City of Sacramento, California Department of Utilities. March 2011

Transcription

1 Department of Utilities Utility Rate Study March 2011

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3 March, 2011 page i TABLE OF CONTENTS EXECUTIVE SUMMARY... 3 SECTION I: INTRODUCTION SECTION II: FINANCIAL POLICIES A. Defining Revenue Needs A.1 Cash Flow Sufficiency Test A.2 Bond Coverage Sufficiency Test B. Utility Reserves B.1 Operating (or Working Capital) Reserve B.2 Rate Stabilization Reserve B.3 Capital Emergency Reserve B.4 Bond Reserves C. Capital Funding C.1 Cash versus Debt Funding C.2 System Reinvestment Funding D. Debt Considerations D.1 Debt Structures D.2 Debt Coverage SECTION III: REVENUE REQUIREMENTS A. Methodology A.1 Basis for Establishing the Rate Revenue Requirement A.2 Defining & Forecasting Needs A.2.1. Operating Needs A.2.2 Capital Needs A.2.3 Policy-Induced Needs A.2.4 Additional Expenses and Unmet Needs A.3 Defining & Forecasting Resources A.3.1 Operating Revenues A.3.2 Capital Revenues B. Forecasted Rate Revenue Requirements B.1 Water Utility Rate Revenue Requirements... 42

4 March, 2011 page ii B.2 Wastewater Utility Rate Revenue Requirements B.3 Storm Drainage Utility Rate Revenue Requirements B.4 Solid Waste Utility Rate Revenue Requirements C. Revenue Requirement Recommendations Summary SECTION IV: UTILITY COMPARISON SURVEY A. Survey Objectives and Limitations B. Rate Comparison B.1 Overall Comparison B.2 Water Utility Comparison B.2.1 Water Service Comparison Profiles B.3 Wastewater Utility Comparison B.3.1 Wastewater Service Comparison Profiles B.4 Storm Drainage B.4.1 Storm Drainage Service Comparison Profiles B.5 Solid Waste B.5.1 Solid Waste Comparison Profiles APPENDICES Appendix 1. Water Scenario 1: Baseline Appendix 2. Water Scenario 2: Cash Funding Appendix 3. Water Scenario 3: Cash and Debt Funding Appendix 4. Wastewater Scenario 1: Baseline Appendix 5. Wastewater Scenario 2: Cash Funding Appendix 6. Wastewater Scenario 3: Cash and Debt Funding Appendix 7. Storm Drainage Scenario 1: Baseline Appendix 8. Storm Drainage Scenario 2: Cash and Debt Funding Appendix 9. Solid Waste Scenario 1: Baseline Appendix 10. Solid Waste Scenario 2: As Needed Cash Funding Appendix 11. Solid Waste Scenario 3: Flat Cash Funding... 83

5 March, 2011 page 3 EXECUTIVE SUMMARY The City of Sacramento (City) Department of Utilities (Department) provides and maintains water, wastewater, solid waste, storm collection, storm drainage, and flood control services and facilities. These services and facilities are provided for its customers to safeguard the health and safety of the public, contribute to economic development, and improve the quality of life. The Department engaged FCS Group to perform a Utility Rates Study (study) for s (FY) 2011/12 through 2015/16 for the City s water, wastewater, solid waste, and storm drainage funds. In addition, the Department requested a regional rate comparison for each utility service. Specifically, the study consisted of three distinct elements and deliverables: Financial Policies Review Revenue Requirements (Needs) Forecast Utility Comparison Survey To meet these goals, FCS Group collected and reviewed a variety of documents from the City, including accounting records, City policies and procedures, utility operating budgets, debt service payments, and capital improvement program costs. These sources were used to prepare budget projections and assess revenue requirements to develop proposed utility rates. While this study did not include an operational review, overall budget requirements and escalation factors were discussed with staff and reviewed for reasonableness; specific escalation factors are discussed later in this report. FCS Group worked closely and collaboratively with City staff throughout the course of this study. The recommendations and findings of this report are those of FCS Group and are based on information and data gathered as part of this study, as well as utility industry best practices. Ultimately, the City Council has the responsibility to approve the rate and financial plan that they believe provides the optimal balance of rate increases with protecting public health and safety and maintaining the longevity of the system infrastructure. Moreover, the findings illustrate a range of rate increases intended to provide direction in achieving this balance. Finally, the recommendations are based on a point in time analysis and should be adjusted over time as the capital improvement program and corresponding funding program is adjusted. The intended use of this study and report is to provide the City with financial guidance as it implements upcoming utility rates. Utility operations and capital needs typically change over time dependent upon a number of variables, such as new development, construction costs, bond issuance costs, and labor contracts. As such, the financial forecast and corresponding rate projections should be revisited periodically to ensure that the City s financial obligations are met, as well as that an optimal balance between user rates and fiscal requirements is achieved. Finally, the analysis described within this report is based on implementing rate increases July 1 for each year. Financial Policies Review A financial policies review was developed for the Department in connection with the study for the water, wastewater, storm drainage and solid waste funds. This review was conducted in collaboration

