Authors: Phil Sapone and John Mastracchio

Cash Reserves and How They Can Help Your Utility

Strategic cash reserve policies can help utilities mitigate risk and reduce rate increases while maintaining financial and operational stability.

There are many fiscal policies that can be implemented by managers striving to ensure a strong financial position for their water and/or wastewater utility. Perhaps none are more important than those pertaining to liquidity needs. Liquidity refers to an entity’s cash position relative to its short-term obligations. At best, a lack of awareness about a utility’s liquidity needs can lead to higher repair and replacement (R&R) costs, rate spikes, and reliance on General Fund support. At worst, it can lead to system failures, long service interruptions, and harmful environmental impacts. Thus, liquidity, or cash reserve policies, play an essential role in helping utilities better serve their customers, while allowing them to operate in a financially stable and self-sufficient manner.

What are Utility Cash Reserves?

Utility cash reserves are funds set aside, separate from user charges, miscellaneous fees and/or other non-rate or fee-based revenues, governmental transfers, grants, or debt proceeds, that are available to fund the operating and capital-related costs of a water and/or wastewater system. In general, there are three main types of cash reserves: operating, capital, and debt-related.

In this article, we will discuss the purpose of operating and capital cash reserves, their associated benefits, and considerations for how to implement these reserves at levels appropriate for each utility.

What is the Purpose of Cash Reserves?

While reserves are maintained to address the utility’s liquidity needs, there are other reasons to have reserves in place. Operating cash reserves are commonly held to:

• Absorb short-term revenue losses from seasonal fluctuations in demand. Utilities that incorporate a volumetric component into their rate structure may realize revenue declines during times of lower than normal water demand. This may occur during winter months or when experiencing higher than normal rainfall during spring or summer months. In such cases, utility revenues may not be sufficient to fund monthly operating costs and reserve balances may be used to address shortfalls.
• Offset revenue losses from lower than expected annual sales. Long-term water-use restrictions, the loss of one or more significant customers, and economic downturns are events that can negatively impact utility revenues over the course of a year or longer. To mitigate the need for significant rate increases to offset these events, operating reserves can be used to address revenue shortfalls in the near-term, while rates are increased gradually over several years to meet revenue needs.
• Address timing differences between periodic cash inflows and outflows. Utilities incur various types of operating costs to provide continuous service throughout the year but recover these costs from customers on a periodic basis (i.e., monthly, quarterly, semi-annually, or annually). Due to billing processes and collection policies, utilities may not recover costs pertaining to a given service period until several months after the period has ended. Therefore, cash reserves are often used to fund operating costs on an interim basis until periodic revenues are collected.Furthermore, utilities commonly incur large, one-time costs that benefit the utility throughout the year, or longer. Examples include insurance premiums, routine maintenance expenses, or professional service costs. Reserves can be used as working capital to help absorb the full amount of these costs on a short-term basis until the remaining portion of annually budgeted revenues are collected over the course of the year.
• Pay for unexpected or extraordinary operating expenses. It is common for water and wastewater utilities to incur expenses during the year that are above what may have been budgeted or planned for. Such expenses could be due to unanticipated vehicle breakdowns or minor equipment failures, excessive overtime incurred in response to a higher than normal volume of leaks or main breaks or higher than anticipated electricity or chemical prices resulting from unexpected economic factors.

Capital reserves can also serve:

