net assets produced $6.50 of gross annual revenue. This is, of course, an extreme example in a business with a very high turn-over.

However, "all-manufacturing" industry in the United States for last year, involving net assets of $109,000,000,000, operated on a basis of about $1.50 of sales for each dollar of net investment, and this, I think, is probably the lowest ratio of sales to net assets in any of the major industries.

In any of these industries, where the annual revenues greatly exceed the net assets engaged in the business, a change in the cost of money does not have any terrific impact on the gross sales price of the product. Bear in mind that I am speaking here of the gross sale price; the gross revenues; not net revenues.

Thus, in the "all-manufacturing" industry which I have cited, in view of the existing ratio, a change of 1 percent in carrying charges covering all the net assets would be accurately reflected by a change of two-thirds of 1 percent in the sales price of the manufactured products.

As we have seen, exactly the opposite condition prevails in the utility industry and the leverage works exactly in the opposite direction. In this field, in order to reflect in the sales price a similar change of 1 percent in the carrying charges covering the net assets, it would be necessary to change the rates to consumers 4 percent.

From this you will see that the sale price of utility services is six times as sensitive to changes in the cost of money as is the sale price of manufactured articles generally.

What, then, is the differential in cost of money as between a privately owned utility and a municipally owned utility, and what is the impact of this differential on rates to consumers?

Let us assume the case of a privately owned utility with net assets of $8,000,000 and gross annual revenues of $2,000,000. Let us make the further reasonable assumption that the cost of attracting capital to this enterprise is 6 percent.

If the people of that same city choose to issue bonds to raise the same $8,000,000 to perform the same service for themselves under municipal ownership, they could, in all but the most exceptional cases, obtain the capital for 2 percent. What effect would this change in cost of money have on rates?

The city could meet all expenses incurred by the private company, including the same salaries to the employees, the same taxes, and all other operating expenses; make the same provision for depreciation and yet cut the rates $320,000 annually. Bear in mind that this is a matter of proportion and that this saving of $320,000 is a deduction from rates which originally aggregated $2,000,000, a very substantial proportion indeed.

It might be urged that this saving in cost of money is due in part to the fact that interest on municipal bonds is exempt from Federal income taxes. This is perfectly true, but this factor could influence the cost of money not more than three-fourths of 1 percent. If we make a full allowance for this factor, we still have a saving in rates in the amount of $260,000.

It might also be urged that in order to achieve this saving in rates the property of the community must be made responsible for the debt. In general, this is perfectly true; I do not suggest that there is some magic in municipal ownership that enables it to give something for nothing. A community undertaking ownership of a municipal utility, like any other owner of property, takes some risk of loss. The assets may be dissipated by bad management, or a withering away of the community may deprive the enterprise of its market. It is my personal belief, however, that for a community in California of a size to be served by an $8,000,000 utility, and confident of its own future, $320,000 annually is a very high premium for the acceptance of this risk.

Bear in mind that, in the comparison which I have made, it was assumed that the private and public operation were on an identical level of efficiency, and it was also assumed that the private utility took, in earnings, no more than the amount necessary to attract capital.

If, in any actual case one operation was less efficient than the other, or the privately owned utility was actually taking in earnings more than the 6 percent stated, then the benefits to the public would vary to that extent.

In conclusion, with respect to the question as to whether or not municipal utilities have a rightful place in the American economy, I should like to discuss one charge frequently leveled at municipal ownership; that is, the accusation that municipal ownership of public utilities is inconsistent with the American free-enterprise system and is in some way a threat to that system.

I am personally not only a believer in, but an enthusiastic supporter of, the free-enterprise system, and I should feel very badly indeed if I thought that I was associated with an institution that threatened free enterprise. I believe firmly that in almost every field of business, free competitive enterprise is the best possible means toward progress. Both instinctively and rationally, I am deeply skeptical of the operations of monopolies and cartels.

But, quite irrespective of my feelings in the matter, there is no place in the public-utility field in California today for the free-enterprise theory. California stands firmly committed by the vote of its people to the publicly owned or publicly regulated monopoly theory for public utilities.

The history of the ups and downs of the competitive free-enterprise principle in the public-utility field in California is, I think, both interesting and instructive. During the period prior to 1879, city councils and other legislative bodies had authority to grant or withhold-franchises for public utilities. There was no legal requirement that these franchises be exclusive, but as a matter of fact competing franchises were rarely, if ever, granted. The people of the State were thoroughly dissatisfied with the service and the rates of the utilities enjoying these franchises, and every instance of bad service or high rates was blamed on the fact that the utility enjoyed a monopoly in the community. Bitter was the denunciation of this monopoly system in the debates of the constitutional convention in 1879.

As a result of these debates, the framers of the constitution proceeded to solve all their utility difficulties by depriving the legislative bodies of the power to grant and withhold franchises. The right to compete freely in every city in California in the business of serving "gas light or other illuminating light or fresh water for domestic and all other purposes" was granted to all comers by section 19 of article XI of our constitution, and the use of the streets was made freely available to all for this very desirable purpose.

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Sad was the disillusionment. It was discovered that no evil was cured; that the established monopolies grew larger and more arrogant; that competitors

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