RATE SHOCK

What is "rate shock"? It is not a jolt of electricity, but it is a jolt of sorts. It is not a rule of utility ratemaking, but it is a concept within it.

Rate shock is a subjective measure of the assumed impact on utility customers of a proposed rate increase. It is a claim that can pop up in a ratemaking proceeding of any public utility, including water and wastewater utilities.

For example, in an Illinois case involving a drinking water utility, a witness for the regulatory commission testified that a rate increase of over 30% could be considered rate shock.* In that case, the commission approved a consolidated rate structure applicable to several water utilities having a common owner. The commission stated that the consolidated rate structure would enable capital costs to be "spread over a larger base of customers, thus mitigating rate shock to a smaller stand-alone division's base when infrastructure improvements are necessary."

In an Arkansas case, a witness for the Attorney General argued that a 22% gas utility rate increase to the residential class of customers would cause rate shock and, therefore, was unreasonable.** The commission did not address the argument.

Commonly, rate shock assertions arise when a large rate increase is proposed due to a sudden increase in a cost of service. Examples could be storm damage to facilities, unexpected failure of infrastructure and need to repair or replace it, new regulatory requirements, and the like. Sometimes, large rate increases arise because a utility has postponed seeking needed rate relief.

Generally, rate shock is not a basis for denying a rate increase that is justified by cost of service analysis. Rather, rate shock may be a basis for mitigating the impact on customers of a large rate increase. When potential rate shock is perceived, a rate increase may be phased in over two or three years. Or, as illustrated in a Connecticut case, an increased cost be recorded as a deferred expense or regulatory asset and amortized in rates over a period of years.*** The court quoted "A regulatory asset is a liability of a utility's ratepayers. Utility companies may incur large expenses in various ways--storm damages, installation of new facilities, increased taxes and so forth. These expenses, if passed immediately on to ratepayers, could create havoc. An immediate recovery of such expenses could cause sudden upward increases in rates, commonly termed 'rate shock.' In order to avoid rate shock, [public utility] commissions often will permit utility companies to recover their expenses from ratepayers on a deferred basis, listing the ratepayers' debt as a 'regulatory asset.' A regulatory asset is, therefore, a future debt of the ratepayers that can be passed on, together with interest, to the ratepayers."

Perhaps the best way for utilities to avoid claims of rate shock is to avoid, as much as possible, cost factors that can give rise to such claims. For example, regular and frequent review of costs of service and regular resulting incremental smaller increases in rates may avoid deferred large increases. Long range planning for repair and replacement of infrastructure along with establishment of reserves for such work in rates may also mitigate future sudden large proposed rate increases. Finally, phasing in of rate increases or using deferred expense and amortization procedures may enable more "gentle" rate adjustments.

Of course, there may be times when a large rate increase cannot be avoided because of a risk to continuity of good service. However, shock may be diminished when the utility adequately explains to its customers the reasons for the increase. There is no substitute for good communication.

________________________________________________


*Lake Holiday Property Owners Association v.
Illinois Commerce Commission,2016 Ill.App3d
150816-U (3rd Dist 2016)

**Winston v. Arkansas Public Service Comm.,
984 S.W.2d 61 (Ct.App.1998)

***Office of Consumer Counsel v. Department
of Public Utility Control, 905 A.2d 1,
(2006)

© 2017 Daniel J. Kucera

THE VALUE OF WATER, PART 7--PRICING

Water utilities do not sell water. They provide water service. Their water service commonly may include withdrawal of raw water from a source, transport to a central treatment facility, treatment of the raw water to safe drinking water standards, storage of finished water in tanks which also may maintain desired pressure, and delivery of the finished water to users in a distribution network. They charge a price for their water service. Accordingly, water utility rates are not the prices of water delivered--such as the price of a bottle of water at a store--but are the prices of water service provided to customers.

From time to time, some have asserted that water utility rates should be based upon the "value of water" perceived by users. Such assertions are flawed and misplaced. It is unlikely that users of a water system could agree on a single definition, or measure, of such "value". Moreover, such perceived "value" has no correlation with the provision of water service and the costs incurred to provide the service. Simply stated, the value of water is incapable of an acceptable objective methodology for its calculation.

The only objective and fair methodology for water utility rate making is cost of service recovery. This fact has been confirmed repeatedly by numerous court decisions, statutes, regulatory commission polices and writings.

At times, some jurisdictions have attempted to adjust cost of service rate making to effect a particular goal or social engineering. For example, to encourage water use conservation, some agencies have modified rate structure to increase rates as water use increases. Others have suggested special rates for certain levels of low income users, with costs subsidized by other users.

Another example may be denial of the full cost of service recovery to reflect a finding that water service was not of an acceptable quality. In one case, an agency reduced a water utility's recovery in rates of its full cost of capital (rate of return on rate base) for such a reason.

In short, water utility rates do not, and cannot, measure or be predicated upon the perceived value of water.

THE VALUE OF WATER, PART 2--ORIGINS OF LIFE

The story of life is the story of water. As discussed in my recent postings, scientists have derived differing hypotheses as to the origin of water on Earth. They range from ice-bearing asteroids and meteors colliding with Earth to water-bearing cosmic dust particles binding together to form the Earth. However, there does not appear to be any cogent evidence to support these assertions. In point of fact, no one really knows how water was delivered to Earth.

Nevertheless, the fact is that there is water on Earth, in aquifers below the surface; in oceans, lakes, rivers, ponds and puddles on the surface; and in clouds above the surface. And, this water is in all its various forms and states.

