Long-Term Funding Strategy

We were a whole step ahead of the grant-writing process.
—Chris Jacobs, Somersworth, NH

Although utilities may regard grants as a more desirable option than loans, these funds may be very competitive, and their availability is diminishing. Many grants also require a loan in addition to the grant in order to fund an entire project. Each state and federal grant program has specific application procedures, eligibility requirements, and deadlines.

In its simplest form, a bond is a written promise to repay borrowed money on a definite schedule and usually at a fixed rate of interest for the life of the bond. Some types of bonds are tax exempt to the purchaser of the bond, making them somewhat more attractive. Bonds can represent a large source of capital for a utility, but the utility must have the authority to issue bonds. It can be a complex and more expensive way to borrow money due to legal and other fees and administrative time. In some cases voter approval is required. A Revenue bond is a bond on which the debt service is payable from revenue generated through the utility. These bonds may be issued by state and local governments, or an authority or special district for the purpose of facility construction. General obligation bonds require that the entity has taxing authority and don’t require voter approval. Utility revenues are obligated to cover the debt payment. Due to the current economic climate, government funding has decreased and the process has become more competitive. This new reality requires utilities to think about using more customer generated sources of funding for future projects and to plan more long term funding to pay for capital expenses. For example, if the utility knows it wants to drill a new well in 10 years and it will cost $400,000 to drill the well, the utility could consider collecting additional revenue at $40,000 per year in order to have sufficient funds to pay for the new well. As discussed in Chapter 6, the utility must carefully examine all capital projects to make sure they are necessary and that the best alternative was selected.

Our alliance got together and went to the legislature and got a grant.
—Larry Covington, Picacho, NM

Utilities may also wish to seriously consider funding projects in phases to reduce the immediate costs of the project and create more time to acquire the needed revenue. Some phases of the project may be paid for with external funds, while others might be financed with internal funds.

To assist utilities with funding options, the Kansas Interagency Coordinating (KAIC) Committee, composed of Kansas Department of Health and Environment, Kansas Department of Commerce, and Rural Development, typically meets once a month to discuss the best mix of potential loan and grant funding available for applicants. Appendix E provides a list of funding sources available for Kansas utilities.

In order to set an effective rate/fee structure, a utility should adopt a full-cost pricing strategy. Full-cost pricing seeks to cover all current and future costs that are not covered by external sources of revenue (grants, loans, bonds, etc). A rate/fee structure based on full-cost pricing needs to provide adequate revenue for four major areas.

Operation and Maintenance Costs
There generally are no outside funding sources for routine operation and maintenance of a water or wastewater utility. Utilities must fund operations and maintenance from internal revenue sources.

Routine Repairs and Replacements
Every utility manager knows that, despite the best maintenance plan, equipment fails and needs to be repaired or replaced. In fact, the core of Asset Management is a system for making decisions about when to do those repairs or replacements. But knowing is only the first step. You have to have the money to do it. Once you have built a schedule for routine repairs and replacements, you will need to “save” money for those events. This is the function of the repair and replacement reserve fund.

Capital Improvements
A Capital Improvement Plan generally includes a plan for obtaining funding for capital projects. However, many grants or grant/loan combinations require a portion of the funding to be provided by the utility. A capital improvement reserve fund is intended to provide those funds.

Debt Service
Few utilities will be able to finance capital improvements without incurring some debt. Your rate/fee structure must provide funds for the repayment of debt. Setting those funds aside in a debt service reserve fund will ensure that the utility can meet its debt obligations.

Emergency Operating Reserves
Some utilities may want to set funds aside to deal with emergencies. This fund may not be a necessity for utilities whose general operating fund is adequate to cover emergencies. Smaller utilities whose day-to-day operations do not leave much surplus will probably want to build a reserve for emergencies.

A “good” rate/fee structure will accomplish the following:

• Meet all operating and maintenance expenses
• Provide reserve funds for capital improvements, repairs and replacements, debt service and emergencies
• Provide revenue stability
• Be fair and equitable
• Be affordable for the majority of customers
• Encourage responsible water use
• Provide for future incremental increases

Many utilities struggle with rate-setting and with gaining public acceptance for rates and fees. Rates are often determined by a political process that is not based on business reality. Such rates will inevitably lead to under-investment in infrastructure and perhaps even an inability to meet current operating expenses.

