To: Mike Wildgen, City Manager
From: Ed Mullins, Finance Director
Date: January 12, 2004
Subject: Rate Study
The City Commission has selected Black & Veatch to assist in determining the cost of providing water and sanitary sewer service and establishing the rate structure necessary to pay for future operating and capital costs. The information in this memorandum primarily concerns water costs and rates but several of the issues also impact the wastewater utility. A few wastewater only issues are addressed at the end of this memorandum. While costs of service and rate study methods are generally governed by industry standards, there are some variations in policy that the City Commission may want to consider prior to the start of the study:
1. Capital Financing – The adopted Capital Improvement Plan for the Utilities Department includes a significant amount of projects. These projects can be financed through either cash or debt. The City Commission may want to express a capital financing mix or preference for cash, system development charges, and debt financing of new capital improvement projects. The City of Lawrence currently has three water and sewer revenue bonds outstanding in the amount of $10,510,000; over $47 million in outstanding State Revolving Loan Funds (SRF); and approximately $8.0 million in cash financing as of 12/31/04. The issuance of debt provides a method of allocating costs to future customers because the debt is paid back over time, usually 20 years. SRF money can typically be obtained at a lower interest rate. Cash financing eliminates the need to pay interest on the funds need to finance the project. System development charge revenue totaled just over $970,000 in 2003. Revenue from the water and sewer development charges is restricted for capital related expenditures. System development charges are paid when a builder purchases a water meter (see item 5).
2. Debt Service Coverage – Revenue bonds are issued on a combined utility basis. The combined utility’s outstanding revenue bond debt requires a rather large coverage ratio of 1.40. The coverage ratio is the amount that net revenue (total revenue less operation and maintenance expense) must exceed annual principal and interest costs on outstanding debt. For Lawrence, net revenue must exceed actual debt service requirements by at least 40 percent. The City Commission should consider taking steps to reduce the coverage requirement to 1.25 or some other value after consultation with a financial advisor. This can be accomplished by refunding the outstanding debt issues and generating a new bond ordinance. However, for rate design purposes, it is suggested that the City always target coverage at a slightly higher value than actually required so that the minimum requirements are always met.
3. Fire Protection – Fire protection cost include actual public fire hydrant costs and an allowance for a portion of demand costs available to fight fires in relation to overall water demand. Since commercial customers with private fire connections directly benefit from the City’s system and may enjoy a lower fire insurance premium due to their private connection, the City Commission may want to consider adopting a private fire protection charge that varies by size of connection.
4. Water Rate Structure – Typically there are four basic types of rate structures; declining block, uniform block, inclining block, and seasonal. In addition, there may be service charges, meter charges, and minimum charges. The City of Lawrence currently has a meter charge combined with a minimum charge and a declining block structure. Summaries of the advantages and disadvantages of each rate structure in terms of simplicity, equity, revenue stability, conservation, and implementation are attached. In addition, the City Commission may want to consider replacing the minimum charge (currently based upon a meter charge plus 2,000 gallons of water usage) with a service charge that would only recover the cost of meter reading, billing, meter maintenance, and other costs directly related to serving customers. In addition, water and sewer rates can vary by customer class. Currently, the City has three classes consisting of residential, commercial and industrial. However, the rates are identical for each class.
5. System Development Charges - Utilities employ system development charges to assign to new customers the cost of improvements that are or will be available to them. The two basic methods for calculating system development charges are the system buy-in method and the incremental cost method. The system buy-in method is based on the principle of achieving equity between new and existing customers. The fee is set to approximate the equity position of current customers. The incremental cost method is based on the concept of new development paying for the incremental cost of system capacity needed to serve new development. This method attempts to mitigate the cost of new growth on existing rates. The City of Lawrence’s current system development charges are based upon the system buy-in method. In 1999, Black & Veatch estimated that the combined water and sanitary sewer system development charges would equal $1,455 in 2004 for a 5/8” residential water meter. The combined rate that is actually being charged in 2004 is $970. Therefore, a 50 percent increase would be required just to implement the 2004 projection, assuming it is still valid. A significantly higher increase would likely be required if the City adopts an incremental cost-pricing approach. The City of Lawrence assesses the system development charge when a meter is purchased. Some utilities assess and collect the charge at the time of platting a new development or when a building permit is issued. However, it may be difficult to determine the number and types of meters at that time of platting. The City Commission may also want to consider dedicated capacity charges. A dedicated capacity charge covers the costs incurred to extend service to a specific area to serve potential future customers. The table below shows the history of the water and sewer system development charges.
1999 2000 2001 2002 2003 2004
Water Development Charge $315 335 355 375 400 420
Sanitary Sewer Development Charge $410 435 460 490 520 550
6. I/I Cost Recovery ‑ The service charge component of the wastewater service charge includes a large share of infiltration/inflow (I/I) costs. I/I is water that enters the sanitary sewer through cracks in the line and manholes. Part of these costs is recovered by the minimum charge because the opportunity for I/I to enter the sewer system is largely a function of length of sewer lines. Current charges allocate two-thirds of the I/I costs to the minimum charge. If lower customer charges are desired, the City Commission may want to review this policy to possibly alter the portion of I/I costs recovered by the respective customer and volume charges.
The above information does not address all of the potential policy questions, but does attempt to address some of the most common concerns and issues that have the greatest potential impact on rates.