So, what does this water mean for us? In the first instance, it appears that animal life on earth originated in water--in seas and oceans. How this happened, again, no one knows for sure. One hypothesis is that life came from rocks. Water, as a solvent, over time eroded certain minerals from rocks, resulting in chemical formation of amino acids from the mineral mix, which in turn resulted eventually in formation of living organisms.

Assertions of chemical evolution, however, were criticized in the book "The Mystery of Life's Origin" by Thaxton, Bradley and Olsen. "They showed that attempts to explain the origin of the first living cell from simpler nonliving chemicals had failed and that these theories had specifically failed to explain the origin of the information necessary to produce the first life." (Meyer, "Darwin's Doubt", 2013, p. 341) In other words, chemistry alone could not produce information in DNA leading to life.

The oldest period in Earth history is called pre-Cambrian, perhaps a little over 4 billion years ago. The first forms of life appeared in the pre-Cambrian period, according to fossil records. They appeared in water, in seas and oceans. They were one-celled organisms and sponges, simple soft tissue organisms having few cell types.

After the pre-Cambrian period, the following period was the Cambrian, which began about 540 million years ago. The fossil record reveals that beginning about 530 million years ago, the "Cambrian Explosion" occurred. Literally, this was an explosion of a multitude of many different and complex animal forms in the seas and oceans. They include trilobites, jelly-fish like creatures, worm like things, shrimp like critters and shell bearing animals. Indeed some of the examples looked like something out of a 1950's science fiction movie. These Cambrian sea animals had sophisticated body plans, including such features as compound eyes, legs, outer skeleton, mouth, digestive system, stomach, reproductive organs, skin, wings and anus. In other words, these sea animals were characterized by features that we can expect to see in all forms of contemporary animal life.

The Cambrian Explosion appeared suddenly. There is no fossil record of any evolution or transition from the simple pre-Cambrian organisms to the complex body plans evidenced in the Cambrian fossils. Darwin's basic theory is that animals have evolved through the process of random mutations and natural selection. In his book "Darwin's Doubt", Meyer reviews Darwin's theory as well all of the off-shoots from that theory that have followed. Meyer concludes that Darwin and Neo-Darwin theories of evolution cannot explain how the genetic information and the novel proteins and systems to regulate expression of that information necessary to build the complex Cambrian body plans could arise. He concludes that the only supportable explanation for the source of the necessary genetic information to build the new body plans is "intelligent design."

The Earth is exceptional. It is designed for life. An important component of the design for life is water. And water was the environment for the beginning of animal life and its explosive Cambrian expansion into countless different and complex body plans. Clearly, water has had value.

THE VALUE OF WATER, PART 1--DEFINITIONS

In water utility rate making hearings and meetings,it is common to hear customer grumbling against rate increases because water they drink, like air they breathe, is perceived to be free. Why should I pay for water that is free? customers object.

If water is free, does it have "value"? In recent years, partially in response to such objections, some industry writers have urged water utilities to inform their customers of the "value of water". Some have gone further to claim that rates for water service should be calculated based upon the "value" of water service to customers, not upon the costs of service.

When applied to water, the word and concept of "value" is capable of many different definitions, sums objective, some subjective. In fact, efforts to describe the "value" of water can take on a metaphysical proportions. Without the particular context for use of the word, reference to the "value of water" in reality can itself become meaningless.

What is "value" and how can it be quantified? What are the possible contexts in which water has value? Does the term "value of water" refer to life;; or to economic activity; or to environment; or to history; etc.? How can value rate making for water service work? Does informing customers of the "value of water" provide any benefit?

In following postings, I will attempt to explore some of the possible meanings of the "value of water"; the contexts in which water may have "value"; whether "value of water" can be measured; and whether the term, in fact, is meaningful.

FIXING RATES TO RECOVER FIXED COSTS WHEN WATER USAGE IS DECLINING

Historically, public utilities--particularly water utilities--have designed rates to recover most, if not all, their costs of service through volumetric usage charges. Under such a rate structure, for example, customers pay a rate per 1,000 gallons, or per 100 cubic feet, of water delivered. Some water utilities also impose a fixed flat rate called a customer charge, designed to recover meter reading and billing costs. Except for the customer charge, which typically is quite small, all costs of service are sought to be recovered under rates which vary with usage.

This historical rate design can be problematic today. First, it assumes that almost all of the costs of water service are variable costs and that fixed costs are minor. In a water utility rate case before a state regulatory commission, the president of the company testified that 90% of the utility's costs actually were fixed costs, not variable costs. He said that variable costs were only such items as power, chemicals and possibly some labor and maintenance. Therefore, he argued for a larger customer charge to recover fixed costs. Regulatory staff in the room laughed and opposed any increase in the fixed rate. Was he correct? Are not depreciation, debt service, return on rate base and some labor and maintenance incurred regardless of the volume of water delivered?

A second issue with the historical rate design is declining revenue due to conservation,more efficient water appliances and usage restrictions. If most of the costs of water service are designed to be recovered from usage charges, and usage has declined, then revenue necessary to recover costs of service has declined as well.

Recently, the Wall Street Journal reported that electric utilities across the country are experiencing these issues and are seeking to resolve them by substantially increasing their fixed customer charges.* Regarding customer charges, "the utilities argue that the fees should cover a bigger proportion of the fixed costs of the electric grid, including maintenance and repairs." One utility official is quoted as saying "Since our cost to provide service is mostly fixed, we think our rate design ought to reflect that more accurately"

The Journal article stated "The problem for utilities is that many consumers are using less power these days, in large part because appliances and equipment are getting more energy efficient....The rise of rooftop solar power in some parts of the country also is chipping away at power sales."

