# 1.7: Water Rates


Student Learning Outcomes

After reading this chapter, you should be able to:

• Evaluate different rate structures
• Understand why water rates are needed
• Analyze water rights and utility ownership

## Why Are There Water Rates?

Water must be sold in order for a utility to be able to treat, distribute, and deliver water. There are chemical, electrical, infrastructure, labor, and a variety of expenses a water utility must cover. In order to pay for all these expenses, they must receive revenue to cover all the costs associated with operating and maintaining a water utility. This required revenue is referred to as revenue requirements.

Revenue requirements can be explained, as the total revenue required to ensure proper operations and maintenance, development, and perpetuation of a distribution system, and preservation of the utilities' financial integrity. Most of the revenue received by a water utility comes from the sale of water. However, some utilities receive supplemental revenue from renting property, merchandising, services related to other utilities, taxes, capacity, and impact fees.

Utilities must properly budget based on projections of water sales and all associated expenses for proper water rates are assigned in order to generate enough revenue. Sometimes budgets and associated projections extend out multiple years. Regardless of budgetary projections, they should be reviewed annually and adjusted accordingly.

Water rates studies and analysis usually accompanying any rate changes. Budget projections aid this process of rate-making. Additional studies can also include financial and budgetary planning, support for issuance of debt, and evaluation of past and future adequacy of contractual, litigation, rate proceeding or other requirements.

When a utility is calculating the adequacy of revenue in order to recover costs. Budgeting may require projections into the future. Projections beyond ten (10) years tend to be quite speculative, while five (5) projections are usually considered adequate. Historical water usage and other data is used to help determine appropriate water rates. However, the data must be normalized or adjusted to reflect conditions that may not continue in the future. For example, if there will be no future growth of additional customers, the need for additional sources of supply and storage may not be needed.

Below is a list of some factors affecting revenues:

• Number of customers served
• Customer water use
• Rate changes
• Non-recurring sales
• Weather
• Conservation
• Use restrictions
• Price elasticity

Below is a list of factors affecting revenue requirements:

• Number of customers served
• Customer water use
• Non-recurring sales
• Weather
• Conservation
• Use restrictions
• Inflation
• Interest rates on debt
• Capital financing needs
• Changes to tax laws
• Other changes in operating
• Economic conditions

There are two general approaches for projecting revenue requirements. They are cash-needs approach and utility approach.

## Cash-Needs Approach

The cash-needs approach ensures revenues are sufficient to recover all the utility cash needs for a given projected time period. This approach simply means the total amount of revenue needed to meet cash expenditures. The cash-needs approach usually relies on debt financing. Debt indentures usually specify sufficient cash to meet cash expenditures, deposits are made to reserve account(s), and debt-service coverage requirements are met.

The accounting term “cash” refers to revenues being recognized as earned when cash is received and expenses charge when cash is disbursed. The term “accrual” refers to revenues being recorded when earned and expenditures are recorded when the become liabilities for benefits received and are not dependent on what period of time they are received.

The cash-needs approach is usually followed by public (government-owned) water utilities. Elected officials of public water utilities are tasked with approving water rates.

## Utility Approach

The utility approach of projecting revenue requirements is mandated for all investor-owned (private) water utilities. This approach is also referred to as “utility basis” approach. This approach is similar to the cash-needs approach. However, the governing regulatory body assigns a “rate payer advocate”. In California, this rate payer advocate group is referred to as the Division of Rate Payer Advocate (DRA) and the governing body is the California Public Utility Commission (PUC).

This approach involves measuring revenue requirements with or without concern for allocating revenue requirements among classes of customers served. This means assigning or not assigning specific revenue requirements to specific classes of customers.

## Revenue Requirement Components

In order to determine the revenue requirements, a utility must determine all the operating expenses. In other words, what does it cost the utility to provide service. On the surface, this might seem like an easy and straightforward task. However, there are a lot of aspects to operating a water utility and it is important to capture all these expenses. The following list is not exhaustive, but it is fairly comprehensive.

• Salaries
• Benefits
• Energy costs
• Chemicals
• Supplies
• Fuel
• Equipment costs
• Equipment replacements
• Principal and interest payments on debt
• Miscellaneous

The paragraphs below will provide additional detail for some of these operating costs.

