It’s that time of year again, initiation of the budget process and the associated assessment of utility rates for the upcoming budget year. Questions may arise, such as “Are we charging enough? Are we charging too much? Can we afford to do the projects that we want or need to do? ” All of these questions, and more, can be addressed with a Utility Rate Study. In this article we will summarize the objectives of a Rate Study, describe the primary components of a Rate Study, and provide some guidance to help you determine whether now is the time for you to consider a Utility Rate Study.
Rate Study Objectives
There are many potential objectives for your community to complete a Rate Study. The most basic reason is to maintain financial viability for your system now and into the future. The information developed throughout the study analysis and from financial modeling tools developed for the study can be used both to help guide long-term strategic planning and to assist in determining rate changes in the near-term. A Rate Study can form the basis for all utility financial discussions, such as planning for specific capital projects, funding annual capital renewal programs, developing/maintaining reserve accounts, determining rate adjustments, and ensuring “fair and equitable” rates for utility customers.
What makes up a Rate Study?
The term “Rate Study” can be used to imply a number of unique components, including:
- Cost of Service Analysis (COSA);
- Rate Design; and/or
- Revenue Adequacy Evaluation.
Depending upon the objectives of your Rate Study and the composition of your utility users, addressing all three of the components listed above may or may not be appropriate. Whether a Rate Study involves one or all three of these components, it should result in the creation of customized tools that your system can continue using for a period of five to ten years.
Whether completing COSA, Rate Design, or Revenue Adequacy Evaluation, the first step in any financial analysis will be to identify revenue requirements. The revenue requirements will become the basis for any or all of the Rate Study components, and include annual costs associated with operation and maintenance, debt service, capital outlays, transfers, and contributions to reserves. Descriptions of each of the three primary Rate Study components follow.
Cost of Service Analysis (COSA)
A COSA is the allocation of costs to the various customer classes served (i.e. Residential, Commercial, Industrial, etc.) corresponding to the level of service provided. Many costs are incurred for the joint benefit of all customers, some costs benefit certain customers more than others, and other costs may benefit only specific customers. A COSA follows the principles of cost-causation (those that cause costs, pay costs).
Basic COSA methodology recommended by the American Water Works Association involves three steps: Functionalization, Classification, and Allocation. To determine the cost of service, a year of data that is representative of typical utility operations is needed (Test Year). In the evaluation, costs are allocated to user classes and an overall cost to provide service to each particular user class is calculated. Gaining an understanding of the cost of service is particularly important for systems with distinctly different user classes, such as residential, commercial/light industrial, institutional, bulk, or heavy industrial users. COSA is also valuable in the consideration of service and associated charges to wholesale customers and/or consecutive users.
The costs of service by user class are then compared to the amount of revenue that was generated from each user class to determine whether inequities exist within user classes. Ideally, the cost percentages for each user class will closely resemble the revenue percentages for each user class. If they do not, the utility may want to consider conducting a Rate Design exercise in which alternate rate structures are developed that strive to remedy inequities between user classes.
Figure 1 illustrates theoretical COSA results in which it can be noted that the Single Family Residential user class, in particular, is paying significantly more than its cost percentage (cost of service). Conversely, it can be seen that the industrial user class is paying significantly less than its calculated cost of service.
It should be noted that a COSA gives a perspective on cost per user class for only the representative Test Year. The cost and revenue percentages associated with each user class will vary from one year to the next, but can be used as a general guideline in developing a fair and equitable rate structure. It is generally recommended that COSA be updated every five years or in conjunction with any major changes to your utility.
It should be further noted that there are often other objectives that weigh into Rate Design decisions. One such example would be a community that desires to promote economic development by making the conscious decision to have other user classes subsidize the industrial user class. In such a situation, the illustration in Figure 1 would represent an intended cost versus revenue incentive for industrial users.
The basic objectives of Rate Design are to develop a system of charges that is “fair and equitable”, not unduly discriminatory, and that will provide adequate revenue to meet utility financial objectives. The primary goals of Rate Design are to develop a structure that is:
- Easy to understand and administer;
- Effective in yielding total revenue requirements;
- Able to generate a stable revenue stream;
- Structured to charge the appropriate customers based on level of service; and
- Fair and equitable, as well as defendable.
