Water Rate Study

Water Rate Study

At RDN, our number one priority is creating the best possible rate model for each water agency’s individual circumstances.

Our goal is to help water agencies establish water and wastewater rate structures that achieve each agency’s objectives of revenue stability, equitable cost recovery, and rate payer affordability. Our rate-making practices incorporate methods described by the American Water Works Association (AWWA) and the Water Environment Federation (WEF). The flowchart below presents a typical process of a rate study. RDN will provide technical and logistical support from beginning to end.

Financial Planning/Revenue Analysis

RDN will analyze the agency’s detailed water billing records to construct histograms of usage by frequency for each of the years as well as an average over all years in the sample. We will project the agency’s revenues for the next five years based on the demand forecasts.

We will also forecast both capital and operating costs of the agency for the next ten years and five years respectively. The base model uses a cash-needs approach for operating and maintenance (O&M) expenses, debt service payments, contributions to specific reserves, and capital expenditures funded from rate revenues. This approach mirrors the accounting and reporting practices of most public water utilities. Costs are based on recent financial data and operating budgets specific to the agency. Projections are developed using escalation factors specific to each type of cost incurred. Particular attention is paid to those costs which vary with the volume of water sold – such as purchased water, power, chemicals, and related consumables – and those costs which, over the five-year forecast period, do not vary with the volume of sales – such as debt service, general administrative overhead, or fixed contractual purchase obligations.

Agency policies regarding reserve and debt service coverage ratio targets will have a significant impact on its revenue requirements and therefore cost of service (COS) analysis and rates.

Revenue Requirement Analysis

Our analytical approach to forecasting and evaluating agency revenue requirements, as embodied in our model, incorporates water rate-making practices as described by the American Water Works Association (AWWA). To forecast short- and long-term revenue requirements, the analysis will use the agency’s most recent budget forecast and translate its budget items into revenue requirements by function (distribution, water supply, customer service, pumping, etc.). These costs are offset by other operating revenues such as connection fees and penalties, and non-operating revenues such as property tax and investment income.

Cost of Service (COS) Analysis

Once revenue requirements are outlined, the next step is to allocate costs among the customers commensurate with their service requirements. The proportionate allocation of costs to various customer classes considers not only the relative quantity of water used by each class but also the peak rate at which it is consumed. These costs are allocated appropriately so that the customer class with higher demands pays proportionately more to offset its cost. The COS analysis determines what cost differences exist between different classes of customers through the process of functionalization and cost allocation.

The following chart presents three major steps of a typical COS analysis for water utilities.

Identifying customer classes

The cost of providing services are determined for groups or classes of customers that have similar service characteristics and demand patterns. Assigning costs accurately to classes of customers based on their service requirements is critical in designing nondiscriminatory rates. We will evaluate the agency’s customer classifications and provide recommendations on any necessary changes.

Functionalizing costs

The agency’s utilities are composed of various facilities that serve a particular function. Facilities are designed and operated to meet the average-day and peak demands as well as other customer-related requirements. The revenue requirements are allocated to the functions which provide specific services. The following are the industry standard functional areas, which we will customize for this analysis as appropriate:

  • Pumping: costs associated with pumping water from treatment facilities to transmission and distribution systems
  • Supply: costs associated with each supply source, including supply development
  • Storage: costs associated with storing water, such as reservoir maintenance
  • Transmission: costs associated with transmitting of water from treatment facilities to the distribution system
  • Distribution: costs associated with distributing water to end users
  • Meters: costs associated with customer water meters, including provision, replacement, servicing, and testing
  • Fire Protection: costs associated with private and public fire hydrants
  • Customer Service and Billing: costs associated with meter reading, billing, collections, and managing customer accounts (such as responding to customer requests and complaints)
  • General and Administrative: costs associated with the overall management of the agency’s operations, as well as supplementary tasks such as accounting, legal services, and human resources

Allocating costs to peaking and non-peaking parameters

The next step of a COS analysis is to allocate identified functionalized costs to peaking and non-peaking parameters. Key factors in this COS allocation are specific geographic characteristics of the agency’s service area and usage patterns of each customer class. This analysis permits the agency to adhere to the general principle of cost proportionality (particularly relevant under Prop. 218), under which the rates paid by customer classes are directly proportional to the costs each class imposes on the agency as a whole.

The cost of serving customers depends not only on the total volume of water used, but also on the rate of use or peak demand requirements. In using the base-extra capacity method described in the AWWA M1 manual, water utility costs are typically separated into three broad cost causative components: “Base,” “Extra Capacity,” and “Customer.” Calculated peaking factors are used as a proxy for determining and allocating the cost of providing extra capacity in the system to meet peak demands. Customer related costs such as billing and meter services are also recognized as a valid cost function as well as direct fire service related costs.

Each cost component for the water utility is described in detail below:

  • Base Costs:  costs that tend to vary with the total quantity of water used, plus the costs incurred to provide water under average daily demand conditions. Base demands for customer classes are measured as the average daily demand of each customer class.
  • Extra‐Capacity Costs (Max-Day and Max-Hour):  costs incurred to meet peak demands for water in excess of basic demand (base). This cost category includes the infrastructure costs related to providing the required extra capacity of the system to meet maximum-day and maximum-hour demands.
  • Customer Services – Meter and Billing:  costs associated with serving customers such as the costs of meter reading and other meter related expenses.  The customer costs are allocated based on the number of customer accounts. Costs related to the bills issued are based on the number of bills rendered to customers within each class.

