Keep it simple with three decision points for capital funding policies

Water and sewer utilities are capital intensive enterprises. To serve customers across sprawling service areas and rugged terrain, they must construct, install, and maintain a vast amount of, often buried, infrastructure. As they re-invest in their systems, or as service areas continue to expand, the utility faces the burden of funding the resulting infrastructure needs.

At a Glance

Utility cash reserves act as a financial safety net, protecting against unexpected costs and ensuring uninterrupted service delivery.

Operating cash reserves stabilize revenue fluctuations, while capital cash reserves fund critical infrastructure repairs and replacements.

Determining the optimal level of operating cash reserves requires careful analysis of various factors to balance financial resilience with operational efficiency.

Decisions related to capital financing can be complex, and municipal financial advisors are a great resource for utilities both before and during the process of a debt issuance. In addition, the American Water Works Association has published the Manual of Water Supply Practices #29, Water Utility Capital Financing, which covers the capital financial planning process, the identification and evaluation of financing alternatives, and the process and players involved in a typical municipal bond issue.

Rather than getting into the details of capital financing, this article aims to identify and discuss three basic capital funding decision points that can be helpful to utility managers as they consider how to fund capital investments. Many utilities we work with ask us to evaluate their capital funding policies, and starting the discussion by explaining these decision points is a valuable first step.

The three decision points are rate impact, intergenerational equity, and debt management.

 


Figure 1.
Basic Capital Funding Decision Points


 

Rate Impacts

A utility’s capital funding mix can be optimized to minimize bill impacts over a forecast period. In other words, depending on various factors, a specific amount of debt and a specific amount of cash, either from rates or from reserves, can be deployed to minimize the degree to which a customer’s bill will increase due to capital spending. Some factors that affect an optimal funding mix include the utility’s existing level of debt service coverage, its free cash flow after paying operating expenses and debt service, and the level of cash reserves on hand to fund capital project costs.

A sensitivity analysis can determine the optimal funding mix to minimize bill impacts. This involves changing a single variable (e.g., the portion of the capital program funded with cash over the forecast period) and seeing how this impacts the analysis result (the percentage increase in a residential bill over a five-year forecast period).

Figure 2 summarizes the results of a sensitivity analysis for a water utility with an internal fiscal policy to cash-fund at least 50 percent of its capital program on a three- to five-year basis. The utility wished to adhere to this policy but, with significant capital expenditures on the horizon, was concerned that, while this policy was helpful from a debt management perspective, rate impacts to customers could be better managed by funding more of the capital plan with debt.

To answer this question, we prepared a sensitivity analysis to determine the optimal funding mix to minimize customer bill impacts and analyzed to what extent this would cause the utility to deviate from its existing capital funding policy. The results in Figure 2 indicated that a funding mix of approximately 55 percent cash and 45 percent debt would result in the lowest cumulative rate increase (42.2 percent) over the five-year period. In other words, these average annual proportions of cash and debt would optimize the capital funding mix and minimize projected rate adjustments over the forecast period.

This provided the utility with the information it needed to know – its policy to cash fund 50 percent of future capital investments over the next five years would not result in significantly higher rate adjustments than if it were to use more debt.

 


Figure 2.
Sensitivity Analysis for Capital Funding Mix


 

Intergenerational Equity

Intergenerational equity refers to how fairly the upfront cost of a capital asset is recovered from those benefiting from the asset. The method used to fund infrastructure can greatly affect intergenerational equity for a utility.

For example, assume an asset has a useful life of 25 years and will benefit customers over this period. If the asset is paid for in cash generated from rates in the year acquired, then only those who were customers of the system in that year contributed to the cost of this asset. An individual who moves into the service area the following year would not have contributed toward the upfront cost of the asset; however, this customer could benefit from the asset over the remaining 24 years of its useful life.

Alternatively, if the asset was financed with debt over 25 years, the customer that moves to the area the next year (the second year of its useful life) would contribute to the upfront cost of the asset for the length of time the customer remains in the service area and benefits from the asset. This is much fairer from a cost recovery perspective.

Assets with shorter useful lives, like office furniture, equipment, software, vehicles, and most other rolling stock and minor equipment used throughout the plant and in the field, are more appropriately funded with cash from an intergenerational equity perspective, as these assets typically have useful lives less than 10 years. In addition, funding these items with cash avoids having customers repay the cost of these assets after they have been retired. For example, a vehicle that lasts seven years could be financed with a 20-year bond; however, a customer who moves into the service area in year eight (the year after the vehicle reached the end of its useful life and was retired) will continue to pay a share of the debt service cost associated with that vehicle for the next 13 years.

Figure 3 summarizes the intergenerational equity concept as follows: from a cost recovery standpoint, it is fairer for assets with shorter useful lives to be funded with cash from rates, while it’s more appropriate for longer-lived assets to be financed with debt.[1]

 


Figure 3.
Intergenerational Equity Concepts


 

Debt Management

Debt management is also a key capital funding decision point. Financing helps to mitigate rate impacts by spreading infrastructure costs over a repayment term, but if a utility accumulates too much debt and becomes too highly leveraged, it can adversely affect the credit rating of the system or the municipality, raising its future borrowing costs. A simple debt-to-assets ratio can be an effective metric to evaluate a system’s debt level.

A utility can manage its debt level by designing rates to generate cash to pay for a desired percentage of its capital program. For example, if over the next five years, a utility will be re-investing $50 million into its system and wishes to manage its debt by funding 30% ($15 million) of these investments with cash, it could set its rates such that they provide $3 million per year in free cash after operating expenses and debt service. Note that unless the rates were reduced, the utility would continue to generate $3 million per year in cash to re-invest into the system. This is why it is helpful from a debt management perspective to cash-fund recurring capital expenditures, such as distribution main replacement programs, with cash from rates.

Conclusion

There is no one-size-fits-all capital funding policy or plan. Each utility must decide what is right for them. Starting the discussion by making sure utility managers understand how a capital funding policy or plan can affect rate impacts, intergenerational equity, and debt management can help a utility develop a policy or plan that is right for them.

Want to learn more about fiscal policies? Check out our additional insight article on cash reserves and how they can help your utility.


[1] An exception to this would be the ongoing replacement of distribution and/or collection pipes. For example, consistently cash-funding the replacement of 1.5% of the system’s distribution pipes per year on an ongoing basis would enable these costs to be recovered fairly across the 75-year replacement cycle.

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