Each year, utility managers and policy makers analyze the cost of operating the utility in the upcoming year, as well as the revenues the utility can reasonably expect in that year. Any anticipated shortfall is then addressed by making adjustments to the budget, delaying capital investment, or increasing user fees. This exercise is generally a simplified revenue adequacy evaluation. The objectives of a comprehensive Revenue Adequacy Evaluation are generally to:
- Ensure sufficient revenue is generated to provide revenue stability.
- Fund recurring operation and maintenance expenses.
- Maintain adequate working capital and required reserves.
- Provide for annual capital costs such as debt service, capital outlays, and other annual capital revenue programs.
- Monitor debt service coverage to ensure any required loan covenants are met.
As part of a Rate Study, a Revenue Adequacy Evaluation typically involves development of a five to 10 year financial model that projects annual revenue requirements and anticipated revenues. Evaluation of Revenue Adequacy is based on total revenue requirements associated with the system’s operating and capital budget and projected revenues based on recent historical billed sales and other operating and non-operating revenue sources. A Revenue Adequacy Evaluation can either be completed using a utility’s existing rate structure or can include recommended future rates resulting from the Rate Design process.
As annual operating and capital costs fluctuate, it is important for utility revenues to be monitored and adjusted to ensure annual revenue adequacy, unless financial planning indicates instances in which reserves will be drawn to address planned revenue shortfalls.
Figure 2 illustrates the result of a situation in which a utility does not make efforts to proactively address increasing costs. As shown in the graphic, (after the first year) projected annual revenue requirements (blue) exceed projected annual revenues (green), resulting in annual revenue deficiencies or shortfalls in years two through five. As a result, the Operation and Maintenance (O&M) reserve fund balance (black) is depleted by the third year. This situation could be corrected by implementing responsible annual adjustments to utility rates and/or fees to offset the increasing cost of O&M and capital.
Figure 3 represents a prudent response to increasing annual costs. One recommendation often resulting from a Revenue Adequacy Evaluation is consideration of annual rate indexing, in which rates are automatically increased annually to keep pace with increasing O&M costs.
Should I Complete a Revenue Adequacy Evaluation?
This is a process that you already complete on some level every year. However, a comprehensive Revenue Adequacy Evaluation can provide you with a robust tool that can be used to manage projected revenues against projected O&M costs, debt service, and capital improvements five to 10 years into the future. A Revenue Adequacy model can be a useful tool in analyzing the rate effects of various capital funding strategies, as well as planning for prudent reserves and tracking reserve balances. In summary, a Revenue Adequacy model tailored to your specific utility is an invaluable planning tool for utility managers.
For more information on Revenue Adequacy, contact Miranda Kleven at Miranda.Kleven@ae2s.com or 701-746-8087.