## Operations and Maintenance

These expenses are usually based on actual expenditures and adjusted to reflect anticipated changes. Operations and maintenance (O & M) costs include employee salaries, wage, benefits, purchased power to operate pumps and equipment, purchased water from other utilities, chemicals for treatment, supplies, tools, equipment, vehicles, fuel, outside services, and general overhead. Some outside services can include, billing services, construction contractors, engineering and other consultants, other utility services. This list is not exhaustive but should provide a good general understanding of the various O & M expenses.

Some utility expenses are considered fixed costs while others are referred to as variable costs. Fixed costs are the costs the utility most cover to keep the utility in operation and are independent on the amount of water the utility sells. For example, if the water utility does not experience the anticipated water demand (this could be due to water use restrictions during a drought) the amount of revenue recovered would be lower than expected. However, the utility would still need to out salaries, benefits, and administrative costs. The staffing requirements are not directly proportional to the amount of water sold. Water meters would still need to be read, infrastructure, equipment, and vehicles would also need to be maintained. These costs would be considered fixed costs. Whereas, the amount of chemicals needed to treat the water might be less if the utility is producing less water. Therefore, the cost for chemicals would be less and this would be considered a variable cost. Regardless of the type of cost, the utility would still need to recover these revenue requirements.

## Debt Service

Sometimes utilities require large amounts of funds in order to pay for large capital improvement projects. Some of these projects consist of new sources of supply such as groundwater wells, large storage facilities, and other major infrastructure improvements. If a utility had to spend several millions of dollars in a given year and tried to collect these expenditures in the same year, water rates would be unusually high. Therefore, a utility acquires debt in order to spread out these costs over multiple years. Debt service is the annual cost to pay the debt back. It includes both principal and interest.

## Reserves

Water utilities commonly maintain reserve accounts. Reserve accounts are savings accounts. They are usually set aside for emergencies or unexpected needs. For example, if a utility has earthquake insurance, a specific reserve account can be set aside to cover the deductible costs and start making payments to begin the immediate process for repairs to the system. Another example might be a reserve account to replace a large expensive facility if there is an unexpected failure.

## Capital Expenditures

Water utilities will typically have normal routine replacement of existing facilities. All equipment and infrastructure have reasonably expected operating lives. For example, groundwater might last fifty (50) years. The utility would have to plan for the replacement of these facilities. Another example is the piping infrastructure. A utility might have two hundred (200) miles of underground pipelines. Let’s assume the average lifespan of this pipe is seventy-five (75) years. This would mean the utility would need to replace on average 2.7 miles or 14,256 feet a pipe per year to keep up on the replacement schedule. Capital improvement projects (CIP) would also include annual extensions and other improvements. Often times, large CIP is financed through debt, reserves, or some combination. Very rarely are large projects paid for with cash. Issuing debt or using reserve funds prevents the customers from paying 100% of the initial cost of facilities.

## Coverage Ratio

A common measurement to help determine the financial health of a utility is the coverage ratio. This is the measure of the ability of the utility to pay the principal and interest on all loans and bonds. It is calculated by subtracting the non-debt expenses from the total revenue divided by debt service expenses. A good financial coverage ration would be above 1.0.

## Revenue

Where does a water utility get the money to fulfill revenue requirements? There are typically three (3) classes of revenue; Operating revenues, non-operating revenues, and contributions to capital.

Operating revenues include both metered and unmetered water sales. Most of the time, the sale of water is metered. This means a customer pays for the water, which flows through their meter. Sometimes, utilities sell water at a flat rate or unmetered. If a water utility sells water to another water utility they would be considered a wholesale water provider. The revenue earned from these sales are also considered operating revenue. Any fee for or charge for water service is also considered operating revenue. For example, some utilities have a monthly fee for something referred to as a “readiness to serve” charge. This means if a customer has a meter service, but does not use any water for a period of time (i.e., month) the utility would still bill the customer for the ability or readiness to serve the customer. Often times this monthly service charge is based on the size of the meter. The larger the meter the higher the monthly charge. If a water utility rents property (i.e., cellular leases) or charges for the use of the utilities operating property, these would also be considered operating revenues.

Non-operating revenues is a smaller amount of revenue most utilities earn, but they still need to be taken into account. Examples of non-operating revenues include merchandising interest, dividends, sale of property, tax revenues, and various other revenues not associated with operating the utility. The last classes of revenue include funds contributed by developers and grant funds. These are considered contributions to capital.

