APPA’s Financial Planning for Municipals

Mark Beauchamp, CPA, CMA, MBA616-393-9722

September 27, 2005

Business & Finance Workshop

Objectives

How to determine revenue requirements

Development of a cash reserve policy Development of long-range financial

plan and rate track Cost of service & Electric Unbundling Contribution to City

Determination of Revenue Requirements

How much should you recover from Customers in Rates?

Two Methods Exist to Determine Revenue Requirements

Cash Basis Revenue requirements defined based

on cash outflows and debt service

Utility Basis Revenue Requirements developed

using accrual accounting basis

Cash Basis Advantages

Understood by City Councils

Attempts to match cash inflows and outflows on a yearly basis

Meets bond obligations

O&M Expenses (Excluding Depreciation Expense)Capital Expenses

Debt Service (Principle and Interest)Total Revenue Requirements

Utility Basis Advantages:

Leads to more stable and consistent rate adjustments

Typically leads to a more financially stable and healthy Utility

O&M ExpensesDepreciation Expense

Rate of ReturnRevenue Requirements

Disadvantages Cash Basis

Conceals major rate problems and revenue deficiencies

Tends to result in unexpected and large rate adjustments

Not generally accepted by courts if rates are challenged

Utility Basis City Councils may

not understand Have to justify

cash reserves Explain funding

non-cash expenses - Depreciation

Explain importance of rate of return

How to Overcome Disadvantages

Do cost of service study on Utility Basis

If Large Adjustments are Needed: Define minimum rate adjustment to

meet debt service obligations Develop a plan to phase-in rates from

a cash basis to a utility basis

Education of Boards and Councils Theory of depreciation expense –

Reasonable representation of the amount of the system used on an annual basis

Cash represents a buffer that allows timely replacement of system to ensure reliability to customers

Cash balances allows the phasing in of large rate adjustments to minimize the rate impacts on customers (Long-Term Rate Track)

Develop a financial plan and explain the consequences of inaction

Rate of Return is a Necessary Component of a Rate Study Net Book Value X

Rate of Return = Target Return

Target Return is typically for operating income

Historical Investment(Accumulated Depreciation)

Net Book Value

May Subtract Contributions in Aid of Construction

Net Book Value(Outstanding Debt)

Equity in Assets

Weighted Average Cost of Capital

AmountPercent of NBV

Interest Rate

Weigted Average

NBV 20,000,000 Outstanding Debt 8,000,000 40% 5.5% 2.2%Equity in Assets 12,000,000$ 60% 7.0% 4.2%Weigted Average Cost of Capital 6.4%

Should a Public Power System Have a Rate of Return? Covers interest expense on debt Assets installed many years ago are

more expensive to replace today The rate of return attempts to recover

sufficient funds to replace the assets at some point in the future

Without an appropriate rate of return customers today may be subsidized by future customers

Cash Reserve Policies

Cash Reserve Policy

Why is a policy important? Ability to pay for normal capital

improvements Reserve fund for catastrophic events Funding of depreciation expense

Cash Reserve Policy

What is an appropriate cash reserve: Simple answer 3 – 6 months

operating expenses/revenues Does not account for storms Does not account for capital

improvement program

Cash Reserve Policy

Maintain 20% of Historical Investment Accounts for replacement of system Ensures cash exists for major catastrophes Should result in cash available for major

improvements Weaknesses

Major improvements to system may result in change in cash reserves at a time when utility does not have cash available

Comparison of Methods

Method AmountPercent to Reserve

Reserve Amount

Method Number

25% of Historical Investment in Utility 57,239,436$ 25% 14,309,859$ 1

Three Months Operating Expenses 21,335,644 25% 5,333,911 2

Six Months Operating Expenses 21,335,644 50% 10,667,822 3

AmountPercent to Reserve

Reserve Amount

Operation & Maintenance 21,335,644$ 15% 3,200,347$ Utility Deposits 115,000 100% 115,000 Principle & Interest Current Portion 1,554,111 100% 1,554,111 Insurance Deductible 1,000,000 100% 1,000,000 Historical Investment in Utility 57,239,436 1% 572,394 Current Construction Requests 2,296,391 15% 344,459 Total of Five Year Work Plan 14,852,308 15% 2,227,846 Minimum Researve 9,014,157$ 4

