Cost-Indexed Rate Increases

Guest author Peiffer Brandt is the Chief Operating Officer at Raftelis Financial Consultants.

“Patrick Cannon… voted twice against raising our water fee.  That means a lot for senior citizens, families, and individuals on fixed income.  He deserves our selective vote.”  In 2011, Patrick Cannon campaigned for re-election using this testimonial to demonstrate his fiscal prudence.  He was re-elected to serve on the Charlotte City Council with the most votes of any at-large candidate, and as a result, became Charlotte’s Mayor Pro Tem.

In today’s political climate, it can be a challenge for a utility to gain approval from its governing body for a rate increase.  Rate increases aren’t especially popular, and approving rate increases, though necessary for a sustainable utility, is not generally good political practice.  Regardless of whether the rate increases are approved, however, utility costs are increasing due to inflation, additional regulatory requirements, and the need to repair or replace aging infrastructure.  Some utilities have begun to rely on indexed rate increases set in place to help increase the revenue stream without requiring annual approval by the governing body.  With indexed rates, a utility’s governing body approves annual rate increases based on a specified cost index (such as the Consumer Price Index) for a certain period of time.  In theory, this approach allows the utility’s revenue to increase without requiring the governing body to approve increases each year.

The Case for Indexed Rates:

The increases to the cost of providing water and sewer service are often consistent with cost indices.  One of the largest O&M cost components for water and wastewater utilities is labor, which is often increased by an index for a cost of living adjustment.  In addition to O&M increases, capital costs are often escalated using a cost index.

Another benefit of having annual rate increases as opposed to increases every few years relates to the power of compounding.  The equivalent to having annual 3% increases for five years is slightly greater than a 15% increase.  The longer the period, the greater is the impact of compounding.  Also, if a utility has a 3% increase in year one and a 3% increase in year two as opposed to just a 6% increase in year two, then the utility benefits from the additional revenue generated in year one.

Finally, indexed rates may be more positively received by those who are critical of government.  The use of indexed rates forces utilities to manage within a defined revenue stream as opposed to having projected cost increases drive rates.  This prevents the utilities from just increasing rates to pay for what critics consider unnecessarily increasing costs.

The Case against Indexed Rates:

The use of cost indices for rate adjustments can cause problems, however.  Even though escalating the rates by an index will provide additional revenue, the amount of revenue may not be sufficient for the utility to operate in a sustainable manner.  Utility management, and more importantly governing bodies, may be lulled into a false sense of financial security.  It may be more difficult to gain approval for additional increases in later years if the public has been convinced that indexed rate increases are sufficient.  For example, additional regulatory requirements may result in revenue needs increasing more significantly than expected, which could cause a shortfall from indexed rate increases.  Also, declines in demand, which many utilities are currently experiencing, could cause financial challenges for utilities that rely on indexed rates.

Decisions:

If a utility decides to implement indexed rates it must make a few decisions.

What index to use?

There are many different indices and hundreds of variations of these indices compiled by the Department of Labor’s Bureau of Labor Statistics.  The most well known index is the Consumer Price Index (CPI).  In addition to the broad CPI, there are numerous subsets that include just urban areas, are regional, or exclude certain commodities.  There is no index that is perfect for every utility or that is perfect for a specific utility.  The most typical approach is to use a regional CPI.  For example, Dublin San Ramon Service District (in Dublin, CA) uses the CPI specific to All Urban Consumers for the San Francisco-Oakland-San Jose, CA area.  These indices show the cost increases for the area and also serve as a proxy for the increased buying power of the population of the area.

Which periods to use?

The Bureau of Labor Statistics updates most indices monthly.  However, there is some lag between the end of the month and when the index is released and there are often slight adjustments to the previous period(s).  Therefore, a utility should choose three or four months in advance to compare from year to year.  For example, if a utility wants to have annual increases on July 1, it should not try and use the June over June change in the index.  Instead, it should select March over March or February over February.  Therefore, a utility may compare the February 2013 CIP to the February 2012 CPI to calculate the increase to become effective July 1, 2013.

How to handle unexpected events?

The utility also must be prepared for unexpected events.  Over time, most indices have averaged annual increases of 2% to 3%.  However, due to the recession, most indices dropped between some months in 2008 and 2009.  If the utility is committed to using the index, it might be required to lower rates if this phenomenon occurs again.  Due to the recession and other factors, many utilities were experiencing declines in water usage at the same time.  The combination of these factors could result in a significant decline in revenue.  If the utility had an increase in its debt service at the same time due to previously approved capital projects (for growth that now isn’t occurring), it could face a perfect storm of lower revenues and higher fixed costs, which could require significant reductions to operating costs to balance the budget, which may or may not be possible.  Even though this is an exaggerated case, it is not unrealistic and shows the necessity of having reserves.

Summary:

Indexed rate increases have potential benefits to utilities.  In general, they provide rate increases (and revenue increases) without the challenges of gaining annual rate increase approvals.  However, indexed rates are not without problems.  The increases provided through indexed rates may not be sufficient for long term sustainability for a number of reasons.  If it comes down to an indexed rate increase or no increase, then utilities would likely be better served to take the former, however utilities should evaluate the potential pitfalls and put into place certain safeguards (such as reserves) if they chose to implement indexed rate increases.  We would appreciate your thoughts on the use of indexed rate increases.