# Presentation: 224075

## Developing Water System Financial Capacity

**Notes:**
This training module was developed for the Drinking Water Academy (DWA) of the U.S. Environmental Protection Agency. 
The Academy is developing a number of training modules.  These modules cover topics identified by the DWA Workgroup as most important in supporting SDWA implementation.  The modules are being developed for new employees in particular.
This module is Developing Water System Financial Capacity.
The purpose of the module is to provide a general introduction and overview and to provide opportunities for discussion.  Additional information resources and training materials are available on many of the subjects reviewed in this module.

## Workshop Objectives

- The methods for assessing financial capacity
- The importance of rate revenues to water system capacity
- The implications for affordability

**Notes:**
The purpose of this presentation is to:
Describe some of the available methods for assessing the financial capacity of water systems;
Highlight the central importance of rate revenues to water systems in terms of developing financial capacity and overall capacity; and
Discuss the implications for water-service affordability.

## Fundamental Goals of Capacity	 Development

- To ensure consistent compliance with drinking water standards
- To enhance water system performance
- To promote continuous improvement

**Notes:**
The 1996 Safe Drinking Water Act (SDWA) emphasizes developing the capacity of water systems.
The fundamental goals of capacity development are:
To protect public health by ensuring consistent compliance with drinking water standards, including Federal and State regulations and other applicable standards of performance;
To enhance performance beyond compliance though measures that bring about  efficiency, effectiveness, and service excellence; and
To promote continuous improvement through monitoring, assessment, and strategic planning.  All water systems, regardless of size or other characteristics, can benefit from a program of continuous improvement.

## What is Capacity?

- Fundamentally, water system capacity is the ability to plan for, achieve, and maintain compliance with applicable drinking water standards.
- Capacity development also extends beyond compliance.
- For a system to have “capacity” it must have *adequate* capability in three areas--technical, managerial, and financial.

**Notes:**
Water system capacity (not to be confused with production capacity as measured in units of water) is:
The ability to plan for, achieve, and maintain compliance with applicable drinking water standards.
Capacity development, however, extends beyond compliance to include activities that  enhance water system performance and promote continuous improvement.
For a system to have capacity, adequate capability is required in three distinct but interrelated areas:
Technical
Managerial
Financial
The three basic elements of capacity have a statutory basis.  Definitions and refinements were developed in EPA guidance documents with the broad-based input of stakeholders.
Participants may want to discuss the meaning of “adequate.”

## Exercise

- Describe a system that “has financial capacity”
- Describe a system that “lacks financial capacity”

**Notes:**
Here is an exercise for defining capacity in practical terms.
Participants in the workshop can provide their practical or working definition of capacity.
How do we know a troubled system when we see one?
How do we know when a system is at risk?
Describe a system that “has capacity.”
List common characteristics and issues.
Describe a system that “lacks capacity.”
List common characteristics and issues.

## A System That Lacks Financial Capacity

- Records nonexistent or disorganized
- Expenditures exceed revenues
- Balance sheet does not balance
- Does not understand the cost of service
- High volume of “unaccounted-for” water
- Does not ,meter, charge for water, or change rates

**Notes:**
Example characteristics of a system that lacks financial capacity:
Records nonexistent or disorganized (also a managerial capacity problem).
Expenditures exceed revenues (efficiency and revenue concerns).
Balance sheet does not balance (accounting problems).
Does not understand the cost of service (lack of knowledge, tools).
High volume of “unaccounted-for” water (non-revenue producing water).
Does not meter, charge for water, or change rates (revenue insufficiency over time).

## Case Study:Indiana System

- Rural system serving 140 people
- No full-time employees
- Purchases all water
- No measure of plant investment (0)
- Operating revenues total $22,000
- Operating expenses total $20,000
- Rate for 7,500 gallons is $44
- Water sales have declined significantly

**Notes:**
This case study explores a small, nonprofit water system in Indiana.
Rural system serving 140 people.
No full-time employees.
Purchases all water.
No measure of plant investment (0).
Operating revenues total $22,000.
Operating expenses total $20,000.
Rate for 7,500 gallons is $44.
Water sales have declined significantly.

## Slide 8

**Notes:**
Sample page from a small system annual financial report.

## Essential Elements of Water System Capacity

- Technical

- Managerial

- Financial

**Notes:**
Three three essential elements of capacity--technical, managerial, and financial, are closely related and can be represented by a “Venn diagram” depicting the intersections among the elements.

## Financial Capacity

- The ability of a water system to acquire and manage sufficient financial resources to allow the system to achieve and maintain compliance with SDWA requirements.

**Notes:**
Financial capacity is defined as:
The ability of a water system to acquire and manage sufficient financial resources to allow the system to achieve and maintain compliance with SDWA requirements.

## Elements of Financial Capacity

- Revenue sufficiency
- Credit worthiness
- Fiscal controls

**Notes:**
The essential elements of financial capacity are:
Revenue sufficiency
Credit worthiness
Fiscal controls

## Revenue Sufficiency

- Are the system’s costs and revenues known and measurable?
- Are system assets properly valued and reflected in rates?
- Do revenues from rates and charges cover system costs?

**Notes:**
Revenue sufficiency can be explored by asking:
Are the system’s costs and revenues known and measurable?
Are system assets properly valued and reflected in rates? 
Do revenues from rates and charges cover system costs?

## Credit Worthiness

- Is the system financially healthy, as measured through indicators, ratios, and ratings?
- Does it have a credit record and access to capital through public or private sources?
- Can it provide assurance of repayment?

**Notes:**
Credit worthiness can be explored by asking:
Is the system financially healthy, as measured through indicators, ratios, and ratings? 
Does it have a credit record and access to capital through public or private sources?
Can it provide assurance of repayment?

## Fiscal Management and Controls

- Are adequate books and records maintained?
- Are appropriate budgeting, accounting, and financial planning methods used?
- Does the system manage its revenues effectively?

**Notes:**
Fiscal management and controls can be explored by asking:
Are adequate books and records maintained? 
Are appropriate budgeting, accounting, and financial planning methods used? 
Does the system manage its revenues effectively?

## Drinking Water Costs

## Water

**system**
**design**

**Demand**
**for**
**water**

**Price**
**of**
**water**

**Cost of**
**water**
**service**

**Notes:**
A circular relationship exists among:
Demand for water (usage);
Water-system design;
Cost of water service; and
Price of water.
A change in any of these factors, in other words, has implications for the others.
For example, a change in the design of a water system (including improvements) affect the cost of service.
As another example, an increase in the price of water can affect how much water customers consume.

## Basic Types of Costs

- Capital costs
- Fixed costs associated with providing and financing the physical assets of the systems (multiyear)
- Operating expenses
- Variable costs associated water production (annual)

**Notes:**
Water system capital costs are associated with physical assets, such as treatment plant, pumps, and pipes.
The capital assets of water facilities have a relatively long useful-life span(even when compared with other utilities).
Capital projects typically are financed over several years.
Water system operating costs include the costs of labor, water, energy, and chemicals.  
Most operating costs recur annually.
Some operating costs (such as chemical costs) vary with water use; others (such as labor costs) do not.
Efficiency practices can help reduce operating costs.
Typically, operating costs are not financed but covered by an annual operating budget (and recovered through water rates).

## Capital Investment for a Large Water System (AWK 2000)

**Capital Investment for a Large Water System (AWK 2000)**

**General structures **

**and equipment**

**8%**

**Transmission and **

**distribution**

**46%**

**Treatment and **

**pumping**

**24%**

**Source of supply**

**5%**

**Services, meters, **

**and hydrants**

**17%**

**Notes:**
For many water system, capital investment in utility plant is concentrated in the transmission and distribution functions.
Data from the American Water Works Company, which provides water to more than 800 water systems in 21 States, transmission and distribution accounts for nearly half of all investment in utility plant.
Source of supply accounts for about percent of utility plant; treatment and pumping account for about 24 percent.
These proportions vary significantly by system size, age, and location.  For example, systems in water scarce regions (such as California) spend relatively more on source of supply.

## Operating Expenses (NAWC 1999)

**Operating Expenses (NAWC 1999)**

**  ****Production **

**expense**

**33%**

**  ****Purification **

**expense**

**12%**

**  ****Transmission & **

**distribution **

**expense**

**15%**

**  ****Customer **

**accounting **

**expense**

**10%**

**  ****Administrative & **

**general expense**

**30%**

**Notes:**
For water utilities, expenses are relatively evenly divided among core functions.
Based on data from the National Association of Water Companies (NAWC), production (source of supply) accounts for about 34 percent of expenses; transmission and distribution accounts for about 15 percent of expenses; and water treatment accounts for about 11 percent of expenses.
These proportions also vary according to the size, age, and location of water systems.
On a nonfunctional basis, for the American Water Works Company systems, labor costs take the largest overall share of operation and maintenance expense (about 41 percent), followed by operation and maintenance materials (27 percent), fuel and power (9 percent), purchased water (8 percent), customer billing and accounting (5 percent), chemicals (4 percent), waste disposal (3 percent), and other (3 percent).

## Current Cost Drivers

- Compliance with drinking water standards
- Replacement and improvement of aging infrastructure
- Meeting demand growth (population)

**Notes:**
Water systems today face three significant cost pressures:
Compliance with Federal and State drinking water standards.
Replacement and improvement of an aging water delivery infrastructure.
Meeting demand growth, that is, growth in consumption associated with growth in population (in areas experiencing growth).

## Estimates of Infrastructure Need

**$144**

**$151**

**$151**

**$366**

**$1,000**

**$100**

**$200**

**$300**

**$400**

**$500**

**$600**

**$700**

**$800**

**$900**

**$1,000**

**$Billions**

**Current assets of com. water systems**

**(EPA 1995)**

**Projected 20-year need (EPA 1995)**

**Projected 20-year need (EPA 1999)**

**Revised 20-year need (AWWA 1998)**

**Estimated total 20-year need for water and**

**wastewater (WIN 2000)**

**Notes:**
EPA has estimated (in 1997 and again in 2000) that the water industry’s 20-year infrastructure need totals $151 billion ($1999).
The American Water Works Association (AWWA) increased the estimate based on anticipated transmission and distribution costs, for a revised total need at $366 billion ($1999).
Recently, an estimate by the Water Infrastructure Network (WIN) s have placed total 20-year water and wastewater need at $1 trillion.
Although the level of need cannot be known precisely, there is little doubt that a substantial amount of investment is required.

## Average 20-Year Need per Household

**$790**

**$1,250**

**$3,000**

**$6,500**

**$51,500**

**$0**

**$10,000**

**$20,000**

**$30,000**

**$40,000**

**$50,000**

**Large**

**systems**

**Medium**

**systems**

**Small**

**systems**

**American**

**Indian**

**systems**

**Alaska native**

**village**

**systems**

**Notes:**
EPA also estimated the average 20-year water infrastructure need on a per-household basis.
The per-household need is much greater for smaller systems (including many native American systems) is much greater than for larger systems.
The difference is largely due to economies of scale; that is, unit costs are lower for larger systems than smaller systems.

## Total 20-Year Need

**Source **

**($9.6 bil.)**

**6%**

**Other**

**($1.9 bil.)**

**1%**

**Storage **

**($18.4 bil.)**

**12%**

**Treatment **

**($38.0 bil.)**

**25%**

**Transmission **

**and **

**distribution **

**($83.2 bil.)**

**56%**

**Notes:**
The primary factor behind the current infrastructure funding need is grounded in demographics, that is, the age of the distribution pipes that were installed to provide service to a sprawling population.
The infrastructure need includes needs related to each of the basic utility functions:
Source of supply
Storage
Treatment
Transmission and distribution
The need to upgrade and replace transmission and distribution systems accounts for more than half of the total estimated need (56 percent). Piping costs illustrate why infrastructure replacement is a major cost driver.  According to many industry experts, pipes costing about $1 per foot when originally installed can cost $100 per foot to replace.  These estimates can vary widely.
Water treatment facilities account for approximately 26 percent of the total estimated need. 

