9 December 2014
Utility financial planners needs to think long term
The 2012 study, Water Main Break Rates in the USA and Canada: A Comprehensive Study, by Utah State University, found that 22% of the approximate 1,287,475 km (800,000 mi) of water mains are more than 50 years old and 8% are beyond their useful life. Water and wastewater utilities in the U.S. are facing unprecedented infrastructure investment requirements. One study estimates more than $4 trillion will be required over the next 20 years to repair the nation’s water and sewer infrastructure and to continue to meet regulatory requirements. Investment anywhere near this amount will put upward pressure on customer rates for many years, according to the U.S. Conference of Mayors’ 2010 report, Trends in Local Government Expenditures on Public Water and Wastewater Services and Infrastructure: Past, Present and Future.
Interestingly, though, a dichotomy exists between these investment requirements and financial planning. Many water utilities approve budgets and rate plans for only 1 or 2 years — even though engineers often have forecasts for the timing and cost of infrastructure replacement projects covering more than 10 years. A longer-term view of financial planning and rate development will better align financial and engineering processes to provide more certainty in terms of investment plans, costs, and sources of funding.
Uncertainty is costly. Customers, utilities, and investors all will benefit from a longer-term view of resource requirements and the effects on rates.
Regulatory mandates have consumed investment
Clean, safe, reliable, and low-cost water and wastewater service is considered a personal right. In recent years, most water utilities have been acutely balancing clean and safe water with low-cost service — in some cases at the expense of longer-term system reliability. The mandates in the Safe Drinking Water Act and the Clean Water Act combined with a host of state mandates have consumed large amounts of capital.
These requirements have led to many water utilities and cities entering into long-term consent decrees with the U.S. Environmental Protection Agency (EPA). These consent decrees have required (and will continue to require) large expenditures to ensure compliance and avoid fines. In recent years, these expenditures have cannibalised infrastructure investment.
Meanwhile, pipes and other facilities are reaching the end of their designed lives
While utility funds largely have been consumed by regulatory requirements, the pipes running under our streets, and pumping, storage, and other facilities, have been reaching their originally designed lives.
EPA’s 2013 Drinking Water Infrastructure Needs Survey and Assessment forecasts almost $775 billion of required water and wastewater system investment over 20 years. It estimates the nation’s drinking water utilities will require $384.2 billion for investment in water infrastructure including thousands of miles of pipe as well as thousands of treatment facilities, storage tanks, and other key assets between 2011 and 2030.
Additionally, in 2007, EPA estimated that approximately $390 billion of capital spending would be necessary over the next 20 years to replace aging infrastructure and ensure quality wastewater systems across the U.S. According to EPA, ensuring public health, security, and economic well-being will require major investments in water and wastewater systems.
Similarly, a study by the American Water Works Association (Denver), Buried No Longer: Confronting America’s Water Infrastructure Challenge, estimates the aggregate need for investment in water mains for the 25-year period of 2011 to 2035 is more than $1 trillion. In the 2011 report, Failure to Act: The Economic Impact of Current Investment Trends in Water and Wastewater Treatment Infrastructure, the American Society of Civil Engineers (Reston, Va.) estimated that as investment needs continue to escalate and current funding trends continue to fall short of the needs, the likely result will be unreliable water service and wastewater treatment. According to the report, this situation can result in water disruptions, impediments to emergency response, and damage to other types of infrastructure such as roads and bridges, as well as water shortages (from failing infrastructure and drought) that may result in unsanitary conditions and increase the likelihood of public health issues.
Based on these and other similar reports, water utilities should be prepared to make increased long-term investments in infrastructure to ensure service remains reliable while continuing efforts to keep our water clean and safe.
The financial planning dilemma
Replacement of decaying infrastructure is not a new development; however, it is an expensive and long-term challenge for water utilities. Some experts forecast water and sewer rates in the U.S. could double or even quadruple during the next 15 to 20 years. Engineers are planning for the long term with capital improvement plans (CIPs) often covering 10 or more years. However, the majority of water utilities currently are employing a rather short-term financial planning and rate setting timeframe. Financial plans may include forecasts for up to 5 years, but most firm budgets and rate plans usually cover only 1 or 2 years. Therefore, despite the long-term nature of investment requirements, financial planning and rate development horizons are still relatively short.
Many regulators and other policy-makers have been keen to push the ball down the road. Political considerations are satisfied more easily by making the big spending decisions someone else’s problem. However, rating agencies and customers understand the dilemma and expect water utilities to have reasonable engineering and financial plans that support safe, clean, and reliable water and ensure strong revenues over the long term. While customers do not like rate increases, they do expect water to flow from the tap on demand and would welcome more certainty about future rates and service levels.
