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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
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.
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 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.
Illinois American Water Rates Under Fire
March 30, 2010
The Illinois American Water Co. (subsidiary of much larger American Water Works Co. – AWK) is seeing new scrutiny from the Illinois Commerce Commission on its proposal for 30% increases in water rates for many Chicago-area utilities that it operates. The rate case has made its way to the ICC where Illinois Attorney General Lisa Madigan has argued that the company’s request is both “unreasonable” and “excessive.” The full story is reported in TheTelegraph.com. There is one gem in this story worth a little more time here though…
One of the cost items the company is trying to justify is the cost of a study it commissioned in 2007 to compare its own water and sewer rates with those of surrounding municipalities. The ICC had commented in the 2007 rate case that American’s rates were two to three times higher than those other cities’ and the company followed up with a study. It seems that after paying $37,000 for the study, the company concluded that no comparison of water rates or sewer rates was possible due to accounting differences.
Accounting differences?
There are several reasons why comparing rates with other utilities will give you dubious information. Not all utilities are supported 100% from user charge rates, some use tax dollars making rate comparisons tricky; some utilities do not recover their full costs of service (not good, but it happens); all utilities have different cost structures and different dynamics in their customer bases. “Accounting differences” is not one of the reasons.
More likely, the real reason is that comparing a privately owned utility like Illinois American with any equally situated utility under public ownership will ALWAYS result in the private company being the one with the higher rates. Since we’ve made this point before here, we can just direct you to the links to find out why private companies have a hard time comparing. Here are two good ones:
Private Does Not Mean Better Water Rates
Corporate Water Utility Rates – Show Me the Efficiencies
Keep in mind that American Water Works Co. is also attempting to increase its rates by similarly large amounts in many of its other jurisdictions simultaneously. Rate increases are in the works in Illinois, Indiana, Missouri, Kentucky, and Arizona just to name the ones we’ve been able to follow. Most of our blog posts on these issues is under our Privatization Tag if you want to see everything we have on this topic.
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.
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”
American Water Increasing Water Rates Yet Again
February 8, 2010
In the continuing saga of American Water and its wide scale requests for large increases in water utility rates in its service areas nationwide, we find the latest such request for its Arizona affiliate. Water Utility Rates will go up in Sun City, AZ by 28% and wastewater rates by 40% under Arizona American’s proposal.
Not surprisingly, the local community is organizing opposition to the proposal.
In the news on the same day, we see the El Dorado Irrigation District in California reduce its planned water rate increases by 50% after voters staged a protest to the board of directors (board seats are elected offices). The contrast between the two cases is helpful in showing some of the differences that exist between private company approaches to utility rates and the process for publicly owned utilities. Arizona American is going forward with its proposal regardless of outcry from the local community; the El Dorado District repealed half of its proposal.
We often hear the argument that private companies are better equipped than government to provide utility services for local communities. If you read through all of the big water rate increases that private companies are proposing listed on this site alone, you will start to see that there is a strong argument that private companies are actually not providing services at lower rates, and that local communities may find themselves mostly at the companies’ whims when it comes to how, when, and why the companies increase rates.
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!
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