Introduction
In the vast majority of cases, important water rate policy issues are never really discussed until the Proposition 218 hearing, which is undoubtedly the worst time to have that discussion. If the rate adoption process is going to blow up, that’s when it will happen. Discussing and adopting well-vetted and well-understood rate-related policies beforehand can reduce the heated battles and tone down the rate-payer venom by settling some key questions, such as: (1) Are we willing to minimize rate increases at the expense of adequately funding capital replacement costs? (2) How do we make trade-offs between revenue stability vs. water conservation?[1] or (3) Are we accumulating sufficient reserves to position ourselves to issue new debt? This paper discusses practical measures to consider prior to the heated debates about rate increases.
Why Are Policies Important?
It is difficult to objectively examine and evaluate important policies in the midst of a heated Prop 218 hearing, when the over-riding concern is the size of the rate increase. At that point, most of the audience, as well as elected officials, cannot focus on anything else. But broader, and maybe more important, issues get lost in the face of strong public opposition to rate increases. Is anyone asking what the guiding policies are that contributed to the increases?
Carefully constructed policies that establish a rationale and a consistent approach to the financial health of the agency, be it a city, special district, or county, should be key factors in rate design, level of rate increases, and longer-term financial goals – but they rarely are. Identifying potentially contentious rate concerns well ahead of the rate study is just common sense. What are some key policies to consider? How about these as policy statements:
- Our agency will establish predictable and cost-based rates to the extent practical.
- Rates will be set to promote efficient and wise use of a limited resource (i.e., water).
- Rates will reflect a balance between debt funding vs. pay-as-you-go in a manner that minimizes rate increases.
- Rates will meet the “fair and equitable” requirements of Prop 218 – based on advice of our attorney.
- Rates will not differentiate costs by area or within a customer class.
- Rates will collect fixed costs from fixed charges and variable costs from volumetric rates – to the extent practical and without unduly impacting low income customers.
- Rates will fully fund costs related to compliance with regulatory mandates.
- Rates will fund at least a minimum level of system maintenance – as defined by our engineering staff.
What’s the Strategy for Using Policies as part of the Rate Setting Process?
Raising rates on customers will always meet some level of rate-payer hostilities. So resolving or at least openly discussing specific criteria for raising rates in a rational and calm setting prior to rate adoption can minimize the surprise, anger, and pressure from customers. For example:
- Do our rates allow for timely replacement of system assets, or do they by default follow a “wait until it breaks to fix it” mentality?
- Should we minimize rate increases for capital improvements by issuing more debt?
- Should our rates reflect actual costs of service that vary significantly within the service area due to elevation differences and related pumping costs?
- Should older sections of the service area, which require higher levels of maintenance and repair, be considered in rates or not?
- Should the costs of expensive storage facilities be solely allocated to customers with high summertime peaking requirements?
There are pros and cons to each of these policy questions. Costs, and often the winners and losers in terms of rate impacts, can be evaluated and contribute to a rational decision by elected officials… if that discussion takes place before voting on rate increases. Building a defensible basis for rate increases is always more effective earlier in the process.
A proactive, forward-thinking process should incorporate a review and discussion of key rate-related policies first, followed by a financial analysis and development of rate design alternatives. Why is it an extremely rare case to see that process included in a rate-study RFP (Request for Proposals)? One answer might be wishful thinking – we hope it’s an easy rate adoption process, even though we’re not even sure yet how big the rate increases are going to be. Another might just be poor planning – we didn’t think that far ahead, and there’s always time to discuss those problems during the study, right?
Bottom line is we should try to be proactive and thoughtful so that we can minimize controversies at the most critical point in the process (that would be the night that elected officials vote to adopt or reject rate increases).
General Concepts
Here are some general concepts to consider as you are planning your next water rate study:
- Ask yourself what the key objectives of the study are and whether you have established policies related to the rate issues that will likely come up during the study.
- Lay out a timeline and process that allows for a discussion (and ideally a confirmation and/or adoption) of the rate-related policies.
- Include a discussion of the pros and cons of each policy so that decision makers can develop an informed opinion when considering adopting each policy.
- Formalize the policies by adopting them after discussion at a public meeting (this allows you to tell rate payers that they were openly discussed and adopted with the intent that they would guide the rate-setting process).