6 March, 2011 page 4 with City staff, building on the recommendations proposed during the 2009 rate setting process. Financial policies are fundamental to good financial management and provide a standard for assessing fiscal performance. These policies can serve as guidelines for operational and strategic decision-making that identify acceptable and unacceptable courses of action. Further, establishing financial policies and funding recommended reserve policies can promote standardization, stability, continuity, and financial balance. The following areas were reviewed as a part of this study: Defining Revenue Needs Utility Reserves Capital Funding Debt Considerations Defining Revenue Needs The Department, like most municipal utilities, operates under an enterprise business model, and does not intend to generate profits above its current needs (with surplus reserves to assist with responsible financial planning). With that in mind, what is the correct level of funding and annual revenues? The following cash flow and bond coverage sufficiency tests are universally used to determine the amount of annual revenue that must be generated from utility rates. Cash Flow Sufficiency Test The cash flow test defines the amount of annual revenues that must be generated in order to meet annual expenditure obligations of the utility. These needs can include direct cash expenditures as well as planned transfers or additions to reserves. Bond Coverage Sufficiency Test Bond coverage refers to the collection in revenues to meet all operating expenses and debt service obligations plus an additional multiple of that debt service. A minimum bond coverage ratio of 1.25 is common for rate revenue backed bonds, meaning that the agency needs to collect expenses plus 1.25 times debt service as a minimum legal level of revenues. Many utilities establish higher policy targets (such as coverage ratios of ) to retain or attain high bond ratings with correspondingly lower interest costs. The Department s historical rate analysis has defined rate revenue requirements based on a cash flow sufficiency test only. Given that the Department will likely issue bonds to fund its future capital needs, incorporating the coverage sufficiency test into the rate analysis becomes integral to defining future rate needs and maintaining legal compliance with bond covenants. Both the cash flow and bond coverage test must be satisfied independently. We recommend that the Department target bond coverages of 1.50 times annual debt service, with a minimum coverage ratio of It should be noted that the 1.25 times coverage test does not provide sufficient annual revenues to protect against fluctuations in revenues and expenditures. Therefore, we also recommend that the Department establish a bond rate stabilization reserve (discussed below) at the time of its next debt issuance. Utility Reserves Utility reserve policies are intended to create a measure of safety and security for the uncertain events of the future that impact a utility s financial health. Reserves can address variability and timing of expenditures and receipts of revenues, as well as occasional disruptions in activities, costs, or revenues. The general objectives of these policies are to facilitate stable and predictable rates and funding sources, along with equitable recovery of costs from customers. These recommendations build upon the policies