Political expediency often results in a “willingness to charge” problem in which officials and managers become over-sensitized to their customers’ desires to keep rates low or general unwillingness to pay for services. However, willingness to pay is not the same as ability to pay. For this reason, it is important to assess your customers actual ability to pay. This can be done with census data on annual median household income (AMHI) in your area. If data is not available for your area or is not specific enough to your customers, you may need to conduct your own income survey or base your assessment on other knowledge of the economic condition of your customers. When ability to pay is assessed objectively, it may be necessary for the utility to develop programs to assist low-income customers. Some may see this as unfair, but setting a rate structure geared to the customers with the lowest income will often result in insufficient revenue and may not be in the best interests of the community as a whole. If rates are set too low to cover all of your costs, everyone suffers in the long run. It is essential to find a way to set a rate/fee structure that is adequate to cover expenses. For many utilities that may mean devising a program to assist low-income customers.

When a utility adopts Asset Management practices, the rate/fee structure may need to increase. This will occur if the utility must move from being under-funded (i.e., collecting insufficient revenues to cover all expenses) to being properly funded. Understanding your customers’ ability to pay will help you defend your rates and fees and to make decisions about whether certain income groups may need to be subsidized. A solid Asset Management program will give you the tools to defend the rates you set. Asset Management brings transparency to the process so that the basis for rates is clear. The more clearly the rates can be defended, the more likely they are to be accepted by the public. The more you inform and involve your customers in understanding how you provide the benefits and services they are receiving, the more they will support you. Generally, once people understand what they are getting and see that their money is being spent responsibly, they will support the rates. This support, in turn, will give elected officials a higher willingness to charge.

A good rate analysis must start with good data on costs and future plans. It is therefore imperative that the utility have a budget and a good record-keeping system for tracking costs. Without good information about your current costs, you will not be able to project future costs with any confidence.

Listed below are 10 suggested steps for an effective rate-setting process. These steps are not meant to be definitive, but rather suggest issues that need to be considered and data that needs to be gathered.

1. Determine your costs. Your budget and record-keeping system should track costs in meaningful categories. It is helpful to separate operations costs into fixed (those costs that don’t change with the amount of water produced or treated) and variable (those costs that go up when you produce more water or treat more wastewater).
2. Determine your revenues. It is helpful to understand how much of your revenue comes from usage rates vs. other fees.
3. Determine your reserve needs. You will consult your capital improvement plan, your repair and replacement schedule and your debt obligations for this information.
4. Determine your current financial position. Do you have a deficit? If you have not met expenses in the past, you will have to correct for this in your new rates.
5. Determine revenue required for the next 5 years. This will be based on your past costs, but don’t forget to take into account future growth and inflation.
6. Gather information about your customers. This information is at the heart of any rate-setting process. Knowing how many customers fall into various usage categories will make it possible for you to set a rate/fee structure that maximizes your revenue, while making sure that the cost is spread equitably among the customers. For example, if you find that 90% of your customers use below 4,000 gallons per month, it will not gain you much revenue to include 4000 gallons in your base fee and start charging incrementally above 4000 gallons.
7. Gather information about production and use. These data will tell you whether you are “losing” water due to leakage or theft. Or you may simply be providing water to community buildings without charge. In any case, this water costs money to produce and must be paid for by your customers. If your utility does not have meters, you cannot set a meaningful rate.
8. Design a rate/fee structure. There are as many different structures as there are people with imagination designing them. However, an effective rate will cover all costs; will spread the cost of operations equitably across all classes of customers; and will encourage conservation.
9. Implement the rate. Do not under-estimate the importance of “selling” the new rate/fee structure to your customers. If you have already involved your customers in your Level of Service Agreement, it is a natural step to let them know what the services will cost.
10. Review your rates regularly. Rates should be reviewed annually.

If you manage your assets related to the fact that they are truly community assets…you can build rate capacity.

—Jim Smith, Louisville, KY

There are many sources of rate setting assistance, including trainings and free rate setting programs. Any approach that includes all costs of operation; reserve accounts for capital improvement, debt service, repairs and replacements, and emergencies; and considers conservation or other utility goals is acceptable. Appendix E lists some resources for assistance with rate-setting.

7.4 Funding For Energy Efficiency

In the case of energy efficiency projects, there are additional options for funding projects beyond those available for “normal” operation and maintenance and capital projects. These projects have the potential to reduce energy costs and therefore have different criteria and potential for funding.

