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Colorado’s Proposed Amendment 61: More Problem Than Solution
July 8, 2010
At last count (and still counting), the US Federal Budget deficit stands at $1.43 trillion, and the national debt is now $13.2 trillion. Those are big dollars, but the US is a mighty economic engine even in these recessionary times. Still, the national debt is now over 90% of the nation’s entire economic output for a year. Put another way, if we took 100% of all income from everyone and everything in our entire country for a whole year, we would just barely repay the current $13.2 trillion debt. Those are disturbing numbers, and they are part of what is driving a set of ballot initiatives slated for the November elections in Colorado.
Amendment 61 is one of these initiatives and arguably holds the most potential harm for the water and wastewater industries. As professionals in these industries, we are all well aware of the large amounts of money it takes to construct, repair, replace, and retire our infrastructure assets throughout their lifecycles. Amendment 61 would limit local governments’ ability to finance those assets in two ways: it would require voter approval of capital acquisitions requiring financing, and it would limit financing terms to no longer than 10 years. On its face, to everyday voters, Amendment 61 would seem like a somewhat logical check against government sector spending. However, what Amendment 61 would actually accomplish would be to nearly eliminate investment in capital infrastructure that is sorely needed in many areas but especially to replace our aged water and sewer infrastructure.
Proponents of Amendment 61 claim that the amendment is an answer to “massive deficit spending.” However, unlike federal spending, there is no deficit spending in Colorado as the State Constitution requires a balanced budget. Local governments also require balanced budgets, and bonds, to the extent they are used, are used for construction projects.
Imagine having to earn voter approval to replace a broken lift station, or a collapsed segment of water transmission pipe. Then, imagine financing those improvements over 10 years instead of a more typical 20 to 30. Now, take a big project like the Southern Delivery System in Southern Colorado, or the Prairie Waters Program in Aurora. Imagine financing $700 million to $1.5 billion in 10-year notes. Here’s some quick math: a $700 million project financed at 10 years at 5% will cost over $90 million/year; the same project financed for 30 years would cost $45 million. Because utilities are funded annually by user fees, the difference in this example equates to Amendment 61 costing ratepayers twice as much each year.
In essence, Amendment 61 creates an unfunded mandate that supporters of the measure would usually decry. With the proposed amendment in place, water and sewer utilities would have to compile massive reserve funds to cash-fund necessary infrastructure, which will also require dramatically higher user charges. As usual, small communities are likely the hardest hit. Mike Brod, director of Colorado’s State Revolving Fund loan program says that the State would not be able to issue bonds to leverage the federal grants that capitalize the program, thus cutting annual SRF lending to about one-third of the current amount, and the SRF loans would be limited to 10-year terms as well.
The amendment comes to the ballot in November, and current polls show it would pass if the vote were today. At a time when the water and sewer industries are in the most need for capital investment in a generation, Amendment 61 would make that investment nearly impossible and prohibitively expensive for ratepayers. It causes problems when what we need is solutions. Our industry can’t afford Amendment 61.
Comments (1)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.
Comments (0)How Customers Understand Utility Rates
June 2, 2010
I recently participated in a brief discussion about potential rate impacts in Gary, IN. The gist of the story is that Gary, IN is facing some very large capital costs to separate its sewer system into two parts: one for sanitary sewer needs, and the other for storm water drainage. Currently, like many older cities in the US, Gary has what is called a combined sewer system. The problem with a combined sewer system is that they can result in raw sewage being discharged into local waterways during high rainfalls, as is apparently the case in Gary, IN. The EPA will often require such combined systems to mitigate overflow events, sometimes by requiring sewer separation.
My comment on the story talks about the need for local funding and working with the EPA to develop a phased-in sewer separation plan to help mitigate rate impacts as much as possible. Read the article from the Post Tribune: Fixing Sewer Overflows Neither Easy or Cheap. At the end of the linked article, you will see a few comments, one of them mine. It’s the other comments there that worth more discussion though.