- During development and discussions of rate alternatives, provide references to specific policies as justification for things like rate design alternatives, level of capital expenditures, new debt issuances, etc.
“Providing Advanced Warning”
The last thing you want happening during the rate adoption process is for the elected officials to say something like “Why is this the first time I’m seeing these rate increases?” The best approach is to thoroughly vet the alternatives and the levels of rate increases with decision-makers in one or more study sessions or hearings so that they are on-board prior to the final public hearing. This is typically the role of a City Manager or General Manager – you are the liaison with your elected officials.
What Policies Should I Consider Adopting?
A number of policy topics are noted above. Basically, these policies should demonstrate that you understand what it takes to create and maintain a well-run and professionally managed utility. They are the fundamental guidelines that should be used during the rate-setting process, and should be available to rate payers so that they understand the rationale for the financial decisions your agency will be making.
Keep in mind that we are in a period when more water agencies are seeing larger rate increases than ever before:
- Free grant money to build infrastructure is no longer available as it was 50 years ago.
- System assets are, unfortunately, approaching the peak of the replacement cycle as assets are aging out; not replacing worn out pipes and tanks not only risks system failures, but can create huge financial liabilities as well as public perception nightmares.
- Generally poor economic conditions, which are likely to continue for the foreseeable future, create an even more difficult environment for passing rate increases.
- Rate-related policies can play a significant role in minimizing resistance to higher rates.
We have created ten examples of positive policies to ensure that there is “full disclosure” of both the positive and negative aspects of rate-related policies.
Principles for Guiding the Rate-Setting Process
The following principles are provided for discussion purposes and are subject to modification by the Utility Rate Advisory Committee (or the Board or City Council).
Principle 1 – Establish rates in compliance with all applicable federal, state, and local laws and regulations.
Discussion: Certain federal, state, and local laws and regulations have an impact on processes involved in setting the City’s (County or Special District) rate structure – most notably Proposition 218. It is imperative that the rate structure be established in compliance with these laws and regulations.
Advantages of the Principle: Clearly states the City’s intent to establish rates in compliance with applicable federal, state, and local laws and regulations.
Disadvantages of the Principle: None.
Principle 2 – Establish rates that are fair and equitable within the limitations of reasonable and attainable data and the City’s administrative systems, personnel, and finances.
Policy Statement: The City recognizes the need for reasonable allocation of the costs of water, wastewater, and solid waste services, as well as the need to provide an easily understood rate structure for its customers. Rates should generally be perceived by the City’s customers as fair, reasonable, and equitable to all customers.
Discussion: This principle highlights the importance of the customer’s perception of fairness and equity, while also recognizing that it is not practical to promise absolute equity among all customers and customer classes.
Advantages of the Principle: Reinforces the City Council’s priority of treating all customers fairly. It also underscores the importance of a perception of fairness and equity for the entire service area as opposed to pacifying the “squeaky wheel.” Finally, it acknowledges the practical obstacles that prevent perfect equity.
Disadvantage of the Principle: This principle ultimately does not clearly define the terms “fair and equitable” and will still require the City Council to apply its discretion and judgment.
Principle 3 – Attempt to make rates simple for the public to understand and reasonable for the City to administer.
Policy Statement: Rates should be easily understood by customers and cost-efficient for the City to administer.
Discussion: The City’s unwritten policy has been to keep rate structures and the process of administering rates simple. Customer education and clarity of customer bills should be considered part of this principle.
Advantages of the Principle: Creating rates that are easy for customers to understand will minimize rate-related customer-service issues. If customers understand the basis for their bills, they will have a greater ability to comprehend their billing statement and conclude that it is fair. Rates that are simple to understand may be more important than a higher degree of equity, as long as any resulting inequities are not viewed as “gross inequities.”
Disadvantages of the Principle: There are tensions between “fairness and equity” and simplicity of the rate structure. Simplifying the rate structure does not always provide a maximum degree of fairness and equity, and may suggest to some customers that a degree of inequity does, in fact, exist.
Principle 4 – Establish stable and predictable rates over time to the extent possible within the City’s overall financial plan.
Policy Statement: Rates should be stable and predictable over time, which requires striving for a balance between generating sufficient revenue for utility operations, funding capital improvements, and improving customer perception of the rates as fair and equitable.