The article cites an opposing view that a higher customer charge to recover fixed costs would be a disincentive to customers embracing rooftop solar power or cutting down on their usage of electricity. This assertion, however, would seem to beg the question as to the adequate recovery of fixed costs of service in view of declining revenue. Water rates, as well as electric rates, should be designed to enable recovery of all costs of service, not to satisfy social or political agendas. Substantial fixed costs are incurred by water utilities to enable them to provide water service to customers on demand.
Fair rate design should reflect that reality and obligation.

_________________________________________

*Rebecca Smith,"Electric Utilities Seek
To Raise Fees As Usage Declines", Wall
Street Journal, October 20,2015,p.B5

DROUGHT: ROUNDING UP THE UNUSUAL SUSPECTS

"But I don't want to go among mad people", Alice remarked.
"Oh, you can't help that," said the Cat: we're all mad here. I'm mad. You're mad."
"How do you know I'm mad?" said Alice.
"You must be," said the Cat, "or you wouldn't have come here."

----Lewis Carroll, Alice in Wonderland

In the 1930s, the center of the United States became the "Dust Bowl" due to prolonged and pervasive drought. The dust was farmland topsoil wind eroded and blown away in dust storms, along with hopes and livelihoods of farm families. As memorialized in John Steinbeck's "Grapes of Wrath", migrant workers and farmers displaced by years of Dust Bowl misery relocated to perceived better times in California.

Now, portions of California and several other western states are experiencing prolonged and pervasive drought which is stressing and displacing lifestyles and livelihoods of residents. Moreover, much of California is naturally dry, and is dependent upon external water sources to sustain population centers and irrigation agriculture. So, the choice now is becoming one of serious reduction in water use or migrating elsewhere, perhaps even back to the center of the country.

The usual approaches to reducing water use have been well publicized, such as
* recycling wastewater
* prohibiting yard watering
* mandating utilities to reduce water deliveries
* mandating reductions in farm irrigation
* requiring installation of low flow water appliances
* adopting inverse rate blocks that rise with volume

These "usual" approaches may produce some success, but perhaps some more "unusual" approaches could also help.

For example, on June 24, the U.S. Department of Agriculture announced a partnership that would invest millions of dollars to restore the Sierra-Cascade California Headwaters, which is the water source for agriculture and some 25 million residents.

One of the most dramatic periods of conservation in the Unites states was during World War II, when many materials and foods were needed for the war effort, forcing citizens to conserve. Two aspects come to mind: (1) citizens were well educated as to the need to conserve resources; and (2) many items were rationed, a form of mandatory conservation. Could these two aspects be applied to help reduce water demand in drought environments? For example, could a per capital standard of average daily water use be established for households, with high volumetric rates applied to excess monthly use?

Agriculture can pose a more difficult issue. There is a significant difference, obviously, between land that produces annual crops such as corn and land that is used for orchards of fruit and nut trees that take years to mature. Perhaps some land can be taken out of temporary production, with governmental financial assistance. Or, irrigation rights temporarily waived or reduced. However, some farms may have contractual water rights which would likely require mutual consent for reductions.

One unique source of additional water could be human sweat. A Swedish engineer created a device to harvest sweat from clothing and to purify it to drinking water. A sweaty T-shirt is said to have produced two teaspoons of clean water. However, sweaty socks may be more productive. A pair of human feet is said to yield a half-pint of sweat every day. If true, sixteen pairs of socks could yield one gallon a day. Perhaps, here is an opportunity for another government program to establish a sock exchange where people would bring in dripping socks and pick up dry ones.*

Two other solutions may be available. If people in California do not like the drought and water use limitations, they might consider moving to the Midwest, where there has been so much record-breaking rain this year that it is a "Flood Bowl."

Or, if people want to stay in California and want more rain, why not just ask God?

______________________________________________________

* Festa, "Sweat", Discover, July/August,2015, p.98

DROUGHT: WATER UTILITIES CONFRONT CONFLICTING POLICIES

"If you don't know where you are going any road can take you there."

---- Lewis Carroll, Alice in Wonderland

The photo depicts the arid wonderland of the South Dakota Badlands. They are a drought stricken moonscape that stands in dramatic contrast to the verdant Black Hills 50 miles to the west.

The Badlands once were full of rich vegetation and animal life also. Fossils evidence now extinct critters such as sabre tooth tigers, sheep-like oredonts, rhinos and miniature horse. At another time, the landscape was under water.

Some have asserted that parts of California naturally are arid and subject to drought--where farming must depend upon irrigation and cities on water sources located elsewhere. Whether current drought conditions in California and other states may be due to climate changes or temporary weather conditions, water utilities must deal with drought in some rational manner. Unfortunately, they can confront conflicting policies that make rational solutions difficult. Some of these policy conflicts include the following:

* Legal Duty To Serve vs. Service Restrictions. Generally, water utilities have a monopoly in their given service areas. This is because of the costly infrastructure required to provide water service; rarely are there competing water utilities within the same service are. For their monopoly status, water utilities incur certain obligations: whether by statute or by court decision, water utilities generally are required to satisfy the water demands of customers within their service areas. This obligation likely can be expected to apply to both investor-owned utilities and to municipal-owned utilities.