A certain “mikeh1993″ writes that “if they [the Gary Sanitary District] raise rates now, there is no guarantee they use that money for those [sewer separation] upgrades.” He continues by saying “I think it’s ridiculous that treatment plant costs always run in the red, even though the costs to the users has gone up every single year and yet they never come in the black at the end of the year.” A person with the nickname of “meeee” wrote that “maybe they [Gary Sanitary District] should have thought of that before allowing all the apartments etc to be built without thinking of the problems down the road.” He concludes, “oh…forgot, isn’t that the norm anyway…Lot of talk and little action. Just keep adding to the problem until it becomes a big disaster.”
These comments are critical of the utility but they are not necessarily responsive to the point that there is a big cost for meeting the EPA requirements to separate the sewer system. That said, comments like these are the rule rather than the exception in any discussion about utility rates. In so many of these instances, the people making the comments are just unaware of how publicly owned utilities work, and tend to vent their frustration rather than address the issue. They are frustrated for the most part because the only thing they ever seem to remember hearing from their water/sewer utility is news about yet another rate increase.
Managers of public water and sewer works need to understand, first of all, that nobody wants to pay more for anything. That’s just one of the basic elements of all economics, and it’s nothing personal. Second, managers need to know that people will pay more for the right reasons and under the right conditions. Most public opposition to rates can be categorized into just a few areas; knowing these general areas can help managers work toward defining the reasons for increases and setting the right conditions:
- There is a lack of trust that the money is being used appropriately. Government-owned utilities will forever suffer from the perception that the only government spending is wasteful government spending. If there have been issues of real fraud, waste, and abuse in the past, then the public may have valid trust issues. Mostly though, the perception that rates and fees are being misappropriated or even just poorly spent are just that: perception. Managers have a lot of tools at their disposal to address these trust issues, but regardless of what tool is used communicating the utility’s financial stewardship to its ratepayers in an ongoing and effective way is what it will take to change perceptions and to gain (or regain) trust.
- There is a lack of understanding about the basic economics of the utility. Typical citizens don’t understand how to run a business, let alone a big business like a water/sewer utility. That’s not their fault really, but it is a problem when managers and elected officials expect ratepayers to just understand how it all works. Public utilities are run at cost and not for profit. This is a major misunderstanding for many people for many different reasons. Even those who are familiar with standard business accounting reports sometimes fail to understand what it really means to run at cost. In addition, most people don’t understand just how much money it takes to pay for a utility’s debt, its operations, or its annual repair and maintenance of plant and equipment. After all, the numbers can be intimidating and far exceed most people’s experiences. A $100 million treatment plant upgrade might as well be a zillion dollars, because very few people have any experience visualizing that kind of money. Again, communication is the key to changing attitudes. Make the dollars and cents common in your communications; break the dollars down into manageable bits (e.g. $/household, $/capita) and talk about how the utility only charges for what it needs. Managers can make a lot of ground by working to increase the general knowledge of their ratepayers about how the utility business works.
- There is disagreement over the timing and/or urgency connected with the increase. Especially when big capital projects are at the center of a requested increase, there is bound to be disagreement over the immediacy of the need and, therefore, the urgency of the requested rate increase. If we can put off capital investments longer, then the needs decrease and the rates stay low, or so the argument goes. One of the things that financial plans, like those we prepare for clients here at StepWise, can be useful for is to show how the timing of big capital projects can affect rates. When it comes to timing big capital projects, there is often a trade off between lower rates now, and even larger ones in the future. Knowing what those impacts are and being able to communicate them effectively is important for winning buy-in from ratepayers. Being objective about financial impacts and clear (and a little conservative) about the assumptions goes a long way to developing the message.
How Federal Deficits Will Impact Water and Wastewater Utilities
March 29, 2010
Eventually the piper must be paid. For municipal governments, balancing the budget is these days a constant concern and budget cuts are starting to hit core services as the recession plods along. In Washington, however, balanced budgets are not a concern, nor it seems is the staggering deficit that comes with massive spending programs that have no tax revenues to support them. The national deficit will reach 10% of total GDP this year and that deficit is being financed with US Treasury bonds that will be issued to investors in the amount of one-trillion dollars. While recent conditions have been favorable to national borrowing and lower rates, those conditions are now changing…and not for the better.