## Opportunities for Cost Reduction

- Efficiency practices
- Technological innovation
- Market-based approaches
- Industry restructuring
- Integrated resource management

**Notes:**
As noted, today’s water systems face considerable cost pressure.
However, opportunities also exist for cost reduction.
These include:
Efficiency practices (least-cost);
Technological innovation (capital and operating);
Market-based approaches (competitive bidding);
Industry restructuring (consolidation); and 
Integrated resource management (supply and demand side).
Planning can help water systems identify and implement cost reduction strategies.

## Screening and Assessment

**Notes:**
Screening and Assessment

## Assessing Financial Capacity

- Importance in capacity development
- Identifies systems in trouble or at risk
- Assessment methods
- Checklists
- Budget worksheets
- Financial indicators and trends
- Benchmarking
- Reports, audits and reviews

**Notes:**
The assessment process (which may include the join evaluation of managerial and financial capacity), can play an important role in capacity development.
Assessment methods can be used to identify systems in financial trouble or at risk of experiencing financial difficulty in the future.
Some of the methods available for assessing financial capacity include:
Checklists;
Budget worksheets;
Financial indicators and trends;
Benchmarking; and
Reports, audits and reviews.

## Checklist for Adequacy of Current Financial Planning

**Do you have an annual budget?**
**Have you budgeted to anticipated needs? **
**Do you know how to set rates?**
**Do use use depreciation or reserves?**
**Do you review rates regularly?**
**Do you have a capital budget?**
**Do you schedule capital improvements?**
**Do you have a capital investment plan?**
**Does your plan consider structural options?**

**Notes:**
The following checklist questions can be used to assess financial capacity in terms of financial planning:
Do you have an annual budget?
Have you budgeted to anticipated needs? 
Do you know how to set rates?
Do use use depreciation or reserves?
Do you review rates regularly?
Do you have a capital budget?
Do you schedule capital improvements?
Do you have a capital investment plan?
Does your plan consider structural options?

## Checklist for Adequacy of Current Financial Management

**Do your revenues meet or exceed expenses?**
**Are your revenues used only to support the system?**
**Do you follow Generally Accepted Accounting Principles and System of Accounts?**
**Do you track budget performance?**
**Do you have billing and collection procedures?**
**Do you keep records of assets and depreciation?**
**Are financial records organized?**

**Notes:**
The following checklist questions can be used to assess financial capacity in terms of financial management:
Do your revenues meet or exceed expenses?
Are your revenues used only to support the system?
Do you follow Generally Accepted Accounting Principles and System of Accounts?
Do you track budget performance?
Do you have billing and collection procedures?
Do you keep records of assets and depreciation?
Are financial records organized?

## Adequacy of Current Financial Management (cont.)

**Do you follow purchasing procedures? **
**Do you follow procedures for hiring contractors?**
**Are controls exercised for expenditures (e.g., review and co-signature)?**
**Are controls in place to ensure that the budget is not exceeded?**
**Are threats to financial capacity identified and understood?**

**Notes:**
Questions regarding adequacy of current financial management (continued):
Do you follow purchasing procedures? 
Do you follow procedures for hiring contractors?
Are controls exercised for expenditures (e.g., review and co-signature)?
Are controls in place to ensure that the budget is not exceeded?
Are threats to financial capacity identified and understood?

## Budget Worksheets

- Expense budget
- Capital budget
- Reserves budget
- Revenue analysis
- Budget surplus or deficit

**Notes:**
Budgeting involves keeping track of revenues and expenditures in major categories.  Budgeting also involves analysis of trends and anticipated changes within categories, such as operations and capital expenditures.  Preparation of a relatively detailed budget is a key element in improving a utility’s effectiveness.
Simple worksheets can be used to develop budgets for the following areas:
Expense budget;
Capital budget;
Reserves budget;
Revenue analysis; and
Budget surplus or deficit.

## Financial Indicators

- Cash flow
- Internal generation of funds
- Rate review and approval
- Rate of return
- Operating ratios

- Capitalization ratio (debt and equity)
- Bond ratings
- Accounts receivable
- Uncollected accounts
- Tax liabilities

**Notes:**
A variety of financial indicators for screening and assessment:
These indicators include:
Cash flow
Internal generation of funds
Rate review and approval
Rate of return
Operating ratios
Capitalization ratio (debt and equity) 
Bond ratings
Accounts receivable
Uncollected accounts
Tax liabilities

## Special Role of Cash Flow

- Positive cash flow:  revenues exceed expenditures
- Cash flow is essential for small business
- Cash flow tends to correlate with other indicators
- Complex assessment methods may not be necessary

**Notes:**
Positive cash flow is achieved when revenues exceed expenditures for a sustained period of time.
Cash flow is essential for all small businesses, including water systems.
Cash flow tends to correlate with other indicators of financial health.
Highly complex assessment methods (such as multivariate financial models) may not be necessary for small water systems.

## Select Financial Ratios

- Profitability  	Net income/operating revenues
- Efficiency	Revenues/expenses
- Liquidity	Assets/liabilities
- Growth	Revenues/assets
- Coverage ratio 	Revenues/debt service
- Investment ratio	Capital outlays/revenue

**Notes:**
Some basic financial ratios also are used in financial assessment.
Each ratio is used to interpret a particular financial characteristic (such as profitability or efficiency).  More than measure can be used for many of these characteristics.
Some typical financial ratios that can be calculated from the data available under a system of accounts are:
Profitability.  Net income/operating revenues
Efficiency.  Revenues/expenses
Liquidity.  Assets/liabilities
Growth.  Revenues/assets
Coverage ratio.  Revenues/debt service
Investment ratio.  Capital outlays/revenue

## Composite Indices

- Combine indicators are used in models
- Generally correlate with basic indicators
- Can be useful for screening
- Most useful if not overly complex

**Notes:**
Composite financial indicators can be used in assessment, as well as predictive models of financial health.
Composite measures generally correlate with the basic indicators.
Composite measures and models can be useful for screening, to see whether systems need further attention or assistance.
Financial models using composite indicators are most useful if not overly complex or difficult to interpret.

## Trend Analysis

- Trends in key financial indicators and ratios
- Requires consistent measurement
- Controls for other factors and helps identify anomalies.
- Short-term and long-term horizons
- Identifies weaknesses and potential remedies

**Notes:**
Trend analysis makes use of time series data for key financial indicators and ratios.
Requires consistent measurement.
Controls for other factors and helps identify anomalies.
Short-term and long-term horizons can be used.
The analysis of trends can point to particular financial weaknesses and potential remedies.

## Benchmarking

- Benchmarks can be used for comparable systems
- Benchmarking requires caution because comparability is difficult
- Ranges are preferable to points
- Comparing rates is problematic
- Benchmarking can provide insights about system costs and efficiency, and identify areas for improvement

**Notes:**
Benchmarking can be used to compare a water system to comparable systems.
Benchmarking requires considerable caution because comparability among systems is difficult to achieve (along such factors as size, age, source water quality, etc.)
Ranges in values are preferable to particular points of reference.
Comparing rates charged for service is particularly problematic because of difference in ratemaking practices.
Benchmarking can provide insights about system costs and efficiency, and identify areas for improvement.

## Useful Benchmarks

- Costs by function ($ per gallon sold, $ per customer, etc.)
- Expenditures in particular areas
- Financial measures and ratios
- Technical indicators or proxy measures that have implications for financial and managerial capacity (for example, water losses)

**Notes:**
Some useful benchmarks are:
Costs by function (such as operating expense per gallon sold or administrative expense per customer, etc.);
Expenditures in particular areas;
Financial measures and ratios; and
Technical indicators or proxy measures that have implications for financial and managerial capacity (for example, water losses).

## Annual Report

- Annual financial reports ensure accountability to oversight bodies
- Useful for evaluating financial and managerial capacity
- Preparing a report enhances capacity
- Can be prepared by an independent analyst

**Notes:**
An annual report is very useful for assessing financial and managerial capacity.
Annual financial reports ensure accountability to oversight bodies, including boards of directors and regulators.  Regulators may have reporting requirements.
Annual reports are useful for evaluating financial and managerial capacity in both qualitative and quantitative terms.
The process of preparing is a means of enhancing the capacity of the water system.
Some annual reports are prepared and certified by an independent analyst.

## Audits and Review

- Annual report
- Financial audit
- Management audit
- Peer review

**Notes:**
Audits and reviews provide the most comprehensive assessment of financial and managerial capacity.
Types of audits and reviews for water systems include:
Annual reports;
Financial audit; 
Management audit; and
Peer review.

## Financial Audit

- Review of books, record-keeping, and procedures
- Review of expenditures
- Review of revenue sufficiency

**Notes:**
A financial audit involves a thorough review of:
Books, record-keeping, and procedures for accounting and financial controls;
Expenditures according to key categories; and
Revenues and revenue sufficiency.
The auditor must have independence in the review process.
Both internal and external review processes may be needed and they should be complementary in terms of achieving accountability goals.

## External Reviews

- Certified accountant or financial auditor
- Board of directors
- Funding agencies (SRF and other)
- State utility commission
- Peer reviewer (QualServe)

**Notes:**
An external review of financial capacity may be conducted by:
Certified accountant or financial auditor;
Board of directors (independent from management);
Funding agencies (SRF and other);
State public utility commission (economic regulator); or
Peer reviewer (QualServe).

## Understanding the Role of Rates

**Notes:**
Understanding the Role of Rates

## Flow of Financial Resources

**Customers**

**WATER SYSTEM**

**Local communities**

**Private sector**

**Public sector**

**Notes:**
Water systems can be supported by different types of financial resources:
The public sector can provide loans and grants.
The private sector can provide loans and equity.
Local communities can provide subsidies, including low-cost debt financing.
Customers can provide revenues through rates (rate revenue  in turn is used to repay debt and equity costs).
Rate revenue from customers is an essential financial resource that ideally supports the cost of service.

## Rates Support Financial Capacity

- Ensure revenue sufficiency and sustainability
- Reduce the need for external subsidies through grants and loans
- Provide an indicator of credit worthiness and fiscal management

**Notes:**
Rates charged by water systems to their customers are the fundamental means of supporting financial capacity.  
Water rates:
Ensure revenue sufficiency and the system’s sustainability over the long term.
Reduce the need for external subsidies through grants and loans from government sources.
Provide an indicator of the water system’s credit worthiness and fiscal management.

## Pressure on Rates

- Rising costs coupled with:
- Flat or declining demand
- Inefficiency (macro and micro)
- Historic underpricing
- Need to promote conservation

**Notes:**
The upward pressure on water rates, and associated problems of affordability, are aggravated by:
Rising costs (infrastructure investment, compliance with drinking water standards, growth);
Flat or declining demand for water;
Inefficiency (macro and micro);
Historic underpricing by many systems and associated ratemaking practices; and
Need to promote conservation, efficiency, and wise water use.
Cost pressures on small systems are particularly significant.

## Ratemaking

- Ratemaking is the process of allocating revenue requirements to customers via the price of water
- Water systems, regulators, courts, and policy analysts follow several accepted ratemaking principles

**Notes:**
Ratemaking is the process of allocating the water system’s revenue requirements to customers via the price charged for water service.  
Water systems, regulators, courts, and policy analysts follow several accepted ratemaking principles when setting rates for water service. 

## Oversight of Ratemaking

- Varies by type of system and State
- State public utility commissions
- Water system boards of directors
- City councils or other local bodies

**Notes:**
Responsibility for overseeing ratemaking, and the overall financial health of a water system, varies with the type of system and the jurisdiction of the State.
Economic regulators at the state public utility commissions provide oversight for most private or “investor-owned” utilities.
Publicly and privately owned systems may also be accountable to boards of directors.
Oversight for municipal systems often is the responsibility of a city council or other local governing body. 

