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Legal background and ownership models for water utilities including financial considerations for utility rates
Citation preview
11
Financial Aspects of Water Utility ServiceWater Prices and Lending OpportunitiesDecember 9, 2010
“financial solutions that make a difference”
Presenter: Jason Mumm, PresidentStepWise Utility Advisors, LLC. | 58 Inverness Drive East, Suite 260Englewood, CO 80112 | (866) 935-3101www.StepWiseAdvisors.com
Presented at The Colorado Law Institute Water Marketing Conference – Beaver Creek, Colorado
22
Legal Aspects of Utility Rate Making
Ownership Models & Financial Issues
Final Thoughts
1
2
3
Discussion Topics
33
LEGAL ASPECTS OF UTILITY RATE MAKING
Colorado Law Institute Water Marketing Conference – Beaver Creek, CO
44
“There are at least two large chucks of the US economy that the competitive market model obviously does not describe or even purport to describe…the growing public sector… and public utilities.”
Alfred E. Kahn, Ph.D.The Economics of Regulation
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Why are Utility Rates Regulated?
Industrial Revolution
Development of new Monopoly enterprises
Legislative and Court response
Invention of steam energy created new industries with very high natural barriers to entry that became monopolies.
Price exploitation became rampant in early monopoly enterprises, like railroads and utilities
Pre-industrial era trades and businesses had already been recognized and regulated : inn keepers, cabs, grist mills
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Utilities: “Affected with a Public Interest”• Established as legal criteria for government
regulation of enterprises in 1877• Munn v. Illinois (94 U.S. 113 - 1877)• What is “affected with a public interest?”
– Wolf Packing Co. v. Kansas (262 U.S. 522 – 1923)– Business carried out under the authority of a public
grant of privileges…such are the railroads, other common carriers, and public utilities.
77
Key Cases and Legislation in Utility Rate Regulation
• Munn v. Illinois (1877) – regulation of enterprises by government is proper when business is “affected in a public interest”
• Interstate Commerce Act (1887) – regulated railroad prices and prevents price fixing and exploitation
• Sherman Act (1890) – first major anti-trust legislation
88
Key Cases and Legislation in Utility Rate Regulation • Smyth v. Ames (1898) – limited government
regulation to the “fair return” standard• Bluefield Water Works v. PSC of West Va. (1923)
– further defined fair return as a return on the “value of the property used at the time its being used to render the service.” Used and useful standard.
• Nebbia v. New York (1934) – affirmed that regulation requires due process that– Has a reasonable relation to proper legislative
purpose– Is not unreasonable arbitrary, or capricious
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Colorado Decisions That Matter• Bennett v. Bear Creek (928 P .2d 1254 – CO
1996).– Judicial review must respect separation of powers
and avoid intruding on policy making function of legislative body
– Rates and charges are rationally related to the government utility purpose
– Rates that are not rationally related to a local government utility purpose are subject to being set aside
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More Colorado Decisions• Krupps v. Breckenridge Sanitation District (19
P.3d 687, 693-694 – CO 2001)– Rates are service fees as opposed to “takings”– Service fees have important attributes
• Reasonably related to the costs• Rationally based• Consistently applied• Fairly calculated• No extraordinary concessions
– Service fees without these attributes may be “inherently unsound” and subject to judicial review and possible court action
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The Essential Standards for What Utility Rates Should Not Be:
Unreasonable
Capricious
Arbitrary
Nebbia v. New York (291 U.S 502)
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Price Takers We Are Not
Price Takers• Operate in competition with
other firms offering the same goods or services
• Prices are set based on customer demand (bids) at given prices (ask)
Price Makers• Monopoly businesses with
little or no competition from other firms
• Prices tend to be regulated to mitigate monopoly market power
• Utilities are monopolies and are price makers
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Regulatory Models
Private Ownership
PUC oversight
Direct Oversight
Public ownership
Elected body oversight
Direct Ownership
Both models are intended to limit monopoly market power (price making) by limiting prices for the public welfare
Both models perform the same essential role
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OWNERSHIP MODELS & FINANCIAL ISSUES
Colorado Law Institute Water Marketing Conference – Beaver Creek, CO
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Basic Utility Governance
• Owners are residents of the jurisdiction
• Customers can be owners or customers
Government Owned
• Owners are Investors• Customers are
customersInvestor Owned
Direct Ownership
Direct Oversight
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Four Aspects of Utility Regulation
Control of Entry Price Fixing
Prescribed of Service Level
Imposed Obligation to
Serve
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The Basic Business Model of Utilities
• Provide Equity Capital
• Assume RiskOwners
• Acquires Assets• Provides ServiceUtility Co.
