Assistance Provider As Consultant

Cost-based Rates, Part 1

Carl Brown, President

GettingGreatRates.com

You want “cost to serve” user rates. Really, you do. It is pretty easy to convince an angry ratepayer or a judge that cost to serverates are fair. That can’t be said of lots of other structures in use today.

This is the essence of cost to serve rates: If a customer causes the utility to incur a cost, that customer should reimburse the utility for that cost.

Simple concept. Not so simple to execute. Thisrate calculation process should have two main parts: cost “classification” and cost“allocation.” This article will cover classification. Allocation will come along next time.

Most costs for a target time period, usually in the near future, need to be classified as “fixed,” “variable,” “capacity to serve” or some combination of the three. Fixed costs are converted to a minimum charge. Variable costs are converted to a unit charge. And capacity costs are converted to some combination of tap-on fees and surcharges to the minimum charge. Let’s start with the minimum charge.

I, for one, usually recommend recovering fixed costs with meter size-based minimum charges composed of two elements:

One is the basic fixed cost to make any level of service available to any customer. Billing, general administration and similar costs that are the same for all customers, regardless of “size,” are basic fixed costs. In small utilities with a uniform customer base, it is reasonable to consider all fixed costs to be basic fixed costs, resulting in one minimum charge for all.
The other major fixed cost is the cost to provideexcess or unusual system capacity(peak flow). It is most logical and mathematical to divvy these costs out to customers on the basis of water meter size. That is because the ability of different water meter sizes to sustainably pass high flows (as determined by American Water Works Association studies) relate well to the cost of building infrastructure “big enough” to handle peak flows.

With this structure, the smallest meter size customers end up paying the lowest minimum charge. Large meter size customers pay proportionately more.

The other main category of costs; variable costs, should be recovered with unit charges. The easy examples of variable costs are electricity to pump water around and chemicals to treat the water. More water used by customers equals more electric and chemical expense.

Unit charges come in three basic flavors. Each is appropriate in different situations:

Conservation rates – Manysystems need, or their administrations simply like the notion of encouraging customers to use less of the commodity. In this rate structure the unit charge goes up as volume used goes up. Most of us respond to being assessed a higher price to buy more of something. Conservation rates are most appropriate in areas with limited water supplies or in utilities that are bumping up against their capacity to produce and distribute water. Almost never are conservation rates used for pricing sewer service. We don’t want to encourage sewer customers to put their wastewater somewhere besides down the sewer drain.
Level unit charges – These stay level regardless of how much volume a customer uses. With level unit charges everyone is assessed unit charges at the average unit cost. Such rates are the easiest to calculate, they are the easiest for a clerk to explain to a complaining customer on the phone and the revenues such rates will produce next year are the easiest to accurately predict. Most water and almost all sewer service is assessed using level unit charges.
Declining unit charges – These are the reverse of conservation rates – “use encouragement” rates. Some belittle others who do not conserve resources at every opportunity. Declining rates are often scorned for that reason. However, if you have ample water supply, ample infrastructure to produce and distribute it, doing so will not cause unintended bad consequences, and if you want to encourage high use (and probably bring more and better paying jobs to town), declining rates make good sense. Declining rates are most appropriate in areas that have a high concentration of high water using industry, or if folks in that area want to attract such customers.

You can classify costs in more detail to arrive at conservation and declining rate structures, but most utilities just do it by political decision.

To be clear, any good rate setting strategy should not be about recovering past, actually incurred costs. Rate setting is about the future, not the past. Therefore, proper rate setting needs to let you:

Build adequate reserves;
Prepare for expensive capital improvements;
Catch up on needed equipment repair, refurbishment and replacement;
Escalate rates as inflation occurs; and
Assess the affordability of rates.

Even the simplest rates situation requires some complex, integrated calculations. For that reason, you or your rate analyst needs to build a spreadsheet or similar model that depicts, in virtual reality, the utility’s real-life financial and rates situation.

While you could “plug” many factors into a spreadsheet as constants, it is best to make the model dynamic so you can test the effects of different costs, timing of capital improvements, funding options, rate structures and more. Such modeling enables you to do “what-if” scenario calculations quickly. That will enable you to arrive at the best fit rates for your utility’s needs.

Costs need to be classified as “fixed,” “variable” or “capacity” related. Each category of costs needs to be totaled up. Each of those amounts needs to be recovered from customers appropriately – fixed costs by a minimum charge, variable costs by a unit charge and capacity costs by a meter sized-based minimum surcharge.

Cost classification puts costs into categories. Allocation divvies those cost categories out to ratepayers. That will be covered in the next article.

Carl Brown is President of GettingGreatRates.com, which specializes in water, sewer and other utility rate analysis. The firm serves as the RATES Program rate analyst for the Kansas, New Mexico, North Dakota, Virginia and Wyoming rural water associations. Contact: (573) 619-3411;