Financial Planning & Long-Term Rate Track

Case Study

Financial Planning Identify Rate Adjustments to Meet

Targets Minimize Impact on Customers Maintain Appropriate Cash Balances Achieve Target Operating Income Keep from getting complaints Re-Elect Officials

Tasks

Development of Long-Term Financial Plan

Define Minimum Rate Adjustment Define Target Rate Adjustment Define Minimum Cash Reserves Develop Rate Track

Financial Projection – Base Case

2005 2006 2007 2008 2009

Rate Adjustment 0.0% 0.0% 0.0% 0.0% 0.0%

Operating Revenues 21,811,953$ 22,134,770$ 22,462,365$ 22,794,808$ 23,132,171$

Operating Expenses 21,335,644 21,729,103 22,130,327 22,539,481 22,956,730

PILOT 1,156,034 1,173,143 1,190,505 1,208,125 1,226,005

Operating Income (679,724)$ (767,475)$ (858,468)$ (952,798)$ (1,050,564)$

Other Income & Expenses (245,806) (242,882) (246,951) (252,689) (252,167)

Net Income (925,529)$ (1,010,357)$ (1,105,419)$ (1,205,487)$ (1,302,731)$

Other Sources of Cash

Net Income (925,529)$ (1,010,357)$ (1,105,419)$ (1,205,487)$ (1,302,731)$

Depreciation Expense 2,043,415 2,114,370 2,247,453 2,322,729 2,400,252

Other Sources of Cash 1,117,886$ 1,104,013$ 1,142,034$ 1,117,242$ 1,097,521$

Other Uses of Cash

Capital Expenses 2,296,391 2,365,160 4,436,104 2,509,200 2,584,100

Principle on Debt 1,025,000 1,085,000 1,145,000 1,200,000 1,270,000

Other Uses of Cash 3,321,391$ 3,450,160$ 5,581,104$ 3,709,200$ 3,854,100$

Net Cash (2,203,505)$ (2,346,147)$ (4,439,069)$ (2,591,958)$ (2,756,579)$

Cash Balance 13,796,495$ 11,450,348$ 7,011,278$ 4,419,321$ 1,662,742$

Projected

Financial Projection – Base Case

2005 2006 2007 2008 2009

Debt Coverage Ratio

Sources of Cash 1,117,886$ 1,104,013$ 1,142,034$ 1,117,242$ 1,097,521$ Add: Interest Expense 525,148 469,111 409,300 345,380 277,390 Total Adjusted Cash Flows 1,643,034$ 1,573,124$ 1,551,334$ 1,462,622$ 1,374,911$ Debt Service Principle & Interest 1,550,148 1,554,111 1,554,300 1,545,380 1,547,390 Debt Coverage Ratio 1.06 1.01 1.00 0.95 0.89

Target from Bond Ordinance 1.20 1.20 1.20 1.20 1.20 Safety Factor 0.20 0.20 0.20 0.20 0.20 Target Debt Coverage 1.40 1.40 1.40 1.40 1.40

Projected

Cost of Service Rate Track

Year

Rate Adjustment Net Income Cash Flows

Cash Balances

2005 12.3% 1,615,149$ 337,173$ 16,337,173$ 2006 0.4% 1,662,082 326,292 16,663,466 2007 0.8% 1,798,444 (1,535,207) 15,128,259 2008 0.3% 1,814,954 428,483 15,556,742 2009 0.4% 1,862,297 408,450 15,965,192

Year

Debt Coverage

RatioMinimum

Cash Target

2005 2.70 9,014,157$ 2006 2.73 9,106,455 2007 2.87 9,500,932 2008 2.90 9,317,630 2009 2.93 9,416,545