• Pay bills • Produce Revenue
Customers
Model is the same whether it is an Investor-
Owned or Government-Owned utility
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Capital Flows by Model
Owners Provide Equity
Equity is Used to Finance Assets
Rates Include Return
Utility Generates
Return
Return distributed to Owners
Customers Provide Equity
Equity is Used to Finance Assets
Rate Excludes Return
Rates are Lowered
Return distributed by
lower rates
Investor-Owned Capital Flows
Govt. -Owned Capital Flows
1919
How Rate Regulation Works• Regulatory body (PUC or elected body) fills the
gap between Monopoly and Competition.• Rates are limited to levels necessary to recover
the “revenue requirement”– Set at a point where Price = Average Total Cost per
Unit – Average Total Cost is also called “Revenue
Requirement”
2020
Major Cost Centers of a Water Utility System
Source of Supply
Raw WaterStoragePipesPumps
Treatment
Well WaterSurface Water
Transmission
PumpingLarger Pipes
Distribution
StoragePumpingSmaller PipesMetersHydrants
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Measuring Revenue Requirements
The Utility Approach• Operating & Maintenance
Costs• Taxes or PILT• Depreciation Expense• Return on Investment
The Cash-Needs Approach• Operating & Maintenance
Costs• Taxes or PILT• Annual debt service
– Interest Expense– Principal
• Capital Project Costs Funded from Rates
2222
Which Method Applies?
Investor Owned
Cash-Needs
Approach
Government Owned
Utility Approach
2323
Simple Service Area ArrangementR
iver
StorageReservoir
Industry Z
TreatmentPlant
Industry Y
Transmission
M
MP M
M
M
System A
Government Owned Model: System assets are owned by customers, and customers pay system costs
Investor-Owned Model: System assets are owned by shareholders, and customers pay system costs & profit
2424
Factoring for Return to Owners• Return compensates
owners for costs of capital– Debt – Equity
• If System A financed assets used to serve B and C, then return is appropriate
• Doesn’t matter if A is government or investor owned
System A
System B
System C
Services
2525
More Complex System Arrangement
StorageReservoir
Industry Z
TreatmentPlant
Industry Y
Transmission
M
M
M
M
P
P
M
M
M
M
M
System A
System BSystem C
System A Owners are now investors in Systems B and C
Systems B and C are now customers of System A
2626
Multiple Service Area System
• The system assets are owned by customers/owners in System A
• The owners of System A earn a return on the assets serving Systems B & C
• Return reduces costs to customers in Sys. A
Simplicity
No. of Owners and Non-Owner Customers
2727
Are They Full Customers?System Component
System A Customers
System B Customers
System C Customers
Source of SupplyTreatment
Transmission
Distribution
Customer Services
2828
Are They Owners?
Attributes of Owners• Legal authority
– Board of Directors– Elected Body
• Makes all operating decisions
• Makes all investing decisions
• Assumes all ownership risks
Attributes of Non-Owners• No legal authority and
cannot vote for representation
• Only responsibility is to pay for service
• Only pay for used and useful property
• Entitled to price protections
2929
Regional Water System
System A
System B
System C
ServicesServices
Services
• System A – Owns assets serving B
and C• System B
– Customer of A– Owns assets serving C
• System C– Customer of System A– Customer of System B
3030
More Parties, More Diligence
Simplicity
No. of Owners and Non-Owner Customers
3131
What’s Used and Useful?
Regional Assets
Who Owns it?
System A System B System C
Source of Supply - A System A
Source of Supply - B System B
Raw Water Pipelines Sys. A & B
Treatment Plant System A
Transmission Pipes System C
3232
Regional Ratemaking Issues
What’s “Used and useful”• What assets are physically used• Who uses them and when
Who Owns What• Single-owner• Multiple-owners• Allow for owner returns
Determine Service Level• Water quality• Delivery schedule / time & place• Different for each customer?
Measuring Usage• Through each asset• Usage of water vs. use of capacity
Measuring Costs• Accounting for each asset• Capital costs!!
Regional Organization• Partnership agreement• Separate governance structures• Legislative approval processes
3333
FINAL THOUGHTSColorado Law Institute Water Marketing Conference – Beaver Creek, CO
3434
Conclusions• Both government-owned and private utilities
are Price Makers because they are natural monopolies within their service areas
• Price Makers are not allowed to exploit their market position – their prices are regulated
• Regulation can be performed by either– Direct Oversight– Direct Ownership
• Regulation has limitations, it must not be:– Arbitrary– Unreasonable– Capricious
3535
Conclusions• The business requirements dictate ownership
model and financial considerations• Ownership models range from simple to
complex• Complexity does not diminish any of the above,
in fact it increases the need for diligence
3636
Further Reading
Bonbright, James C., Albert L. Danielsen and David R. Kamerschen. Principles of Public Utility Rates. Arlington: Public Utility Reports Inc., 1988
Keezer, Dexter and Stacy May. The Public Control of Business. New York: New York Times Co., 1973
Kahn, Alfred E. The Economics of Regulation, Principles and Institutions. New York: John Wiley & Sons Inc., 1988
Taylor, Graham. State Regulation & The Politics of Public Service, The Case of the Water Industry. New York: Mansell Publishing Ltd., 1999
3737
For Further Questions
Presenter: Jason Mumm, PresidentStepWise Utility Advisors, LLC. | 58 Inverness Drive East, Suite 260Englewood, CO 80112 | (866) [email protected]
3838
SUPPLEMENTAL SLIDESColorado Law Institute Water Marketing Conference – Beaver Creek, CO
3939
Return Charged to Non-Owners
Pays ForMeasured AsCapitalOwners
Invest
Debt
Depreciation Expense
Debt Principal
Interest Rate Interest Expense
Equity
Depreciation Expense
Investment Principal
Return on Equity
Opportunity Costs