The solution: Longer-term CIPs, financial plans, and rate programs
Recently, some water utilities have begun to expand their financial planning horizon, but change appears to be reluctant and slow. To accommodate the long-term nature of infrastructure investments (and continued regulatory mandates), more water utilities should develop and adopt firm, longer-term financial plans, budgets, and multiyear rate plans. Because CIPs tend to cover at least 10 years, financial and rate plans can and should be able to cover at least 5 years. A multiyear view will serve many purposes, including
higher predictability for customers, regulators, and investors;
more robust organisational and financial discipline;
greater financial certainty for the water utility; and
clearer plans to fund critical infrastructure needs.
Based on available data and the nature of major projects found in many CIPs, most water utilities should be able to develop high-level CIPs for up to 20 years with the first 5 years considered firm enough to drive meaningful financial planning and rate development. Major CIP updates could then be made approximately every 5 years. Some allowance for shifting funds among projects each year could be possible as long as the aggregate spending levels stay relatively constant. A longer planning time period will match more closely the lifetime and sequencing of many major capital projects with spending and revenue plans. Many electric utilities historically have chosen time frames of at least 10 years for integrated resource plans; water utility planning can follow a similar framework.
With solid 5-year capital investment plans in place, water utilities should be able to develop budgets covering 5 years with higher-level forecasts for at least an additional 5 years. Longer-term financial planning will drive increased budgetary discipline, afford more clarity for rating agencies, and provide more transparency for policy-makers and other stakeholders.
Firm 5-year budgets could then serve as the basis for 5-year rate plans and associated cost-of-service studies. Development of these studies can be time-consuming and expensive, so reducing the number of studies will reduce costs. Multiyear rate plans will provide greater customer certainty, increased financial discipline, and reduced administrative costs. Public relations challenges often associated with rate actions also will be less frequent.
A longer-term comprehensive planning process is consistent with the nature of investment and other strategic requirements facing a water utility.
Current legislative requirements in some jurisdictions may require governing authorities to approve budgets formally and other plans on an annual basis. Absent changes to existing statutes, budgets can be adopted formally more frequently; however, this requirement should not affect a utility’s ability to develop longer-term investment, financial, and rate plans.
Creative rate design can facilitate multiyear rate plans
Setting rate plans to be implemented over multiple years can increase revenue risk; however, water utilities can take advantage of two emerging trends in rate design to mitigate this risk.
Decoupling. This mechanism basically separates recoverable revenues from volumes of water sold. Typically, water utility rates include a combination of a fixed monthly meter or service charge and usage charges based on volume consumed by the customer. Therefore, water usage is a major component of revenue. Because a significant amount of the water utility’s cost is fixed — for example, maintenance of pipe and treatment facilities, call center operations, billing — a decrease in usage can cause a water utility to under-recover its cost of service. The decoupling mechanism allows recovery of base costs regardless of usage by determining the required amount of base revenue and using an adjustment factor to bill any shortfall (or pass back to customers any surplus) from that level of revenue. The California Public Utility Commission has been a leader at decoupling revenues from water sold to help achieve the state initiative to reduce water usage by 20% by 2020. Without decoupling, a water utility would have little incentive to implement conservation rates and programs, ensure cost savings are passed on to ratepayers, and reduce overall water consumption.
Distribution system improvement charge (DSIC). A DSIC is a voluntary rate mechanism that some regulators have established to promote accelerated rehabilitation and replacement of certain nonrevenue-producing, critical water distribution components that enhance reliability, safety, water quality, and/or conservation. This mechanism allows water utilities to charge customers an incremental rate (with annual increases often tied to a cap) for the costs of rehabilitating, improving, or replacing infrastructure such as pipes, valves, and pumping equipment. To some degree, the DSIC unbundles the cost of certain infrastructure investments from base rates.
These types of creative rate designs are gaining momentum in the U.S and will help provide financial security to water utilities that adopt longer-term financial and rate plans.
These types of creative rate design metrics, which delink revenues and sales, to some degree enable longer-term financial planning and rate development by reducing financial risk while also encouraging efficient use of resources and providing better incentives for water conservation.
Benefits create a win–win for customers, regulators, and water utilities
Longer-term financial planning and multiyear rate programs produce benefits for many stakeholders. Utilities reduce costs, improve organisational discipline, and increase financial stability. Investors get increased certainty. Customers benefit from more predictable rates. Everyone benefits from more transparency into the longer-term outlook for the water utility.
Longer-term planning does increase the importance of accurate forecasting and data rigor and could lead to increased activity to revise forecasts and address governance requirements. However, the benefits, especially when accompanied with creative rate design mechanisms, far outweigh the challenges.
As water utilities face the highly anticipated barrage of large infrastructure investment projects expected to span decades, moving toward longer-term financial planning and developing multiyear rate programs will help provide more stability across the board. It is a common sense approach to an expensive long-term challenge that will affect the entire water sector and its stakeholders for years.
Wayne Lafferty is an energy and water expert at PA Consulting Group