WATER AND SEWERAGE FINANCIAL MANAGEMENT PLANNING

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1 WATER AND SEWERAGE FINANCIAL MANAGEMENT PLANNING ABSTRACT Chris Adam, Cardno MBK (Qld) Pty Ltd In recent years, the utilities industries have been subject to far greater commercial scrutiny than ever before. This emphasis on economic efficiency comes as a result of increased pressure on Australian industry to remain competitive in a global economy and the subsequent need for the inputs into industry (including water services, electricity, transport and telecommunications) to be provided at their most cost efficient levels. The challenge for water service providers (WSPs) is to develop a greater understanding on how we balance the new commercial focus with the traditional social and environmental objectives of the industry. The first part of this paper provides an overview of Financial Management and seeks to explain and de-mystify the process. The second part of the paper raises some issues facing the industry and asks the question Is cost the single or even best measure of performance for the industry? BACKGROUND Traditionally, the water industry has focussed on its role as the provider of a range of public health, social and environmental objectives. It is only comparatively recently that commercial objectives have been seen as a key priority in service delivery. This increased commercial emphasis stems from the early 1990 s when various governments acknowledged the need for Australian industry to be as efficient as possible if they were to survive in a global market place. As the outputs of the infrastructure industry (ie water services, energy, telecommunications and transport) are key inputs into many Australian industries, then these upstream industries needed to be operated as efficiently as possible. In addition, increased competition for capital has also generated a need for greater commercial focus in development of new projects. This increased emphasis on commercial issues is supported by market trends and consumers (both large and small) who are increasingly demanding efficiency in the management of their (typically publicly owned) Water Service Providers (WSP s). In 1995, the Committee of Australian Governments (COAG) adopted what is known as the Competition Policy agreement. The objective of Competition Policy was to ensure that Australian industry was as competitive as possible on a world stage. The Industry Commission report of 1994 indicated that the economic savings from competition policy could add up to $23 billion annually to Australia s Gross Domestic Product. Of this sum, annual savings of the order of $450 million per annum were to come from reform of the water industry. To achieve these savings, it is necessary for the industry to have greater understanding of the commercial drivers of their businesses and to ensure that services are provided in their most efficient manner.

2 Part 1 Outline of Financial Management: WHAT IS FINANCIAL MANAGEMENT? Financial management is the process of assessing the organisations current and projected performance in a manner which provides meaningful information for planning, performance measurement, internal control and corporate management The objective of effective financial management is to develop strategies which support the businesses overall goals and establish a range of quantitative and qualitative measures which provide management with the tools to ensure that the business remains on-track. THE FINANCIAL MANAGEMENT PROCESS Effective financial management requires the development of both a Financial Management Plan and a Financial Model. The Financial Management Plan is a qualitative document that describes what works needs to be undertaken and why. This document should provide an overview of the businesses strategies, the link to the higher level corporate strategies and identify what the organisation intends to achieve over the next 10 to 20 years. To be effective, the financial management strategy of a Water Service Provider needs to: give effect to strategies identified in the Corporate and Operational Plans, and TMP Business Management Plan; clearly demonstrate the long term viability of the organisation; be integrated with the organisations broader Financial Management and Planning; be an iterative process (ie regularly reviewed and revised); comply with legislative and administrative requirements (including Queensland Competition Authority (QCA), Department of Natural Resources (DNR) and Department of Communication, Information, Local Government, Planning and Sport (DCILGPS)); and provide mechanisms for effective monitoring and review. The Financial Model quantifies the impact of the organisations financial objectives and demonstrates (in dollar terms) the commercial performance of the organisation over time. The objective of the Financial Model is to act as a long range radar by indicating how the organisation will fund its strategies over time. The Financial Model is a decision tool which effectively quantifies how the business will meets its obligations, particularly in respect of: a) funding of infrastructure investment (capital works) and recurrent expenditure to meet desired customer service standards b) meet regulatory requirements c) meet financial obligations to owners/shareholders; and d) assess the impact of potential risks to the business.

3 BENEFITS OF FINANCIAL MANAGEMENT Given the billions of dollars invested in the State s water infrastructure and the millions spent each year by WSPs in operating and maintaining these assets, the benefits of improved financial planning management can significantly affect both local and State economies. Beneficial outcomes from effective financial management are: the business remains viable in the short, medium and long term; customers get value for money; statutory requirements are met; and managers have financial information (costs, KPIs, etc) to allow them to manage the business more effectively and efficiently in both the short and long terms. These outcomes are achieved by: identifying the need for funds for future infrastructure investment (capital works) and potential sources of this funding (eg reserves, debt, subsidy etc). This allows the business to plan its future capital requirements; assessing the validity of revenues and charges (ie are we generating sufficient revenues to meet our financial obligations over the long term); developing a link between the general purpose accounting and management requirements (ie getting the message across to the Board of Management); and highlighting changes in the business cash position, profitability and size over time. THE FINANCIAL MODEL IN DETAIL MYTHS AND MISCONCEPTIONS The Financial Model is the engine room of the organisation s overall planning. All proposed capital or operational initiatives needed to be funded somehow and it is the Financial Model which indicates how this can be carried out. However, it is the Financial Model that is perhaps the least well understood. Ideally, a Financial Model should include at least the following three components: 1. Cash Flow Forecast This is the most important section of any Financial Model and indicates the physical flow of cash into and out of the business. The cashflow statement tells you whether the business will be able to pay its bills as and when they fall due. If the cashflow statement indicates a large or negative repeated cash balance then this indicates that the business may not be viable and the original assumptions should be reviewed. This is the first step in developing a Financial Model. Until the statement of cashflows indicates a regularly positive cash balance, there is little advantage in proceeding further. 2. Operating Statement The next step in developing a Financial Model is to establish an operating (or profit and loss) statement. The main difference between the operating statement and the statement of cashflow will be the addition of non-cash revenues or expense (eg depreciation) in the calculation of operating profit. In addition, the operating statement may include an outline of how operating surpluses are to be distributed (ie dividend payment, retained earnings, transfer to capital account or other reserve, etc).