Demand for US Treasuries has been strong up to this point in part because of investor concern over fiscal crises in Europe and lack of quality alternative investments in the US economy. Now, as the EU gets things under control with Greece, and demand for corporate bonds returning, there has been a fall in demand for US Treasuries. Lack of demand means that if the US wants to sell bonds (a trillion dollars of them), then it will have to offer better yields (rates) to investors. That means the historically low rates paid by the US on its sovereign debt is expected to increase. It’s a trend that many see lasting for the foreseeable future as deficit spending continues unabated in Washington (click for WSJ article).
That’s bad news for you and I as US citizens, but it is also bad news for us for other reasons. When US Treasury rates increase, rates for most other things increase as well. That’s because US Treasury instruments make up a “floor” called the “risk-free rate” that is the first building block for virtually every other interest rate in the world. The prime rate, LIBOR, mortgages, corporate bond yields, and even expected returns on the stock market have a tie to the risk-free rate, which is normally indexed to the long-term US Treasury Bond. If the risk-free rate increases, all other rates increase too.
That includes the rates for municipal bonds, a critical financing vehicle for water and wastewater utilities as they look to fund infrastructure replacement and upgrades to major facilities. Since the US Treasury rates have been low, so have municipal bond rates. Highly-rated municipal bonds have enjoyed rates hovering within 50 basis points of 4% for quite a while now, but if interest rates get upward pressure thanks to what’s going on in the treasury markets, then utility managers should expect upward movement in municipal bond rates as well. Higher borrowing costs translate into higher debt service, which translates into higher water rates and higher wastewater rates. Eventually, the piper must be paid.
Comments (0)US Conference of Mayors Foresees Major Spending on Water and Sewer Utilities
March 19, 2010
In a report published in February, the US Conference of Mayors is predicting that spending on water and wastewater systems will increase by by as much as four times. Depending on how fast the country’s population grows, spending could double, triple, or quadruple, according to the report. We’ve posted the full report here, which is an interesting read at just 56 pages. Toward the end of the report, the author cites the Congressional Budget Office’s so-called best management practices for utilities to reduce costs thereby, presumably, opening up financial resources to pay for the identified infrastructure needs pointed out earlier in the report. Among these best management practices:
- Demand management – conservation and the like.
- Labor productivity – automation and cross-training are mentioned
- Consolidation of systems - this sometimes goes by the name of “regionalization” and is probably one of the best recommendations to come from Washington in a long time. Physical consolidation of small systems, where possible, is a money saver.
- Asset management planning – a topic to itself, but the CBO cites increased equipment life, reduced O&M, and elimination of redundant assets as benefits to be gained.
- Innovative construction contracting - alternative contracting like design-build-operate (DBO) offer some cost savings over traditional contracting approaches.
In all, the US Conference of Mayors’ report is more on point with the issue than most reports we’ve seen. The report correctly identifies the need for increased water and wastewater utility infrastructure, estimates the annual spending at reasonable assumptions for growth, addresses the existing gap in infrastructure (between functional infrastructure and dilapidation), and correctly characterizes the funding issue as primarily a local one with a limited role in funding from federal and state sources.
Local utility rates will be the battleground where the funding issue get sorted out. Firms like StepWise, are already immersed in these issues. Understanding the need is one thing, but getting local communities to get into a “willing to pay” mode is easier said than done. Water and wastewater rate consultants know that even small increases to utility rates can lead to big problems for communities on a political and even an affordability level. We see affordability as a major issue for most utilities going forward. Making sure your water and sewer rates meet the actual costs of service, are transparent , and are clearly equitable to rate payers are principles that will be core strengths for utility managers in an era where spending is predicted to quadruple.
Click to Download “Trends in Local Government Expenditures on Public Water and Wastewater Services and Infrastrcuture: Past, Present and Future”
NYT Story on Water Infrastructure is Telling
March 16, 2010
The latest NY Times article on water infrastructure does a good job of demonstrating the seemingly impossible issues between the great need for reinvestment in water and sewer infrastructure, the reluctance of the government owners of those systems to actually pay for that investment, and the increasing consequences of infrastructure failure. The article focuses on Mr. George Hawkins, whom the author describes as a well-educated environmental activist who wound up as the general manager for one of the largest utilities in the US in Washington DC. The article shows how Hawkins has done much to point out the obvious to the city’s leaders: that our capitol city’s water and sewer infrastructure built over 100 years ago is decaying to a point where line failures are a daily routine causing everything from loss of water service to raw sewage spilling into the Potomac River.