## Customer Classes

There are generally four (4) main classes of customers. These are identified as residential, commercial, industrial, public authority, and dedicated landscape. Residential customers consist of single and multi-family dwellings. This would include attached and detached homes, apartment buildings, condominiums, and townhomes. Commercial customers would include businesses such as restaurants, small and large businesses. Industrial customers would include manufacturing and processing establishments. Public authority would be public establishments such as schools, city, and county buildings. Dedicated landscape service connections are commonly separated from other service classes.

There are also some special classes of customers. These would include wholesale service, fire-protection, and service for air conditioning and refrigeration.

Wholesale service is usually defined as a situation in which water is sold to a customer at one or more major points or delivery for resale to individual retail customers within the wholesale customer’s service area. This water is typically treated before being sold and is sold to a separate municipality or water district.

Fire protection service is primarily a standby service. There is a readiness to deliver relatively large quantities of water for short periods of time at any of a large number of points within a distribution system. The total quantity of water used is typically small and service costs are based on one of the following two criteria:

1. Cost of service is determined on the basis of the potential demand for water for fire fighting purposes in relationship to the total of all potential demands for water.
2. Cost of service is allocated as an incremental cost to the costs of general water service. It is based on the premise that the prime function of a water utility is to supply general water service.

Air conditioning and refrigeration is water sold for use in water-cooled air conditioning and refrigeration systems. Most units now use water referred to as “make-up” water. This is water recycled within the business.

## Water Rates

It is common practice for a water utility to provide water service to all general service customers within a given jurisdiction through a single rate schedule, comprised of a two-part rate. There are three (3) common general classes of customers and these are:

• Residential—This customer class generally comprises of one and two family dwellings, usually physically separate.
• Commercial—This customer class is commonly comprised of multifamily apartment buildings and nonresidential, nonindustrial business enterprises.
• Industrial—This customer class represents manufacturing and processing establishments

Sometimes a utility will subdivide the general classes of customers into more specific groups. Water use characteristics, service requirements, and other various reasons may set certain customer classes apart from one another. Sometimes utilities will create special classes of customers, which can include wholesale, fire-protection, irrigation, and air conditioning/refrigeration services.

The jurisdictional area referred to above is the service area boundary. A governing body of each water utility determines service area boundaries. In the case of investor-owned private utilities in California, the governing body is the California Public Utilities Commission (CPUC). Within the County of Los Angeles, the governing body is the Local Agency Formation Commission (LAFCO). Commonly, a two-part water rate includes an initial charge, which generally recovers customer related and possibly some volume related costs of the utility, together with a volumetric charge to recover the remaining costs. Some utilities recover their fixed costs with a monthly charge not associated with the amount of water sold. The variable revenue requirements would then be covered by the volumetric charge for water. The volumetric charge is based on the amount (or volume) of water sold.

Why would a utility have a two-part rate versus just charging water based on the actual usage of each customer? This is a common question people sometimes ask. The simple answer is because of the variability in how much water people use. What would happen if every customer only used a small quantity of water? Earlier in this text, we discussed revenue requirements. A utility must sell enough water or more importantly collect enough revenue from the sale of water, to cover all their related “requirements” to operate. If customers use too little water, then the utility would not be able to collect enough revenue, unless they charged an exorbitant amount for each unit of water. An example of this will be presented in the last chapter of this text (Waterworks Mathematics). Therefore, oftentimes, a utility will have a “fixed” charge. This fixed charge is sometimes referred to as a readiness to serve charge. This allows the utility to collect sufficient revenue to keep the utility running regardless of the amount of water sold. It commonly covers meter reading, billing, and day-to-day operational costs. Therefore, a two-part rate, one part fixed and the other part variable is commonly used.

## Flat Rates

A fixed charge is different than a flat rate. A flat rate is something utilities sometimes use when the water supply is plentiful. It is the same charge across all customer classes and users. It is an amount, which must cover the revenue requirements of the utility, but is blind to the amount of water each customer uses. This type of rate is becoming less common, especially in California where drought often affects certain parts of the state. It is also not an even or equitable means of charging for water service. It also does not encourage water savings or conservation.

## Variable Rates

As previously mentioned, a variable rate is based on the amount of water customers use. Therefore, the more water a customer uses the more revenue the utility collects. Conversely, if a customer uses zero units of water over the billing cycle, then the utility would collect no revenue from this particular customer. Also, as previously mentioned, fixed charges can and are oftentimes included with a variable water rate.