One consideration in terms of funding is the amount of potential cost savings. If the cost savings are great compared to the cost of the capital expenditure, the investment will pay for itself in a short time. If the cost savings is small relative to the capital expenditure, it may take a long time to pay for the project. This concept is called Return on Investment or ROI. As an example, consider changing a constant speed pump to a variable speed pump. Suppose the new pump cost $40,000 and the expected energy cost savings was estimated to be $5,000 per year. In 8 years, the energy savings would equal the cost of the investment, so the pump would pay for itself in 8 years. If the expected life of the pump was longer than 8 years, it would be worth doing this project because everything after 8 years would represent a cost savings to the utility. If the expected life of the pump was less than 8 years, the project would not be worth doing because it would cost the utility more money than it would save.

Another consideration is when to make an investment in a more energy efficient piece of equipment. If an asset has reached the end of its useful life, the decision to make the investment in a more energy efficient asset may be fairly simple. The asset has to be replaced anyway, so even if the more energy efficient asset has a long pay-back period, it may make sense to do this project. If an asset has not reached the end of its useful life, but a new, energy efficient asset will pay for itself in a short amount of time, the utility may decide to replace the asset immediately instead of waiting until the asset fails or reaches the end of its life. For example, a wastewater plant may have a very inefficient blower that costs $5,000 per year in energy costs and $4,000 per year in O&M costs. Its remaining useful life is 15 years. Suppose a new blower costs $30,000 to install, will cost $3,000 per year for energy usage, and $2,500 per year for O&M. The savings in energy and operational costs are $3,500 per year. In 10 years the savings will be $35,000, which is more than the cost of the new blower. The blower will pay for itself before the old blower would reach the end of its useful life. In this example, it is beneficial to remove the existing inefficient blower and replace it with a new blower right away, rather than waiting until the old blower has served its full expected life.

Another option available for utilities related to energy savings is the potential to use an energy service company (ESCO.) An ESCO is a commercial business that will analyze the utility’s current energy use and determine the potential for energy savings. The ESCO will prepare a plan for energy saving projects and suggest the highest priority projects to accomplish. There are many ways that the ESCO can be used, but generally the ESCO pays to install the equipment and the utility pays the ESCO the normal utility bill for some amount of time, which would be longer than the pay-back (ROI) on that equipment. Because the new equipment is more energy efficient, the ESCO will use the reduction in energy cost to pay for the equipment it installed. The advantage to the utility comes from the capital cost being provided by the ESCO, saving the utility the time and expense of securing other funding. In addition, ESCOs often guarantee energy savings and have to pay the utility if these energy savings are not realized, so the risk to the utility is reduced. A disadvantage is that in the long run, the utility will pay more for the project because it will be a longer period of time before the utility itself starts to reap the benefits of the reduced energy costs. Another disadvantage is that the ESCO will probably be focused on assets that consume large amounts of energy where cost savings will be significant and may miss opportunities within the utility to save smaller amounts of energy (e.g., changing light fixtures and bulbs.) Therefore, the utility may need to have additional activities in energy efficiency to address these smaller incremental savings, and to address assets that indirectly use energy (e.g., leaking pipes.) There are many ESCOs available. If a utility wishes to follow this route to pay for energy projects, a Request for Proposals can be done.

Another funding source that applies to the energy efficiency projects is the “Green Reserve” of the State Revolving Fund (SRF.) This money is specifically meant for “green” projects and this definition includes projects that address energy efficiency, reductions in greenhouse gases, water use efficiency improvement, and treated wastewater effluent non-potable re-use.

Thus far, the discussion has focused on how energy use reductions will save the utility money and therefore, it is easy – or easier – to justify this type of project. However, there may be cases when a utility might wish to subsidize a project because it addresses energy goals in the Level of Service, such as a reduction in carbon footprint or greenhouse gas emissions. Elected officials or boards may decide to go forward with a project, even though it may be more expensive in the long term or have an insufficient ROI, because they are trying to reach an energy goal.

Advice…would be to look long-term and not worry so much about what’s the cheapestequipment today.
—Steve Hunt, Columbia, MO

For the most part, energy efficiency projects will result in cost savings and each dollar saved can be spent on something else, such as employee salaries, preventative maintenance, training, or equipment purchase.

However the utility decides to structure the strategy, it should have the following components:

• It should clearly demonstrate the source and adequacy of revenue for day-to-day operations.
• It should specify the anticipated source of funding for capital projects, from design to implementation (including demolition and/or disposal of existing facilities) and clearly define any portion that needs to be met with internal sources of revenue.
• It should include repayment of debt that might be incurred for capital projects.
• It should define the source of revenue for an increased operational costs resulting from capital projects.

One of the key things with Asset Management, it’s telling us where we need to spend our dollars.
—Stan Allred, Albuquerque, NM