In addition, there may be other goals specific to your utility, such as economic development, rate relief for fixed income users, asset management/capital renewal planning, or water conservation, to name a few. You should review the basis for your existing rate design, and determine whether the structure in place is still appropriate. Think again about the similarity or dissimilarity of water use or wastewater discharge patterns of your user classes. If there are not good reasons to charge one user differently than another, then a simple rate structure that applies to all classes is appropriate. However, if there are marked differences in the level of effort and/or cost to provide service to different user classes, then a multi-level rate structure that charges user classes differently is probably warranted.
Rate Design activities can be as simple as calculating an across-the-board increase needed to meet the identified revenue requirements, or as complicated as evaluating how to apply the increase to the fixed and variable components of the rate structure. If you elected to do a COSA, the results of that analysis will have shed some light on the equitability of your current rate structure. The existing rate structure should then be reviewed for potential changes that could correct existing inequities and generally improve the performance of the rate structure. It is recommended that improvements to rate structures be implemented gradually to allow constant evaluation and ensure continued revenue stability.
Revenue Adequacy Evaluation
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 annual revenue adequacy evaluation. The objectives of a 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 (e.g. debt service, capital outlays, and other annual capital revenue programs); and
- Monitor debt service coverage to ensure 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 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 rates resulting from Rate Design.
As annual operating and capital costs fluctuate, it is important for utility revenues to continue to be 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 2 through 5. As a result, the Operation and Maintenance (O&M) reserve fund balance (black line) is depleted by the third year. This situation can be corrected by implementing responsible annual adjustments to utility rates and/or fees to offset the increasing cost of operations and capital. Figure 3 represents a prudent response to increasing annual costs. One recommendation often resulting from a Revenue Adequacy Evaluations is consideration of annual rate indexing, in which rates are automatically increased annually to keep pace with increasing O&M.
So how do you determine if it is the right time for a Rate Study and what it should entail? It is important that comprehensive financial planning is integrated into your basic utility operations. The particular Rate Study components in which you may be interested depend on a number of unique factors. The right approach for your Rate Study will depend upon the makeup and operation of your system, as well as any near-term objectives and the future vision for your utility.
Do I Need COSA?
Give some thought to your customer classes. Do they all use water in the same way? That is, are there variations in seasonal and peak demands by user class? Are average water sales consistent most months of the year, with all classes using more water during the hot and dry periods? Or do you have classes whose water usage does not vary with climatic conditions? Do they all discharge wastewater that is generally below the domestic limits? Are your users all within the City boundaries? Do you provide service to neighboring communities? If the answers to these questions lead you to conclude that usage patterns and service characteristics associated with all user classes are similar, then there is probably limited benefit from in-depth COSA. If you have one or more user classes whose water use patterns are markedly dissimilar from the others, then a COSA should be considered to help you to determine whether your current rate structure is fair and equitable.
Should I Complete Rate Design?
Does your current rate structure meet your objectives? If you desire to promote conservation, does it send a price signal to motivate users to reduce water use? Does it provide adequate revenue stability, even under conditions of reduced billed sales? Is it easy to administer and is it perceived as fair? If you completed a COSA and there are significant disparities between cost percent and revenue percent for some user classes, then you should probably explore alternative rate design options. Before making changes, however, be sure to take a comprehensive review of all desired objectives, so that concepts such as lifeline (minimum) rates, conservation, potential economic incentives, responsible annual reinvestment in the utilities, etc, can be considered. If your current rate structure is viewed as fair and equitable and supports both near-term and long-term objectives, rate changes within the existing structure is likely the most appropriate strategy.
What About a Revenue Adequacy Evaluation?
As previously noted, 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 operation and maintenance costs, debt service, and capital improvements five to ten 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.
Whether your utility is in need of a comprehensive financial evaluation or interested only in accomplishing a very specific financial objective, a customized Rate Study tailored to your unique objectives can help accomplish your goals. A Rate Study is a powerful tool to help guide proactive, responsible decision-making for your utilities.
For more information on COSA, Rate Design, or Revenue Adequacy, contact Shawn Gaddie at 701.746.8087 or Shawn.Gaddie@ae2s.com.
To view the typical rate study steps, click here.