7 March, 2011 page 5 proposed by City staff during the 2009 rate setting process. 1 Based on our review, the following is a summary of the reserves suggested and corresponding recommendations. Reserve Type Purpose Recommendation Operating (or Working Capital) Reserve Rate Stabilization Reserve Capital Emergency Reserve Bond Reserve Provides working capital for day-to-day operations and absorbs fluctuations in cash balance Provides a revenue source during revenue shortfalls that result from lower than expected customer consumption. A rate stabilization reserve may also be established at the time of debt issuance, setting aside money in a restricted fund can be used to meet the utility s annual debt service coverage obligation. Provides a source of emergency funding for emergency repairs and replacements Provides a means of protecting against the risk of nonpayment of bond covenants The Department should set its operating reserve minimum targets at a range of 60 to 120 days of its annual operating expenses (including general fund transfers). Based on current market conditions, an aggregate, minimum unrestricted working capital balance of 120 days should be maintained between the various reserves. The Department should formalize a rate stabilization reserve policy related to appropriate reserve levels, as well as criteria for replenishing and liquidating the fund. As the Department issues new debt, it should revisit the working capital reserve targets so that both the necessary on-hand liquid cash is available for ongoing operations, as well as the necessary restricted set aside for the purposes of meeting bond coverage obligations. The presence of a rate stabilization reserve can also consequently lower the appropriate target for unrestricted working capital. In the future, the Department should consider establishing and funding a capital reserve minimum in order to be in a position to make short-term emergency repairs and to provide some buffer against capital cost overruns. As of the writing of this report, the Department does not have the user rate capacity to fund a minimum target. The Department should maintain a reserve in compliance with existing bond official statements. Future bond reserve requirements will be defined at the time of each subsequent debt issuance. Capital Funding Capital needs can be defined by a capital plan and capital-related policies. Capital resources, such as system reinvestment funding, impact fees, debt and capital reserve balances are defined and constrained by fiscal policies and practice. Given the variety of available funding sources, utilities often find themselves having to choose among funding sources when establishing a financing plan. While grants and developer contributions would first be applied to project costs, the next choice in the funding hierarchy is not necessarily apparent. The specific decision regarding whether to fund projects by debt or by cash is a policy decision that is driven by a number of considerations. While cash funding can be cheaper in the long run because there is no interest cost, debt funding allows for the payment of project costs over an extended period of time. 1 FY 2009/10 Proposed Budget and Two Year Utility Service Rate Adjustment Department of Utilities ; Staff Report; June 9, 2009.

8 March, 2011 page 6 Using impact fees to pay debt service will lead to a higher interest expense, but that expense will be offset to a degree by interest earned on the impact fees kept in reserve. In addition, using debt to spread the cost over time can be used so that future customers pay for their fair share of system costs. Our review indicates that the Department has a significant replacement capital program and does not have adequate reserves to cash fund its water, wastewater, and storm drainage capital program without causing significant rate increases. Given these observations, we recommend the following: The Department should consider a balance of both debt and cash financing, using debt in the near-term to mitigate the impact on rates and a long-term strategy of cash funding replacement projects Because debt financing carries added costs, we strongly recommend that the Department implement a long-term pay-as-you-go strategy for capital replacements. Cash funding of a capital program is most appropriate when the annual capital needs are relatively flat from year-to-year and these needs are mostly capital replacements. Debt can be used to mitigate capital expenditure spikes as necessary. Debt Considerations Debt can be issued for investments in system infrastructure that provide capital assets. Debt may not be used to fund ongoing utility operations and maintenance costs that cannot be capitalized. When debt is used for capital investment, the term of debt shall not exceed the reasonable useful life of the asset being acquired or constructed. In determining debt structure, the following may be considered: the useful life of assets, existing debt and debt service load, plans for future debt issuance, market conditions, impacts on rates and charges, potential effect on organization s credit-worthiness, and other factors deemed relevant. The City has historically issued debt with level annual debt payments. As of the writing of this report, it is our understanding that the City expects to continue this practice, helping to minimize future debt obligations. Each borrowing will be unique and should be evaluated on a case by case basis in collaboration with the City Treasury Department and the City s designated Financial Advisor. This rate analysis is intended to provide a reasonable projection of future debt requirements for the purposes of establishing a future 5-year rate plan in compliance with AB Moreover, this analysis incorporates conservative, but reasonable, debt issuance assumptions developed in collaboration with the Utilities and City Treasury Departments. 3 The Department has a number of debt issues, each with its own debt coverage requirement. In addition to being a criterion for complying with debt requirements, the coverage ratio realized is an important statistic used to rate a utility s financial integrity and ability to meet its debt obligations. While the official bond offering documents will specify the required security provisions, many communities set higher coverage ratios by policy action to retain or attain higher bond ratings and achieve lower interest costs. As such, the Department should establish a bond coverage ratio target of 1.50 times debt service, so that net revenues are sufficient to generate a coverage ratio of 1.50 times debt service (or eligible revenues less operating expenses must be equal to at least 150% of annual debt service). Establishing a policy target coverage ratio of 1.50 times debt service will help to provide a buffer against unexpected revenue or expenditures swings. 2 AB 3030 allows a utility to notice and adopt up to 5 years of rates, with the ability to adjust rates upwards in accordance with defined escalation factors without being subject to a Proposition 218 protest following the original adoption. Public notification is still required for any upward adjustments. 3 The City is currently working with Goldman Sachs to evaluate future debt funding options.

