Contact StepWise Today!
303.800.6638 Email Us
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.
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.
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.
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.”
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.
Corporate Water Utility Rates – Show Me The Efficiencies
October 21, 2009
We have previously commented on the fact that having a private water utility does not necessarily translate into lower water rates. In that post, we discussed the woes of the Indianapolis experience with Veolia being the private contractor in charge of the water utility’s operations. In the news today is yet another example where private utility operators have proven, yet again, that they are as beholden to the laws of economics as any municipally-owned water system. The Illinois American water company serving about 10,000 customers in the Chicago area has asked the Illinois Commerce Commission to approve a 30% increase in water rates and a 50% increase in sewer rates. The company states that the reasons for the increase include the usual suspects: the costs of repairing and maintaining infrastructure, and to cover the increasing costs of employee benefits. About 350 of the company’s customers (from the cities of Homer Glen, Orland Hills, and Lockport) showed up at a public hearing to protest the increase which would make the company’s rates triple those of the municipally-owned utilities in nearby communities.
What the protesters probably don’t understand, and what everyone who thinks substituting public ownership of their water/sewer utilities with private (corporate) ownership needs to know is that the private utility owner has a constitutional right to charge rates that will allow it the opportunity to earn a reasonable profit. That right has been established in US case law since the 1898 case in Smyth v. Ames . Of course, there are certain protections offered to determine just what is a “reasonable profit” and the Illinois Commerce Commission in this case, or its equivalent in any other state, has the charge to make sure that the rates are indeed reasonable. Still, if the real reason for the increases comes down to infrastructure repair costs and employee benefits, the company is very likely to have its request for higher rates approved.
On top of those costs, the company is allowed to profit from operating the utility. Meanwhile, a municipally-owned utility would not include profit in its rates. Instead, municipal systems allow whatever “profit” exists in the utility’s operations to flow directly back to its customers by way of lower rates (read more about this topic here). Increasingly, we see that private operators are unable to provide the economic efficiencies that they like to claim they can provide in anything but the short-term. They tend to realize short-term savings by deferring rather than eliminating costs as the Illinois American and Indianapolis stories both suggest.
A Case of Politics vs. Practicality
October 15, 2009
We’ve been following the story in Oceanside, CA for several weeks now and were not surprised to awake to today’s headline that the city council rejected the water rate increases that had been proposed by the utility managers (Council Rejects Water, Sewer Rate Increases). As this story has unfolded, we’ve learned a few things: a) Oceanside purchases 80% of the water it sells to its residents from the Metropolitan Water District, b) the rate charged by MWD was recently increased by 18%, c) Oceanside has water revenue bonds outstanding that require the utility to meet certain requirements called debt service coverage (more on that in bit), and d) the city council is not convinced that the utility’s costs are appropriate.
When you read the latest story (see the link above), you see the City manager and the utility director’s concern that the council’s rejection of the proposed increase would result in the utility failing to meet its “coverage.” Coverage refers to something called “debt service coverage” and it is a covenant provision contained in most municipal revenue bond agreements. In short, the debt service coverage provision requires a utility to achieve net revenue (gross revenue less operating & maintenance expenses) to be some percentage equal to and, in most cases, greater than the annual principal and interest payments on the utility’s outstanding debt. A typical debt service coverage requirement is 1.25, meaning that net revenues must be 125% of the annual debt payment. If you fail to meet those requirements, the bondholders’ lawyers have the right to step in and seek legal remedy to enforce the covenants.
The problem that has emerged for Oceanside and many other utilities in the country is that costs have continued to increase even in the current stagnant economy while political tolerance for rate increases has evaporated. In this particular case, we see the utility’s wholesale rate going up 18%. In other cases, we find the costs of electricity, gas, and treatment chemicals as the main culprits. Increases in costs alone would have been enough to force a rate increase to maintain compliance with the bond agreements, but Oceanside like many California utilities got hit on the revenue side as well. As drought conditions persisted, mandatory water restrictions took effect and water use declined and, along with it, the utility’s revenues. As a result, Oceanside is looking at decreased revenue as well as significant increases in costs, neither of which are variables that the utility can conceivably control.
The political reaction of the city council is unfortunate. The politics are understandable, but not implementing necessary rate increases is impractical. The consequences could be severe and could impact the utility’s credit rating, which would result in higher borrowing costs down the road. In turn, that could limit their access to credit markets and constrain access to debt capital to invest in system repairs and replacements; that all points to even higher rate increases in the future.
The Cost of Equity in Muni Utility Rates
September 7, 2009
From the archives, I found this article that I wrote a few years ago. It was first published in the Rocky Mountain Section of the AWWA/WEA magazine. The article speaks to how much the ratepayers of a utility should expect as a return for the equity they provide as part of a utility’s capital structure. We have since tied the notion of return on equity to the phenomenon we call “rate shock” (the negative reaction of ratepayers when faced with a sudden increase in user charges); StepWise has theorized that rate shock is largely a result of failing to meet the ratepayers (owners) expectations for return on investment. More on this topic to come in the days ahead. In the meantime, here’s the article.
The Cost of Money, Part 2 (by Jason Mumm, 2006)
© 2010, StepWise Utility Advisors