• As a set aside to cash fund all, or a predefined portion, of a future capital project, as part of a capital financing policy. Some utilities have debt management policies stating the maximum extent to which debt can be used to finance capital project costs. This can help the utility to manage default risk and reduce interest costs.
  An example of the use of a capital reserve under this type of policy would be a situation where a pump station is expected to be replaced in 10 years at an estimated cost of $10 million. If the utility’s debt management policy is to finance no more than 75 percent of capital project costs, it may decide to set aside $250,000 ($10 million × 25% = $2.5 million ÷ 10 years = $250,000 per year) each year, over the next 10 years, into a dedicated capital reserve. At the end of 10 years, $2.5 million will have been deposited in the reserve and can be used to fund 25 percent of the pump station replacement project, as required by its debt management policy.
• To pay for unexpected or extraordinary capital R&R projects. From time to time, utilities may experience unexpected infrastructure failures, requiring substantial repair or replacement (R&R) costs. In order to commence work on these projects as soon as possible, utilities can use capital reserves to fund project costs rather than waiting until borrowed funds can be secured.In addition, some utilities opt to pay for planned capital projects with cash reserves prior to obtaining long-term financing. Thus, the new debt is issued on a partial or full reimbursement basis, and the net proceeds of the debt are used to reimburse the utility for project costs incurred prior to issuing the debt. The benefit to this approach is that utilities can begin work on projects according to their own schedule, without having to wait for financing to be obtained.
• To smooth out routine capital R&R project revenue needs. Routine capital R&R costs are those that occur each year or every few years. Because they are recurring expenditures and have a relatively short service life, they are typically funded with cash from current revenues. While the work performed is routine in nature, the project costs incurred may fluctuate on a year-to-year basis. Capital reserves can be built up in years where planned R&R costs are lower than normal and utilized to fund project costs in years where planned routine R&R costs are higher than normal, thereby mitigating the need for rate increases.

What are the Benefits of Cash Reserves?

Maintaining adequate cash reserves involves encumbering rate payer funds for non-specific or uncertain events and their associated costs. The utility should be able to realize a clear benefit by holding the reserve.

There are multiple benefits that can be realized by maintaining sufficient operating and capital reserves. As reserves address liquidity needs, one benefit is that they ensure bills are paid on time and in full, and the utility can continue to operate without interruption. Reserves also support utilities in their operation as self-sustaining enterprises independent from general governmental support. Without the help of cash reserves to supplement system revenues at certain times, utilities might require general governmental support to meet their obligations. In addition, reserves can help eliminate or mitigate rate spikes in response to unexpected operating expenses or higher than normal routine R&R costs, allowing customers to enjoy the benefit of relatively stable and predictable bills on a year-to-year basis.

Capital reserves can also be used to commence work on urgent R&R projects with minimal lead time. The utility will incur fewer service interruptions to customers, avoid possible adverse environmental impacts, and minimize further damage to the system or to nearby public infrastructure, as problems within the system can be addressed in a more timely manner. When capital reserves are established in response to debt management policies, they can help to reduce the need for new debt, decreasing interest and other finance-related costs. The utility can also reduce the administrative burden associated with new debt issuances when cash is used to fully fund capital project costs.

Lastly, reserves can serve to reduce borrowing costs by maintaining strong, or improving weaker, credit ratings. Bond rating agencies such as Fitch Ratings, Moody’s Investor Services, or Standard and Poor’s Financial Services consider various factors in developing their credit ratings; however, a utility’s financial strength remains a key aspect of a strong rating and agencies view adequate reserve levels favorably as part of their ratings criteria.

What Level of Reserves is Recommended?

No special formula exists to determine the level of reserves a utility should carry and there is no “one size fits all” amount. The appropriate level of minimum operating and capital reserves that should be maintained varies from utility to utility, and several factors should be carefully considered in determining these amounts. In addition, it should be noted that minimum reserve levels can be stated in dollar terms, as a specific dollar amount, or they can be expressed as the number of days cash on-hand. In general, days cash on-hand is understood to represent unrestricted and available cash on-hand, divided by annual operating expenses, multiplied by 365 days per year.

