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Financial Aspects of Water Utility ServiceWater Prices and Lending OpportunitiesDecember 9, 2010

“financial solutions that make a difference”

Presenter: Jason Mumm, PresidentStepWise Utility Advisors, LLC. | 58 Inverness Drive East, Suite 260Englewood, CO 80112 | (866) 935-3101www.StepWiseAdvisors.com

Presented at The Colorado Law Institute Water Marketing Conference – Beaver Creek, Colorado

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Legal Aspects of Utility Rate Making

Ownership Models & Financial Issues

Final Thoughts

1

2

3

Discussion Topics

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LEGAL ASPECTS OF UTILITY RATE MAKING

Colorado Law Institute Water Marketing Conference – Beaver Creek, CO

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“There are at least two large chucks of the US economy that the competitive market model obviously does not describe or even purport to describe…the growing public sector… and public utilities.”

Alfred E. Kahn, Ph.D.The Economics of Regulation

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Why are Utility Rates Regulated?

Industrial Revolution

Development of new Monopoly enterprises

Legislative and Court response

Invention of steam energy created new industries with very high natural barriers to entry that became monopolies.

Price exploitation became rampant in early monopoly enterprises, like railroads and utilities

Pre-industrial era trades and businesses had already been recognized and regulated : inn keepers, cabs, grist mills

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Utilities: “Affected with a Public Interest”• Established as legal criteria for government

regulation of enterprises in 1877• Munn v. Illinois (94 U.S. 113 - 1877)• What is “affected with a public interest?”

– Wolf Packing Co. v. Kansas (262 U.S. 522 – 1923)– Business carried out under the authority of a public

grant of privileges…such are the railroads, other common carriers, and public utilities.

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Key Cases and Legislation in Utility Rate Regulation

• Munn v. Illinois (1877) – regulation of enterprises by government is proper when business is “affected in a public interest”

• Interstate Commerce Act (1887) – regulated railroad prices and prevents price fixing and exploitation

• Sherman Act (1890) – first major anti-trust legislation

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Key Cases and Legislation in Utility Rate Regulation • Smyth v. Ames (1898) – limited government

regulation to the “fair return” standard• Bluefield Water Works v. PSC of West Va. (1923)

– further defined fair return as a return on the “value of the property used at the time its being used to render the service.” Used and useful standard.

• Nebbia v. New York (1934) – affirmed that regulation requires due process that– Has a reasonable relation to proper legislative

purpose– Is not unreasonable arbitrary, or capricious

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Colorado Decisions That Matter• Bennett v. Bear Creek (928 P .2d 1254 – CO

1996).– Judicial review must respect separation of powers

and avoid intruding on policy making function of legislative body

– Rates and charges are rationally related to the government utility purpose

– Rates that are not rationally related to a local government utility purpose are subject to being set aside

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More Colorado Decisions• Krupps v. Breckenridge Sanitation District (19

P.3d 687, 693-694 – CO 2001)– Rates are service fees as opposed to “takings”– Service fees have important attributes

• Reasonably related to the costs• Rationally based• Consistently applied• Fairly calculated• No extraordinary concessions

– Service fees without these attributes may be “inherently unsound” and subject to judicial review and possible court action

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The Essential Standards for What Utility Rates Should Not Be:

Unreasonable

Capricious

Arbitrary

Nebbia v. New York (291 U.S 502)

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Price Takers We Are Not

Price Takers• Operate in competition with

other firms offering the same goods or services

• Prices are set based on customer demand (bids) at given prices (ask)

Price Makers• Monopoly businesses with

little or no competition from other firms

• Prices tend to be regulated to mitigate monopoly market power

• Utilities are monopolies and are price makers

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Regulatory Models

Private Ownership

PUC oversight

Direct Oversight

Public ownership

Elected body oversight

Direct Ownership

Both models are intended to limit monopoly market power (price making) by limiting prices for the public welfare

Both models perform the same essential role

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OWNERSHIP MODELS & FINANCIAL ISSUES

Colorado Law Institute Water Marketing Conference – Beaver Creek, CO

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Basic Utility Governance

• Owners are residents of the jurisdiction

• Customers can be owners or customers

Government Owned

• Owners are Investors• Customers are

customersInvestor Owned

Direct Ownership

Direct Oversight

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Four Aspects of Utility Regulation

Control of Entry Price Fixing

Prescribed of Service Level

Imposed Obligation to

Serve

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The Basic Business Model of Utilities

• Provide Equity Capital

• Assume RiskOwners

• Acquires Assets• Provides ServiceUtility Co.