Yet, there in Washington DC, one of the most affluent cities in the US, the push back from local politicians and citizens has been as severe as anything we’ve ever described on this blog. That nobody wants to pay for the infrastructure issues even when it affects their own community is the major point that readers should take away from this article. As we’ve said before right here at the StepWise blog, the cost of addressing the infrastructure issue is enormous. In many cases, communities are relying for critical water and sewer services from a set of pipelines installed between 50 and 100 years ago. There is a $335 billion price tag out there just for our drinking water systems, it’s a bigger price tag when you factor in the sewer systems.
The cost may be “federally-sized” when added up, but the reality is that the total cost is the summation of those for thousands of communities across the country. Water and sewer infrastructure is a local issue requiring local responsibility and local funding. It is not a federal issue, nor should it be seen as such. To those communities who address their infrastructure issues smartly – like not waiting until the entire system is in cataclysmic failure – the reward is manageable costs over the long run. To those who are less prepared, the consequences are potentially large. Flooded homes and businesses, insurance losses, sewage backups, service losses, sinkholes, etc. Every community has a choice to make with respect to infrastructure investment. Waiting for the end is probably not the best option.
Comments (0)Economics of Small Water Systems
February 11, 2010
As water and sewer infrastructure across the country ages, deteriorates, and eventually fails the cost of replacing it all becomes a growing concern. The cost of replacements is fantastically large, and it doesn’t help that these needs have been largely unplanned, meaning that these large costs tend to come as a shock to oblivious rate-paying customers. It’s enough to cause even large well-heeled utilities to gnash teeth. The problem can sometimes be insurmountable for small water systems though.
According to the EPA, small systems – those serving fewer than 3,300 customers – make up nearly 85% of all water systems in the US. For these systems, the cost of infrastructure replacements is more than large, it’s unfathomable. In Lebannon, OR – a small town – the cost of replacing its incredibly old water treatment plant is going to cause water rates to go up by 60% . It’s one small example of how just one major capital replacement in one small town can cause a major disruption in the water rates.
What’s a small utility to do? First off, there are no simple answers. The days of never ending grant money for these systems is mostly gone and that means that in order to avoid a 60% hitch in rates, even small systems have to be smart about planning ahead for their needs. In the Lebannon example, the water plant had been in service since 1946! Running at capacity, the plant was only able to stay one day ahead of demand. In other words, it should have come as a surprise to no one that the plant would need to be substantially upgraded or replaced at some point (before the 64th year of operations). The costs of those upgrades and replacements can also be reasonably estimated by any professional engineer and, with enough foresight, small communities can start implementing small increases to rates to build cash funds as well as debt capacity to finance the costs of replacement. For small communities who lack access to credit markets and don’t have much cash in reserve, forward planning like this is even more critical.
Financial planning is the key. StepWise provides this service, but any utility manager can get started with the key elements of financial planning without consulting help. Start by understanding the need. Know what your fixed assets are, where they are, and when they were put there. Once you know that, you can start making reasonable estimates as to when you should expect those assets to be replaced. Then, get some estimates as to how much those replacements will cost, and you suddenly have a decent picture of what the future holds for your utility. Will rates need to be increased? Probably. The key is that you will now have some control over how much and when. Wait until the last minute though, and your options will be extremely limited.
Comments (1)StepWise’s Utility Credit Rating Scorecard
February 10, 2010
An important part of our financial planning toolbox is the Credit Scorecard. Embedded in our financial plan models prepared for clients, we compare your own metrics against the published median benchmarks for Fitch Ratings’ AAA, AA, and A rated credits, and to S&P’s Strong, Avg., and Low indicators. While not an official credit rating by any means, the Credit Scorecard allows you to quickly see how your utility enterprise stacks up against the benchmarks. In this age of tight credit markets, we find that knowing how you compare before you go to market can be very valuable for any utility manager. Contact us if you’d like to find out more about our Credit Scorecard.
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.
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