The COVID-19 crisis is affecting water and sewer utilities in unexpected ways. For example, as many commercial properties, manufacturing facilities, schools, and universities suspend operations, the volume of water sold, and wastewater treated is reduced dramatically. Similarly, many utility systems serving bedroom communities are experiencing an increased burden on their infrastructure as most people have been confined to their homes. Now as states begin to reopen and find their “new normal,” some of these changes to water and sewer operations may become permanent.
This upheaval is set against a backdrop of overall negative impact on municipal revenue sources through loss of income tax, sales tax, and other sources of revenue. The general fund doesn’t have the capacity to help subsidize utility operations.
It’s imperative that water and sewer rates are set to ensure utility systems are self-sustaining in the short term and future.
So, how do utilities set water and sewer rates amid the uncertainty? During normal economic times, determining rates is a difficult component of the budgeting process. Today with the COVID-19 disruption ravaging revenues, expenses, and cash flows, it’s imperative that water and sewer rates are set to ensure utility systems are self-sustaining in the short term and future. For some utilities, this may require overhauling the rate-setting strategy.
Establishing your starting point
A review of your rate-setting strategy should begin with an assessment of your current cash and capital requirements. Ask the following questions to establish your starting point:
- Has cash flow been negatively impacted in the recent months?
- Do you expect cash flow to be negatively impacted in the future due to customer delinquencies or other factors caused by COVID-19?
- Is your existing rate structure currently covering the costs of operation? Will it continue to cover with a lower volume of sales?
- Can your existing utility rate structure support upcoming capital needs necessary to maintain your utility plants, lines, mains, and other infrastructure?
- Are your planned capital projects emergent and time-sensitive, or can timelines be adjusted in consideration of the current environment?
- How much is your systemwide water loss costing your average consumer?
- How much working capital does your system have?
If the answers to the above questions point to difficulties ahead, you may need to review your rate structure.
Reviewing your rate structure
There is no single right answer for how to develop rates. Approaches vary by community and by system based on the philosophy driving the rate decisions. But every rate structure review should address the following questions:
- Fee structure: Is your structure 100% variable based on a commodity (per unit sold) basis? Or is it primarily fixed on a per-customer basis? It could be somewhere in the middle. If your rates include a fixed component (a “readiness-to-serve” charge), determine which expenses are recouped by this charge. Then establish whether all customers pay the same amount or if the fee is graduated based on meter size or some other customer classification.
- Rating basis: Are your rates set on a cash-needs basis that considers the actual cash flow of debt payments and capital outlay? Or on a utility-basis whereby customer payments cover the current depreciation expense on the infrastructure of the system? Each method is recognized as acceptable within the utility industry, but implementation has very different impacts on customer rates paid.
- Financing: Will your system utilize debt-financing for large-scale construction projects, or will it pay for renovations with current cash flow?
- Cash reserves: Does your rate structure provide for the establishment of adequate cash reserves for working capital needs, operational emergencies, and potential catastrophic events?
- Time frame: Are you using a multiyear outlook when evaluating system costs and needs?
Once you’ve established your rate philosophy and structure, the next step is determining your necessary rate adjustment. Simply passing along a wholesale cost increase can be a costly mistake — the adjustment should include all cost factors such as upcoming capital spending, debt payments, and administrative or operational expenses.
First consider working capital reserves. How much cash or working capital does your water and sewer operation need on hand to make unexpected repairs and planned capital improvements without having to resort to temporary “rate spikes” or incurring undesired interest or financing expenses? Unfortunately, there’s no formula to determine the right amount of cash or working capital to have on hand — you’ll need to determine your system’s needs over a multiyear horizon to balance the scales of too much or too little.
There is no single right answer for how to develop rates. Approaches vary by community and by system based on the philosophy driving the rate decisions.
Next, calculate the rate adjustment. The best practice for approaching a rate adjustment starts with an annual rate increase in accordance with the municipality’s or system’s normal budget process. Steady, measured, and predictable rate increases give customers certainty and are preferred to drastic yearly fluctuations or long periods without any rate changes. This decision can be difficult during times of recession, and some municipalities even consider a temporary rate cut to ease the burden on customers who may be having financial difficulties. This is commendable but cutting rates when the system’s cash flow requirements aren’t decreasing can lead to a potentially bigger and less manageable shock to customers down the line.
Creating a decision-making tool
To help your leaders make informed decisions on setting water and sewer rates, we recommend creating a long-term model or forecast. Software packages designed specifically for this purpose are available but an Excel-based model — customized to fit the needs of your system and be updated each year as part of the annual budget process — can work very well.
A good long-term utility rate-setting model will enable you to run scenarios to determine:
- The budget impact of increases or decreases to the volume sold.
- The priority of capital projects or big-ticket equipment purchases.
- Whether to pay for projects out of cash or finance them and pay debt service.
- The impact of changes to the fee structure: For example, if the fixed readiness to serve charge were increased by 10%, how much could the variable commodity rate be reduced?
The model should be a living document that can be revised as new information becomes available, old assumptions are proven true or abandoned, and new assumptions are formulated. In our experience, a five-year model works best. It’s a long enough period to allow trends to develop and plan for known capital projects but not so long that the results of extrapolated assumptions become unrealistic. The model should capture all of the unique qualities of your system to ensure revenue is sufficient to meet cash flow needs while maintaining a target amount of cash or working capital.
To help your leaders make informed decisions on setting water and sewer rates, we recommend creating a long-term model or forecast.
We recommend using a “smoothing” technique to forecast a consistent rate increase year over year for five years to help customers get accustomed to annual increases and to limit controversy associated with less frequent but larger rate hikes. The model can be configured to calculate how the resulting rate increases will affect different groups of customers and can be a valuable tool for educating stakeholders, building consensus for setting rates, and educating the public on the impact increases will have on their bills.
If you need help creating a forecasting model tailored to your system’s needs, contact us. We’re here to help.