As a final step of the COS analysis, all costs are summed for each customer class, determining the cost of service to be recovered from each customer class. The revenue requirements are offset by non-operating revenues and other operating revenues – that is, the rate revenue requirements.

Rate-Setting Analysis

The last step of a rate study is designing rates. Rates must be designed to equitably recover the rate revenue requirements from each customer given the projected customer demand identified as a resultant of COS analysis.

Fixed Charges

Utility revenues that come from fixed customer charges reduce the overall volatility of revenues. However, setting higher fixed charges generally results in higher rates for small users and lower rates for large users. Placing a larger weight on volumetric charges could promote conservation but the utility may experience financial hardship resulting from reduced demand and thus a significant decrease in revenues. RDN will review the agency’s current fixed charges and recommend how to apportion fixed verses volumetric charges so that the impact of new rates on customers is minimal while meeting the agency’s revenue requirements. The most common method to levy fixed charges is by meter size. Meter size is a proxy for the estimated demand that each customer places on the water system. Capacity-based meter ratios are widely used in California rate setting and are consistent with meter ratios adopted by the California Public Utility Commission for private water companies.

Volumetric Charges      

The volumetric charges are those portions of rate revenue requirements by customer class not recovered via fixed customer charges. There are three types of rate structures (uniform rate, increasing block rate, and water budget rate structure) that are commonly used by California utilities. Our analysis will include comparisons to the existing rate structure to a proposed rate structure, which will be selected through consultation with the agency.

Uniform Rate Structure
The RDN model can calculate uniform rates necessary to cover all costs allocated to each customer class. The figure below illustrates a simplified uniform rate structure for a given customer class. In this example, $3.50 per HCF is charged regardless of the amount of water used. The model computes the remaining costs allocated to each customer class that are not covered by fixed charges. These costs are then divided by the total expected sales of water to each customer class as determined by the demand component of the model.

Uniform Rate Structure

Increasing Block Rate Structure
The RDN model also calculates increasing block rates necessary to cover all costs allocated to each customer class. The following chart illustrates a simplified increasing block rate structure for a given customer class. The number of consumption blocks is determined by the number of specific water sources to which the utility has access with consideration of the need to keep the structure as simple as possible. This principle is based on the goal of maintaining a clear connection between a tier and its underlying cost structure. The basic configuration of the model includes four tiers, though this could be modified as utility needs dictate. In this example, $2.50 per HCF is charged for the first 5 HCF of water used, $3.50 per HCF for 6 to 15 HCF, $5.00 per HCF for 16 to 20 HCF, and $7.00 per HCF for over 20 HCF of water used. The model computes the remaining costs allocated to each customer class that are not covered by fixed charges. The utility’s water supply costs are first computed and divided by the volumes supplied from each water source. The RDN model accomplishes this by scaling all costs associated with each customer class according to the estimated fully burdened (capital and operating) costs attributable to each water supply source. These are then ranked from least expensive to most expensive, with the expected volume derived from each source. This establishes a tiered structure that has strong nexus to its costs associated with the tiers. If tiers cannot be established this way (i.e. there is only one water source), RDN may develop tiers by using peaking factors based on customers water usage patterns identified in the COS analysis. In either case, each tier must be linked to the corresponding costs and justified in its pricing and volume of each tier.

Increasing Block Rate Structure

Water-Budget Rate Structure
Building on these fixed and variable components, water budget based rates incorporate customer-specific allocations to set customized increasing-block tiers reflecting indoor and outdoor water needs for that customer. The fundamentals of the water budget based rate structure are identical to those in increasing block rates, except that the blocks are different sizes depending on the usage characteristics of each customer.

For example, Customer 1 of an agency has a lawn with some native plants on its 6,000 ft2 landscaped area. Customer 1 is allocated 5 HCF of indoor water use (Tier 1) and 10 HCF of outdoor water (Tier 2), which constitute 15 HCF as their water budget per month. Under this rate structure, the second, third, and fourth tiers are typically determined by the percentage of the excess water used over the water budget as 100 percent. In contrast, Customer 2’s water budget was established based on two acres of land with two horses on the property. Customer 2 has 7 HCF of indoor and 15 HCF of outdoor water allocated per month, which constitute 22 HCF for the first and the second tier allocations in total.

The RDN model estimates indoor and outdoor water budgets, which quantify the amount of water that would be considered an efficient level of water use for each utility customer. The model uses California efficiency standards as a starting point for setting customer water budgets, though it can estimate any “efficiency level” desired, including levels driven by emergencies such as drought restrictions.

The indoor allocation is based on the number of people per household. The model utilizes a default value based on average household size from the Census for the service area, and then adjusts this value user by user as data become available.

Water-Budget Rate Structure

Proposition 218 Support

Compliance with Prop. 218 and the recent San Juan Capistrano ruling requires explicit analysis of the expected available quantities and likely costs of water from each supply source or other costs that vary with usage. This was the principal deficiency the court found in the San Juan Capistrano tiered rate case (and reiterated by the court in the Nesbitt case). RDN will conduct a thorough analysis and design a rate structure that is compliant with Prop. 218 and other legal requirements. We will provide support on creating and mailing a Prop. 218 notice and attend a public hearing for the agency’s customers.