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What’s a “Revenue Requirement?”

December 7, 2009

Like all technical fields, the utility ratemaking field has its own lingo that while useful in discussions amongst experts, can leave the bystander dazed and confused.  One of the more important ratemaking terms out there is  revenue requirements.   If you are an elected official or someone sitting an audience somewhere that has heard a rate study presentation given, you will have undoubtedly heard this term (but maybe not its definition).  Revenue requirements are nothing more than the total costs of the utility; it has special meaning in ratemaking because the utility is “required” to earn “revenues” that are at least equal to its costs.  There are two ways to measure revenue requirements, but today we will focus on the one that is most used by municipal utilities.  We call that method the “cash-needs approach” because as the name suggests, the approach focuses on annual cash requirements to fund the utility and its operations. That focus works well in a government budgeting environment, which is why it is most often used when preparing rates for municipal utilities. Here are the components of Cash-Needs Revenue Requirements.

Operating & Maintenance Expenses.

Pretty simple.  The O&M expenses are the normal and recurring expenses incurred to run the system.  Things like staff salaries, fuel, power, chemicals, etc. all are considered O&M costs.

Debt Service

Debt service includes the principal as well as the interest on all outstanding debt.  In addition, though, debt service costs can include other items like debt service reserve funding, and debt service coverage requirements.  Debt service reserve funding simply refers to the need for the utility to fund a reserve account in order to comply with the terms of the bonds known as the bond covenants.  In some cases, bondholders will require a utility to keep a reserve fund as a means to mitigate repayment risks.  If so, then the money that has to be put into that fund on an annual basis is an additional revenue requirement.  Debt service coverage is another bond covenant requirement; it is a provision that requires the utility to maintain its revenues at a high enough level to ensure that there is more than enough money available to make the annual debt service payments.  A typical requirement is to maintain revenues net of O&M expenses at 125% of the annual debt service payment.

Cash Funded Capital Expenditures

The tricky part of calculating revenue requirements is to determine how much money the utility will spend from its operating revenue in a given year on capital outlays.  Capital costs tend to dominate the total cost structure of a water or sewer utility, so this final component is critically important.  Financing for capital needs comes from debt, development fees, operating revenue, cash reserves and, in some cases, taxes.  In order to figure out how much cash is required to meet the capital expenditure plan, one needs to spend some time evaluating the financing alternatives.  In short though, if after deducting all other funding sources there remains an amount to be funded by operating revenue, then there is a revenue requirement.

If the rates in your community are going up, the reason is most likely linked to capital costs, either debt service or cash funded capital expenditures, than operating costs.  Because the water and sewer utility industries are among the most capital intensive anywhere, the need to constantly reinvest capital into the infrastructure is a major cash need.  As infrastructure systems age, they require more and more such investment.  We are at a point in the US now where such systems are getting a little old in many cases and the rates you see proposed could well have a lot to do with the need to keep your community’s infrastructure in good working order.

In our next post, we will talk about other ways to measure revenue requirements.  Stay tuned.

Comments (1)

1 Comment »

1. 

   Where did you get your blog layout from? I’d like to get one like it for my blog.

   Comment by Susan Kishner — December 7, 2009 @ 7:55 am

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