## Costs and Rates

- Rates ideally reflect the “true” cost of providing water service, which will ensure adequate capacity *and* promote economic efficiency
- Rates must recover costs from water sold (revenue-producing water)

**Notes:**
Water costs and water rates are intrinsically related.
Rates ideally reflect the “true” cost of providing service to ensure adequate capacity and promote economic efficiency.
Rates must recover costs from water that is actually sold (revenue-producing water); the true cost of water and the associated rate impact is measured by dividing all costs by water sold (not water produced).

## What are True Costs?

- For a water utility, true costs include all prudently incurred costs associated with operations and capital investment, including appropriate financing costs, depreciation expenses, and reserves

**Notes:**
True costs include all prudently incurred costs associated with water utility operations and capital investment, including appropriate financing costs, depreciation expenses and reserves.
Economic theory defines true costs in terms of marginal costs, discussed later in this workshop.

## AWWA Policy

***1. Every water utility should receive sufficient revenues from water service and user charges to enable it to finance all operating and maintenance expenses and all capital costs. ***
**2. Water utilities should maintain their funds in separate accounts. Such funds should not be diverted to uses unrelated to water utilities...**
**3. Every water utility should adopt a uniform system of accounts ...**
**4. Water rate schedules should distribute the cost of water service equitably...**

**Notes:**
AWWA’s policy statement on financing and rates (revised January 26, 1992) clearly supports the use of user charges to pay for the total cost of water service.
Water systems, in other words, should be self-sustaining.
The policy states that:
Every water utility should receive sufficient revenues from water service and user charges to enable it to finance all operating and maintenance expenses and all capital costs. 
Water utilities should maintain their funds in separate accounts. Such funds should not be diverted to uses unrelated to water utilities...
Every water utility should adopt a uniform system of accounts ...
Water rate schedules should distribute the cost of water service equitably...

## Pricing at Cost

**Cost/**
**unit**

**Under-pricing**

**Cost-based pricing**

**Over-**
**pricing**

**Price/**
**unit**

**Efficient**
**price**

**Pricing at Cost**

**Notes:**
Economic theory suggests that prices should reflect true costs.
Water systems avoid under-pricing or over-pricing in order to promote economic efficiency.
An efficient price encourages efficiency in production  and consumption.
An efficiency price also promotes sustainability.

## Underpricing

- Rate revenues do not cover revenue requirements
- Underpricing often is associated with underinvestment
- Underpricing induces over-consumption (inefficient use)

**Notes:**
Underpricing is a problem for some--possibly many--water systems.
For systems that underprice, rate revenues do not cover revenue requirements.
Underpricing can be associated with underinvestment, including postponement of essential investments.
Underpricing induces overconsumption, that is, customers will use more water than is economically efficient.

## Overpricing

- The system collects more revenues than requirements justify
- Revenues may be used to subsidize other services or functions
- Price induces under-consumption (inefficient use reduction)

**Notes:**
Overpricing by water systems presents problems as well. 
A system that overprices collects more revenues than requirements justify.
Revenues from overpricing are sometimes used to subsidize other services or functions.
Subsidies from ratepayers are inconsistent with cost-based ratemaking and generally unfair, particularly if customers have not explicitly approved the subsidy.
The higher price induces customers to underconsume, that is, to use less water than is economically efficient.

## Perspectives on Ratemaking

**Notes:**
Perspectives on Ratemaking

## Perspectives on Water Rates

- Water utilities
- Water customers
- Society at large
- Price regulators

**Notes:**
Different stakeholders have different views about the ratemaking processes.
Alternative perspectives of ratemaking come from:
Water utilities;
Water customers;
Society at large; and
Economic regulators. 

## Utility’s Perspective

- Does the rate meet revenue requirements?
- Does the rate provide a fair “rate of return”?
- Is the rate sound for planning and management purposes?

**Notes:**
From the utility’s perspective, ratemaking raises the following key questions:
Does the rate meet revenue requirements?
Does the rate provide a fair “rate of return”?
Is the rate sound for planning and management purposes?

## Customer’s Perspective

- Are the process and the result fair?
- Is the rate structure understandable?
- Is the water bill affordable?

**Notes:**
From the perspective of customers or ratepayers, ratemaking raises the following key questions:
Are the process and the result fair?
Is the rate structure understandable?
Is the water bill affordable?

## Society’s Perspective

- Does the rate structure promote economic efficiency?
- Do rates reflect proper valuation and priority uses?
- Do rates encourage resource preservation?

**Notes:**
From the perspective of society at large, ratemaking raises the following key questions:
Does the rate structure promote economic efficiency?
Do rates reflect proper valuation and priority uses?
Do rates encourage resource preservation?

## Price Regulator’s Perspective

- Do rates balance system and customer interests?
- Is the process in accordance with accepted principles?
- Is the result administratively feasible?

**Notes:**
From the perspective of price regulators, ratemaking raises the following key questions:
Do rates balance system and customer interests?
Is the process in accordance with accepted principles?
Is the result administratively feasible?

## Price Regulation: State PUC Jurisdiction

**Notes:**
Jurisdiction and authority for the water industry varies substantially by state.
Among the States, 45 regulate investor-owned water utilities; 11 regulate municipally owned utilities and 7 regulate water districts (to some degree).  
Jurisdiction for municipal systems often is triggered by the provision of service outside of city boundaries and other conditions.
Jurisdiction for other types of water systems (such as as cooperatives, homeowners’ associations and nonprofits) is limited.  
A total of 28 States have jurisdiction for investor-owned wastewater utilities; jurisdiction for other types varies.
For most jurisdictions, regulators have the authority to review:
Rates or prices;
Profits or returns;
Investment decisions;
Financing decisions;
Service quality; 
Service territory; and
Customer complaints.

## Price Regulation as Substitute

**Public Ownership**

**Regulation**

**Competitive market**

*Competitive municipal contracts*

**Notes:**
Economic regulation substitutes for public ownership and competitive markets.
Regulation prevents abuse of economic power by monopoly service providers with respect to their captive ratepayers (who have no choices with respect to service).
In effect, municipal contracts can circumvent economic regulation.

## Fundamental Principles of Regulation

- Regulation ***in the public interest***
**Prudence **of investments and expenditures
**Used and usefulness** of utility property
**Cost-of-service** basis of rates
**Justness and reasonableness** of rates
**Reasonableness** of the rate of **return** (profit)

**Notes:**
Several basic principles, grounded in tradition, law, accounting, and economics, guide the regulatory process.
An overarching principle is that regulation should be in the public interest, in connection with which a number of other operating principles:
Utility investments and expenditures must be considered by regulators to be prudent;
Utility property must be used and useful in fulfilling the service obligation to customers;
Rates for service should reflect the cost of service;
Rates for service charged to captives should be just and reasonable; and
The rate of return or profit earned by the utility (a monopoly) should be reasonable.

## Small System Regulatory Methods

- Simplified reporting
- Simplified filing
- Simplified proceedings
- Limited or single-issue case
- Operating-ratio method
- Price indexing
- Rate-case assistance
- Exemption and safe harbors

**Notes:**
Economic regulators at the commissions also have devised a number of methods to address the particular circumstances and needs of the small water systems they regulate.
Small system regulatory methods include:
Simplified reporting;
Simplified filing;
Simplified proceedings;
Limited or single-issue case (reduces expense);
Operating-ratio method (alternative for calculating revenue requirements);
Price indexing (automatic adjustments to rates);
Rate-case assistance (direct staff assistance); and
Exemptions and safe harbor (reduced or relaxed regulation based on size thresholds, consumer complaints, or other criteria).

## Cost Accounting

**Notes:**
Cost Knowledge

## Cost Knowledge

- Water systems are not unlike other businesses in terms of cost issues
- Knowing system costs is critical for financial capacity development, particularly revenue sufficiency
- Cost knowledge provides the basis for developing rates

**Notes:**
Water systems are not unlike other businesses in terms of fundamental cost-of-business issues.
Knowing water system costs is critical for financial capacity development, particularly in terms of ensuring revenue sufficiency.
Cost knowledge provides the basis for developing rates.

## Cost Accounting

- A system of accounts is a valuable tool for revenue enhancement, planning, and financial capacity development
- Water utilities should follow generally accepted accounting principles (GAAP)
- Activity-based accounting can be useful

**Notes:**
Cost accounting for water systems is essential.
A system of accounts is a valuable tool for revenue enhancement, planning, and financial capacity development.
Water utilities should follow Generally Accepted Accounting Principles (GAAP).
Activity-based accounting can also be useful for understanding the costs associated with particular functions and actions.

## GASB 34

- GASB is the General Accounting Standards Board
- Rule 34 requires local governments to show how they will maintain their infrastructure investments
- Greater accounting comparability and accountability expected

**Notes:**
GASB is the General Accounting Standards Board.
Rule 34, adopted recently, requires cities to show how they will preserve their infrastructure investments.
According to the rule, "Infrastructure assets that are part of a network or subsystem of a network are not required to be depreciated as long as the government manages those assets using an asset management system that has certain characteristics and the government can document that the assets are being preserved approximately at (or above) a condition level established and disclosed by the government.”
Greater accountability and comparability is expected.
Some expect GASB 34 to stimulate interest in privatization because of its emphasis on asset management expertise.

## Valuation

- A valuation study establishes the value of a water system, including a full accounting of utility plant and other assets
- Understanding value is essential for setting rates
- Plays an important role when water systems are bought and sold

**Notes:**
A valuation study establishes the value of a water system, including a full accounting of utility plant and other assets.
Understanding the utility’s value is essential for setting rates.
Valuation studies play an important role when water systems are bought and sold.

## NARUC System of Accounts

- The NARUC system of accounts is available by system size based on annual operating revenue:
- Class A = > $1 million
- Class B = $200,000 to $1 million
- Class C = < $200,000

**Notes:**
The National Association of Regulatory Utility Commissioners (NARUC) has established a system of accounts for water utilities (revised in 1996).
NARUC commissions regulate almost all private (investor-owned) water utilities, and some publicly owned utilities.
The NARUC system of accounts is available by system size based on annual operating revenue:
Class A = > $1 million
Class B = $200,000 to $1 million
Class C = < $200,000
NARUC also has established a system of accounts for wastewater utilities.

## Basic Accounting System (NARUC)

- Balance-sheet accounts
- Water utility plant accounts
- Income accounts
- Water operating revenue accounts
- Water operation and maintenance expense accounts

**Notes:**
The NARUC system of accounts consists of five interrelated sets of accounts:
Balance-sheet accounts;
Water utility plant accounts;
Income accounts;
Water operating revenue accounts; and
Water operation and maintenance expense accounts.

## Balance Sheet

- Assets and other debts, including utility plant *(see next)*
- Equity (stock)
- Liabilities and other credits
- Accounts payable
- Debt, interest
- Contributions, advances
- Taxes

**Notes:**
The utility’s balance sheet includes represents:
Assets and other debts, including utility plant (detailed in “water utility plant accounts”);
Equity (stock);
Liabilities and other credits;
Accounts payable;
Debt, interest;
Contributions, advances; and
Taxes.

## Balance Sheet Example

- Utility plant in service	$63,800,000
- 	Less accumulated depreciation	($18,600,000)
- 	Plus net adjustments	100,000
- Net utility plant 	45,300,000
- Total other property and investments	200,000
- Total current and accrued assets	2,800,000
**TOTAL ASSETS****	****$48,300,000**
- Total equity capital	24,700,000
- Total long-term debt	13,300,000
- Total current and accrued liabilities 	2,200,000
- Contributions in aid of construction	8,100,000
**TOTAL EQUITY CAPITAL AND LIABILITIES****	****$48,300,000**

**Notes:**
An example of a water utility balance sheet.

## Water Utility Plant Accounts (General)

- Intangible plant
- Source of supply and pumping
- Water treatment
- Transmission and distribution
- General plant

**Notes:**
Utility plant accounts cover the major functional areas of the utility:
Intangible plant;
Source of supply and pumping;
Water treatment;
Transmission and distribution; and
General plant.
The system of accounts actually provides for 28 specific account categories.
For different systems, different cost drivers will be important.