However, there can be a conflicting policy when, for example, state or local governments seek to impose restrictions on the amount of water utilities may deliver to their customers. The restrictive regulation limiting water delivery can clash with the legal obligation to serve customer water requirements.

* Higher Rates To Force Conservation vs. Cost Of Service Ratemaking. Some have urged dramatic increases in rates, such as inclining rate blocks as volume of water delivered increases, as a way of forcing reductions in water usage. However, while such measures may appear to have merit from the standpoint of objective, they can clash with applicable legal requirements that to be reasonable, rates must be based upon costs of service.

* Higher Rates To Force Conservation vs. Affordability. Some have argued that higher rates will enable "market forces" to naturally enable the desired reductions in water usage, and thus conservation. However, such a policy may well conflict with the notion of affordability of water. While "affordability" is not a precise concept, one can assume that higher water rates will take a larger chunk out of low income earner budgets. Moreover, affluent customers may feel no pain from higher rates and continue to use their typical amounts of water, thereby reducing the effectiveness of the conservation effort.

* Higher Rates To Force Conservation vs. Reductions In Revenue. Assuming that increased rates are successful in creating reductions in usage, the end result of conservation may also be a reduction of needed revenue to the utility as eell as excess treatment and delivery capacity that still must be funded--pushing rates still higher or forcing excess capacity to be abandoned as no longer used and us full.

* Contracts vs. Abrogation Of Contracts. A water utility serves customers pursuant to contract, which includes the tariffs of a regulated utility and ordinances of a municipal utility. However, if a governmental authority imposes service restrictions, does such an action also abrogate the contracts between utility and its customers?

For water utilities in limited source water environments, determining the best road to travel can be perplexing and full of potholes of policy conflicts. Indeed, the best destination may not be clear. It may seem that the only road available could be a circle.

SHOULD WATER UTILITIES PROVIDE FOR A WORKING CAPITAL REQUIREMENT?

Like many situations in life, success can be a matter of timing. In normal operations, water utilities can experience a significant timing issue. In any billing period, receipt of operating revenues lags operating expenses incurred to provide the service being billed, as water utilities usually do not bill in advance of service. In the case of monthly billing, the lag in receipt of revenue, or the lead in operating expenses, roughly reflects a the 30 days of the billing period plus a portion of the time for payment of the billings.

Regulated water utilities can request a cash working capital allowance as part of a proposed rate increase. Regulatory commissions have approved such an allowance computed using a simple formula method such as one-eighth of test year annual operating expense. In the alternative, large utilities may be required to perform a formal lead/lag study taking in account each line item of expense.

The working capital allowance is included as a component of rate base in recognition that investors are funding working capital for the revenue lag period. Regulators that have approved the formula method often state that it provides a reasonable estimate of working capital requirements without the time and expense of performing a formal lead/lag study.

Unregulated municipal-owned water utilities that use the "utility method" to calculate costs of service and rates may consider including a working capital allowance in rate base. An alternative for some municipal-owned utilities may be to establish an operations and maintenance expense reserve funded from revenues. Such a reserve may offer benefits particularly when revenues seriously lag higher operating expenses such as during high demand summer months.

AFFORDABILITY OF WATER SERVICE--PART 2

One issue arising from any discussion of affordability of water service is how should affordability be measured. Is it really simply a percentage of some assumed mean or median household income statistic? Water service benefitting users is not confined to water entering a house from a service line tapped into a street main. A public utility water system also includes water provided to hydrants that are essential for fire protection, water to places that provide employment to occupants of houses, water to shops where such people shop for food and goods, etc. Moreover, how should the percentage of income spent for water service compare to how much water users' income is spent on such items as cigarettes, television, beverages, etc.?

Court decisions may provide a measure of affordability. Under case law, a utility is required to charge reasonable rates for its service. Reasonable rates are defined as rates which recover reasonable costs of service from those who receive the service and thereby cause the costs. Generally, utilities establish reasonable rates by using the "cash basis" methodology or the "utility basis" methodology. Under the cash basis, rates are established to recover all the cash requirements of the system, including debt service, operating and maintenance expense, and reserves for repair and replacement Under the utility basis, rates are established to recover operating, maintenance and depreciation expense and a reasonable return.

Accordingly, affordability of rates for water service could be measured by the reasonableness of the rates--ie, whether the rates recover reasonable costs of service. Rates which recover more than costs of service from a customer class would be unreasonable. The same would be true for discounted rates to any customer class. Discounted rates would imply subsidization by other classes of customers--ie, unreasonable rates to the others. Accordingly, discounted rates would be unreasonable.

Another concern is whether it would be appropriate for water public utilities to engage in "social engineering", particularly even in the case of municipal-owned water systems, enterprise accounting is required. Subsidies for lower income utility users may be more appropriate for general governmental or other institutions. This may be true given the general legal prohibition against unreasonable rate discrimination in favor of or against particular classes of customers. Rate discrimination can arise when a particular class of customers is charged more or less than the reasonable costs to serve the class.

AFFORDABILITY OF WATER SERVICE--PART 1

From time to time, some commentators have sought to address "affordability" of rates for public utility water service. More recently, such discussions may be accelerating as utilities seek to cope with rising costs of service resulting from more stringent regulations, infrastructure replacements and increased operating expenses.

Some times, affordability is viewed as an issue only for low income water users. Other times, the concept is seen as a matter of willingness to pay, particularly if based upon perceived value of water or perceived poor quality of service, regardless of income level.