Minimum Rate Track – Bond Coverage Ratio

Year

Rate Adjustment Net Income Cash Flows

Cash Balances

2005 2.6% (388,475)$ (1,666,451)$ 14,333,549$ 2006 1.0% (250,289) (1,586,079) 12,747,470 2007 0.0% (334,101) (3,667,752) 9,079,719 2008 0.0% (422,754) (1,809,224) 7,270,494 2009 0.0% (508,413) (1,962,261) 5,308,233

Year

Debt Coverage

RatioMinimum

Cash Target

2005 1.41 9,014,157$ 2006 1.50 9,106,455 2007 1.49 9,500,932 2008 1.45 9,317,630 2009 1.40 9,416,545

Projected

Minimum Rate Track – Cash Reserve Target

Year

Rate Adjustment Net Income Cash Flows

Cash Balances

2005 2.6% (388,475)$ (1,666,451)$ 14,333,549$ 2006 1.0% (250,289) (1,586,079) 12,747,470 2007 2.0% 106,762 (3,226,888) 9,520,582 2008 5.1% 1,188,292 (198,179) 9,322,403 2009 2.0% 1,613,183 159,335 9,481,738

Year

Debt Coverage

RatioMinimum

Cash Target

2005 1.41 9,014,157$ 2006 1.50 9,106,455 2007 1.78 9,500,932 2008 2.50 9,317,630 2009 2.77 9,416,545

Projected

Minimum Rate Track – Cash Flow Target

Year

Rate Adjustment Net Income Cash Flows

Cash Balances

2005 10.7% 1,284,654$ 6,679$ 16,006,679$ 2006 0.5% 1,348,559 12,769 16,019,448 2007 8.7% 3,347,325 13,674 16,033,122 2008 -7.3% 1,407,468 20,998 16,054,120 2009 0.5% 1,471,685 17,837 16,071,957

Year

Debt Coverage

RatioMinimum

Cash Target

2005 2.49 9,014,157$ 2006 2.53 9,106,455 2007 3.86 9,500,932 2008 2.64 9,317,630 2009 2.68 9,416,545

Financial Projection – Recommended and Approved

Year

Rate Adjustment Net Income Cash Flows Cash Balances

2005 3.6% (181,916)$ (1,459,892)$ 14,540,108$ 2006 3.6% 526,046 (809,744) 13,730,364 2007 3.6% 1,275,639 (2,058,011) 11,672,353 2008 3.6% 2,074,918 688,448 12,360,801 2009 0.0% 2,026,224 572,377 12,933,178

Year

Debt Coverage

RatioMinimum

Cash Target

2005 1.54 9,014,157$ 2006 2.00 9,106,455 2007 2.53 9,500,932 2008 3.07 9,317,630 2009 3.04 9,416,545

Cost of Service & Rate Designs

Cost of Service Information

Cost of Service is critical to understanding your costs, the rate design process, and justifying the costs charged to Customers

Do not use cost of service exclusively in designing rates

Other Factors to Consider Price Signals on Marginal Costs Social Concerns Economic Development Rate Impacts Legal Issues

If you move away from cost of service to increase a subsidy legal issues could arise