## Income Statement

- Utility operating income
- Revenues *(see next)*
- Expenses *(see next)*
- Other income and deductions
- Taxes applicable to other income and deductions

**Notes:**
The income statement consists of:
Utility operating income;
Revenues (detailed in “water operating revenue accounts”);
Expenses (detailed in “water operation and maintenance expense accounts”);
Other income and deductions; and
Taxes applicable to other income and deductions.

## Income Statement Example

- Operating revenues	$7,800,000
- Operating expenses	5,000,000
- Depreciation expense	1,300,000
- Taxes	300,000
- Utility operating expenses	6,600,000
- Net utility operating income	1,200,000
- Other income	100,000
- Total utility operating income	$1,300,000

**Notes:**
An example of a water utility income statement.

## Water Operating Revenue Accounts

- Metered water revenue by customer class
- Unmetered water revenue by customer class
- Fire protection revenue
- Sales to irrigation customers
- Sales for resale
- Other water revenue

**Notes:**
Water operating revenue accounts include:
Metered water revenue by customer class;
Unmetered water revenue by customer class;
Fire protection revenue;
Sales to irrigation customers;
Sales for resale; and
Other water revenue.

## Water Operations and Maintenance Expense Accounts

- Salaries and wages, pensions, benefits
- Purchased water, purchased power
- Fuel and chemicals
- Materials and supplies
- Contract services
- Rents, transportation, insurance
- Regulatory expenses
- Bad debt
- Miscellaneous

**Notes:**
Water operations and maintenance expense accounts include:
Salaries and wages, pensions, benefits;
Purchased water, purchased power;
Fuel and chemicals;
Materials and supplies;
Contract services;
Rents, transportation, insurance;
Regulatory expenses;
Bad debt; and
Miscellaneous.

## Principles of Ratemaking

**Notes:**
The Ratemaking Process

## Ratemaking and Discretion

**1. Revenue requirement**

**2. Cost allocation **

**3. Rate design**

***Discretion***

***lesser***

***greater***

**Notes:**
In the course of ratemaking, discretion is less for determining revenue requirements (cost), is somewhat greater for cost allocation, and plays a greater role in rate design.
In effect, in other words, the range of choices expands as the ratemaking process proceeds

## Traditional Ratemaking Criteria

**1.****	****Revenue recovery ******** **
**2.****	****Fairness in cost allocation (equity) ******** **
**3.****	****Efficient resource use ******
- 4.	Practicality (understanding, acceptance)
- 5.	Interpretability (noncontroversial)
- 6.	Revenue stability
- 7.	Rate stability
- 8.	Discrimination avoidance

*** **Most important*

**Notes:**
Ratemaking for public utilities has been guided by a set of fundamental evaluation criteria (or goals), identified by regulatory scholar James Bonbright.
These principles are followed in traditional ratemaking for water and other regulated public utilities (such as electric, gas, and telephone companies).
Bonbright identified eight principles:
1.	Does the rate provide adequate revenue recovery ? 
2.	Does the rate promote fairness in cost allocation (equity)? 
3.	Does the rate promote efficient resource use?
4.	Is the rate practical (understanding, acceptance)?
5.	Is the rate easy to interpret (noncontroversial)?
6.	Does the rate provide revenue stability for the utility?
7.	Does the rate provide rate stability for customers? 
Does the rate avoid undue discrimination among customers?
Bonbright’s top criterion—revenue recovery—and others speak directly to capacity development for small water systems.

## Other Potential Evaluation Criteria

- Long-term **sustainability**, investment, and environmental compliance
- Beneficial **restructuring**, including consolidation and regionalization
**Affordability** to customers, particularly low-income households
- Acceptance by stakeholders and institutional (policy) **legitimacy**

**Notes:**
For water systems, some additional ratemaking criteria might be applied:
Does the rate structure encourage long-term sustainability, adequate infrastructure investment, and compliance with all appropriate environmental and other regulations?
Does the rate structure facilitate beneficial industry restructuring of the water industry, including consolidation and regionalization?
Is the rate affordable to customers, particularly low-income households, given the essential nature of water service?
Do water stakeholders and prevailing policymaking institutions support the legitimacy of the rate structure and the policy it reflects?

## Possible Tension Among Criteria

**Notes:**
Potential tension persists even among the traditional evaluation criteria for rates.
Policymakers should recognize these inherent tensions explicitly when designing rates. 
Ultimately, rate design usually involves tradeoffs among competing criteria.

## Affordability as anEvaluation Criterion

- Affordability is **not **among the fundamental evaluation criteria
- The consideration of affordability in ratemaking is always controversial
- Ignoring affordability is increasingly difficult and risky for the utility
- A rate must be affordable to sustain the system

**Notes:**
Affordability is not among the fundamental evaluation criteria.
The consideration of affordability in ratemaking is always controversial.
The essential nature of water services, the pressure on rates from rising costs, and the challenge of building adequate financial capacity make ignoring affordability increasingly difficult and risky for the water utility.
At a basic level, the rate charged to customers must be affordable to customers in order to sustain the system.  

## Rates and Equity

- Horizontal
- Same costs, same rates
- Vertical
- Different costs, different rates
- Intergenerational
- One generation is not forced to subsidize another

**Notes:**
Equity considerations are very important in ratemaking.
Three types of equity are considered:
Horizontal equity
Customers with the essentially the same costs pay the same rates for the same service.  Some degree of cost averaging is always used.
Vertical equity
Customers with substantially different costs pay different rates for the same service.  Often applies to different customer “classes” (residential versus nonresidential).
Intergenerational equity
One generation of customers is not forced to subsidize another generation of customers.  This issue is especially important in the context of long-life capital investment.

## Fairness

- Tension between equity versus efficiency
- Often highly subjective
- Values vary from place to place
- Regulation considers whether rates are just and reasonable
- In practice, rate design is as much art as science

**Notes:**
Ratemaking also raises issues of “fairness.”
A tension often exists between equity and efficiency. 
Ideas about fairness often are highly subjective. 
Perceptions of fairness also vary from place to place: a type of rate considered fair in one community may be considered unfair in another.
Regulators look to whether a rate is “just and reasonable.”
In practice, the process of rate design is as much art as science, in part because of the need to address equity issues.

## Some Fairness Issues in Water Ratemaking

- Spatial differences in costs
- Water needs
- Family size
- Household income
- Value of service

**Notes:**
Several issues in water ratemaking raise issues related to fairness.
These include:
Spatial differences in costs.  Should people who live in different areas served by the system be charged differently based on differences in the cost of service?
Water needs.  Should people who need more water be charged more or less for water service?
Family size.  Should large families receive discounts for water service?
Household income. Should poor households receive discounts for water service?
Value of service.  Should the price of water reflect the value of service to the customer?  For example, should a family living in a more expensive home pay more for water service because of the value of fire protection service?

## The Ratemaking Process

**Notes:**
The Ratemaking Process

## Key Steps in Ratemaking

- Determination of revenue requirements (cost assessment) for a test year
- Allocation of costs to customers based on usage patterns
- Rate design to recover costs through rates and charges

**Notes:**
The ratemaking process consists of three distinct but interrelated steps:
1.	Determination of revenue requirements (cost assessment) for a test year;
2.	Allocation of costs to water customers based on usage patterns and associated functional costs; and
3.	Rate design to recover costs through various rates and charges.

## Utility Revenue Requirements (simplified)

- Annual revenue requirements =
- 	Annualized **capital costs** (including debt and equity costs) + **annual operating expenses** (including operation and maintenance expenses, depreciation, and taxes)

**Notes:**
A water system’s annual revenue requirements consist of:
Annualized capital costs (including debt and equity costs) + 
Annual operating expenses (including operation and maintenance expenses, depreciation, and taxes).

## Fixed v. Variable Costs

- In the short-run, almost all costs (capital and operating) are “fixed” or obligated
*In the long-run, all costs are variable *or subject to change

**Notes:**
Costs also can be distinguished according to whether they are fixed or variable.
In the short-run, almost all costs (capital and operating) are “fixed,” or obligated.  In other words, they must be “covered” by the water system.
In the long-run, all costs are variable, or subject to change.  In other words, water systems can change their cost profile over time.

## Slide 91

**Notes:**
Components of revenue requirements for an investor-owned water utility.
Fixed costs include mostly costs related to capital recovery, including equity return, interest on debt, depreciation, taxes, and other miscellaneous costs. 
Variable costs include certain labor, water, energy, chemicals, and other variable operating costs that vary with production.

## Test Year

- A twelve-month accounting period used to establish revenue requirements
- Data are “normalized” and “known and measurable” costs are considered
- Three types
- Historical (accounting data)
- Future (forecast data)
- Mixed (combined data)

**Notes:**
The test year used for ratemaking purposes is a twelve-month accounting period used to establish revenue requirements.
Data are “normalized” (to account for anomalies in the test year) and “known and measurable” anticipated costs generally are considered for ratemaking purposes.
Reconciliation with actual costs is needed whenever costs are projected for ratemaking to avoid overcharging customers.
Three types:
Historical (accounting data)
Future (forecast data)
Mixed (combined data)
A forward-looking test year can help support the goals of capacity development.

## Cash Needs v. Utility Basis

- Cash-needs basis (public systems)
- Utility-basis (private systems)
- Operating-ratio method (a variant of the utility method for small private systems)

**Notes:**
Three methods are used to assess the utility system’s revenue requirements for the specified test year:
Cash-needs basis (typically used by public or nonprofit water systems);
Utility basis (used by privately owned water systems); and
Operating-ratio method is used in some regulatory jurisdictions for small private systems (a variation of the utility basis).

## Cash Basis v. Utility Basis

|  | Cash Needs | Utility Basis |
| --- | --- | --- |
| Capital-related costs | Capital expenditures (major and recurring)
Debt service on bonds | Depreciation
Return on asset  debt and equity)  |
| Taxes | Payment in lieu of taxes | Taxes |
| Operation and maintenance | Same |  |

**Notes:**
For the cash-needs basis, the major categories of costs are:
Capital-related costs
Operation and maintenance
Payment in lieu of taxes
For the utility basis, the major categories of costs are:
Capital-related costs
Taxes
Operation and maintenance
Note that capital-related costs vary
Depreciation
Return on assets

## Cash Basis (Publicly Owned Systems)

**RR = CC + O&M + PILT**
- where:
- 	RR = revenue requirements
- 	CC = capital-related costs
- 	O&M = operation & maintenance expense
- 	PILT = payments in lieu of taxes

**Notes:**
The cash-needs basis for determining revenue requirements (used by many publicly owned water systems) adds capital-related costs, operation and maintenance expense, and payments in lieu of taxes (if applicable). 
According to the method:
	RR = CC + O&M + PILT
	where:
	CC = capital-related costs
	O&M = operation and maintenance expense
	PILT = payments in lieu of taxes

## Utility Basis(Privately Owned Systems)

**RR = r(RB - d) + O&M + D + T**
- where:
- 	RR = revenue requirements
- 	r = authorized return
- 	RB - d = ratebase less depreciation
- 	O&M = operation & maintenance expense
- 	D = depreciation expense
- 	T = taxes

**Notes:**
The utility basis for determining revenue requirements (used by privately owned systems and some publicly owned systems) provides an authorized rate of return on the utility’s depreciated investment (ratebase), plus expenses for operation and maintenance, depreciation, and taxes.
Utilities and regulators follow a system of accounts and other procedures for determining each of these elements, all of which may be subject to a regulatory deliberation in which various parties participate.
According to the method:
	RR = r(RB - d) + O&M + D + T
	where:
	RR = revenue requirements
	r = authorized return
	RB - d = ratebase less depreciation
	O&M = operation & maintenance expense
	D = depreciation expense
	T = taxes

## Utility Basis (Operating-Ratio Method)

**RR = r(O&M + D) + O&M + T + D**
- where:
- 	(O&M + D) substitutes for RB
- Used for very small water systems with little or no ratebase on which to earn a return

**Notes:**
Some regulatory agencies have used a “operating ratio” method for very small (often privately owned) water systems.
The method was developed because many small systems have little or no ratebase on which to earn a return or profit.
The value of operation and maintenance expenses are used as substitute for the ratebase in the revenue requirements formula.
According to the method:
	RR = r(O&M + D) + O&M + T + D 
	where:
	(O&M + D) substitutes for RB

## Cash-Basis Example (publicly owned system)

- Capital-related costs
- 	Bond debt service	$214,000
- 	Major capital improvements	150,000
- 	Recurring improvements	140,000
- 	*Total capital-related costs*	$504,000
- Operation and maintenance	$259,000
- Payment in lieu of taxes	$189,000
**Total revenue requirement****	****$952,000**

*Source:  Banker (1973)*

**Notes:**
Example of cash basis for determining revenue requirements. 
The major categories of costs are:
Capital-related costs;
Operation and maintenance; and
Payment in lieu of taxes.

