Tag Archives: Woodland-Davis Clean Water Authority

Davis Should Set Its Utility Reserve Targets with a Transparent and Rigorous Method

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The City of Davis Utilities Commission is considering on February 19 whether to disregard the preliminary recommendations of the Commission’s Enterprise Fund Reserve Policies subcommittee to establish a transparent, relatively rigorous and consistent method for setting City reserves. The Staff Report, written by the now-departed finance director, ignored the stated objectives of both the Utilities and Finance and Budget Commissions to develop a consistent set of policies that did not rely on the undocumented and opaque practices of other communities. Those practices had no linkage whatsoever to risk assessment, and the American Water Works Association’s report that the Staff relied on again to reject the Commission’s recommendation again fails to provide any documentation on how the proposed targets reflect risk mitigation—they are simply drawn from past practices.[1]

The City’s Finance & Budget Committee raised the question of whether the City held too much in reserves over five years ago, and the Utilities Commission agreed in 2017 to evaluate the status of the reserves for the four City enterprise funds—water, sanitation/waste disposal, sewer/wastewater, and stormwater. A Utilities Commission subcommittee reviewed the current reserve policies and what is being done by other cities. (I was on that subcommittee.) First, the subcommittee found that the City was using different methods for each fund, and that other cities had not conducted risk analyses to set their targets either. The subcommittee conducted a statistical analysis that allows the City to adjust its reserve targets for changing conditions rather than just relying on the heuristic values provided by consultants.

The subcommittee’s proposal adopted initially by the Utilities Commission achieved three objectives that had been missing from the previous informal reserves policy. Two of these would still be missing under the Staff’s proposal:

  1. Clearly defining and documenting the reserves held for debt coverage. While these amounts were shown in previous rate studies, the documented source of those amounts generally not included and the subcommittee’s requests brought those to the fore. The Staff method appears to accept continuance of that practice. The Staff proposes to keep those separate, which differs from past practice which rolled all reserves together.
  2. Reserve targets are first set based on the historic volatility of enterprise net income. In other words, the reserves would be determined transparently with a rigorous method on the basis of the need for those reserves. The method uses a target that is statistically beyond the 99th percentile in the probability distribution. And this target can be readily updated for new information each year. The Staff report rejects this method to adopt a target that refers to the practice of other communities, and none of those practices appear to be based on analytic methods from research done by the subcommittee.
  3. Reserve targets are then adjusted to cover the largest single year capital improvement/replacement investment made historically to ensure enough cash for non-debt expenditures. Because the net income volatility is a joint function of revenues, operating expenditures and non-debt capital expenditures, the latter category is not separated out of the analysis. However, an added margin can be incorporated. That said, the data set for the fiscal years of 2008/2009 to 2016/2017 used by the subcommittee found that setting the target based on the volatility has been sufficient to date. The Staff report appears to call for a separate, unnecessary reserve fund for this purpose based on annual depreciation that has no relationship to risk exposure, and implicitly duplicates the debt payments already being made on these utility systems. This would be a wasteful duplication that sets the reserves too high.

The Finance and Budget raised at least two important issues in its review:

  1. Water and sewer usage and revenues may be correlated so that the reserves may be shared between the two funds. However, further review shows that the funds have a slight negative correlation, indicating that the reserves should be held separately.
  2. The water fund already has an implicit reserve source when a drought emergency is declared because a surcharge of 25% is added to water utility charges. I agree that this should be accounted for in the historic volatility analysis. This reduces the volatility in fiscal years 2014/2015 and 2015/2016, and reduces the water fund volatility reserve from 26% to 21%.
  3. Working cash reserves are unnecessary because the utility funds are already well established (not needing a start up reserve), and that the volatility reserves already cover any significant lags in the revenues that may occur. This observation is valid, and I agree that the working cash reserves are duplicative of the other reserve requirements. The working cash reserves should be eliminated from the reserve targets for this reason.

Finally, the Staff proposal raises an issue about the appropriate basis for determining the sanitation/waste removal reserve target. The Staff proposes to base it solely on direct City expenses. However, the enterprise fund balance shows a deficit that includes the revenues and expenses incurred by the contractor, first Davis Waste Removal and then Recology. We need more specificity on which party is bearing the risk of these shortfalls before determining the appropriate reserve target. Given the current City accounting stance that incorporates those shortfalls, I propose using the Utility Commission’s proposed method for now.

Based the analysis done by Utilities Commission subcommittee and the recommendations of the Finance & Budget Committee, the chart above shows the target % reserves for each fund without the debt coverage target. It also shows the % reserve targets implied by the Staff’s proposed method.[2] The chart also shows corresponding dollar amount for the proposed total target reserves, including the debt reserves, and the cash assets held for those funds in fiscal year 2016/2017. Importantly, this new reserve target shows that the City held about $30 million of excess reserves in 2016/2017.

[1] It appears the Staff may have misread the Utilities Commission’s recommendation memorandum and confused the proposed targets policies with the inferred existing policies. This makes it uncertain as to whether the Staff fully considered what had been proposed by the Utilities Commission.

[2] The amounts shown in the October 16, 2019 Staff Report on Item 6B do not appear to be consistent with the methodology shown in Table 1 of that report.

The URAC could not agree on a recommendation to the Davis City Council on a preferred rate option. We probably had too many options with too many proposals for most members to sort through. In retrospect, we probably should have used pairwise comparisons to narrow down the choices for a final vote.