Factors to consider when determining the minimum level of operating cash reserves include, but may not be limited to:

• Billing Frequency: Utilities that charge customers on a monthly basis generate relatively frequent cash inflows. Utilities that charge customers quarterly, semi-annually, or annually, must wait a longer period of time from when costs are incurred to when the revenues associated with the service are collected. Thus, operating reserve balances should be higher for utilities with longer revenue cycles.
• Rate Structure: Utilities that utilize a volumetric rate component as part of their rate structure are subject to revenue declines due to short-term decreases in demand. While utilities are increasingly implementing fixed charges industry-wide, a significant portion of user charge revenues are still derived from volumetric rates. As a result, utilities that generate a larger portion of revenues from volumetric rate components should consider carrying a higher level of reserves.
• Variability of Water Consumption: When a volumetric rate component is used, fluctuations in water demand can result in changes to billed revenue. Utilities serving areas where there is outdoor water use or variable weather conditions, may be more vulnerable to this effect and should consider higher than normal reserve levels to mitigate negative revenue impacts.
• Historical Review of Minor Emergency or Unanticipated Expenses and Assessment of System Condition: Where reserves are implemented to address emergency R&R work, utilities should consider historical annual costs incurred that are of a similar nature, assets that are operating beyond their known or depreciable service lives, as well as the overall condition of system assets.
• Use of Budget Contingencies: Utilities that incorporate contingencies into their annual operating budget are typically able to maintain a lower level of cash reserves than utilities that do not, as these line items serve to absorb losses from unexpected events during the year.
• Bond Ratings: Utilities that desire to establish or maintain strong credit ratings should consider credit agency rating criteria and the typical level of reserves held by water and wastewater utilities with strong ratings. On an annual basis, Fitch Ratings analyzes key financial metrics of utilities whose debt it has rated during the year and publishes the median values of each metric, including the days cash on-hand, for these utilities.

According to the Fitch 2018 Medians, for utilities with an “AAA” rating, the median level of reserves was 692 days cash on hand, for “AA” rated utilities, the median level was 572 days, while for “A” rated utilities, the median was 311 days.[1] These figures include both operating and capital reserves. While comparing a utility’s cash reserves to these medians may be useful, as discussed above, there are many factors that should be considered in establishing cash reserve levels and targeting a median industry value may not be appropriate considering a utility’s specific circumstances.

The main factor to consider when determining an appropriate minimum target for a capital reserve is the intended use of the reserve. For example, if the utility wishes to establish a capital reserve as part of a fiscal policy related to debt management, the size of the reserve will depend on the policy for cash funding, the number of years until the asset is to be acquired, and the estimated cost of the capital asset or assets to be acquired. Alternatively, if the reserve is being established to address unexpected capital R&R costs, utility managers should consider the replacement value of assets that could be at risk of failure based on their knowledge of the system’s overall condition, or historical cost of unexpected capital R&R expenditures in prior fiscal years. Another option to assess possible R&R reserve levels is to review the fixed asset register, estimate the replacement value of assets that have reached the end of their depreciable, or industry-accepted, service lives, and compare that amount to the R&R spending from current revenues.

When the purpose of the capital reserve is to mitigate rate spikes by smoothing out revenue needs associated with routine capital R&R, contributions to the reserve may be made based on the estimated average annual routine R&R capital need and the actual amount spent in a given year. For example, if the average annual routine R&R capital spend over a 10, 15, or 20-year time horizon is estimated to be $5 million per year and the utility spends $3 million in a given year, then $2 million should be deposited into the capital reserve in that year. Of course, in years where the actual cash funding requirement for these projects exceeds the annual estimate, a withdrawal will be made from the reserve to offset the revenue need and, as a result, mitigate required rate increases.

In conclusion, understanding the utility’s liquidity needs and implementing a cash reserve policy is an important step that utility managers can take to operate their water and/or wastewater systems in a more fiscally responsible manner. Operating and capital reserves are two types of reserves commonly used by utilities to address their liquidity needs. While establishing policies and implementing these reserves in response to utility needs is a rather simple and straightforward process, the benefits associated with operating and capital reserves are significant, and in the end, will better allow the utility to meet its most important goal, which is the provision of safe, reliable, and sustainable service to its customers.

[1] 2018 Water and Sewer Medians, Fitch Ratings, Inc.