Indeed, some authors have asserted that utilities should educate customers as to the "value" of water and water service. Frankly, such "value" has no rational relationship to rates based on cost of service recovery. In the case of unwillingness to pay due to perceived service issues, utilities can and should respond with corrective measures on a timely basis--which sometimes by themselves can result in rate increases to fund infrastructure upgrades.

Generally, it has been suggested that "low income" water customer affordability can be measured as a percentage of total income--for example, 1 to 2.5 % of median household income, as computed by one or more federal or state agencies that compute that sort of thing.

Assuming "low income" can be defined, the issue becomes how rates for water service can respond. Generally, two alternative rate scenarios have been proposed by some commentators: (1) a discounted base rate specifically only for low income customers; or (2) an entire discounted rate structure solely for low income users.

Under a discounted base rate, low income customers would be entitled to an initial rate block of say 5,000 gallons per month, at a charge below cost of service. Some have asserted that this would be akin to a "lifeline" rate. A discounted rate structure would have all rate blocks below cost of service, but perhaps would recover more of cost as the blocks increase.

In my next post, Part 2 of this series will discuss issues arising from "affordability" rate proposals.

RAISING WATER SERVICE RATES TO BENEFIT CUSTOMERS

Last week, the Wall Street Journal reported that the Chinese government is raising rates for water service charged urban users with high levels of demand.* According to the Journal, cheap pricing for water in China had reflected a government policy to protect against inflation. However, low rates were resulting in overuse of water resources and deferred investment in infrastructure.

Under the rate increase, higher uses of water by customers will result in rates that are multiples--3x or 1.5x, depending on demand--of the base rate for water service. Thus, the revised rate structure is intended to encourage conservation as well as to facilitate new investment in water treatment facilities to meet expected more stringent drinking water standards in the near future.

The article also points out that the increased rates will address the "profitability concerns" of Chinese water utilities , as many allegedly operate at a loss or with low revenues that result in a disincentive to upgrade infrastructure to improve water quality.

Does this story sound familiar? Whether it is China, the United States or any other country, reasonable rates that recover all the costs of water service from customers who cause those costs are an imperative for safe and adequate water service. Revenue requirements include not only operating expenses but also funding of reserves for replacements, upgrades and expansions of infrastructure or for funding of debt service incurred for those purposes.

Depending on the availability of adequate sources of raw water supply, rate structure can facilitate conservation measures. Historically, water utilities frequently have structured their rates with declining rate blocks or steps for higher usages, reflecting economies of scale. However, rising rate blocks, along the lines of the Chinese model, have been implemented to encourage conservation of water resources.

In the United States, often water utilities--particularly those owned by municipalities--have maintained low rates that do not recover full costs of service and have resisted rate increases for political reasons. Maintenance of insufficient rates does not benefit water users, for all the reasons apparent to the Chinese regulators. Customers benefit only when revenues are sufficient to enable utilities to recover all costs of service and to fund infrastructure that assuredly provides safe and adequate water to meet demand.

_________________________________________________________

* January 4/5, 2014, p.A6

RETAINING CUSTOMERS CONSIDERING DISCONNECTION AND SELF-SUFFICIENCY

Last month, the Wall Street Journal reported that more commercial and manufacturing customers are generating their own electricity supplies instead of purchasing power from electric public utilities. (September 18, 2013, page A1). This trend, which has quadrupled since 2006, in turn is threatening the revenues and growth of the utilities losing such loads on their systems.

Regulators as well as electric utilities are concerned. As large electric users leave a utility system, the remaining customers, including residential users, likely will pay higher rates to produce sufficient revenue to pay costs associated with infrastructure such as power generation facilities and transmission and distribution lines.

The movement to self-generation appears to be driven by advances in solar panels, fuel cells, wind turbines, and natural gas turbines and reciprocating engines, which make energy independence economically feasible. In addition, for some, self-generation may seem to be more reliable.

Water utilities also can experience a similar trend toward customer water self-suffiency. For example, a large commercial or industrial water user may decide to install its own wells and to disconnect from its local water utility. Or, the customer may retain connection only for standby purposes. The effect upon remaining customers of the utility can be quite dramatic. They will likely experience rate increases necessary to bear the full revenue requirements for the infrastructure such as wells, treatment facilities, pumping and storage facilities and mains.

Can a water utility protect its customers and itself when faced with a significant revenue shortfall resulting from a large volume customer leaving the system? I think there are some possible measures.

For example, a large user institutional customer of one of my water utility clients threatened to leave the system to become self-sufficient by drilling its owns wells and constructing its own treatment facilities. The utility and the customer negotiated a long term contract under which the customer agreed to purchase all its water requirements from the utility at a discounted rate which covered variable costs plus a contribution to fixed costs. The arrangement provided an attractive alternative to the customer building its own system. Retention of the customer benefited the other customers because the special rate produced revenue to cover a portion of fixed costs. The regulatory agency approved the contract.

Where a large water user installs its own water supply but seeks to retain a connection to the water utility for standby purposes, it would seem appropriate for the utility to develop a standby service rate or readiness to serve rate that would produce revenue sufficient to recover the customer's allocable share of revenue requirements associated with infrastructure needed to provide service if called upon.

Some municipalities require that all residents take water service from the municipal-owned water utility. Some court decisions have upheld such requirements. Accordingly, a large water user in such a municipality may not have the option to become water self-sufficent. When a potential large water user requests service from a utility, and infrastructure expansion or upgrade is necessary to provide the requested service, contracts can be structured to obtain from such a customer advances for the cost of such construction and commitments for a term of service.