## Utility-Basis Example(privately owned system)

- Capital-related costs
- 	Depreciation	$126,000
- 	Return on assets	$378,000
- 	*Total capital-related costs*	$504,000
- Operation and maintenance	$259,000
- Taxes	$189,000
**Total revenue requirement****	****$952,000**

*Source:  Banker (1973)*

**Notes:**
Example of utility basis for determining revenue requirements.
The major categories of costs are:
Capital-related costs;
Operation and maintenance; and
Taxes.
Note that capital-related costs vary:
Depreciation; and
Return on assets.

## Sample Calculation of Ratebase

**Notes:**
A sample calculation of revenue requirements for a regulated water utility.

## Sample Calculation of Revenue Requirements

**Notes:**
A sample calculation of revenue requirements for a regulated water utility.

## Depreciation

- Many systems do not adequately charge for depreciation
- Recognizes the depletion of capital assets over time
- Depreciation expense provides a source of internal cash flow
- Reserves usually are used for reinvestment
- Depreciation studies and guidelines can be helpful

**Notes:**
Because of the capital intensity of the water industry, depreciation is an important concept.
Many water systems do not adequately charge for depreciation or build a depreciation reserve.
Accounting depreciation recognizes the depletion of capital assets over time.
Depreciation expense provides a source of internal cash flow; accelerating depreciation can bring in additional resources but must be done in accordance with accepted practices.
Depreciation reserves generally are used for reinvestment in the water system to maintain its value and service capability; however, a private water utility is not formally obligated to reinvest depreciation expense; however, to maintain its franchise, it must reinvest as necessary to meet its obligation to serve.  
A depreciation study can be helpful to the water system in establishing a schedule for all depreciable assets; alternatively, some systems use a simple composite rate of depreciation (e.g., 2-3 percent).
Some state public utility commissions provide guidelines for depreciation (for example, the Florida Public Service Commission). 

## Reserves

- Water systems can use reserve accounts to fund repairs during emergencies and avoid interruptions of service
- The amount placed in reserve should be based on reasonable planning assumptions
- Regulatory requirements and ratepayer equity are important considerations

**Notes:**
Water utilities can establish reserve accounts. 
Water systems can use reserve accounts to fund repairs during emergencies and avoid interruptions of service.
The amount of funds placed in reserve should be based on reasonable planning assumptions.
Regulatory requirements and ratepayer equity and are important considerations; one generation of ratepayers should not benefit from the reserve to the detriment of another generation of ratepayers.

## Cost Increases and Returns

- An increase in costs will reduce the water utility’s rate of return
- For an investor-owned utility, large amounts of contributed capital will accentuate the effect of cost increases on returns

**Notes:**
For any water system following the utility basis of ratemaking, an increase in costs will reduce the system’s rate of return.
For an investor-owned utility, large amounts of contributed capital will accentuate the effect of cost increases on returns (as illustrated in the following examples).

## Slide 105

**Notes:**
Illustration of the impact of a cost increase on the water utility’s rate of return (courtesy of John Guastella).
The overall rate of return supports the utility’s debt and equity.  
Assumes a debt/equity ratio is 60/40 (thus, the capital structure is $600,000 debt and $400,000 equity.  For overall rate of return, or weighted cost of capital, the calculation is weighted cost of debt of 4.8 percent (60 percent x 8 percent) plus weighted cost of equity of 5.2 percent (40 percent x 13 percent), or 10.0 percent.  The income tax rate is 34 percent income tax rate.  The gross-up calculation is based on the equity return of $52,000 ($400,000 x 13 percent) divided by 0.66 (1 - .34) and multiplied by 34 percent, or $26,788 which I rounded to $27,000.  For the increase, taxes are calculated directly (not grossed up).  The taxable income is calculated by taking revenues of $500,000 less total deductions of $456,300.  The taxable income of $43,700 is multiplied by the 34 percent tax rate to produce $14,900.

## Slide 106

**Notes:**
Illustration of the impact of a cost increase on the water utility’s rate of return with 50 percent contributed capital in ratebase (courtesy of John Guastella).
The overall rate of return and the return on equity are significantly affected by a cost increase when contributions account for a substantial share of the ratebase.
Same assumptions as in previous illustration (except for contributions).

## Methods for Adjusting Rates	

- Periodic rate case or rate review
- Adjustment mechanisms
- Special purpose surcharges
- Rate indexing

**Notes:**
Methods for adjusting rates include:
Periodic rate case or rate review, in which revenue requirements are established for a test year;
Adjustment mechanisms that adjust rates based on changes in major cost categories;
Special purpose surcharges used to finance capital improvement projects; and
Rate indexing to adjust rates periodically based without a comprehensive rate case or rate review.

## Adjustment Mechanisms

**Adjustments to rates without a rate case**
**Unpredictable and substantial, including**
**Purchased water **
**Energy**
**Chemicals**
**Testing fees**
**Taxes**
**Weather (demand repression)**
**Audit and reconciliation procedures**

**Notes:**
Adjustment mechanisms (or adjustment clauses) allow water utilities to change rates as certain types of costs change.
Unpredictable and substantial expenses for which an adjustment mechanism my be useful and appropriate include:
Purchased water; 
Energy;
Chemicals;
Testing fees;
Taxes; and
Weather (demand repression).
Use of an adjustment mechanism usually is conditioned on audit and reconciliation procedures.

## Special-Purpose Surcharges

- Distribution System Improvement Charge
- Quarterly adjustments to rates
- Capped (for example 5 percent of total bill)
- Annual reconciliation audit
- Encourages accelerated replacement
- Less frequent rate cases (reduced expense)
- Addresses rate shock through gradualism

**Notes:**
Special-purpose surcharges include the Distribution System Improvement Charge (DSIC), developed by investor-owned water utilities in Pennsylvania (with the approval of regulators).
The DSIC generally involves:
A quarterly rate adjustment;
A cap (for example, 5 percent of the total bill); and
An annual reconciliation audit.
Benefits of the DSIC include:
Accelerated system remediation;
Less frequent rate cases and reduced expenses; and
Ability to address rate shock through gradualism.

## Rate Indexing

**Notes:**
Once rates are established, based on a thorough review of costs, rate indexing can help avoid a full review of revenue requirements.
Rate indexing ties rate changes to changes in consumer prices (CPI), producer prices (PPI), or some other metric
If well justified by costs, a fixed annual percentage increase may be used.
Indexing simplifies the ratemaking process and reduces administrative and regulatory expenses once the base is established.  
Simplification through indexing may be especially useful for smaller systems.
Indexing can be used in conjunction with incentive regulation for larger systems.  Price caps (used in Great Britain) often include an indexing feature.
Indexing can present a problem if true and unavoidable costs exceed the rate of inflation based on the specified index.

## Rate Changes and Water Usage (Price Elasticity)

- Water use in general is relatively price inelastic
- Indoor use is less price responsive  than outdoor use
- Residential use is less price responsive than nonresidential use
- Even small price responses can be meaningful
- “Demand repression” adjustments account for changes in usage caused by changes in price or other factors

**Notes:**
Water use in general is relatively price inelastic; that is changes in price do not induce big changes in water usage.
Indoor use is less price responsive than outdoor use.
Residential use is less price responsive than nonresidential use.
However, even small price responses can be meaningful in terms of water utility revenues.
“Demand repression” adjustments account for changes in usage caused by changes in price or other factors.

## Cost Allocation

**Notes:**
Cost Allocation

## From Costs to Rates

**Revenue**
** ****requirements**

**Cost**
**allocation**

**Rates**

**Notes:**
Cost allocation translates revenue requirements (costs) to rates.

## Cost Allocation

- Revenue requirements are allocated to classes of customers based on their use of water system facilities
- Costs are allocated to *revenue-producing water *that is sold to customers
- A degree of cost averaging is required
- Various methods are available
- Cost-of-service studies are used

**Notes:**
Specifically, cost allocation is the process of allocating revenue requirements to classes (groups) of customers based on their estimated use of water system facilities.
Revenue-producing water is water that is produced and sold to customers
Some degree of cost averaging is required for all ratemaking (rates are not “individualized” except under special circumstances).
Various methods are available for allocating costs.
Cost-of-service studies are very useful for the process of cost allocation.

## Cost-of-Service Study

- Supports the process of determining and allocating the cost of providing water service
- Assess costs by function
- Allocate costs to customers
- Design water rates and charges

**Notes:**
A cost-of-service study supports the process of determining and allocating the cost of providing water service.
A cost-of-service study involves:
Assessing costs by function (source, treatment, distribution, services);
Allocating costs to customers by pattern of usage; and
Designing water rates and charges to collect revenue requirements.

## Steps in Cost Allocation

- Functionalization
- Classification
- Allocation by usage
- Assignment to classes
- Design of rates and charges

**Notes:**
Cost allocation consists of several distinct but interrelated steps:
Functionalization of cost (e.g., source, treatment, transmission).
Classification of costs (customer, capacity, commodity).
Allocation of costs according to types of usage.
Assignment of costs to water users (residential, nonresidential).
Design of rate and charges (tariffs).

## Cost Functionalization

- Source of supply
- Water treatment
- Transmission and distribution
- Customer services
- Administration

**Notes:**
Water system costs can be separated into functional categories:
Source of supply;
Water treatment;
Transmission and distribution;
Customer services; and
Administration.
Cost functionalization is useful both for understanding and estimating revenue requirements and for cost allocation (because different types of water usage are associated with different water supply facilities).

## Water Plant and Demand

**Average-day** demand  source-of-supply facilities, including raw water storage (such as reservoirs)
**Maximum-day** (peak) demand  treatment plants and major transmission lines
**Maximum-hour** demand (maximum-day demand plus fire-flow requirements)   treated water storage, distribution mains, pumping stations

**Notes:**
Different types of water demand are associated with different types of facilities:
Average-day demand  source-of-supply facilities, including raw water storage (such as reservoirs).
Maximum-day (peak) demand  treatment plants and major transmission lines.
Maximum-hour demand (maximum-day demand plus fire-flow requirements)   treated water storage, distribution mains, pumping stations.

