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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.
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.
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.
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.
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.
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.
© 2010, StepWise Utility Advisors