THE INFRASTRUCTURE ISSUE, PART 2--WHO SHOULD PAY?

The long established principle of sound ratemaking is that rates should recover all the costs of service from those receiving service. That is, the cost causers should pay the costs of serving them. For example, one of the costs of service is depreciation expense on physical assets such as treatment facilities and mains used to provide service.

If water or wastewater infrastructure needs to be replaced or upgraded, what alternative sources of funds may be available for such work? In other words, who should pay for the infrastructure improvements? Possible alternatives may include the following:

** Rates. Depending upon the extent and timing of improvements, rates may provide a source of funding, either through rate increases, surcharges or special assessments.

** Reserves. A prudent utility have have established a depreciation reserve or replacement reserve from revenue to provide a source of funding for infrastructure improvements.

** Debt. Issuance of revenue bonds or other borrowings amy be a source of funding. Along these lines, a refinancing of existing debt to lower debt service may be helpful. The costs of debt will be recoverable in rates.

** Equity. In the case of investor owned utilities, additional equity investment may provide funding, with a return allowed on rate base increases.

** Contributions. In communities experiencing growth in residential or commercial customers, developer contributions of actual plant or payment of connection fees may satisfy infrastructure expansion or upgrade requirements.

** Privatization. In the situation of municipal owned utilities privatization may provide a solution. Privatization can be achieved through outright sales or leases, management contracts or public-private partnerships, any of which may include commitments by the private entity to fund capital improvements.

** Consolidation and Regionalization. Where individual utilities may be in proximity to each other, efficiencies and economies may be achieved by combining resources. For example, perhaps one utility may purchase finished water from an adjoining one, thus eliminating the need for a separate treatment plant or source of raw water.

** Regulatory Action. Where upgrade needs arise from possible regulation changes, a utility may choose to respond to more strict requirements by objecting to a proposed regulation, or seeking a variance or exemption, or asking for a phase-in over time or by outright litigation against the requirement.

** Government grants and low interest loans. Various federal agencies, including USEPA, give grants from time to time to utilities and states for infrastructure projects. In addition, with funding from USEPA, states may offer low interest loans to certain utilities. Two issues should be considered in the case of such programs. First, these resources are limited and clearly not every utility needing infrastructure improvements will get a grant or even a loan. Second, in the case of grants or possibly even loans, someone is subsidizing the funding for the benefit of some one else. The person subsidizing is, of course, the taxpayer, not the utility customer receiving service.

THE INFRASTRUCTURE ISSUE, PART 1--WHY IS THERE A WATER INFRASTRUCTURE PROBLEM?

There has been extensive media discussion about the purported need to replace aging water and wastewater infrastructure in the United States. This week, USEPA released the conclusions of a survey showing the alleged need to spend $384 billion to replace drinking water infrastructure through 2030 to enable safe water to be provided. It stated that this cost reflects the needs of some 73,000 water systems. USEPA asserts that "the nation's water systems have entered a rehabilitation and replacement era in which much of the existing infrastructure has reached or is approaching the end of the useful life."

The survey results raise an interesting question: Why is there such a need to replace water infrastructure? USEPA asserts that the need is due to the aging of water facilities: "In many cases, drinking water infrastructure was reported to be 50-100 years old".

However, it would seem that the age of infrastructure is not the only cause of a need to upgrade facilities, and it may not be the most important. Age alone does not imply inadequacy. For example, ductile iron or plastic water mains may have useful lives of 100 years or more. Older facilities may be functioning well provided that they have been properly maintained over time.

What are some possible other causes of the infrastructure issue?

** Failure To Plan For Replacements. In many cases of then growing municipalities, backbone water and wastewater plant and mains were contributed to utility systems by developers at no cost to the municipalities. If the municipal systems have not charged rates which recover depreciation or accrue reserves, there may be no funds available at the end of the useful lives of the contributed facilities to enable replacement.

** Failure To Properly Maintain. If water and wastewater utilities have not charged rates over time to recover full costs of service, including maintenance expense, it may be maintenance of facilities that is deferred. Without proper maintenance, facilities' useful lives obviously will be compromised.

** Regulation. It is perhaps ironic that much of the need to upgrade infrastructure discussed by USEPA's survey may result from the need to comply with USPEA's increasingly more strict and pervasive regulatory requirements.

** Demand. When a new subdivision or factory is proposed, a local water utility may need to expand treatment capacity or mains to satisfy increased demand for service, including fire protection.

** Security. Since 9-11, utilities have faced a need to upgrade security for water and wastewater facilities. Such measures, including electronic security measures and physical barriers, can impose substantial infrastructure costs, particularly for smaller utilities.

** Technology. Advances in technology, particularly relating to monitoring of treatment processes and flows and data processing, can impose infrastructure requirements.

** Failure of materials. Sometimes, regardless of age, such factors as corrosion and excessive breaks can create the need to replace components of systems.

There is not a sense that the need to replace or upgrade infrastructure in many systems is exaggerated or unrealistic. If the current need were satisfied today, it is likely that the whole discussion will be repeated in 50 years. For a look at resolving the infrastructure issue today, I will discuss funding of new infrastructure in Part 2--Who Should Pay The Bill?

IS "VALUE" OF WATER RELEVANT TO RATES?

