Creating a Long-Term Funding Plan

Although it’s difficult to see into the future with certainty, planning activities that address near-term needs while keeping an eye on potential long-term needs can lay the groundwork for a well planned capital improvements plan (CIP). When it comes to rate-setting, capital is often the primary driver. As a result, comprehensive capital planning that is updated routinely to reflect changing conditions and objectives is critical to setting responsible and appropriate rates that will generate sufficient revenues and lead to financial stability.

The three financial topics that we often touch upon in The Source newsletter are capital planning, rate planning, and financial reserves. Together, these three topics cover a broad range of financial decision points. There are some baseline financial questions under the umbrella of these three topics that can help you better understand your own system.

Capital Planning

Condition of System: How old is the system? Has regular renewal/replacement kept it in good operational condition? Are major investments looming on the horizon? Understanding the age and condition of the system is what most of us think of first when we hear the words “asset management.” This is generally the first step in developing an approach to asset management. If the system is new, you may make significant expenditures annually in terms of debt service principal payments. As debt on system components is retired, the system should continue to “invest” either through renewal/replacement or by contributing to a reserve fund for future replacement. A general rule of thumb is annual investment either through debt service, reserve contributions, or rate-funded capital should be at least equal to total annual depreciation on the system.

Condition of User Base: Is the system growing? Is the customer base shrinking? When the user base is growing, new revenues are available to meet operation and maintenance (O&M) and capital requirements, but it can be challenging to keep up with demand. When population and/or water use is declining, revenue levels can also decline and become insufficient. While each of these situations poses different challenges, both situations can be addressed with good planning.

Rate Planning

Rate-Setting Practices: How do you evaluate the need for a rate adjustment each year? Do you index the rates annually? Do you have a multi-year rate plan based on anticipated capital expenditures? As previously noted, a comprehensive CIP is crucial to charting a rate plan that will not result in “rate shock” for your users. Delaying increases might seem like a gesture of goodwill to rate payers who annually face increasing prices with other expenses, but they will likely not appreciate a large, one-time increase when suddenly faced with a capital investment that imposes a significant new revenue requirement on the utility. Many systems have successfully implemented a practice of annual rate indexing based on a justified method or reasonable factor, such as the Consumer Price Index (CPI). The development of a five- to ten-year rate plan that incorporates annual increases in O&M, the CIP, and targeted contributions to reserves is an excellent tool for a utility to use in planning for and communicating near-term rate increases and potential long-term adjustments.

Financial Reserves

Reserves: Does the utility annually fund reserves? Are reserve targets in place? What constitutes adequate reserve levels varies by utility based on the objectives of the utility and where it is at “in life.” A new utility may be carrying a heavy debt burden, and it may not be feasible or appropriate for rate payers to simultaneously pay for existing debt and contribute to capital reserves for replacement. This is where understanding the components of your system and the useful life of each becomes critical. Items with shorter service lives will theoretically need rehabilitation or replacement sooner than items with longer service lives. This should be taken into account as you plan your CIP and/or contributions to reserves. The rule of thumb regarding investment equal to at least annual depreciation was noted earlier. If that’s a financial stretch, don’t panic. The key is to establish responsible reserve fund goals and develop a plan to work toward them.

General guidelines for reserve funding levels:

Operating Reserves: 30-90 days of operating requirements.

Capital Reserves: Recommended target values for Capital Reserves vary based on the age of the system. Guidelines on Capital Reserve targets range from 15 percent of the planned CIP expenses to a full year of average annual cash-funded CIP expenditures.

Debt Service Reserves: Normally specified in bond/loan documents, these funds are restricted and can only be used to pay off debt. This is sometimes not understood by policy/decision makers, so communicating the requirements and allowable use of reserve funds as part of annual budgeting/rate-setting activities can be helpful.

Emergency Reserves: Some systems elect to fund a reserve with a specific intended use, such as emergency replacement of a critical piece of infrastructure, or the cost of purchasing water in the event of inadequate source water levels. A reserve of this nature would have a very system-specific target.

Rate Stabilization Reserves: Once a system has target levels for all other intended reserves, it is becoming more common for systems to also establish a Rate Stabilization Reserve. These funds can be used to minimize the rate increases needed in a given year or period of years, giving the utility time to increase rates slowly to potentially avoid a sharp, one-time rate increase. One example of the use of a Rate Stabilization Reserve would be if a utility is planning to complete a large project several years into the future. If current rates are adequate to fund all revenue requirements, including Operating and Capital Reserves, small and steady rate increases could be applied, with the additional generated revenue deposited into a Rate Stabilization Reserve account. By slowly building rates to meet a future revenue requirement associated with the new facility, the utility has: 1) avoided rate shock, 2) built Rate Stabilization Reserve funds that can be used to minimize future rate increases (as long as debt service coverage is met), and 3) built reserve funds that could be used to reduce debt on the new facility.

Comprehensive capital planning that accounts for long-term system goals is where to start when determining appropriate reserve accounts and reserve levels for your system. Responsibly funding reserves will support both capital planning and rate planning activities, and help ensure a utility’s financial sustainability.

If you have questions about long-term funding planning, contact Miranda Kleven, PE, Nexus Financial Analyst at