## Cost Classification

- Customer costs
- Do not vary with usage
- Commodity costs
- Vary with usage
- Capacity costs
- Vary with aggregate usage over time

**Notes:**
Cost classification is the process of separating three types of costs:
Customer costs that do not vary with usage; 
Commodity costs that vary with usage; and
Capacity costs that vary with aggregate usage over time.
Separate charges for customers can be developed for each of these types of costs, although most water systems use a simple two-part rate with a customer charge and a commodity charge (capacity costs are included in these charges).

## Methods of Cost Allocation

- Functional or average use
- Peak responsibility
- Commodity-demand
- Base-extra capacity or average-excess
- Embedded-direct
- Fully-distributed
- Marginal-cost

**Notes:**
Cost allocation methods are used to assign the various types of costs to customers according to patterns of usage.
Methods used in cost allocation include:
Functional or average use;
Peak responsibility (coincident and noncoincident);
Commodity-demand;
Base-extra capacity or average-excess;
Embedded-direct;
Fully-distributed; and
Marginal-cost.

## Customer Classes 

**Residential**
- Single family
- Multi-family

**Nonresidential**
- Industrial
- Commercial
- Wholesale
- Public authorities
- Fire protection

**Notes:**
Water-system customers can be separated into classes:
Residential
Single family
Multi-family
Nonresidential
Industrial
Commercial
Wholesale
Public authorities
Fire protection (public and private)
Many small water systems serve only residential customers.
A simple two-class system (residential and nonresidential) also is used by many systems.

## Median Percentage of Residential Customers

_**Population**_
**< 100****	**
**100 – 500**
**500 – 1,000**
**1,000 – 3,300**
**3,300 – 10,000**
**10,000 – 50,000**
**50,000 – 100,000**
**> 100,000**

_**Median**_
**100 percent**
**98**
**90**
**75**
**69**
**63**
**60**
**55**

*Median for publicly owned systems*

**Notes:**
For most water utilities, the majority of water sales are to residential customers.
Most very small water systems (<500 population) sell all of their water to residential customers. 
The larger the system, the greater the percentage of sales to the nonresidential sector.
The same basic pattern holds for both publicly and privately owned water systems.

## Customer Distribution

- 0

- 20

- 40

- 60

- 80

- 100

- 0

- 25

- 50

- 75

- 100

- 125

- 150

- 175

- More

**CCF**

**Frequency**

***Annual total***

**Notes:**
Example of a customer distribution based on customer billing data.
Most customers will fall within an expected range of typical water usage.
A customer-bill or customer-impact analysis is used to assess the distribution of water consumption across the customer base. 
The results of the bill analysis are used to assess how costs can be recovered through variable charges under alternative rate-design scenarios.
A bill analysis also can be used to predict how total water bills and water usage might change with changes in rates (impact analysis)

## Cost Assignment:The Water Bill

- Fixed charges
- Variable charges
- Other charges
- Information for customers

**Notes:**
The typical water bill consists of:
Fixed charges (that do not vary with water usage);
The fixed charge may also cover a water allowance or first block of usage but practices vary widely (sometimes the water included in the fixed charge is incorrectly called “free water”);
Variable charges (that vary with water usage based on per-unit price);
Other charges (such as surcharges and penalties); and
Information for customers (e.g., water quality, conservation).

## Slide 125

**Notes:**
A sample water bill.

## Fixed Versus Variable Charges

- Do *not *necessarily correspond to fixed and variable costs
- Recovering more costs through fixed charges enhances revenue stability but can cause affordability concerns
- Recovering more costs through  variable charges can promote conservation and efficiency, but increase revenue instability

**Notes:**
Fixed and variable charges that appear on the water bill do not necessarily correspond to fixed and variable costs.
Many water utilities do not try to collect all of their fixed costs through fixed charges.
Some water utilities, for example, impose no fixed charges.
Recovering more costs through fixed charges enhances revenue stability but can cause affordability concerns.
Recovering more costs through variable charges can promote conservation and efficiency, but can add to revenue instability due to variations in usage (including weather-related variations).
The variable charge may or may not include a water allowance.  

## Rates Design Options for $20

**Notes:**
This illustration shows the variety of rate design options that might be used to collect a $20 monthly bill from customers, based on an assumption of 5,000 gallons of usage.
The five examples are:
All fixed
$10 fixed plus $2 per 1,000 gallons
$5 fixed plus $3 per 1,000 gallons
$4 fixed including 1,000 gallon allowance plus $4 per 1,000 gallons
All variable at $4 per 1,000 gallons

## Simplified Illustration for Small System

- Revenue requirement	$36,000
- Customers	200
- Total usage	12 mil. gallons
- Average customer usage	5,000 gal. per mo.
- Fixed charge
- $5 per customer per month	$12,000
- Variable charge
- $2 per 1,000 gallons	$24,000

**Notes:**
A highly simplified illustration of ratemaking for a small water system serving 200 customers.
The revenue requirement should include all appropriate costs for the test year.
Together, the fixed and variable charges recover the total revenue requirement.
In reality, the allocation of costs requires a method for determining fixed and variable charges and allocating costs across more complex patterns of usage.

## Metering and Billing

- Most systems meter and bill quarterly or monthly
- Administrative costs are a consideration
- Metering is considered essential for sound ratemaking

**Notes:**
Most water systems read meters and bill customers on a monthly or quarterly basis.
Administrative costs to the system are a consideration.
Water usage can be estimated in between meter readings, but actual and estimated usage must be reconciled.
While many smaller systems do not meter, metering is considered essential for sound ratemaking (where variable charges are used to enhance the price signal to customers).

## Submetering

- Can be used for condominiums, apartments, mobile home parks
- May create a new water system and raise capacity issues
- May be cost effective and induce conservation under some circumstances
- Shifts incentives from landlords to tenants
- May create affordability problems for low-income renters

**Notes:**
Submetering involves putting separate meters on properties or units otherwise served by a master meter.
Submetering:
Can be used for condominiums, apartments, mobile home parks;
May create a new water system and raise capacity issues;
May be cost effective and induce conservation under some circumstances;
Shifts incentives from landlords to tenants; and
May create affordability problems for low-income renters.

## Types of Water Rate Structures

**Notes:**
Types of Rate Water Structures

## Rate Design

- Ratemaking is the process of allocating revenue requirements to customers through the price of water
- Water systems, regulators, courts, and policy analysts follow several accepted ratemaking principles

**Notes:**
Rate design is the process of allocating the water system’s revenue requirements to customers through the price charged for water service.  
Water systems, regulators, courts, and policy analysts follow several accepted ratemaking principles when setting rates for water service. 

## Evolution of Rate Design

- Unmetered rates
- Metered rates
- Alternative rates
- Complex rates
- Other charges

**Notes:**
Water rates have evolved over the years as technologies and policies have changed: 
Unmetered rates
Metered rates
Alternative rates
Complex
Other charges

## Unmetered Rates

- Flat fees
- Fixture rates (proxy for use)

**Notes:**
Two types of unmetered water rates are:
Flat fees that do not vary by customer characteristic or water usage; and
Fixture rates, which provided a crude proxy for water use based on the number of kitchen, bathroom, and other water-using fixtures on the customer’s premises.

## Metered Rates

- Metering is essential for **volumetric** rates
- Meter accuracy is important
- More frequent metering and billing improve the rate signal and encourage efficient use
- Metering can induce a short-term reduction in usage

**Notes:**
Most larger water systems charge rates that are based on the metered quantity of water delivered to the customer.
Metering is essential for volumetric or usage-based rates.
Meter accuracy (and reconciliation with estimated usage) is important to the integrity of the ratemaking process. 
More frequent metering and billing improve the rate signal and encourage efficient water use.
Changing from unmetered to metered rates can cause a short-term reduction in usage (an “elasticity effect”) -- as much as 25 percent, but usage may increase over time.

## Cost of Metering

- Can be a problem for many small systems
- Costs can be mitigated by
- Bulk purchasing
- Grants and loans
- Customer funding (special charges)
- Efficiency gains (reductions in usage)

**Notes:**
The cost of metering can be a problem for many small water systems.
The cost of purchasing and installing meters can be offset by:
Bulk purchasing;
Grants and loans;
Customer funding (special charges); and
Efficiency gains (reductions in usage).

## Other Charges

- Adjustments
- Special-purpose surcharges
- System-development charges
- Penalties and fees
- Direct charges

**Notes:**
Other types of charges that water systems sometimes use include:
Adjustments (based on adjustment mechanisms)
Special-purpose surcharges (including system improvement charges and support for programs);
System-development charges (charged to new customers and pay for growth-related costs);
Penalties and fees (for late payments and other purposes); and
Direct charges (to recover the actual cost of special services, such as repairs or extensions).

## Basic Rate-Design Options

- Uniform (uniform volume)
- Uniform by customer class
- Decreasing-block (declining)
- Increasing-block (inclining)
- Seasonal (peak management)
- Variations and combinations

**Notes:**
The basic options for recovering costs on a variable (metered volumetric) basis are:
Uniform rates (uniform volume);
Uniform rates by customer class;
Decreasing-block rates (declining);
Increasing-block rates (inclining);	
Seasonal rates (peak management); and
Variations and combinations of different types of rates.

## Water Rate Design in the U.S. (2000)

**Uniform rate:  36 percent**

**Increasing-block rate:  29 percent**

**Decreasing-block rate:  36 percent**

**Notes:**
In the United States, the three prevailing methods of rate design are uniform rates (used by 36 percent of systems surveyed), increasing-block rates (29 percent of systems), and decreasing-block rates (35 percent of systems).  (Raftelis 2000)
Given the rising marginal cost of water, the rationale for providing decreasing-block rates has declined.
Uniform and increasing-block rates, along with seasonal, excess-use, and other types of rates, are considered more conservation-oriented.
EPA data from the 1995 Community Water System Survey (a broader sample) indicate that about half of all water systems use a uniform rate; many systems use more than one type of rate.

## Uniform Rate

**Price/**
**unit**

**Quantity consumed**

**Notes:**
A uniform rate charges the same price per unit (for example, $2.50 per 1,000 gallons) for water usage beyond that include the the fixed customer charge. 
The total water bill still varies by the amount of water used.
The customer usually will also pay a fixed monthly (or quarterly) customer charge to cover some fixed costs.  Some water usage may be included in the customer charge. 
The form is administratively simple and sends a price signal because the water bill will vary by usage.

## Uniform Rate by Class

**Price/**
**unit**

**Quantity consumed**

**Large-volume customer**

**Notes:**
A uniform rate by class charges the same price per unit for all customers within a customer class (such as residential and nonresidential). 
Sometimes a uniform rate by class is implemented with a decreasing-block rate where all customers in a class fall within a block of usage (see discussion of decreasing-block rate). 
Fine tunes the uniform rate recognizing cost differences among classes.

## Decreasing-Block Rate

**Price/**
**unit**

**Quantity consumed**

**Tier**

**Tier breakpoint**

**Notes:**
A decreasing-block rate charges a lower price per-unit for successive blocks of water usage or “tiers.”
Different rates are associated with different tiers, defined by tier breakpoints. 
The quantity of usage within each block or tier is charged at the rate for that block or tier.
The rate enhances revenue stability, by recovering costs in early blocks, but appears to discount later blocks, and is generally not considered consistent with conservation goals.

## Increasing-Block Rate

**Price/**
**unit**

**Quantity consumed**

**Tier**

**Tier breakpoint**

**Notes:**
A increasing-block rate charges a higher price per-unit for successive blocks of water usage or “tiers.”
It recovers costs from successive blocks and can introduce a degree of revenue instability.  
The rate is considered a conservation-oriented rate and useful for load management.

## Seasonal Rate

**Price/**
**unit**

**Quantity consumed**

**Peak season**

**Off-peak season**

**Notes:**
Seasonal rates charge different per-unit prices for water usage during peak and off-peak seasons.
Peak-water usage is a key driver of many types of costs.
The higher peak season rate allocates a greater share of costs to peak season users and can encourage more efficient water use and conservation.