Recently, I read an article which asserts that whether a water utility charges sufficient rates depends upon the perceived "value" of the water service it provides. The article submits that the ability to raise rates to provide revenue requirements for infrastructure improvements depends upon customer acknowledgement of the "value" of water. It added that the starting point for water utilities to achieve approval for rate increases is for utilities and their customers to understand the full "value" of water, and the need for customers to pay for this value.

However, contrary to these assertions, the so-called "value" of water has nothing to do with well-established rate-maaking principles. As enunciated in many court decisions and statutes, and echoed in the American Water Works Association rate-making manuals, the only proper basis for setting reasonable rates for water service is cost of service.

Reliance on the "value" of water service to justify rates is misguided and can deliver a wrong message to customers. First, "value" in this setting is a subjective term, and can mean different things to different water users. Indeed, as I wrote in my previous posting, who remembers, and therefore values, the water that flows from a faucet? People appear to value water only after it stops flowing.

Second, setting of rates based on recovery of costs of service necessarily requires objective numbers. Subjective opinion of "value" is incapable of quantification and does not advance establishment of revenue requirements.

Third, that water is essential for life, public health and safety, and is useful for production of food and products, is not in dispute. However, that rates must be increased from time to time to fund operating expenses, depreciation, debt service and reserves--all of which are costs of service--also is not in dispute.

Customers will understand that rates for water service must recover the costs to provide that service, with adequate communication to those customers. There is no reason to interject amorphous concepts of "value" in the rate-making equation to confuse both utilities and their customers. Instead, utilities should perform frequent reviews of the adequacy of their rates, and have the courage to increase rates when needed instead of trying to appease customers by deferring needed maintenance or infrastructure upgrades to avoid rate adjustments.

The fact is that the "value" of safe and adequate water service depends upon ongoing recovery of all costs of service, not upon philosophical verbiage about "value."

ADEQUATE RATES ARE IMPERATIVE

A municipality is considering hiring a consultant to prepare its first cost of service study since 1985 for its water utility. A large government-owned water utility uses reserve funds to subsidize operating expenses so that rate increases to satisfy revenue requirements are deferred. A small municipal water utility refuses to turn off water to customers who do not pay their bills because officials do not want to upset their neighbors.

What do these examples have in common? A general principle of public utility law is that rates must be reasonable and not unreasonably discriminatory. The only acceptable methodology to assure compliance with this principle is to base rates and rate design on a current, comprehensive cost of service study. Such a study will assign costs to the cost causers so as to avoid any cross-subsidization and unreasonable discrimination as between classes of customers. The study also will develop revenue requirements using test year principles and recommend appropriate rate design to recover those revenue requirements.

Deferring needed rate relief based upon perceived appeasement of customers will benefit neither customers nor the utility. Instead, it can result in deferral of necessary maintenance and capital improvements, with adverse consequences for quality of service.

Prudent management will realize that appropriate recovery of revenue requirements can only be achieved with timely rate adjustments founded upon cost of service analysis. Moreover, frequent review of costs and resulting application of smaller rate changes can militate against rate shock controversies that likely will arise from occasional proposed large rate increases.

SOCIAL ENGINEERING OF UTILITY RATES

The governing principle for water and wastewater utility rates is that rates should be based upon costs of service. These costs are to be assigned and recovered respectively from classes of customers who create such costs. Cross-subsidiztion of one class of customers by another is contrary to the cost of service concept. Well-established case law and AWWA Manual M-1 enunciate this ratemaking principle.

Social engineering of rates can occur when charges are based upon perceived social objectives and/or subsidization instead of costs of service. Recent media stories about federal government subsidization of ticket prices for flights to rural airports provide an example. According to the Wall Street Journal, taxpayers subsidize air service at 109 airports at a cost of $175 million per year. Allegedly, these subsidizes can be as much as $200 to $3,000 per ticket.

Now, it appears that federal social engineering may be entering utility ratemaking. In July, 2011, the Federal Energy Regulatory Commission (FERC) entered an order which apparently allows non-utility developers to construct segments of interstate electric transmission lines to connect remote wind and solar generators to the grid. The obvious purpose of the order is to promote wind and solar generation. FERC asserts that the costs of such new transmission lines are to be borne by utility customers who benefit. It is to be noted that these costs will not be created by utility customers but by developers and the wind and solar generators. Further, determination of who benefits from these costs can be questioned, particularly if the costs of wind and solar generation coupled with the new transmission costs are not competitive with other electric sources of supply. It also should be kept in mind that some jurisdictions may require electric utilities to purchase a portion of their supply as higher-priced wind/solar generation, which suggests that ultimate customers may be bearing no benefit.

There may be another consideration. Currently, some federal regulatory agencies appear to be extending rules and authority into areas where Congress has not spoken. Apparently, there was a Senate bill to socialize the costs of new electric transmission lines. After the Senate bill stalled, FERC initiated its regulatory proposal culminating in the July order. That order, therefore, seems to do what Congress refused to do.

The potential implications of social engineering for water and wastewater ratemaking are not wholly speculative. Simply stated, costs of service can be manipulated to be vulnerable to social "adjustments." Diligent utilities, and their customers, should remain vigilant in their application and acceptance of appropriate cost of service ratemaking.

WATER USE LOWER, WATER RATES HIGHER?

One of the current "hot" topics in the drinking water industry is the declining water use that many water utilities are experiencing. (For example, see Hunter, et al "Declining Residential Water Use Presents Challenges, Opportunities," AWWA Outflow, May, 2011, pp. 18-20).

