Bad for business?

That title may have gotten your attention, but not in a good way. The utility business works a bit differently than "traditional" businesses. In a retail business, if items, say clothing, are appropriately priced, then the aim is to sell more items and increase the gross margin (revenues minus cost of goods sold).

The utility and electric co-op business model walks a fine line between encouraging customer conservation to be a steward of the environment and recovering the utility's cost of providing service to its customers. Other factors in play, such as greater efficiencies in water use in plumbing fixtures, recycled water, and smart watering, naturally drive down water use. In the electric business, reductions in electric use due to more efficient appliances, air conditioning, hearting, lighting, and computers, coupled with increase in electric use due to electric cars (just the start of that trend) leads to an interesting landscape when it comes to electric rates.

But our topic in this article is how to connect the recovery of the costs of serving water customers and reduce consumption by all customers.

Key takeaways on water conservation rates

1. Traditional water rates used a declining block rate structure - the more used, the cheaper the cost per gallon.

   2. The current approach is to use water rate structures to encourage the conservation of water resources.

   3. The creative use of inclining block rates, surcharges, summer/winter rates, and impact fees can be sued to recover the water utility's revenue requirement and incentivize customers to use less water.

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A very brief water rate history

The traditional approach to water rates decades ago was to use "declining block" rates, where the more water used, the less the cost per gallon. An example of a declining block water rate is shown in this table:

Also, "flat rates" were prevalent. A flat rate charges the same rate per gallon of water used, no matter the amount used.

Rates were designed to recover the cost of serving customers. The process was efficient, effective and reflected the views of water use at that time.

The cost to serve customers, aka the "Revenue Requirement"

Utility revenues should be sufficient to recover annual operating costs, debt service, and capital additions. The first step in the ratemaking process is to develop a "revenue requirement" that forecasts those three items for one year into the future. The components of a cash basis revenue requirement is:

Next, analyzing the cost of service

The cost of service uses the revenue requirement to develop cost allocations.

Step 2 allocates the revenue requirement to the significant cost categories - base, extra capacity, maximum day, maximum hour, and fire protection. While costs are allocated into deeper subsets of these categories, these main drivers are the engine that runs the cost of service and customer rates. The tool used to categorize customer usage is a consumption curve, which is shown in the following Illustration:

The curve shows the hour and day of the month where this customer class contributes to the water system's peak usage. These drivers direct the impact of costs since the water system must be designed to meet maximum customer usage (with a potential fire event).

The final step - Designing customer rates - Conservation rules the ratemaking process

Now we get to the fun part - designing customer water rates. There are various rate approaches used to encourage customer conservation of water resources. Remember that the total revenue requirement has to be recovered to operate the utility, and pay employees and debt holders. Each rate needs to cover the revenue requirement or add to the goal of meeting the revenue requirement.

In many utilities, the long-term goal is to reduce the average daily usage per person (gallons per capita per day). These conservation rates are designed to provide needed water to the average user at an equitable rate and charge an exponentially higher rate to large water users.

Some common conservation-inducing rates include:

Inclining Block

An inclining block rate charges more per unit of water the higher the usage per billing period. The rate is designed to induce conservation by making the usage at the top rate expensive enough for the customer to take notice. The rates should be designed to recover up to 80% of the variable water costs, leaving the remaining 20% for the high water users.

An example of an inclining block water rate is shown in this table:

Summer and Winter Rates

Summer and winter rates are designed around the "summer" season of the utility, so it varies depending on location. The summer rate is 10% - 20% or higher than the winter rate. The goal is to reduce water use for non-essential areas, such as watering lawns daily. Electricity prices historically have been higher in the summer months, so the additional revenue from the summer rate can contribute to the increase in operating costs.

Demand Charges

Demand charges reflect the cost of providing water "on demand" to customers based on their meter size. The bigger the meter, the bigger the customer. Demand costs also include the costs of billing customers, serving customers, and meter reading.

In water rate design, the demand charge should reflect the customer's potential demand on the water system whether or not the customer is using that water level. The meter size dictates the "available for use" of the system by the customer. Just as in serving electric customers, the utility must size the water system to meet the maximum potential demand of all customers.

Surcharges and impact fees

Surcharges can be adders to any water rate for short-term or long-term cash flow needs. For example, customer growth will eventually trigger the need to construct additional sources of water supply, pumping, and storage facilities. Water utilities can add a surcharge to each customer's bill for this future growth or charge users above a specific monthly water usage. The monies collected are kept separate until needed for the construction project.

Likewise, a water utility may include an additional surcharge for water usage over a monthly amount (focusing on high usage) as a peak charge. The goal is to reduce the peaks.

Sprinkler Credits

It was common for municipalities that operate both the water and wastewater utilities to offer "sprinkler credits" in the summer months for sewer customers to reflect that lawn watering takes place by the customer, so not all water used is entering the wastewater system. Many utilities still provide these credits.

Wastewater rates per gallon are generally higher than water rates per gallon. As the water and wastewater customers are usually at the same household, NOT offering sprinkler credits for wastewater billing can encourage water conservation.

You can be creative with water rates

As a public service, a municipal water system's goal is to provide clean water to all customers at an affordable price. The goal is also to conserve water resources and the source of water supply. This article does not discuss the socio-economic impact of higher water rates on different customer groups.

The rate process can do just that, charging high users pricing that may provide an incentive for using less water. There will always be customers with a price elasticity of zero, meaning that whatever the water rate is, they will use whatever they need regardless of price. But, creative pricing in water rates can positively impact the utility's usage and recover the cost of serving all customers.

About Russ Hissom - Article Author

Russ Hissom, CPA is a principal of Utility Accounting & Rates Specialists a firm that provides power utilities rate, expert witness, and consulting services, and online/on-demand courses on accounting, rates, FERC/RUS construction accounting, financial analysis, and business process improvement services. Russ was a partner in a national accounting and consulting firm for 20 years. He works with electric investor-owned and public power utilities, electric cooperatives, broadband providers, and gas, water, and wastewater utilities. His goal is to share industry best practices to help your business perform effectively and efficiently and meet the challenges of the changing power and utilities industry.  

Find out more about Utility Accounting & Rates Specialists here, or you can reach Russ at russ.hissom@utilityeducation.com.

The material in this article is for informational purposes only and should not be taken as legal or accounting advice provided by Utility Accounting & Rates Specialists. You should seek formal advice on this topic from your accounting or legal advisor.