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How Much is Enough for Utility Fund Reserve?
January 28, 2010
Water and sewer utilities are normally operated as an enterprise fund within a municipal organization. All that means is that the utilities operate like an enterprise (i.e. a business) where the the revenues earned are supposed to be used to support the business without subsidization from a city’s general (i.e. taxes) fund. Since utilities are supposed to be self-supporting, it follows that utility managers need to plan for unforeseen contingencies. Such contingencies can range from normal ebb and flow of cash flow from operations, to hedging against unusually wet or dry years, to all kinds of emergency needs. Reserve funds are a prudent way to manage these types of things. Without adequate reserves, every blip on the financial radar is bound to cause a panic and may cause the utility to rush out to capital markets unprepared, or worse yet the utility may not be able to respond to the unplanned event with potentially disastrous consequences.
Most utility managers understand the need for adequate reserves even if their city leaders don’t always. In tough times, a utility’s reserve can be a tempting pot of gold that some city leaders have a hard time staying away from. In the Chicago area, we see this recent example where the City of Park Ridge couldn’t resist the temptation and depleted the reserves in order to pay for normal expenses in lieu of a needed rate increase. The city council in this case depleted the reserves against the recommendation of the utility manager because at least one councilmember said that the reserve level was excessive. All of this begs the question: how much is enough reserve, and how much is too much?
A good rule of thumb is to use benchmarks available from the various credit rating agencies. Fitch, Moody’s, and S&P all have median levels for “days cash on hand” that provide some insight on reserve levels. In a recent publication, Fitch Ratings provided a median Days Cash on Hand for AA-rated water and sewer agencies of 266 days. The figure is calculated as:
Days Cash on Hand = $ Ending Fund Balance / ($ Annual O&M Expenses / 365)
Let’s say there is an ending fund balance of $25m and annual O&M expenses are $15m. The Days Cash on Hand would be 25/(15/365) = 625 days. If the ending fund balance were just $8m, the Days Cash on Hand would be just 200 days, and so on. If you want your utility to be in the same league as AA-rated credits, then you would want at least 266 days of cash (the AAA level is 623 days, by the way). What the medians tell us is that highly rated credits take care of their systems with reduced risk to potential bondholders; the Days Cash on Hand is one such characteristic of highly rated agencies. It follows that lower levels of cash on hand is seen as at least one characteristic of riskier operations.
Is this guideline enough for your utility? Circumstances vary, of course. Some utilities may need even higher reserves for individual circumstances, but the above is a pretty good place to start.
Comments (0)Meet Our Consultants
January 22, 2010
We’ve recently finished some updates to our site and are glad to have added pages for all of our utility consultants. We’re proud of our team and proud of the clients we serve. Take a minute to get to know us:
Comments (0)A Good Example of Financial Planning
January 11, 2010
We came across this news article last night and thought it was a good example of strong financial planning by the community of Laurel, Mississippi. In this community, despite an identified need of over $11 million in line replacement costs, the city leaders used a five and ten-year financial plan to determine that they could proceed with the needed projects, issue new debt to pay for it, and all at a cost of less than 2% increases to ratepayers. Utility financial planning done right is a very powerful approach to proactively getting on top and staying on top of the problems of infrastructure replacement. Nice work, Laurel!
Comments (0)Are Sewer Rates the Next Battleground?
January 8, 2010
Sewer utilities and their operations, including their rates, tend to get less press than their more glamorous water utility cousins. Perhaps this is because there are just 16,000 sewer utilities in the US as compared to some 52,000 drinking water systems, or perhaps it is because the topic of sewer treatment and collection is, well, uncomfortable for some. Regardless of the reasons, when it comes to financial issues, sewer utilities have as many or even more pressing times ahead than water utilities. Sewer utilities face the same infrastructure replacement issues as water utilities, and they even tend to have higher regulatory requirements to meet from EPA and local authorities.
We have spent some time on this blog pointing out the accelerating rate of increase of utility rates in general. Usually, those comments were related to both water and sewer increases, but today we’re talking only about sewer rates and it’s a topic we will continue into the future.
Today, we will talk about some of the basic elements of sewer rates. As usual, we have a recent example to frame the discussion. Customers in Scranton, PA were recently notified that their sewer rate structure will change from one based partly on usage (which we call ‘flow’ in sewer parlance) to one that is a fixed amount every three months. The net effect is to reduce rates for those who were causing more than 6,000 gallons of flow per month, while increasing rates for everyone contributing less than 6,000 gallons. If you read the article, you’ll see that many customers in Scranton are angry over the change; the utility is receiving a steady stream of complaints. Some of the complaints are listed at the link provided above.
Many sewer utilities use flat-rate billing for residential customers. However, when the costs of the utility start to increase, customers tend to prefer a system that causes customers pay in proportion to flows. What Scranton has done is to move from proportionality to flat while costs are increasing, which will lead to customer dissatisfaction. It will lead to dissatisfaction because the rate departs from what we call “cost-of-service principles” which generally speak to the need to charge customers proportionately based on the costs that those customers cause the utility to incur. The two principles in play here are “causation” and “proportionality.” Scranton has abandoned both with the proposed rate structure. Customers have a strong sense for causation and proportionality and therefore have a strong sense for when those things have been ignored. Hence the problem.
Luckily there are methods for determining causation and proportionality in sewer rates. StepWise Utility Advisors is a firm that specializes in preparing cost-of-service studies in these kinds of situations, and there are others. The bottom line is that where cost differences exist, rates should be designed to match them. When you don’t do that, you are very likely to end up with angry customers and even unstable rates leading to other financial problems.
Comments (0)United Water Speaks to NY Rate Hikes
January 6, 2010
A VP for United Water New Rochelle recently published a letter explaining the reasoning behind the company’s requested rate increase that is now being considered by the NY commission (click here to read the full letter). He brings out a couple of points in the letter that bear additional commentary.
“Capital improvements are not a one-time, optional expense for utilities such as United Water; they are an essential, core part of our business.“
This is true for any water utility. Capital is constantly reinvested in utility systems, and it is one of if not the largest costs in terms of cash expenditures in any given year. That being said, one of the ways that private companies like United Water can generate cash flow for their investors is to delay required capital improvements for as long as possible. If properly regulated, private utilities cannot start recovering the costs of capital improvements until after those improvements are constructed and placed into service. Therefore, there is a balancing act that takes place between minimum required levels of service and the need for capital investment on the part of the company. If the company has truly made the investment, then it has a constitutional right to seek fair rates to pay for them.
“Harris [the person that the VP's letter is in response to] also takes exception to the fact that United Water is part of a shareholder-owned, multinational company, implying that government ownership would be better for the public. I believe he is mistaken. Many water systems owned by local governments are in disrepair because of a lack of resources required to maintain and update infrastructure.”
Comments (0)The cost of debt for most municipal/local governments is LESS than the cost of debt for a private company due to the tax-exempt nature of municipal bonds. The cost of equity capital for both entities should be expected to be the same for the same utility. Therefore, the only difference in the cost of capital between municipal and private owners would be differences in capital structure (the relative use of equity v. debt to finance the assets). In addition, as we’ve said before here on this blog, a private utility also pays income and other taxes where a municipal utility does not (see: Corporate Water Utility Rates – Show Me the Efficiencies). Altogether, these cost differences mean that private owners would have to generate substantial operating efficiencies in order to compare favorably to a municipally owned utility. It is true that many locally-owned utilities are in disrepair, but so are private systems and if I were Mr. VP I wouldn’t want to take any bets on whether private systems are in better overall condition than their municipal counterparts.
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