Reserve Funding Guidelines

The ability of a utility to fund and maintain adequate reserves to meet utility objectives is one indicator of financial condition. Utilities operate as an enterprise (i.e. a business), typically with a goal to be financially self-supporting without subsidization from non-utility revenues, such as a City’s general fund. For a given utility to be truly self supporting, it must plan for unforeseen financial needs with contingency funds in the form of cash reserves. In general, maintaining reserves is the maintenance of cash or financial capabilities to meet unknown changes in the budgets and financial needs of a utility.

Types of Reserves

The Water Environmental Federation (WEF) Manual of Practice No. 27, Financing and Charges for Wastewater Systems, identifies possible types and uses for reserves in utilities and enterprise operations. A brief description of each of these reserves is provided below.

General Operating Reserve: Operating reserves are typically established for unforeseen fluctuations in expenses, revenues or both and can be used to supplement rate revenues if needed to meet operation and maintenance (O&M) expenses. Operating reserves are intended to cover general operating needs such as annual float, normal ebb and flow of cash flow from operations, unplanned repairs or replacements, and/or emergencies. A general operating reserve can range anywhere from one to six months of O&M expenses, with three to four months being typical. The industry standard is generally 25 percent of annual O&M expenses.

Emergency Capital Reserve: An unanticipated capital failure can be costly. An emergency capital reserve can be established to help cover these unforeseen capital needs. Example funding levels for these types of reserves can be set at a percentage of asset value, or equal to the replacement cost of critical infrastructure.

Rate Stabilization Reserve: Rate stabilization reserves are established to cover wide fluctuations in projected revenue from season to season or year to year. A rate stabilization reserve allows a utility to draw on the fund balance during revenue shortfalls that result from lower than expected customer consumption. These reserves should be set at a level that can cover this variation in cash flow. There is no set industry standard target for this type of reserve; however a value ranging from five to 15 percent of annual utility revenues is often suggested.

Bond Covenant Reserve: A bond covenant or debt service reserve is created under coverage requirements established as part of the utility’s bond resolutions, covenants, or ordinance. A bond covenant reserve is often funded through the proceeds of a bond issue, and is only used if there are insufficient revenues to make a bond payment. This type of reserve typically includes a year’s worth of principal and interest. The covenant applied to State Revolving Fund (SRF) loan recipients varies by State, but generally requires a reserve fund equal to one year’s annual payment.  In addition, SRF programs also often have a coverage requirement of up to 1.25, meaning that after O&M expenses, net annual revenues must equal at least 120 to 125 percent of the annual debt service payments for principal and interest.

It should be noted that the target funding levels as well as the timeframe to reach any of these reserve goals will be dependent on each utility’s unique financial situation.