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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.
Comments (0)What’s a “Revenue Requirement?”
December 7, 2009
Like all technical fields, the utility ratemaking field has its own lingo that while useful in discussions amongst experts, can leave the bystander dazed and confused. One of the more important ratemaking terms out there is revenue requirements. If you are an elected official or someone sitting an audience somewhere that has heard a rate study presentation given, you will have undoubtedly heard this term (but maybe not its definition). Revenue requirements are nothing more than the total costs of the utility; it has special meaning in ratemaking because the utility is “required” to earn “revenues” that are at least equal to its costs. There are two ways to measure revenue requirements, but today we will focus on the one that is most used by municipal utilities. We call that method the “cash-needs approach” because as the name suggests, the approach focuses on annual cash requirements to fund the utility and its operations. That focus works well in a government budgeting environment, which is why it is most often used when preparing rates for municipal utilities. Here are the components of Cash-Needs Revenue Requirements.
Operating & Maintenance Expenses.
Pretty simple. The O&M expenses are the normal and recurring expenses incurred to run the system. Things like staff salaries, fuel, power, chemicals, etc. all are considered O&M costs.
Debt Service
Debt service includes the principal as well as the interest on all outstanding debt. In addition, though, debt service costs can include other items like debt service reserve funding, and debt service coverage requirements. Debt service reserve funding simply refers to the need for the utility to fund a reserve account in order to comply with the terms of the bonds known as the bond covenants. In some cases, bondholders will require a utility to keep a reserve fund as a means to mitigate repayment risks. If so, then the money that has to be put into that fund on an annual basis is an additional revenue requirement. Debt service coverage is another bond covenant requirement; it is a provision that requires the utility to maintain its revenues at a high enough level to ensure that there is more than enough money available to make the annual debt service payments. A typical requirement is to maintain revenues net of O&M expenses at 125% of the annual debt service payment.
Cash Funded Capital Expenditures
The tricky part of calculating revenue requirements is to determine how much money the utility will spend from its operating revenue in a given year on capital outlays. Capital costs tend to dominate the total cost structure of a water or sewer utility, so this final component is critically important. Financing for capital needs comes from debt, development fees, operating revenue, cash reserves and, in some cases, taxes. In order to figure out how much cash is required to meet the capital expenditure plan, one needs to spend some time evaluating the financing alternatives. In short though, if after deducting all other funding sources there remains an amount to be funded by operating revenue, then there is a revenue requirement.
If the rates in your community are going up, the reason is most likely linked to capital costs, either debt service or cash funded capital expenditures, than operating costs. Because the water and sewer utility industries are among the most capital intensive anywhere, the need to constantly reinvest capital into the infrastructure is a major cash need. As infrastructure systems age, they require more and more such investment. We are at a point in the US now where such systems are getting a little old in many cases and the rates you see proposed could well have a lot to do with the need to keep your community’s infrastructure in good working order.
In our next post, we will talk about other ways to measure revenue requirements. Stay tuned.
Comments (1)What’s Driving High Utility Rates?
December 1, 2009
If you’re a reader of this blog, you will have noted that we often cite news articles showing how utility rates are being increased in different parts of the US. We track these stories because we feel it’s important for our clients, our readers, and our own staff to understand the political dynamics that make water and sewer rate setting unique in our public square. There is no question that water and sewer utility service is a basic public good. Whether the services are provided by a local government, which is in our opinion to be preferred (see why), or by a private company, the factors driving the need for rate increases are common. We have noted before that utility rates appear to be going up at increasing frequency right now, and at a higher level. What’s behind the trend?
Diminishing Growth
Because water and sewer utilities tend to have high operating leverage (high amounts of fixed cost relative to total cost), growth in customers can help keep rates down. As the number of customers and demand grows, total revenue goes up. If growth exceeds inflation and real increases in costs, then rate increases are not necessary. In many parts of the country, growth has been one of the factors that has helped keep utility rates in check. With the recession, however, growth in some of these areas has decreased, and some areas actually lost customers due to displacement (think Detroit). Demand has also fallen off in general either due to overall conservation, or just because people tend to cut back on everything during difficult economic times. Less demand, regardless of the reason, means that the utility’s fixed costs are shared by fewer people, and that means that rates have to be increased. Utility’s can fight back by slashing budgets, but the reality is that many costs cannot be avoided. At a point, higher rates are the only solution.
Disappearing Development Fees
Many utilities charge a fee for connecting a new home or business to the utility system. Those fees fall into two categories: the first is a fee to cover the cost of just connecting a meter, the second is a larger fee that is meant to recover some portion of the capital the utility will need to invest in order to provide capacity for that new connection. This second category of fees goes by many names but we will just call it a development fee. In some parts of the country, these development fees can be quite large. In the West, in particular, development fees for a single-family home can run $20,000 or more. Although the purpose of the fees is to offset capital requirements (to acquire pipes, pumps, tanks, etc.), the simple truth is that the income generated by the fees provides cash that utilities need. When growth slows, the income from these fees dries up. As the income from the fees dries up, it may need to be replaced and that can translate into higher rate increases.
Massive Capital Requirements
It’s no secret that water and sewer utilities are two of the most capital intensive businesses anywhere. There is a reason why these utilities are natural monopolies, and the extremely high amount of capital that is required to be invested in infrastructure before earning a single dollar of revenue is that reason. Utilities have tons of assets. Pipes, pumps, tanks, treatment plants…it all costs money, not only to acquire them in the first place but also to maintain, repair, and replace those assets. The cost of these assets is enormous, and we are at a point in many parts of the US where these assets have have reached the end of their useful lives. We see examples of this daily with main breaks and sewer backups. As the assets are replaced, huge amounts of capital have to raised. That usually means higher debt payments for utility customers and big increases in rates to pay for it. For example, we recently assisted on a project where a small community of about 2,000 customers was required to construct a new sewer treatment facility at a cost of about $13 million. The debt service on the plant comes to about $460/yr/customer – the debt alone would have caused the sewer bills to double.
Increasing Supplier Costs
The costs of treatment chemicals, electricity, and fuel have all gone up substantially in the past couple of years due to a variety of factors that are well beyond the control of any local water/sewer utility. Some of these costs can be managed, but more often than not they have to be absorbed translating into a need for higher rates in many cases.
Waiting for the Wrong Time
There’s never a good time for a water/sewer rate increase when you’re an elected official, but some times are worse than others. Now would be one of those “worse” times. Unfortunately, when times are good the need for rate increases is not always obvious. There are untold thousands of stories out there about how communities have not addressed let alone increased their utility rates for years and years and are now faced with the need for a big increase to catch themselves up (look at a recent example). Avoiding large and sudden increases in water and sewer rates should be a major objective of utility managers. Solid management and planning can help avoid the bad timing as well as the large increases. Communities can help themselves be prepared by addressing utility rates on a frequent basis and making the small adjustments when they are necessary. When you wait until deficits start appearing, then all those small increases that were avoided in the past tend to compound into a much larger increase later.
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