Contact StepWise Today!
303.800.6638 Email Us
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!
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.
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.
Inside a Water Rate Case
December 15, 2009
As Global Water’s testimony supporting its requested rate increase before the Arizona Commerce Commission begins, we are starting to see a small glimpse inside what can be a very involved process. Rate cases are not new: they are the rule for privately owned utilities and have been part of our history since pre-1900 times. Your electric company, gas company, phone company, and cable company all are likely required to file rate cases in front of a state regulatory agency before they can legally increase their rates. Although it sounds like the public is in control in such a process, it is really more like a court case where the judge applies the law and legal precedent to make a decision to approve, deny, or amend the rate request. The judge is bound by the law, and the law requires much from the utility to be sure; the law also allows the utility to increase its rates to recover all of its expenses, plus a reasonable return to shareholders. So, if the utility is performing its role by providing the utility services to customers at a reasonable standard, and the expenses incurred in providing the service are also found to be reasonable, then the judge is more or less bound to approve the rate request. Whether service is being provided at a high enough level, and whether the expenses -including the requested return to shareholders – are reasonable, are the major areas for argument during the case.
A recent article about Global Water’s requested increase in Arizona sheds some light. What we hear from the company’s CEO during testimony is that the proposed rate for recycled water is $2.00/thousand gallons and that 60% of all HOA’s (homeowner associations) are now paying just $0.33. If you go to the company’s web site ,you will find that they appear to have not changed their rates for about 10 years, during which time the company claims to have added over $200 million of new infrastructure to serve the area (in Maricopa County). The article goes on and describes a few strange things about this rate request:
- The company is not seeking a “fair and equitable return.” The CEO claims that the company will not earn a return in this case for 20 years. That is quite a statement. Shareholders may want to sell at this point!
- The company says that the rate should be $2.00/thousand gallons, yet they propose to phase in the rate over five years. All that means is that the company is not asking the commission to approve a rate that would recover its costs of service. Why?
- The water rate requested is increasing by 34% and the sewer rate (the company also owns and operates) is increasing by 130%. These kinds of increases are indicative of failure to revisit rates more frequently. Most likely, the company didn’t get any real increases for 10-years and need those increases now.
In an earlier article I posted here (What’s Driving High Utility Rates?) I discussed that growth, or lack thereof, was one of the key drivers to the need for higher utility rates. Phoenix has been one of the highest growth areas in the US over the last 10 years. That growth has come to a near standstill of late and the rate case has been filed coincidentally. It’s no coincidence.
Stay tuned for more. We hope to follow this case and publish a few more tidbits as they come out.
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.
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.
Water Rates Up for Arizona American Water
November 18, 2009
A pattern is definitely developing for American Water Co. We have been tracking their activities through news releases since earlier this summer. Already, we have blogged about the large increases requested of the utility commissions in Illinois, Indiana, and Missouri. Now, we can add the company’s Arizona affiliate to the list of suspects. Water rates in Anthem, Arizona are set to increase by $77 per month under the company’s latest proposal. In this case, the residents of Anthem will see their rates nearly double. Although the Arizona commission has not yet approved the company’s request, one has to assume that the company at least intends to impose a large increase; it maybe less than double, but it’s not likely to run down to single-digit increases.
Is a private water company right for your community? The City of Chicago is considering leasing its water system to a private company as we speak. When you look at the body of evidence (especially in Illinois!) of what private companies are doing with their rates and charges, you will get the sense that it is perhaps not such a great idea to hand over control of a utility - a natural monopoly enterprise – to a private operator. Those private companies do have a constitutional right to have rates approved that will allow the companies to earn a return to their shareholders. While a utility commission would regulate what that return will be, the commissions are still required to provide a return of some kind (a profit) and approve rates that can provide it. Think twice before you jump.
More Private Utility Increases
November 4, 2009
It looks like American Water Co. is out to get back in the black on a national scale. We now have three examples, all within the last 30 days, of subsidiary companies of American Water seeking very large rate increases in different service areas. Add the Veolia case from Indianapolis, and we have four examples.
Here are links to the stories:
Illinois American, 30% increase
Missouri American,18% increase
Veolioa (Indianapolis, IN), 35% increase
Our point in these examples is not that the increases are not necessary, but rather that private utilities are no better suited to absorb costs or even operate at a lower over all cost than municipal providers. The body of evidence is growing against the so-called efficiencies of private utility companies.
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.
Connection Fees Anyone?
September 22, 2009
Utility managers should understand that you only get one chance to charge new customers connecting to your system for the capital costs of providing them the capacity they need for service. Connection charges (aka. system development fees, impact fees, tap fees, capacity charges, etc.) are the right way to ensure intergenerational equity between existing customers and new ones. If designed and applied correctly, these fees can help keep rates lower in the long run while the utility continues to expand its system for a growing customer base. However, once the customers are already connected, your opportunities are reduced like they were for this small utility in Indiana. To avoid a big rate increase like the one in the Indiana example, this utility could have been charging all their new customers a cost-based connection charge all along. Instead, they get to explain to their users why system growth (double the planned capacity) is going to cost them a 23% rate increase.
© 2010, StepWise Utility Advisors