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Why Affordability is the New Challenge for Water and Sewer Utility Owners
July 20, 2010
It’s not that affordability hasn’t always been a concern, but a recent look at some important data now suggests that affordability has become a major concern for providers of water and sewer utility services in the US. For the first time since the 1950′s, personal income in the United States has experienced negative annual growth – meaning personal income has actually fallen in real terms for the first time in almost 60 years. That may come as no surprise to those who read the daily news and understand the recession’s deepening hold on the US economy, but utility providers may want to pay special attention because while water and sewer rate increases were never popular, they are even less so when family income is declining instead of increasing.
US Personal Income - Click to Enlarge
This decrease in personal income comes at a time when the water and sewer industries are also in great need for capital investment. Aging infrastructure for water and sewer systems cause major service disruptions and damage to local residences, businesses, and even damage to local waterways. The US Conference of Mayors recently released a report showing that capital spending on water and sewer infrastructure could quadruple from current levels.
Of course, affordability means different things to different people. The EPA version of affordability is that a utility bill is unaffordable if it exceeds 2.5% of the median household income. Income is unevenly distributed in the economy though and one thing that often goes overlooked in rate setting is the difference in water usage between newer, presumably more affluent homes, and older neighborhoods with presumably lower incomes. The argument is often made that affluence equates to higher water usage, and this has been one rationale used to argue for increasing unit prices for increased usage levels (i.e. inclining block rates). However, that argument is many times based on a false premise. In Milwaukee, for example, research found that water usage was highest in older neighborhoods and found an inverse correlation between household income and water usage, the lowest incomes had the highest usage (Mikwaukee Wisconsin Journal Sentinel, July 17, 2010). High usage in older neighborhoods is very much a possibility in every community due to newer homes being constructed under newer building codes with more stringent plumbing requirements that tend to conserve water; older homes were not subject to those codes and have older plumbing fixtures that tend to use more water (including more sewage thanks to older toilets and sinks).
So, while there is increasing pressure to increase water and sewer rates to pay for very expensive infrastructure replacements, the burden on customers is also becoming more severe in relative terms as their own personal incomes decline. Older neighborhoods with lower household incomes could actually be using more water than originally thought, and therefore the impact on those customers’ bills is even more pronounced. It is very possible that affordability in your community may be a more difficult thing to measure than just comparing the average utility bill to the median household income (the method the EPA uses). A more detailed analysis might show that affordability in your community’s most economically disadvantaged neighborhoods is a real problem.
Links Related to This Blog Entry:
2006 EPA Report on Household Affordability
Comments (0)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.
Should Cities Sell Water & Sewer Utilities as Defense vs. Recession?
April 22, 2010
In these tough times, some cities and local governments are considering selling their water and sewer utilities to private concerns. USA Today ran a story on this recently: “Cities consider selling water, sewer systems for cash“. The issues raised in the USA Today story are interesting. As noted on this blog, we’ve seen at least one high-level example where the City of Indianapolis changed its water utility operations from purely private (Veolia Water) to a public-private partnership. The question raised here though is whether selling a utility makes sense as an effort to raise cash in an environment where tax revenue is too low to support other local government programs.
We’ve commented many times here on what we characterized at the pitfalls of private ownership. We have written many articles on the topic, all of which show how water rates and sewer rates spiral upward under private ownership. In general, selling a utility currently owned and operated by a local government to a private interest is likely to turn out with higher rates for customers. We’ve certainly documented the huge rate increases proposed by private companies in these pages, but the USA Today article provides yet another example:
“Pekin, Ill., City Manager Denny Kief tracked rates for the first 20 years after Illinois American Water bought the water system from a local company and says rates — for 6,000 gallons a month — rose 204%.”
Sometimes, local communities face impossible choices and selling an asset like a water or sewer utility is the only reasonable choice. However, if the criteria are about long-term costs and benefits to the customer, all else being equal, selling to a private utility is probably not the best choice. As we’ve documented before, unless the private operator is able to achieve steep long-term efficiencies, there is really no comparison.
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”
Kentucky American Latest in Big Water Rates
February 28, 2010
Illinois, Indiana, Missouri, Arizona and now Kentucky. We’ve been tracking American Water Co. all year and reporting on the large increases that the company has requested in each of these states. Kentucky is the latest. The increase requested there is 37%. The Kentucky American water rate increase contains very similar elements to all the others too. In this case the company tries to justify the increase on the cost of a new water treatment plant that is nearing completion. At a cost of $160 million, the new plant will treat 20 million gallons per day. The only problem is that the numbers don’t add up. If indeed the plant is the source of the increase, what consumers should know is that the company will be allowed to recover the depreciation expense on this facility, plus a return on the book value (the value of the asset after subtracting depreciation). A water treatment plant can be depreciated over different periods, but 20 years is typical – that’s $8.1 million per year. To make up the difference between $8.1m and the total of the $26m that is being requested, the Company would need about 11% exactly in return to its shareholders.
If you know of an investment out there with very little risk associated with it (like a water utility) that is paying 11%, please send your information to us so we can put everything we have into that investment! Is this rate increase justified. Obviously we don’t know enough to say definitively, but the information in the news article leaves a lot of questions.
Comments (1)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.
Global Water’s Hackneyed View of CIAC
December 22, 2009
As the Global Water rate case in Arizona unfolds, we are starting to see “under the skirt” of the water utility that is seeking a 34% increase to its approved water rate and 130% for its sewer rate. We were pretty sure that we would see some fireworks in this case given the size of the increase within the context of new construction (i.e. growth) coming to a standstill in the Phoenix area after over a decade of white-hot activity.
During recent testimony before the Arizona Commerce Commission, the state agency charged with approving or rejecting the company’s rate request, the company stated that it has not removed contributions in aid of construction (CIAC) from its rate base in calculating its requested rates. Doing so, the company says, is the only way Global Water will consider purchasing more small, troubled water systems. (Click here to read the article from Maricopa.com).
First, a few definitions. CIAC is free capital that the utility receives from a third party, usually a real estate developer. The CIAC can come in the form of cash or often in the form of infrastructure assets. Either way, the contribution is given to the utility with the understanding that services will be provided in exchange. Rate base, on the other hand, represents the utility’s investment in the system and in the case of Global Water, a private company, the utility is allowed to earn some reasonable return on that investment through the rates it charges. We summarized the rate of return aspects of the rate case in a separate article, so I won’t go into much detail here. The important thing to know is that rate base represents the company’s investment; CIAC is not an investment by the company and so it is correct to subtract them from rate base before calculating rates.
What happens if you don’t? Since the company isn’t subtracting CIAC in some cases, the result is that the rate base is too high. In testimony, the company says it has $93 million in rate base; but $16 million of that is CIAC that has not been deducted. Assuming an 8% return (for the sake of illustration only), the company is asking to earn an additional $1.28 million per year on money and assets that it received for free. That’s additional money that the ratepayers will pay in their rates, if approved.
This is all part of something that seems to be a disturbing trend in the US: lack of proper regulatory oversight of private water companies. How else to explain the huge increases that are being approved over the past several months? Treatment of CIAC is one issue, including planned investment instead of actual investment in rate base is yet another and potentially larger issue. Stay tuned as we continue to track these rate cases and get to the bottom of the drivers and implications.
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