Insights

Building Asset Renewal into Rates

Building Asset Renewal into Rates

Key to Financial Viability of Water and Wastewater Utilities

Financial Challenges Ahead

The water and wastewater business is a very capital intensive business. The good news is, most of these assets last a very long time. The bad news is, many of these assets in the U.S. are near the end of their service life and are in need of renewal or replacement.

In an era of dwindling state and federal grants, water and wastewater utilities are facing the need to develop a business model based on self-sufficiency. This new reality is the impetus behind all the focus on optimized infrastructure asset management.

There are many aspects of a sound asset management program, some of which we have touched on in past INSIGHTS articles. One of the key attributes of a sustainably managed utility is financial viability.

Financial Viability

Financial viability is much more than having a balanced check book. Financial viability requires that municipalities build into the rates the full cost of the service, including replacement. In fact, the Rules and Regulations for EPA’s Construction Grants Program required in 40 CFR Part 35.2140 that all wastewater user charge systems “must be designed to produce adequate revenue required for operation and maintenance, including replacement.”

Studies across the country suggest the majority of the water and wastewater utilities have rates that do not reflect the full cost of the service.

Build in Adequate $$$

While most communities adequately build into the rates the cost of operations and maintenance of these assets and debt service, most do not adequately build in the cost of depreciation to allow for asset reinvestment. Ideally, asset renewal investment decisions are based on asset condition/criticality information. In the absence of this data, service life is a reasonable surrogate for estimating the asset renewal funding requirements.

An easy way to check the adequacy of your asset reinvestment funding is to:

  • Tabulate the replacement value of all your infrastructure assets
  • Tabulate the service life for each class of assets
  • Calculate the dollar value weighted composite service life(CSL) of the entire system
  • Compute the sustainable asset renewal rate (1/CSL)
  • Compare this with your average annual asset renewal investment

Many of these steps are already performed annually during an audit of the utility and are readily available. However, it should be noted that the depreciation calculations and resulting depreciation values typically contained in audit reports are based on the original cost of the assets, not the present value (or replacement cost), and so do not adequately account for asset renewal needs.

As an example…

One of our wastewater utility clients serves a population of about 20,000 people. This utility has approximately $100 million in assets in today’s dollars. Some of their pipeline assets have 100 year service life expectations and some of their pump station and treatment plant assets have much lower service life expectations. The composite service life was estimated at 75 years, which means the average asset renewal investment rate should be: 1.3%/year (1/75yrs) or $1.3 million/yr. This utility thought they were being proactive by investing about $300,000/year in asset renewal projects, but as you can see from this simplified analysis, they were only funding about one quarter as much as they should for sustainable operations.

Saving for Asset Renewal Projects

If a utility has operated for years with no or very low asset renewal investment rates, then it will be necessary to invest at even a higher rate going forward to catch up and restore residual asset value. Asset renewal accounts should be proprietary funds that are dedicated and protected for their intended purpose of funding asset renewal projects. Asset renewal projects should be prioritized based on asset condition and risk analysis consistent with sound asset management strategies.

Under funding asset renewal results in shifting real cost from today’s users to tomorrow’s users. This will place an unfair burden on future generations. There are many ways to account for depreciation and utility managers need to have sound financial metrics to confirm you are on a path to financial viability.

Establishing Asset Renewal Priorities

While service life is a reasonable surrogate for estimating asset renewal investment needs, service life alone should not be the criteria for establishing asset renewal priorities. Priorities should be established based on asset condition and criticality. An asset management program should employ a range of interventions, from repair through rehabilitation, in order to extend asset life rather than simply replace the asset at the end of the service life.

Conclusion

Utility operations are like running any other capital intensive business. It requires solid financial management. Utility managers need to have a financial director that can track all the appropriate financial metrics and advise about the full cost of providing the service. In future newsletter articles we will focus on some of the other metrics that are useful to track.

Wright-Pierce is assisting clients throughout the Northeast establish responsible asset management strategies, including financial management strategies.