Cost of Service SummaryCost of Service

Projected Revenues % Change

Residential Service Rate 1 Standard Service 9,033,134 8,164,848 11%

Residential Service Rate 1 Space Heating Provision 54,393 49,519 10%

Residential Service Rate 1 Space Heating and Water Heating 67,848 59,070 15%

Residential Service Rate 1 Water Heating Only 404,848 357,077 13%

Residential Service Rate 1 - Senior Citizen Standard 641,816 459,470 40%

General Service Secondary Rate 2 3,725,583 3,407,969 9%

General Service Primary Rate 2A 178,031 150,755 18%

General Service Electric Heating Rate 113,668 105,001 8%

General Service Secondary Public Pumping Rate 13 22,019 20,209 9%

Traffic Signals 64,459 54,843 18%

Street Lighting 414,138 443,018 -7%

Security Lights 107,481 125,146 -14%

General Service Secondary Rate 3 4,907,395 4,490,400 9%

General Service Primary Rate 4 1,229,775 1,089,783 13%

General Service Primary High Load Factor Rate 15 704,317 596,982 18%

Test Customer Number One 711,938 639,532 11%

Test Customer Number Two 481,555 447,598 8%

Test Customer Number Three 317,113 282,949 12%

Test Customer Number Four 278,703 272,339 2%

Test Customer Number Five 183,499 156,024 18%

Total 23,768,046 21,476,623 10.7%

Customer Class

Unbundling Rates Unbundling has lost its influence in recent years

as customer choice legislation has slowed. Used to determine wheeling rates for customers

provided a choice of providers. Unbundling is beneficial in developing special

rates for customers or more accurately determine some existing rates.

Identify transformer costs for primary metered customers

Standby rates Net Metering Rates Economic Development Rates Electric Line Extension Policies

Unbundled Distribution Rates

Customer Class

Monthly Customer

Charge Dist. RateBilling Basis

Residential Service Rate 1 Standard Service 7.50 0.016 kWh

Residential Service Rate 1 Space Heating Provision 7.59 0.015 kWh

Residential Service Rate 1 Space Heating and Water Heating 7.81 0.016 kWh

Residential Service Rate 1 Water Heating Only 7.60 0.016 kWh

Residential Service Rate 1 - Senior Citizen Standard 7.33 0.015 kWh

General Service Secondary Rate 2 25.03 0.019 kWh

General Service Primary Rate 2A 91.67 0.017 kWh

General Service Electric Heating Rate 27.37 0.022 kWh

Residential Farm Service and Life Support Service Rate 12 - Standard 7.67 0.017 kWh

General Service Secondary Public Pumping Rate 13 24.78 0.010 kWh

General Service Secondary Rate 3 31.71 5.28 kW

General Service Primary Rate 4 112.29 3.97 kW

General Service Primary High Load Factor Rate 15 112.29 3.69 kW

Test Customer Number One 155.11 4.34 kW

Test Customer Number Two 155.11 1.36 kW

Test Customer Number Three 155.11 1.41 kW

Test Customer Number Four 155.11 1.43 kW

Test Customer Number Five 155.11 1.43 kW

Serving Outside City Customers

Cost Differences Customers may be more spread out resulting

in greater investments It may cost more to issue a bill and read

meters because of economies that exist when providing water and wastewater services to the same customers inside the city

Rate of Return issues (Not recommended to charge a greater rate of return outside the city for electric service

Typically cost differences exist only in the customer charge

Be careful it may be your biggest area of growth

Example of Cost Differences

Unbundled Charge

Residential Inside City

Residential Outside City Difference

Distribution Customer Costs 2.22 3.22 1.00 Transformer Customer Costs 0.79 1.63 0.84 Substation Customer Costs 0.18 0.26 0.08 Meter O&M 1.25 1.25 - Meter Reading 0.52 0.76 0.24 Billing 0.61 0.89 0.27 Services 0.79 0.90 0.11 Customer Service 1.14 1.14 - Subtotal 7.50$ 10.04$ 2.54$

Contributions To City

Contributions to City

Forms of Contributions Payment in Lieu of Taxes Free Electric Services Free services Over allocation of City Support

Services Under allocation from Electric to

Other Utility Services

Contribution to City

Is your contribution to city above “normal” contributions in your area. What is your direct contribution How much one time transfers Are allocations for city provided

services appropriate What is the cost of “free services” to

the city

Contribution to City

Allocation to Utilities for City Provided Services

Allocation for common utility functions Meter Reading Billing Customer Services Administration

Contribution to City

National average of cash-only contributions approximately 3.7%

National average including free service 5.8%