## Rationale for Seasonal Rates

**Total usage**

**Year**

**Base**

**Seasonal**

**Notes:**
Suppressing peak water usage through rates and other management techniques, allocative efficiency is improved and some capital and operating costs can be avoided. 

## Alternative Rates

- Spatially differentiated (zonal or district)
- Single-tariff (consolidated rates)
- Budget billing
- Lifeline rates
- Excess-capacity
- Economic development

- Negotiated rates
- Flexible rates
- Drought rates
- Excess-use (budget)
- Value-of-service pricing
- Quality differentiated (treatment, reliability)
- Interruptible (curtailment)
- Stand-by rates

**Notes:**
Water systems also use a variety of alternative rates to a limited degree, including:
Spatially differentiated (zonal or district according to cost differences);
Single-tariff pricing (consolidated, regional, or equalized rates);
Budget billing (equalized payments);
Lifeline rates (first block priced affordably, often below marginal cost);
Excess-capacity rates (discounts water);
Economic-development rates (price breaks for economic activity);
Negotiated rates (for large-volume users);
Flexible rates (for large-volume users);
Drought rates (during water shortages);
Excess-use (based on an allowable water budget per customer);
Value-of-service pricing (can be based on property value);
Quality differentiated (level of treatment or reliability);
Interruptible (or curtailment rates for large-volume users); and
Stand-by rates (for self-supply customers). 
Most of these rate structures are used by larger water systems and many are designed specifically for large-volume customers.

## Complex Rates

- Excess-use or water-budget rate
- Marginal-cost pricing
- Multi-tiered rates

**Notes:**
Complex rate structures include:
Excess-use or water-budget rate;
Marginal-cost pricing; and
Multi-tiered rates.

## Excess-Use andWater-Budget Based

**Price/**
**unit**

**Quantity consumed**

**Excess use/use above budget allotment**

**Notes:**
An excess-use rate assigns a substantially higher price for usage considered in excess of budgeted or estimated need. 
Various methods and formulas are used to estimate base and excess amounts.

## What is Marginal-Cost Pricing?

- Economic theory emphasizes marginal-cost pricing, which sets prices equal to the marginal cost of production
- The marginal cost is the cost of next unit of production
- Example:  the value of gasoline you use in your car is not what you last paid to fill it but what you will pay to refill it

**Notes:**
Economic theory emphasizes marginal-cost pricing, which sets prices equal to the marginal cost of production.
The marginal cost is the cost of next unit of production.
An example can help illustrate the concept of marginal-cost pricing:  the value of gasoline you use in your car is not what you last paid to fill it but what you will pay to refill it.

## Marginal-Cost Pricing

**Price/**
**unit**

**Quantity consumed**

**S1**

**S3**

**S2**

**S = supply option**

**Notes:**
Marginal-cost rates are favored by economists because they improve the economic efficiency of the rate signal.
A price based on marginal costs reflects the cost of providing the next unit of water to customers.
One very rough approximation method is to set rate tiers based on the costs associated with incremental additions to water supply capacity based on the available options.
Each successive water supply option is more costly, as reflected in the rates.  
For example:
Alternative conventional supply (S1)
Imported water (S2)
Desalination (S3)

## Exercise

- What should be included in the marginal cost of drinking water?

**Notes:**
The purpose of this exercise is to explore the concept of marginal-cost pricing.
What should be included in the marginal-cost of water?

## Multi-Tiered Rate (L.A.)

**Multi-Tiered Rate (L.A.)**

**Notes:**
Illustration of City of Los Angeles water rates.
The rate is a complex, two-tier increasing-block seasonal rate.
The second tier is based on the marginal cost of reclaimed water, varies by season.
For residential customers, the tier breakpoint is based on:
Lot size (five categories);
Temperature zone (three zones); and
Household size (sliding scale for households with up to 13 members).
Nonresidential customers with high seasonal variations can apply to have 95 percent of their usage in peak period billed at the first-tier rate

## Rates and Affordability

**Notes:**
Rates and Affordability

## Pricing and Affordability

*Low enough to be affordable to customers so that the system can be supported over time*

*High enough to cover the cost of service and send efficient price signals to guide consumption and production decisions*

**Price/**
**unit**

**Notes:**
The price of water must be:
Low enough to be affordable to customers so that the system will have adequate capacity and can be sustainable over time; and
High enough to cover the cost of service and send efficient price signals to guide consumption and production decisions.

## Affordability

- Increasing problem as costs rise and subsidies decline
- The *reluctance* to pay is not the same as the *inability* to pay
- Affects eligibility for variances
- Small systems are constrained in terms of affordable solutions
- May require intervention or structural change

**Notes:**
Water affordability is an increasing problem for water systems as costs rise and available subsidies decline.
The reluctance to pay (or complaining about rising bills) is not the same as the inability to pay
Affordability can affect whether a water system is eligible for a variance and therefore the quality of water people receive.
Small water systems are constrained in terms of solutions because of their small customer base and associated lack of diversity.
Addressing small system affordability may require intervention by the State (including special assistance or incentives) or structural solutions (including reorganization, partnerships, or consolidation).

## Consumer Price Index (1982 to 1984 = 100)

**Consumer Price Index ****(1982 to 1984 = 100)**

- 0.0

- 50.0

- 100.0

- 150.0

- 200.0

- 250.0

- 1970

- 1972

- 1974

- 1976

- 1978

- 1980

- 1982

- 1984

- 1986

- 1988

- 1990

- 1992

- 1994

- 1996

- 1998

- 2000

- Garbage collection

- Cable television

**Water/sewer**

**maintenance**

- Local telephone

- service

- All items

- Electricity

- Natural gas

- Interstate

- telephone service

**Notes:**
Consumer price index (CPI) data indicate that since the middle 1980s, water rates have increased at a pace greater than the general rate of inflation or the rate of increase for most other utility service (energy and telecommunications).

## Consumer Utility Expenditures (1999)

**Natural gas and **

**fuel oil ($420)**

**14%, .9%**

**Telephone **

**($1,050)**

**35%, 2.1%**

**Electricity **

**($1,162)**

**38%, 2.4%**

**Water & public **

**services ($385)**

**13%, .8%**

***Four-person household ***
*** ******percent of utilities,  percent of expenditures***

**Notes:**
Water and other public services (sewer and solid waste) account for a relatively small share of the household utility budget ($385 annually, less than .8 percent of total expenditures), particularly in comparison to electricity and telecommunications.
These estimates, which come from the Consumer Expenditure Survey, may underestimate the magnitude of typical water bills because expenditures for households that do not pay directly for water service (such as many renters) are counted as “zero.”
Also, averages mask relevant variations and actual expenditures are affected by many factors. 

## Sample Monthly Water Bills

**Sample Monthly Water Bills**

**$15.27**

**$16.50**

**$18.21**

**$17.06**

**$14.85**

**$14.37**

**$17.74**

**$15.48**

- $0

- $2

- $4

- $6

- $8

- $10

- $12

- $14

- $16

- $18

- $20

- Group A (42)

- Group B (55)

- Group C (78)

- All Systems

- (175)

- Average

- Median

**Notes:**
Based on a recent survey, monthly household water bills for consuming 1,000 cubic feet (7,480 gallons) average about $17 (Raftelis 2000). 
Households served by larger systems pay less for water than households served by smaller water systems, which is likely due to both economies of scale and other factors.

## Utility Expenditures as a Percentage of Income (1999)

**Utility Expenditures as a Percentage of Income (1999)**

- 0.00 %

- 2.00 %

- 4.00 %

- 6.00 %

- 8.00 %

- 10.00 %

- 12.00 %

- 14.00 %

- 16.00 %

- 18.00 %

- 20.00 %

- $5, to $9,999

- $10,000 to

- $14,999

- $15,000 to

- $19,000

- $20,000 to

- $29,000

- $30,000 to

- $39,000

- $40,000 to

- $49,000

- $50,000 to

- $69,000

- $70,000 and

- over

- Income

- Percentage of expenditures

**Utilities**

**Water and **
**other public**
**services**

**Notes:**
Utility services have a regressive impact on households in terms of income.
At lower levels of income, expenditures take a greater share of total household expenditures.
At higher income levels, more water use is discretionary (that is, used outdoors for irrigation, car washing, swimming pools, etc.).

## Exercise	

- How much can people afford to pay for water service?
- How much can people afford to pay for water and wastewater service?
- How should water affordability issues be addressed?

**Notes:**
This exercise considers affordability thresholds for water service.

## Measuring Affordability

**Household-level measures:**  Water bill relative to income
**System-level measures:**  Financial condition of utility
**Demographic measures:**  Poverty, unemployment, eligibility for assistance
**Community measures:**  Fiscal health of local government

**Notes:**
Several measures are used to assess water affordability and potential affordability problems.
The leading measures of affordability include:
Household-level measures:  Water bill relative to income.
System-level measures:  Financial condition of utility.
Demographic measures:  Poverty, unemployment, eligibility for assistance.
Community measures:  Fiscal health of local government.
All of these present useful information for understanding affordability.
Most programs and policy focus much attention on household-level measures.

## Affordability Threshold

- The percentage of median income that households can afford to pay to the water system through user charges as determined by policymakers

**Notes:**
An affordability threshold is the percentage of median income that households can afford to pay to the water system through user charges as determined by policymakers.
The threshold may consider water charges alone or the combined effect of water and wastewater charges.
Specifying a threshold can be controversial.
A general threshold may be inappropriate for a particular population.
Thresholds or other eligibility criteria can be adopted from other programs.  
Customers having difficulty paying their water bills are probably having other affordability problems as well.

## Annual Water Bills at Alternative Incomes and Affordability Thresholds

**$0**

**$100**

**$200**

**$300**

**$400**

**$500**

**$600**

**$700**

**$800**

**$27,000**

**$30,000**

**$33,000**

**Annual Household Income**

**3.00 %**

**2.50 %**

**2.00 %**

**1.50 %**

**Baseline (.7 %)**

**Notes:**
A baseline level of household expenditures can be compared to alternative affordability thresholds.
The difference between the baseline expenditure level and the affordability threshold is the expenditure margin that is theoretically available to support improvements to the water system.

## Thresholds and Margins

- Time

- Cost of water service

***Costs with efficiency improvements***

***Baseline costs***

*Expenditure margin for improvements*

- Affordable threshold

**Notes:**
In this example, efficiency gains would help keep the cost of service below the affordability threshold for a service territory, postponing the time point at which rates might become unaffordable (crossing the threshold).
Efficiency gains can delay the point at which the threshold is reached and rates are considered unaffordable.
Thresholds are a useful tool for analysis, but they are not without problems:
The threshold level can seem arbitrary and potentially capricious.
Thresholds are based on means or medians and may mask important variations.
Thresholds do not consider the worst-case scenario.
Thresholds can cause a subsidy from the near-poor to the barely poor (for example, a using a 2 percent threshold, the 1.99 percent family will subsidize the 2.01 percent family).
Family size and other demographics and circumstances affect actual affordability.
The use of a threshold for variances could create a two-class system for drinking water quality.

## Pressure on Rates

- Rising costs coupled with:
- Flat or declining demand
- Inefficiency (macro and micro)
- Historic underpricing
- Need to promote conservation

**Notes:**
The upward pressure on water rates, and associated problems of affordability, are aggravated by:
Rising costs (infrastructure investment, compliance with drinking water standards, growth);
Flat or declining demand for water;
Inefficiency (macro and micro;)
Historic underpricing by many systems and associated ratemaking practices; and
Need to promote efficient water use.
Cost pressures on small systems are particularly significant.