Discussion: It is imperative to establish rates that generate adequate revenues from year to year, regardless of weather and consumption characteristics. Large and unexpected year-to-year rate changes impose financial hardships on customers and promote customer perceptions that the City is arbitrary in its rate-related decisions and/or poorly managed. This principle recognizes the need to establish an appropriate balance between minimizing large rate adjustments without discouraging annual smaller systematic rate adjustments.
Advantages of the Principle: The principle attempts to stabilize the cash flow of the utilities and, at the same time, improve the predictability and customer perceptions of fair and equitable rates and management approach of the City.
Disadvantages of the Principle: It is difficult to define “stable,” since this term has different meanings for different people. Customers may construe stable to mean no increases from year to year.
Principle 5 – Make rates cost-based to the extent possible.
Policy Statement: Rates should be cost-based to the extent possible, meaning that other rate-setting policies of the City and the financial impacts to customers must also be considered. Fundamentally, “cost‐based” rates are rates that meet a utility’s overall revenue requirements for the City’s water, wastewater, and solid waste enterprises. From the customer’s perspective, “cost-based” means fair and reasonable allocation of costs to customers based on the degree to which customers cause the City to incur costs.
Discussion: Cost-based rates are generally recognized as being the most fair and equitable. However, this principle again needs to strike a balance between establishing cost-based rates in an excessively detailed and confusing manner vs. establishing overly simplified rates. The City should strive for rates that satisfy both the City revenue requirements and the customer’s perception of fairness and equity.
Advantages of this Principle: Striving for cost-based rates is an important element in achieving rates that will generally be perceived as fair and equitable, and also meet the City’s financial needs. Although cost responsibility among classes of service is not essential to the financial stability of the City, it is important if customers are to perceive rates as fair and equitable, as well as meeting the requirements of state law (i.e. Proposition 218).
Disadvantages of the Principle: A commitment to cost-based rates may imply different levels of refinement and detail in the rates for various customer groups. Therefore, this principle could be misconstrued as requiring an excessively detailed and costly approach to establish rates.
Principle 6 – Set rates to promote efficient customer use.
Policy Statement: Rates should recognize the value of water and wastewater system capacities as limited resources and should encourage efficient use of these resources.
Discussion: This principle is intended to recognize the limited resources and the environment. In light of the 20×2020 State Water Conservation Plan, the California Urban Water Conservation Council’s Best Management Practice (BMP) related to retail conservation pricing (BMP 1.4), and the recently enacted Senate Bill 814 (SB 814), the City’s rates should encourage efficient use of water. However, recent court cases such as the San Juan Capistrano decision place an additional requirement on tiered rates – that the City be able to demonstrate the cost basis for each tier and how much of the “cheaper” sources of supply are allocated to customer classes. Similarly, the City’s wastewater treatment plant capacity is limited, and plant expansions are very expensive. This principle is not intended to discourage reasonable uses of the resources, but instead, by attempting to price commodities roughly equal to their true costs, the City will be encouraging efficient use of its limited resources.
Advantages of the Principle: This principle recognizes the multiple uses of our natural resources and makes a positive statement to all customers and outside parties that the City encourages the efficient use of its resources.
Disadvantages of the Principle: Some customers and outside parties may believe this principle implies the need to adopt highly aggressive conservation-based water and wastewater rates, and/or a mandate for the City to consider complex water-budget based rates.
Principle 7 – Establish uniform rates within a service class; do not differentiate by area or within a service class.
Policy Statement: Rates for the City shall be uniform for all customers within a class of service and shall not be differentiated by location within the service area or by the particular facilities required to provide them service, such as pumping to different elevation zones or length the of transmission or collection system.
Discussion: Establishing rates that are uniform for a class of service is the approach most commonly used by utilities across the United States. Utilities generally recognize that cost differences for service exist within a customer class of service, but also recognize the advantages of a uniform rate structure. Policymakers are usually willing to accept some level of inherent inequities to gain the advantages and benefits derived from uniform rates by class of service.
Furthermore, industry standards, such as the American Water Works Association[2], support an approach that considers other community priorities:
“…the costs of water rates and charges should be recovered costs from classes of customers in proportion to the cost of serving those customers. However…other considerations may be equally or more important in determining rates and charges and may better reflect emerging objectives of the utility or the community it serves.”
and
“…pricing policies may support a community’s social, economic, political, and environmental concerns.”