4 A healthy operating statement is one in which the operating profit is consistently positive 1 and grows over time. 3. Balance Sheet The final stage in developing a Financial Model is the development of a forecast balance sheet. The balance sheet will take information from both the cash flow and operating statements and use these to illustrate changes in the businesses overall position over time. A healthy balance sheet is one in which the equity (or net assets) increase over time. RISKS ASSOCIATED WITH INADEQUATE FINANCIAL MANAGEMENT A lack of adequate financial management and planning can compromise the business s ability to meet its long term obligations. The more significant potential risks include: Sudden significant increases in charges due to unforeseen expenditure; non-compliance with financial obligations; inability to fund necessary capital works; inability of commercialised/corporatised entities to pay agreed dividends to the owner; changes in subsidy rates; and significant changes in (ie reduction) in customer growth (revenue base). Development of a comprehensive financial management strategy will assist WSPs in both identifying and overcoming financial risks which may affect the business s viability in the short or long term. Part 2 Financial Management in Context: ECONOMIC vs OTHER MEASURES OF INDUSTRY PERFORMANCE Despite the above arguments, some members of the water industry have asked the question: Is price the single or even best measure of effectiveness of the water industry? Given the industry s role in the attainment of a range of social and environmental objectives, financial management must be carried out in context. Importantly, limitations of the principles of economic efficiency in certain markets was recognised in the original inquiry into Competition Policy (Hilmer Report). This report stated: Competition Policy is not about the pursuit of competition for its own sake. Rather, it seeks to facilitate effective competition in the interests of economic efficiency whilst accommodating situations where competition does not achieve economic efficiency or conflicts with other social objectives 1 Please note that a positive operational surplus is NOT necessarily a prerequisite for the business to remain viable. It is possible for a business to survive over an extended period without making an operating surplus.

5 The water industry is arguably like no other industry in the need for financial management to be undertaken in context to ensure that such social objectives are addressed. To achieve this, financial management should be undertaken as part of a broader management review. In this sense, the Department of Natural Resources Total Management Planning (TMP) process provides the opportunity for WSPs to develop financial strategies in conjunction with their broader environmental and social obligations in a manner which ensures that the business can meet all of its obligations whilst still remaining financially viable over the long term. The TMP format enables a WSP to identify its objectives across a range of areas. This inherently means that the WSP needs to identify how it intends to address the range of social and environmental objectives for which it is responsible. The cost of these strategies are key inputs into a financial model. Trends in the modelling may, in turn, affect the intended strategies (ie we may not always be able to afford the strategies that we intend to put in place). Hence, the process involves a series of iteration between the nominated social/environmental/technical strategies and the financial capacity of the organisation. In this way, a WSP can balance its various commitments in a financially responsible way. FROM THE REGULATORS VIEWPOINT: One of the features of competition policy is the need for regulatory overview of monopoly markets (such as the water industry). The job of the regulator is to develop a means of balancing the multiple and often conflicting intentions of various industry stakeholders (ie WSP s, customers, political interests etc). This is a complex balancing act. When asked to make a decision, the industry stakeholders often have more detailed information than that available to the regulator. Whilst the regulator has the power to request such information, the stakeholders are likely to present the data in a manner which supports their position. In addition, the cost of compliance with a regulators request introduces an element of inefficiency back into the market. So, the problem from the regulators perspective is how to make decisions (in the new environment) which benefit the broadest possible audience whilst not having complete information. POSSIBLE SOLUTIONS (?) Perhaps a solution to the issue of conflicting economic, social and environmental objectives is to develop a process which facilitates fair and reasonable assessment of conflicting goals. This is what the Total Management Plan (TMP) sets out to achieve. In addition, recent growth in the popularity of broader economic evaluation tools which attempt o balance the social and environmental as well as commercial value of a proposal (Multicriteria or Triple bottom line analysis) may be a recognition of the need for a broader frame of reference in analysing infrastructure projects. SUMMARY In conclusion, it must firstly be said that economic efficiencies are an important objective in the management of a Water Service Provider. Whilst it may be argued that the essential nature of the water industry in the attainment of a range of social, environmental as well as economic objectives may mean that cost is neither the single nor best measure of

6 performance of the industry, practitioners cannot ignore the current emphasis on effective Financial Management. To achieve a good result, Technical staff, Financial personnel and Management need to work in close cooperation to ensure that financial management is undertaken in a manner which meets the various goals and objectives of the business. In this way, an organisation can establish mechanisms for balancing the various goals of the business to ensure that commercial decisions are made in context with the organisations broader objectives Effective Financial Management is essential in ensuring that a water service business will remain viable and deliver an agreed standard of service over a longer term.

7 Author Biography Chris has over ten years in the water industry and local government sector, undertaking a range of financial analysis, business review, tariff modelling, project delivery, asset management and optimisation projects. Chris has recently assisted the Department of Natural Resources in writing the revised Financial Management Planning component of the TMP Guidelines. Chris has both Engineering and Business Administration qualifications and has a detailed appreciation of the issues and constraints which characterise the water industry including the current changes resulting from implementation of National Competition Policy and the corresponding regulatory regimes. Postal Address: Chris Adam; PO Box 388 Toowong, Qld, cadam@cardno.com.au