## Recipe for Trouble

- Rising costs + flat or falling demand = higher water rates

**Notes:**
Particularly problematic for water systems is the combination of rising costs and flat or falling demand, which limits the production quantity over which costs can be spread.
Many water systems will need to raise rates to cover costs.
Rate shock is the repression of demand that can result from sharp rate increases.

## Affordability of Water Service

- Water affordability is a function of:
- Customer’s ability to pay *and*
- The water bill, *a function of*
- Water usage *and*
- Water rate, *a function of**	*
- The cost of service
- The rate structure

**Notes:**
The affordability of water service is a function of the water bill and the customer’s ability to pay.
Each of these in turn can be separated into the several factors affecting the affordability of water service:
Affordability is a function of the water bill and the customer’s ability to pay.
Ability to pay is a function of socioeconomic conditions, income assistance, total nondiscretionary obligations.
Water bill is a function of water rate and water usage.
Water rate is a function of cost of water service and rate structure.
Cost of service is a function of capital and operating costs. 
Rate structure is a function of cost allocation, rate design, and billing structure.

## Ability-to-Pay Problems

- Evidence to utilities
- Late payments
- Uncollectible accounts
- Service disconnections
- Low-income and fixed income consumer advocacy on the rise
- Ignoring affordability can be costly

**Notes:**
Utilities see evidence of ability-to-pay problems in a number of areas:
Late payments;
Uncollectible accounts ; and	
Service disconnections.
Low-income and fixed income consumer advocacy also is on the rise.
Ignoring affordability can be costly to the utility and its customers.

## Affordability Strategies

- Non-rate strategies
- Direct payment assistance to households
- Internal subsidies (voluntary contributions)
- External subsidies (other agencies)
- Targeted conservation
- Flow restriction (very limited use)

**Notes:**
Strategies for addressing affordability include nonrate and rate-design strategies.
Non-rate strategies include:
Direct payment assistance to households;
Funded with internal subsidies (voluntary contributions); or
Funded with external subsidies (other agencies);
Targeted conservation; and
Flow restriction (very limited use).
Non-rate strategies can help avoid or reduce the need for subsidization through rates charged for water service.

## Affordability Strategies

- Rate-design strategies
- Monthly billing cycle
- Low or zero fixed charge
- Peak-period pricing
- Rate discounts and waivers
- Low first-tier price (all customers)
- Lifeline rate (eligible customers)
- Consolidated rates
- Prepaid water service

**Notes:**
Rate-design strategies involve to the utility’s tariff and include:
Monthly billing cycle (improves manageability)
Low or zero fixed charge
Peak-period pricing 
Rate discounts and waivers
Low first-tier price (all customers)
Lifeline rate (eligible customers)
Consolidated rates
Prepaid water service (as in prepaid cellular, limited use)
Discretion in rate design can be used to address affordability for some households, if the customer base is larger and diverse.
When addressing affordability, total revenue requirements ideally should be provided by the customer base (that is, minimal system subsidies).
All rates should not be suppressed in the interest of perceived “affordability” issues (the reluctance to pay and the willingness to charge problems).

## Lifeline Rate

**Price/**
**unit**

**Quantity consumed**

**Marginal cost**

**Notes:**
A lifeline rate provides a subsidy to low-income customers who meet specified program criteria.
The first block of water usage, generally considered “essential” usage, is priced below the marginal cost of water service.  The rate may be available to all customers or only to eligible customers (usually based on their eligibility for other forms of assistance).
The difference required to fund the subsidy is recovered in subsequent blocks.
A lifeline rate closely resembles some conservation-oriented rates.

## Consolidated Rates*

- $A

- $C

- $D

- $E

- $B

- * Single-tariff pricing

**Notes:**
A consolidated rate (or single-tariff pricing) averages the cost of service across multiple water systems owned and operated by the same utility, regardless of differences in stand-alone costs.
This approach has been advanced by several larger investor-owned water utilities in the United States and is also implemented throughout Great Britain by the large, privately owned water utilities.
Consolidated rates can potentially be used by any multi-system water utility.
The systems are commonly owned and managed but may or may not be interconnected.
Consolidated pricing provides rate and revenue stability, administrative simplicity, equity across all customers served by the utility, and improved affordability for customers in high-cost areas (often served by smaller systems).  
Rate consolidation sacrifices a degree of economic efficiency for achieving these goals.

## Illustration of Consolidated Rate

- $0

- $200

- $400

- $600

- $800

- $1,000

- $1,200

- System A (78)

- System B (62)

- System C (50)

- System D (29)

- System E (99)

- System F (458)

- System G (36)

- System H (88)

- System I (102)

- System J (75)

- System K (63)

- Core system (18,273)

- Community (population served)

- Annual Water Bill

**Current rate**

**Stand-alone rate**

**Consolidated rate**

**Notes:**
An example where current rates are compared to rates based on the stand-alone cost of service and consolidated rates.
The consolidated rate improves affordability for the smaller, high-cost systems in managed by the utility.
The state public utility commissions have supported the use of single-tariff pricing by multi-system investor-owned water utilities, in part to encourage consolidation, although controversy over this ratemaking method persists.
Because all ratemaking involves some degree of averaging, a considerable degree of judgment is involved in the allocation and sharing of costs.
When cost sharing becomes subsidization is especially subjective and controversial. 

## Sustainable Systems

**Water  system customers**

**External agencies**

***Cost-based rates for service***

***Tax revenues, grants, and other subsidies***

**Sustainable Systems**

**Notes:**
A sustainable water system relies, for the most part, on cost-based rates for water service.
Both operating and capital costs are recovered through rates charged to water customers, which improves efficiency.
Tax revenues, grants, and other subsidies are minimal and temporary, so that the system is self-sustaining in the long term.
Subsides in the forms of grants or low-cost loans may be needed on a limited basis to help water systems make the transition to sustainability and address serious affordability concerns.
Subsidies can be provided in accordance with an assessment of affordability (ability to pay).
In the absence of subsidies, service abandonment is possible.  In this case, customers would be forced to self supply or relocate.

## Designing Water Rates

**Notes:**
Designing Water Rates

## Goals and Values

- All ratemaking involves some averaging
- Many rate options can fulfill the water utility’s revenue requirements
- Utility choices will tend to reflect value preferences and weights
- Values can play a role in the broad context of ratemaking

**Notes:**
All ratemaking involves some averaging; that is, unique rates are not established for individual water users (except for some large-volume users).
Many alternative methods of cost allocation and rate design can fulfill the water utility’s revenue requirements.
The utility exercises a considerable degree of discretion in this area, which will tend to reflect value preferences and weights.
Values can play a role in the broad context of ratemaking as long as the departure from basic principles is explicit and reasonable.

## Goal Orientation of Different Rates

_**Rate**_**	**_**Goal**_
- Uniform	Simplicity
- Block, seasonal 	Load management
- Lifeline 	Affordability
- Marginal cost 	Efficiency
- Penalties 	Conservation
- Zonal 	Spatial cost allocation
- Single-tariff 	Regionalization
- Negotiated 	Development, retention, competition

**Notes:**
Different types of rate structures help water systems achieve different types of goals.
For example (generally):
Uniform rates accomplish simplicity;
Block and seasonal rates promote load management;
Lifeline rates improve affordability;
Marginal-cost pricing encourages efficiency;
Penalties can induce conservation;
Zonal rates achieve spatial cost allocation;
Single-tariff pricing promotes regionalization; and
Negotiated rates address economic development, customer retention, and (sometimes) competition.

## Multi-Objective Ratemaking

- Incorporate and balance multiple goals and values
- Recognize tradeoffs among competing objectives
- Attempt to optimize based on identified evaluation criteria

**Notes:**
In reality, ratemaking often involves multiple goals and objectives.
A multi-objective rate:
Incorporates and balances multiple goals and values;
Recognizes tradeoffs among competing objectives; and
Attempts to optimize based on identified evaluation criteria.

## A Multi-Objective Rate

- Affordability
- Attention to the first block
- Equity
- Rate averaging across customers and systems to recognize commonality and encourage regionalization
- Efficiency
- Price variation in the tail block to reflect significant differences in marginal cost

**Notes:**
As an example, a multi-objective rate might jointly consider affordability, equity, and efficiency.
For affordability, attention is paid in particular to designing the first block.
For equity, rate averaging can be used across multiple customers and systems to recognize commonality and encourage beneficial regionalization.
For efficiency, price variation in the tail block to reflect significant differences in marginal cost.

## Illustration

**Price/**
**unit**

**Quantity consumed**

***Marginal cost***

**High cost**

**Low cost**

**Mid cost**

**Lifeline for eligible customers**

**Consolidated rate**

***Affordability >>>> Equity >>>>> Efficiency***

***Location/season***

**Notes:**
A lifeline rate provides a subsidy to low-income customers who meet specified program criteria.
The first block of water usage, generally considered “essential” usage, is priced below the marginal cost of water service.
The difference required to fund the subsidy is recovered in subsequent blocks.
A lifeline rate closely resembles some conservation-oriented rates.

## Choosing a Rate

- Establish clear goals, priorities, and preferences
- Select a rate that best achieves objectives
- Involve stakeholders (customers) to the greatest extent possible

**Notes:**
Choosing a rate structure can be a challenge, particularly given the many available options.
When choosing a rate, water utility decision-makers should:
Establish clear and explicit goals, priorities, and preferences;
Select a rate that best achieves objectives, while maintaining consistency with accepted ratemaking principles; and
Involve stakeholders (particularly ratepayers or customers) to the greatest extent possible.

## Stakeholders

- Residential customers
- Commercial customers
- Industrial customers
- Consumer advocates
- Environmental advocates
- Business leaders
- Media representatives

**Notes:**
Involving key stakeholders is an important part of the ratemaking process.
Some of the relevant stakeholders include:
Residential customers;
Commercial customers;
Industrial customers;
Consumer advocates;
Environmental advocates;
Business leaders; and
Media representatives.
Participants may want to discuss other potential stakeholders.

## Rate Structure Complexity

- Rate design need not be overly complex
- An overly complex rate is undesirable
- Benefits of rate design should outweigh costs
- Cost recovery and efficiency are fundamental
- Resources are available for basic ratemaking
- Rate structures can evolve with needs

**Notes:**
Rate design for water systems need not be overly complex to be reasonably efficient or achieve other goals.
An overly complex rate structure is undesirable because it may confuse customers and encumber system administrators.
The benefits of sound rate design should outweigh the costs of implementation.
Cost recovery and efficiency are the fundamental goals of ratemaking for most water systems.
Resources are available for basic ratemaking, including manuals and workshops. 
Rate structures can evolve with the needs and priorities of water systems, as well as their capabilities.

## Implementing Rate Change

- Communicate goals clearly to all stakeholders
- Recognize trade-offs explicitly
- Follow sound principles and practices
- Provide opportunities for stakeholder input
- Explore a full range of options
- Weigh complexity against simplicity
- Phase-in big changes (gradualism)
- Approach experimentally
- Monitor and evaluate impacts and outcomes
- Modify rates as needs change and goals evolve

**Notes:**
Strategies for implementing a change in rates or the rate structure include:
Communication goals clearly to all stakeholders;
Recognize trade-offs explicitly;
Follow sound principles and practices;
Provide opportunities for stakeholder input;
Explore a full range of options;
Weigh complexity against simplicity;
Phase-in big changes (gradualism);
Approach experimentally;
Monitor and evaluate impacts and outcomes; and
Modify rates as needs change and goals evolve.

## Small Systems

- Do not ignore the importance of rates in capacity development
- Use available assistance and resources from various sources
- Keep it simple to avoid administrative costs and revenue instability

**Notes:**
Small water systems may need special strategies for implementation.
Some key strategies include:
Do not ignore the importance of rates in capacity development;
Use available assistance and resources from various sources; and
Keep it simple to avoid administrative costs and revenue instability.

## Discussion andConclusions

**Notes:**
Discussion and Conclusions