U.S. public utilities, like water, wastewater and solid waste, are generally operated by government entities or local municipalities. These governing entities establish dedicated departments within their overall operations to oversee the planning, construction, operations and maintenance of the aforementioned public utilities for their citizens. Depending on the size and complexity of overall operations, we may see public utilities structured in the following models: Municipal Utilities Department (MUD), Utility Authorities/Districts, Public-Private Partnerships and Cooperative Utilities.
Regardless of the model, the primary goal is to ensure the reliable and efficient delivery of essential services to the public while adhering to regulatory standards and maintaining growth and strong fiscal health. Typically, the utility operations are largely funded through the utility rates that citizens pay for these services. Hence, the need to review and adjust the utility rates is the single critical piece to ensure the longevity and growth of any utility operation are adequately funded to meet future demands.
In this article, we will take a closer look at the process of utility rate setting and the dire need to incorporate comprehensive financial forecasting in the entire process.
Understanding the Utility Rate Setting Process
Setting public utility rates is relatively complex as it entails balancing the financial sustainability of the utilities and protecting the economic well-being of the public, while also garnering public support throughout the rate setting process. The utility’s fiscal sustainability includes mitigating financial troubles to balancing operational costs while keeping in mind the socio-economic conditions of the community served.
Transparency in Rate Setting
Clear and open communication about how rates are determined fosters trust between utility providers and the public. Citizens should have access to information about the breakdown of costs, upcoming infrastructure projects and the rationale behind rate adjustments. This transparency ensures that rate increases are seen as fair and necessary, rather than arbitrary.
Comprehensive Cost Analysis
Utility rates should accurately reflect the actual costs associated with providing services, including maintenance, upgrades and investments in new technologies. By conducting thorough cost assessments, the governing bodies can establish rates that cover operational expenses while avoiding unnecessary financial burdens on consumers. This approach ensures that utilities remain financially viable without placing undue strain on the community. This part also entails close coordination with the municipality’s finance/Treasury teams on identifying the funding mechanisms for larger upgrades or expansion strategies – long-term debt issuance vs cash on hand.
Long-Term Rate Forecasts
Utility rate setting isn’t limited to the upcoming fiscal/calendar year or simply ensuring that new utility rates are adequate to keep the utility financially afloat for the next year. Strategic financial forecasting allows utilities to anticipate future needs and plan infrastructure investments accordingly. By adopting a proactive approach, communities can avoid reactionary rate adjustments that may catch residents off guard and lead to financial strain.
Collaboration Between Regulators and the Community
It’s important to understand that regular public consultations provide an opportunity for stakeholders to voice concerns, ask questions and contribute to the decision-making process. This collaborative approach ensures that the diverse needs of the community are considered, fostering a sense of shared responsibility and a more equitable distribution of the financial burden associated with public utilities.
Hence, mitigating financial troubles in public utilities requires a multifaceted approach that prioritizes transparency, accurate cost assessment, long-term planning and collaborative decision-making. However, the municipality staff/utility has to propose a rate hike and/or forecast for the community and public to consider, which requires comprehensive financial modeling.
Financial Modeling in the Public Utilities Rate Setting Process
The use of financial modeling is imperative to set rates based on the appropriate charges for the services provided. The financial model is a dynamic and multifaceted tool that considers operational and capital costs, regulatory requirements, social considerations and long-term planning. It aims to strike a balance between ensuring the financial viability of the utility and addressing the needs and concerns of the community it serves. Now, let’s review some of the main financial considerations and components often included in public utilities rate-setting:
Cost of Service Analysis
In terms of operational costs, the financial model assesses the day-to-day expenses of providing utility services. This includes salaries, maintenance, repairs and administrative costs.
Meanwhile, capital costs are expenses associated with infrastructure investments, such as the construction, expansion or upgrade of facilities. This may involve long-term borrowing for capital projects.
- Revenue Requirements
The financial model calculates the total revenue needed to cover both operational and capital costs. This involves determining the minimum revenue requirement to maintain and enhance the utility’s services.
- Establishing and/or Funding the Utility Reserve
Utility reserve is funding set aside, beyond the cost of service, to either stabilize the future rate increases or funding unanticipated costs that could arise throughout the operational year. Although governing entities and/or utility boards may decide what percentage of total operational cost should be held as the reserve, the Government Finance Officers Association (GFOA) recommends roughly two months of total operational cost to be held in the reserve – representing 17% of the total operational cost.
- Regulatory Considerations
The financial model takes into account regulatory constraints and requirements. Public utilities are often subject to regulatory oversight to ensure that rates are just and reasonable. Regulatory considerations may include rate caps, performance standards and reporting requirements.
- Affordability and Social Considerations
This model considers the socio-economic conditions of the community. Affordability is a critical factor, and the financial model may incorporate mechanisms such as tiered pricing or subsidies for low-income households to ensure that essential services remain accessible to all residents.
- Long-Term Planning
The financial model incorporates long-term planning to anticipate future needs. This involves forecasting changes in demand, considering technological advancements and planning for infrastructure investments to avoid sudden rate spikes.
- Sensitivity Analysis
Sensitivity analysis is often conducted to assess the impact of changes in key variables on the financial model. This helps identify potential risks and uncertainties, allowing for more informed decision-making.
- Public Engagement
The financial model may incorporate feedback from public consultations and engagement processes. This ensures that the community’s concerns and preferences are considered in the rate-setting process, promoting transparency and accountability.
The Bottom Line
American public utilities are typically run as separate enterprises and their financials aren’t combined with the other municipality funds. Therefore, the municipal debt issued to finance utility operations may be issued by the city that’s overseeing the operations of that utility; however, the fiscal strength of the utility should be based on its own financials and separate from the city’s annual comprehensive financial statements.
For investors interested in utility enterprise debt, they should assess the fiscal strength of the utility based on past performance, rate setting to mitigate any future fiscal challenges and expansion strategies to meet the growth of their customer base. Investors must perform their own in-depth research before investing.
Muni Bond ETFs With Exposure to Utilities
Here are some muni bond funds with significant exposure to U.S. utilities. These funds are selected based on their YTD total return, which ranges from 0.9% to 5.2%. They have expenses between 0.07% and 0.25% and assets under management between $100M and $8.8B. They are currently yielding between 1.8% and 3.7%.
|YTD Total Ret (%)
|Xtrackers Municipal Infrastructure Revenue Bond ETF
|iShares New York Muni Bond ETF
|VanEck Long Muni ETF
|iShares Short-Term National Muni Bond ETF
|SPDR Nuveen Bloomberg Municipal Bond ETF
Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisors prior to making any investment decisions.