Structuring water rates to account for rising expenses and reduced demand

Water utilities are highly capital intensive industries and many municipal owned water utilities throughout the country are working feverishly to maintain and replace the nation’s aging drinking water infrastructure which serves nearly 300 million Americans. Water rates would ideally be structured to include the cost of transmission, treatment and distribution, while accounting for the capital cost of reservoirs, treatment systems, and future facilities anticipated to meet changes in demand. In essence, this would create more stable rates due to the fact the utilities are accounting for the long-run costs associated with operating a water utility while planning for future supply acquisition and construction. However, this long-run pricing model would create excess revenues in the short-term and most municipal owned water utilities are allowed to only recover current costs, but not earn a profit in excess of a low regulated rate of return. Because of this, it is more typical to see rate structures designed to cover the average cost of supplying water in the short-term, but as utilities witness a decline in usage by consumers they are also experiencing revenue and cash flow streams insufficient to cover budgeted capital projects and day-to-day operations. This is due to the normal practice of utilizing average-cost pricing designed to meet a utility’s short-run costs and the inherent mismatch between the fixed cost nature of operating water utilities and the variable revenues they receive.

As the general population becomes more aware that fresh, clean water is a scarce resource, conservation efforts have increased. Conservation efforts come from municipal water conservation programs, customers installing water efficient facilities and a general decline in demand as people become more cognizant of their usage and the direct impact on their yearly utility expenses. While conservation efforts are necessary to maintain the limited existing water supply, utilities are now realizing that conservation efforts counter-intuitively raise water rates. This trend toward higher and higher bills is being driven mainly by:

  • The cost of paying off debt issued to fund repairs and upgrades on aging water systems.
  • Increases in the cost of electricity, chemicals and fuel used to supply and treat water.
  • Compliance with federal and state clean-water regulations.
  • Rising pension and healthcare costs of municipal employees.
  • Water utilities typically tap the cheapest water sources to develop first while later additions to water supply are generally more expensive.

The major question water utilities are facing is how to develop stable rates to account for declining customer consumption and the inability to use a long-run pricing model. There are many variables in a utility's economic environment, but in the end, management's best way to mitigate these issues is through frequent review of their current rate structure. This allows for rates to be structured in a way that reflect changes in population, decreased volume demand and ever changing regulatory requirements while avoiding the political fallout that inevitably comes with large, one time increases in rates.

Frequent rate reviews allow utilities to quickly adapt to the current economic environment. Some areas of the country are experiencing large population booms. Utilities with many new customers joining may consider the use of impact fees on newly developed areas to ensure existing rate payers do not bear the burden of additional capital plant requirements. Through the effective use of impact fees, new customer connections are charged a fee to connect to the system. The money collected from impact fees is used to pay for the related capital additions, in essence creating a long-run pricing model without affecting the existing customers’ rates.

Conversely, other areas of the country have experienced significant population or volume decline, specifically when losing large industrial customers. Utilities in this type of environment face a unique situation of maintaining excess capacity beyond the system's needs creating the need for even more frequent rate reviews to maintain adequate revenue and cash flow streams.

Lastly, environmental regulators continuously continue to tighten regulations surrounding water safety standards. As more stringent laws and requirements are put in place, additional financial resources will be needed to achieve the new standards and changes in rates will be required to recover the costs associated with implementing these new standards.

Prior to reviewing existing rate structures utilities should consider the both positive and negative factors associated with appropriate rate structuring. Some factors to consider include:

  • Decreasing demand by consumers could slow the impact of population growth on the water distribution and supply infrastructure, resulting in existing facilities being adequate to handle the demands of a higher population.
  • Rate increases may have a disproportionate impact on low-income consumers. Many of these water users spend a large portion of their income to meet basic needs, even after cutting back on discretionary water use. For these households, increased water rates typically translate only to higher water bills, not less water use.
  • The general message conveyed to customers is mixed. In some areas of the country, more water usage, results in a lower per unit cost or a discount. Meanwhile in other areas, high water users are charged more per unit as their usage increases or what could be considered a penalty.

If you have additional interest on how to effectively structure your water rates based on specific utility performance, Baker Tilly's energy and utilities specialists are available for further discussion.