Advantages of the Principle: Any rate-setting principle that results in the same rate structure for all customers within a class of service recognizes, and is willing to accept, some obvious cost differences because the benefits outweigh the disadvantages, and is likely to be perceived by customers as fair and equitable. It will be more cost-efficient for the City to administer, since no consideration is given to the particular facilities used to serve individual customers or the location of the customer. It can also eliminate the dramatic rate differentials that can occur when specific areas need costly infrastructure improvements. The principle may also help to eliminate the perception that there are “multiple service areas” within the City (i.e., this principle establishes the idea that the City has only one service area).
Disadvantages of the Principle: This principle does not recognize the cost differences associated with serving different areas of the City (e.g., old vs. new areas, higher- vs. lower elevations, etc.). Customers who believe rates should be individually defined to the greatest extent possible may object to this principle.
Principle 8 – Calculate water and wastewater rates independently and, where practicable, without subsidies.
Policy Statement: Although some shared costs such as administrative overhead must be appropriately allocated between water and wastewater utilities, other costs will be separately identified and allocated to each utility, such as: capital improvements, operating and maintenance costs, and debt service payments. There should be no subsidy of one utility by another.
Discussion: This principle recognizes that each utility has different customers and, therefore, subsidizing one utility by another can create inequities.
Advantages of the Principle: This approach holds closely to Proposition 218 requirements that rates reasonably reflect the proportional costs of service to a particular property, and minimizes dissatisfaction by customers who believe their rates are subsidizing other customers or that they are paying for benefits they are not receiving.
Disadvantages of the Principle: The disadvantage of this principle is that it does not allow for the possibility of allocating costs in a manner that may result in a win-win outcome for all customers (e.g., water customers sharing some wastewater treatment costs if it makes recycled water available for landscaping purposes and, thereby, reduce the overall use of more costly sources of potable water supplies).
Principle 9 – Consider financial tests, such as debt-service coverage, in all financial planning and rate adjustments.
Policy Statement: The City is legally obligated to meet certain financial tests specified in the documents resulting from issuing revenue bonds or similar debt instruments. These obligations need to be considered and reflected in financial plans and future rate increases.
Discussion: While these requirements are intended to assure bond holders that the City will have sufficient revenue to repay them, they are also beneficial in that they force the City to maintain adequate reserves and meet annual revenue requirements, which contributes to the overall financial health of the City.
Advantages of the Principle: This principle can help ease political pressure to not increase rates except in the most dire circumstances. Meeting the coverage ratios specified in bond covenants can help the City avoid falling into disrepair because it provides a specific means for the City to adhere to its current legal obligations of maintaining the general financial health of the City’s water and wastewater utilities.
Disadvantages of the Principle: The City is already legally obligated to maintain its debt‐service ratios and the principle may be redundant to those obligations.
Principle 10: Establish water and wastewater rates that collect fixed costs from fixed charges and variable costs from variable charges.
Discussion: Water and wastewater rates typically have a combination of fixed and variable charges. The fixed charges are intended to cover debt service, capital costs, and those operation and maintenance costs that do not vary with the amount of water consumed or wastewater discharged. The variable cost component is the actual volumetric rate that is based on the amount of water used or wastewater discharged.
Advantages of the Principle: Recovering fixed costs from fixed charges provides greater revenue stability. It would also reduce average monthly single-family water bills for customers using more than the average amount of water consumption. This approach more closely reflects the cost of service and proportionality requirements of Proposition 218.
Disadvantages of the Principle: Conflicts with the California Urban Water Conservation Council’s BMP #1.4, in that it would collect less than 70 percent of water-rate revenue from volumetric charges. It would also increase average single-family monthly water bills for customers using less than the average monthly water consumption.
[1] This is related to the percent of rate revenue collected from volumetric rates vs. fixed charges.
[2] Principles of Water Rates, Fees, and Charges, Manual of Water Supply Practices, M1, AWWA, sixth edition, 2012. Also, see Financing and Charges for Wastewater Systems, Manual of Practice No. 27, Water Environment Federation, 2004, page 91.
Published in CSMFO Magazine November 2016, Page 38