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Are You Recovering Your Water and Sewer Utility’s Capital Costs?

June 17, 2010

In the water and sewer utility, costs tend to pile up quick and they are seemingly endless if not formidable.  As an industry, water and sewer utility services are among the most capital intensive anywhere.  There are very few industries in the world where one has to invest so much capital to produce even the first dollar of revenue.  For water rate consultants like StepWise Utility Advisors, one of the challenges is to describe the capital needs of a utility in terms of annual dollars.  It’s easier said than done because capital investments tend to come in big chunks rather than nice smooth annual payments.  Managing capital needs for most public utilities owned by local governments is about managing the ebb and flow of reserve funds and bridging gaps with financing.  When done well, utilities can keep user rates low or at least reasonable.  When done poorly, system demands for capital dollars can quickly overwhelm an otherwise well-run utility.

The battle for a continuous flow of capital into water and sewer utilities is neverending.  To answer the bell, some utilities have decided that the solution is to “recover our depreciation costs” annually.  Especially as it relates to the issue of aging infrastructure, the idea of recovering the depreciation of those assets has some logical allure, but unfortunately recovering depreciation expense is probably not going to fit the bill for most utilities.

Before I go on, it should be said that recovering any kind of normal capital dollars, whether you call it depreciation or something else, is a far better strategy than recovering no capital at all from water and sewer rates.  The problem with this strategy of “recovering depreciation costs”, however,  is that the strategy depends on a flawed understanding of  the definition of depreciation expense.  Most utility managers believe that depreciation expense measures the the loss in value of the utility plant-in-service (i.e. assets) due to age, usage, obsolescence, etc.  Unfortunately, the real meaning of depreciation as reported for financial purposes is that it really measures the return of the asset’s purchase cost, in cash, to the utility over a certain period that may be roughly equal to the asset’s economic life.  Those are two completely different definitions and the important thing to note is that, financially, depreciation expense is not related whatsoever to the actual condition or actual useful life of the asset.

Simple Example:
If a utility acquires a $10m pump, for example, with a 10-year estimated life, then that utility would recover $1m per year for 10 years.  Great!  The utility has at least recovered the initial purchase price of the pump.  However, over the course of 10 years a couple of things will have happened that make that $10m much less impressive.  First, inflation will have eroded the purchasing power of the $10m recovered; a 2% inflation rate over the 10 year period will have caused the utility to lose just over $2.1m in purchasing power, meaning the the utility would need about $12.2m to buy the exact same pump at the end of 10 years.  Secondly, if the price of the pump or the labor to install it increases above the rate of inflation at all during the 10 years, then the replacement cost will be higher still.  So, even if the pump lasts exactly as long as expected with no problems, the $1m collected each year will leave the utility short in the end.

What if the pump wears out sooner than expected?  More capital will be required sooner than expected to replace and/or repair it, leaving the utility short of time and funds.  What if it lasts longer than expected?  Then the utility will have recovered $10m from its depreciation while time and inflation keep ticking away, again leaving the utility short later on down the road.

The fact is that depreciation expense was never meant to be a substitute for real asset management.  A consistent approach to condition assessment and capital planning is always the best practice for keeping the utility system in working order and able to meet the community’s expectations for service.  Such approaches when paired with consistent financial planning will result in the lowest overall long-term costs and lower, more predictable rates for customers.

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