"Cause" for declining water use is attributed to federal law (Energy Policy and Conservation Act of 1992 and Energy Independence and Security Act of 2007), which has resulted in efficiency standards for fixtures and appliances such as toilets, faucets, showers, dishwashers and washing machines. Other presumed causes include declining number of occupants per residential unit, conservation programs and rate increases. Two other potential causes are foreclosures translating into empty homes and older water meters which do not fully register use.

While reductions in water use can result in reductions to certain utility operating costs, obviously not all costs of service are variable. Water utilities may have incurred substantial fixed costs for infrastructure, which as time goes by must be replaced and upgraded. Further, a decline in usage does not necessarily translate into a comparable, if any, decline in demand. Treatment, storage and distribution assets must be able to satisfy peak demand periods.

Two other factors should be considered. New regulatory requirements continue to impose increased operating and infrastructure costs on water utilities, which in turn create higher costs of service to be recovered in rates. Further, water utilities may have incurred financing costs for current facilities, which costs must be recovered in rates and paid.

The paradox, therefore, is that a decline in customer usage does not necessarily correlate with a corresponding decline in customer water bills. Even if some costs of service are mitigated, other costs continue or may even increase. Neither utilities nor their customers should assume that water use efficiency means rate relief. An efficient utility will carefully monitor its revenue requirements, adjust rates to fully recover costs of service, and keep customers informed.

GOOD TO THE LAST DROP

Recently, I attended an estate auction held in a farm yard surrounded by hovering corn stalks, mysterious metal storage structures and biting flies. Several generations of possessions were piled upon farm wagons awaiting eager bidders. On one of the wagons, I spied two cast iron water hand pumps, one red, the other green.

When a ring man held up the green one for the auctioneer to start his chant, the ring man pumped the handle up and down as if he were pumping water at a sink in an imaginary farm kitchen. But, of course, there was no water to be pumped--only the dusty air of the farm yard. At that moment, I wondered what it would be like if my pump or faucet were dry and produced only air. Many parts of this country as well as other parts of the world face that prospect.

But, alas, there WAS water to be had at the auction, though at a significant cost. A food vendor squeezed within a small trailer next to the auction site was selling bottles of drinking water for about $1 each. That works out to be about $8 per gallon or $8,000 per 1,000 gallons.

What is the point? There are two points to be made. First, safe drinking water increasingly is becoming a scare commodity, particularly as demand grows across the world.

Second, to deliver safe drinking water to our hand pumps and faucets costs more and more as time goes on. In August, Black & Veatch issued the findings of its sixth "50 Largest Cities Water and Wastewater Rate Survey." The survey found that the average annual increase in typical residential water bills from 2001-2009 was 5.3%, and for residential sewer bills, 5.5%. These annual increases were more than twice the average annual CPI-D increases of 2.4%. (See www.bv.com/top50ratesurvey)

According to Black & Veatch's analysis of the survey, causes for the bill increases included:

1. Increases in operating and maintenance expenses, such as for electricity and chemicals.

2. Lower usage, and corresponding lower revenue to cover fixed costs such as debt service.

3. Pension and health care benefits.

4. Regulatory and legal requirements.

5. Aging infrastructure, requiring replacement and upgrading.

To the list, I would add the "scarcity factor." In some areas, ground water supplies are diminishing and surface water supplies are becoming less reliable or more costly to utilize. Utility systems are being compelled to search for alternative supplies, which may involve construction of transmission pipelines or more extensive treatment facilities.

No, I did not bid on either hand pump, nor did I buy a bottle of water. I journeyed home thirsty but more appreciative of the glass of cool water from my faucet. It really was good to the last drop.

WATER UTILITIES FACE RATE INCREASE PRESSURES

Although the economy may be viewed as sluggish, and inflation rates currently are low, water and wastewater utilities nevertheless are experiencing pressures to increase rates for service. What are some of the drivers for the need to increase rates at this time?

1. Replacement of Aging Infrastructure. Various estimates range from $200 to $300 billion nationally to replace mains, treatment and pumping facilities that have exhausted their useful lives.

2. Compliance with Increasingly More Stringent Standards and Monitoring Requirements. Under the Safe Drinking Water Act and the Clean Water Act, utilities are subject to what appear to be ever increasing USEPA regulations as well as litigation claims.

3. Need for Enhanced Security Measures. Security has come to the forefront in imposing capital and operating costs, particularly for water utilities because water is essential for public health and safety.

4. Response to Diminishing Sources of Water Supply. Not every utility has the benefit of Lake Michigan water, but even that source of supply is limited. Surface waters such as rivers and ground water aquifers also have limitations in both quantity and quality. The more contaminated a source is, the more treatment and cost are required.

5. Expansion of Capacity. Although current economic conditions may have dampened customer growth for now, the fact is that growth can be expected in the future, which translates into expansion of mains and treatment facilities.

These factors, as well as other pressures, cause the need for rate adjustments to alleviate these cost drivers. Without such rate adjustments, utilities can be tempted to defer addressing needed expenditures. Insufficient rates can cause misallocation of water as a resource, impede replacement of assets, frustrate regulatory compliance, and reduce security and quality of service.

Rates should be reviewed and adjusted on a regular periodic basis and established to recover fully all costs of service, based upon cost of service studies. Further, innovative rate structures can be developed. For example, many utilities successfully have implemented rate riders or surcharges to base rates to recover costs incurred for ongoing main replacement programs.

Adequate rates also should facilitate utilities' attraction of financing at reasonable costs for required capital requirements. Certainly, utilities should not avoid needed rate increases in the hope of receiving federal or state grants of limited availability.