• Pay bills • Produce Revenue

Customers

Model is the same whether it is an Investor-

Owned or Government-Owned utility

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Capital Flows by Model

Owners Provide Equity

Equity is Used to Finance Assets

Rates Include Return

Utility Generates

Return

Return distributed to Owners

Customers Provide Equity

Equity is Used to Finance Assets

Rate Excludes Return

Rates are Lowered

Return distributed by

lower rates

Investor-Owned Capital Flows

Govt. -Owned Capital Flows

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How Rate Regulation Works• Regulatory body (PUC or elected body) fills the

gap between Monopoly and Competition.• Rates are limited to levels necessary to recover

the “revenue requirement”– Set at a point where Price = Average Total Cost per

Unit – Average Total Cost is also called “Revenue

Requirement”

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Major Cost Centers of a Water Utility System

Source of Supply

Raw WaterStoragePipesPumps

Treatment

Well WaterSurface Water

Transmission

PumpingLarger Pipes

Distribution

StoragePumpingSmaller PipesMetersHydrants

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Measuring Revenue Requirements

The Utility Approach• Operating & Maintenance

Costs• Taxes or PILT• Depreciation Expense• Return on Investment

The Cash-Needs Approach• Operating & Maintenance

Costs• Taxes or PILT• Annual debt service

– Interest Expense– Principal

• Capital Project Costs Funded from Rates

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Which Method Applies?

Investor Owned

Cash-Needs

Approach

Government Owned

Utility Approach

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Simple Service Area ArrangementR

iver

StorageReservoir

Industry Z

TreatmentPlant

Industry Y

Transmission

M

MP M

M

M

System A

Government Owned Model: System assets are owned by customers, and customers pay system costs

Investor-Owned Model: System assets are owned by shareholders, and customers pay system costs & profit

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Factoring for Return to Owners• Return compensates

owners for costs of capital– Debt – Equity

• If System A financed assets used to serve B and C, then return is appropriate

• Doesn’t matter if A is government or investor owned

System A

System B

System C

Services

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More Complex System Arrangement

StorageReservoir

Industry Z

TreatmentPlant

Industry Y

Transmission

M

M

M

M

P

P

M

M

M

M

M

System A

System BSystem C

System A Owners are now investors in Systems B and C

Systems B and C are now customers of System A

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Multiple Service Area System

• The system assets are owned by customers/owners in System A

• The owners of System A earn a return on the assets serving Systems B & C

• Return reduces costs to customers in Sys. A

Simplicity

No. of Owners and Non-Owner Customers

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Are They Full Customers?System Component

System A Customers

System B Customers

System C Customers

Source of SupplyTreatment

Transmission

Distribution

Customer Services

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Are They Owners?

Attributes of Owners• Legal authority

– Board of Directors– Elected Body

• Makes all operating decisions

• Makes all investing decisions

• Assumes all ownership risks

Attributes of Non-Owners• No legal authority and

cannot vote for representation

• Only responsibility is to pay for service

• Only pay for used and useful property

• Entitled to price protections

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Regional Water System

System A

System B

System C

ServicesServices

Services

• System A – Owns assets serving B

and C• System B

– Customer of A– Owns assets serving C

• System C– Customer of System A– Customer of System B

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More Parties, More Diligence

Simplicity

No. of Owners and Non-Owner Customers

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What’s Used and Useful?

Regional Assets

Who Owns it?

System A System B System C

Source of Supply - A System A

Source of Supply - B System B

Raw Water Pipelines Sys. A & B

Treatment Plant System A

Transmission Pipes System C

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Regional Ratemaking Issues

What’s “Used and useful”• What assets are physically used• Who uses them and when

Who Owns What• Single-owner• Multiple-owners• Allow for owner returns

Determine Service Level• Water quality• Delivery schedule / time & place• Different for each customer?

Measuring Usage• Through each asset• Usage of water vs. use of capacity

Measuring Costs• Accounting for each asset• Capital costs!!

Regional Organization• Partnership agreement• Separate governance structures• Legislative approval processes

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FINAL THOUGHTSColorado Law Institute Water Marketing Conference – Beaver Creek, CO

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Conclusions• Both government-owned and private utilities

are Price Makers because they are natural monopolies within their service areas

• Price Makers are not allowed to exploit their market position – their prices are regulated

• Regulation can be performed by either– Direct Oversight– Direct Ownership

• Regulation has limitations, it must not be:– Arbitrary– Unreasonable– Capricious

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Conclusions• The business requirements dictate ownership

model and financial considerations• Ownership models range from simple to

complex• Complexity does not diminish any of the above,

in fact it increases the need for diligence

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Further Reading

Bonbright, James C., Albert L. Danielsen and David R. Kamerschen. Principles of Public Utility Rates. Arlington: Public Utility Reports Inc., 1988

Keezer, Dexter and Stacy May. The Public Control of Business. New York: New York Times Co., 1973

Kahn, Alfred E. The Economics of Regulation, Principles and Institutions. New York: John Wiley & Sons Inc., 1988

Taylor, Graham. State Regulation & The Politics of Public Service, The Case of the Water Industry. New York: Mansell Publishing Ltd., 1999

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For Further Questions

Presenter: Jason Mumm, PresidentStepWise Utility Advisors, LLC. | 58 Inverness Drive East, Suite 260Englewood, CO 80112 | (866) 935-3101jay@stepwiseadvisors.comwww.StepWiseAdvisors.com

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SUPPLEMENTAL SLIDESColorado Law Institute Water Marketing Conference – Beaver Creek, CO

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Return Charged to Non-Owners

Pays ForMeasured AsCapitalOwners

Invest

Debt

Depreciation Expense

Debt Principal

Interest Rate Interest Expense

Equity

Depreciation Expense

Investment Principal

Return on Equity

Opportunity Costs