Top tactics for setting municipal utility rates after ARPA

The $1.9 trillion American Rescue Plan Act (ARPA) includes $350 billion of Coronavirus State and Local Fiscal Recovery Funds (CSLFRF). Unlike previous economic stimulus bills passed to provide relief during the COVID-19 pandemic, ARPA offers federal funding to states and local governments of all sizes. For some local units of government, this can be quite substantial. As with any federal funding, there are strict guidelines that dictate how municipalities can spend this money. Included in CSLFRF’s four categories of allowable use are investments in water and sewer infrastructure.

All recipients of CSLFRF funds should plan strategically to determine the best use of this funding and evaluate any long-term infrastructure and capital plans. A municipality may determine that water and sewer infrastructure is the highest priority for utilizing some or all of a community’s CSLFRF funding. This would both improve the overall quality of the system and potentially mitigate the need for future customer rate increases. Every CSLFRF dollar invested into your water and sewer system is one dollar that doesn’t have to come from your customers.

It’s imperative that water and sewer rates are set to ensure utility systems are self-sustaining in the short term and incorporate future capital needs. Determining rates can be a difficult component of the budgeting process. How should utilities set water and sewer rates if they plan to make a substantial investment with CSLFRF funding? 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:

• With employees working from home and businesses temporarily or permanently closed, has cash flow been positively or negatively impacted in recent months due to changes in usage?
• 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?
• Do you have a comprehensive capital needs assessment for your water and sewer system?
• Have you delayed capital improvements that would be helpful now but have not yet reached the point of necessity? Are your planned capital projects emergent and time-sensitive, or can timelines be adjusted in consideration of the current environment? 
• Are there longer-term plans that could be accelerated due to the influx of CSLFRF funding over the next few years?
• How much is your systemwide water loss costing your average consumer?
• How much working capital does your system have?

The answers to the above questions could either point to difficulties ahead or to an opportunity to invest ARPA funds and pass the savings on to your customers. Either way, it may be time for an in-depth review of 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? How does CSLFRF funding change this equation?
• 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? Does a significant CSLFRF investment now lower the need for capital replacement reserves? 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. And if financing, whether the model can replace debt funding with CSLFRF and calculate the resulting effect on rates.
• 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.

A new or refreshed rate model, with or without the influx of CSLFRF funding, will help you ensure you’re charging your customers the right amount now and into the future while also making sure the system’s infrastructure is properly funded and maintained.

If you need help creating a forecasting model tailored to your system’s needs, contact us. We’re here to help.