## Tiered Rates

Much like variable rates, a fixed charge is usually included with tiered rates. Tiered rates are another type of variable rate structure. However, in a tiered rate the variable price increases with usage. For example, each unit of water would be sold at a specific amount up to a certain unit usage set point. Then after the designated amount, the charged amount is increased until another specific usage amount, and so on. See a simple example below.

• 0 – 9 Units of Water Used = $1.00 • 10 – 19 Units of Water Used =$2.00
• 20 – 29 Units of Water Used = $3.00 • 30 or More Units of Water Used =$4.00

Tiered rates are designed to encourage water conservation. The belief is as water becomes more expensive as usage goes up, usage would be curbed. While tiered rates have been shown to contribute to conservation efforts. However, there are other issues associated with charging more for water based on customer usage. The utility must explain the reason they are charging more for quantities above specific usage amounts. There have been several lawsuits associated with the legality of tiered water rates. One such lawsuit was in 2015 between a group of San Juan Capistrano taxpayers and their local water utility. It is extremely important a utility properly explains and notifies their customers before implanting water rates, especially tiered water rates.

## Budget Based Rates

A budget based rate structure is similar to a tiered rate structure. The difference between the two is instead of charging water purely based on the quality of water used. In a water budget based rate structure, water charges are assigned based on customer usage both indoors and outdoors. While most utilities do not measure these (indoor/outdoor) uses separately, under a budget based water rate, a certain volume is often assigned for indoor water use. In addition, a specific amount is assigned for outdoor water use (irrigation). These assigned amounts are considered a customer’s budget. The rate assigned to the budget is a standard volumetric water rate. If customer’s stay within their budget, do not use more than the allocated amount, then the rate does not change. However, if a customer uses more water than their allocation, the cost of water increases similar to a tiered structure.

Another difference to a water budget rate structure compared to a standard tiered rate structure is budgets are commonly personalized for each customer. In a tiered system, all customers follow the same tiered rate, whereas budgets can be based on the specific water needs of each customer.

Regardless of the rate structure, the utility must be able to adequately recover its revenue requirements with the chosen rate structure. Rates are designed for specific periods of time known as the rate schedules. Projections of expenses are compared against projections of water use and then a rate can be calculated. During a water rate study, utilities will commonly use something referred to as a test year. A test year is an annualized period for which costs are analyzed and rates are established.

Utility costs for ongoing operations and maintenance of the system as well as past large capital improvements must be incorporated into the water rate. In addition, utilities need to properly account for future replacements and growth of the utility. While existing customers typically cover a large portion of these costs, some of the future expansion of a system should be and often times is paid for through fees to construction developers. These fees are referred to as facility capacity and connection fees. These fees are associated with expanding a system in order to supply water to additional customers.

The concept of recovering costs and expenditures through the sale of water is a fairly simplistic concept. However, determining necessary costs and expenditures and calculating the water rate associated with recovering this money is a difficult and complex process in order to keep the customer of water reasonable to the customer, but also ensuring the utility has enough cash flow to keep operations flowing.

## Sample Questions

1. Budget projections beyond 10 years tend to be ___________.
1. Accurate
2. Speculative
4. Both 1 and 3
2. The “Cash-Needs” approach is typically used by ___________.
1. Private utilities
2. Public utilities
3. Agencies with multiple commodities
4. All of the above
3. Which of the following is not included in O&M expenses?
1. Salaries
2. Purchased water
3. Chemicals
4. None of the above
4. Investor-owned utilities are governed by ___________.
1. An elected board of directors
2. A City Council
3. The California Public Utilities Commission
4. A Mayor
5. A periodic stated charge for utility service not based on the metered quantity of service defines ___________.
1. Firm service
2. Flat rate
3. Rate blocks
4. Standard rates
6. The annualized period for which costs are to be analyzed and rates established defines ___________.
1. Test year
2. Yearly projections
3. Annual analysis
4. None of the above
7. Connection fees are charged to ___________.
1. Create revenue for O&M expenses
2. New customers for the costs of new facilities needed to apply water
3. Help establish service area boundaries
4. All of the above

This page titled 1.7: Water Rates is shared under a CC BY license and was authored, remixed, and/or curated by Mike Alvord (ZTC Textbooks) .