URAC members now have the option to submit a statement in support of a rate proposal. Frank Loge and I previously composed a statement on why summer water costs are higher, a portion of which I posted here. We will submit another statement in support of seasonal rates.

The proponents of Measure P have argued that voters the completely supported all of their reasons for rejecting the original rates, but the reality is quite varied, ranging from concerns about rate increases to rejecting the original water to concerns about the complexity of the new rate structure to resentment over the “look back” provision in the new rates to objections over summer prices. Given the razor thin margin and the low turnout, addressing anyone of these issues would have lead to rejection of Measure P. And now even Measure P proponent Bob Dunning has said that he will accept higher summer rates.  With that in mind, here’s our comments to be sent to the new City Council:

Fellow URAC Member Frank Loge and I wrote about why Davis water supplies cost more in the summer and why simple economic principles lead to those costs being allocated to the highest period of use—the summer in this case.  We want to expand on that statement of economic principles to suggest that the Council adopt seasonal rates with a summer premium.

Davis has extolled itself as being environmentally progressive. We have adopted an aggressive plan to reduce our greenhouse gas emissions and we have required proposed housing developments to adopt stringent standards that minimize environmental impacts. We should extend that commitment to how we use our water.

Moving to a surface water supply is an environmentally responsible way to reduce the impact of our wastewater discharges and the GHG emissions created by pumping water with electricity. However, we don’t get a free pass on using this new water source. The greatest environmental stress on the Sacramento-San Joaquin Rivers Delta occurs in the summer months when river flows ebb. The SWRCB already has ordered curtailments for junior water rights holders (which includes Conaway Ranch) and may order further summer cutbacks. We need to set water rates that reflect our commitment to reducing our footprint on the environment. That means charging a premium on summer water use when environmental costs are higher.

These higher environmental costs are consistent with other system costs including infrastructure and water rights, so the Council can rely on the draft rates constructed with to reflect those underlying seasonal cost patterns. According to analysis prepared by Bartle Wells and presented to the URAC, 55% of total system costs are higher during the summer than the winter period. In addition, current water pumping costs also are higher during the summer as that PG&E commercial time-of-use rates go up during the summer. Under the draft seasonal rates, summer volumetric charges would be 46% higher than winter.

These rates should not be tiered for two reasons. First, examining single family residential (SFR) use by decile shows that all but the lowest rank uses about twice as much water in the summer as in the winter. That means all customers are creating higher summer costs, both financial and environmental, and all should be signaled to conserve. Second, recent studies have shown that tiered rates have not delivered on promised conservation. While the highest users who see a high price may conserve, the lowest users see a below-average price that causes them to overuse water. The two effects offset each other. Using tiers to address concerns about low-income and senior customers causes such benefits to leak to wealthier customers who don’t need the assistance—this issue is best addressed through other rate assistance programs outside of setting the standard rate.

Finally, the Council should look closely at the amount of fixed charges included in the rates. While a large portion of the costs may appear fixed in the short run from an accounting standpoint, from an economic standpoint (which the appropriate stance for setting rates) the City has invested in much of the infrastructure and water rights to meet long-term variations in demand. This means that the water supply and even some of the local distribution system costs are actually variable costs. The Water Advisory Committee (WAC) found that 87% of system costs fall into this variable category and we haven’t seen information to cause us to revise this estimate.

Of concern though is that the City can’t ignore the financial accounting of costs, most importantly debt service.  Debt rating agencies that drive bond interest rates want a higher fixed revenue component. For investor-owned water utilities in California, particularly smaller ones, which rely on higher variable revenues than most municipal utilities, the swings in revenues have caused financial distress of late.

The City must balance the desire to match rates to costs with the need to meet financial commitments. This can be done in one of two ways. The first is to establish a hydrologic conditions or “drought” balancing account that accrues revenues in low-cost “wet” years and is drawn down in high-cost “dry” years. Establishing such an account, however, means that rates are likely to be higher in most years than if the rates had a higher fixed cost component due to higher financing costs. The City essentially has to carry two components of debt, the first to pay for the new water supply system and the second to fund the balancing account. The second method is to increase the amount collected in fixed charges each year so that the variation in revenues doesn’t cut into debt service. Bartle Wells has recommended a minimum of 40% in fixed charges that is consistent with practices with other municipalities. We don’t have a strong preference for either approach, but the Council should be aware of its choices.

Below are two charts I prepared during the URAC meeting (and shared) that compare bill shares across usage deciles for SFR customers. The first chart shows allocations with 40% fixed costs, the second with 13% fixed costs. Note that the consumption shares are steeper than the cost shares due to the fixed costs. At 0% fixed costs, cost and consumption allocations would be identical. It’s important to note that consideration of fairness must not be a simplistic analysis of average water consumption, but also must consider the other investments and costs incurred to deliver that water.

CostAllocation-40P Cost allocation by Decile with 13% Fixed Costs

One final note: the City may not have been in this position if it had more clearly communicated the CBFR rate structure to the community. Measure P passed by only 2%–a swing of 144 votes would have defeated it. I think that most people will understand that water costs are higher in the summer; the City just says, “we live in California where it doesn’t rain during the summer and everyone starts watering their lawn.” The CBFR component could have been more clearly labeled as the “Summer Demand Charge.” Most people would have made the connection and there would have been much less outcry over “complexity.”