9 March, 2011 page 7 Revenue Requirements (Needs) Forecast Once guidelines for establishing financial policies have been defined, the next step in the rate study process is to determine the rate revenue requirement, or the amount of revenue that rates must generate in order for the Department to be able to meet its various financial obligations. This analysis has two main purposes it serves as a means of evaluating the Department s fiscal health and adequacy of current rate levels, and it sets the basis for near- and long-term rate planning. For each utility, multiple rate revenue forecasts were developed to explore the feasibility of cash funding versus debt financing for future capital needs. Given each utility s existing financial position current fund balance, the need to formalize and follow industry standard fiscal policies, and the need to fund critical capital projects the revenue requirement analysis projects rate revenue increases for each utility over the next five years. The magnitude of these increases is contingent on the financing mechanism employed, as well as the costs associated with the critical capital needs for the particular utility. Methodology The rate revenue requirement is defined as the net difference between total revenue needs (or expenditures) and the revenue generated through non-rate sources. This analysis involves defining and forecasting both needs and resources within the context of both a cash flow test and a bond coverage sufficiency test. Each of the Department s utilities must satisfy both tests, each of which provides a different perspective on how much revenue is appropriate. It is worth noting that the grouping of these tests results in an overlapping of multiple benchmarks, so that (in tandem) each separate objective is met at all times. As noted, the difference between a utility s needs (expenses) and available resources (revenues) serve as the basis for a revenue requirement analysis. These needs can be categorized as operating, capital, or policy-induced. Further, Department staff identified additional needs during the course of this study that are not included in its current budget noted as unmet needs. Budgeted line-item expenditures in the Department s FY 2011/12 operating budget served as the basis for forecasting future operating expenses for each of the utilities. The revenue used in the analysis includes: user fees, interest earnings, miscellaneous revenue, and capital funding sources (when appropriate). Revenue Requirement Scenarios Various rate revenue requirement scenarios were developed for the Department to consider for each utility. These scenarios were developed in conjunction with Department staff and considered the long-term viability of each utility, the feasibility of rate increases, and maintaining the necessary level and quality of service for each system. The revenue requirement analyses accounts for recommended financial policies described in the financial policies section. Specifically, unless otherwise noted, each of the scenarios target a minimum unrestricted working capital balance equivalent to a minimum 120 days (32.9%) of annual operating expenses by FY 2015/16 and a bond coverage ratio of 1.50 times annual debt service by the time of the first debt issuance, with the exception of the baseline scenario. Generally, three types of scenarios were evaluated: Baseline Assumes that the Department continues its current operations and level of investment. Capital expenditures would continue at current levels, increasing by annual cost inflation only. All critical and essential capital needs identified for each utility would not be addressed. Fiscal policies are reduced from the recommended levels. Unrestricted working capital balances are set at 45 days of annual operating expenditures and a bond coverage ratio of 1.25 times annual debt

10 March, 2011 page 8 service is required. The baseline scenario is provided for comparative purposes and is not the recommended alternative. Cash Funding Assumes that each utility cash funds all critical and essential capital projects identified in its capital improvement program (CIP) through rates and charges. Given that the solid waste utility is not projected to need debt funding to meet its capital needs, two variations of the cash funding scenario ( As Needed and Flat ) are explored for this utility. Further, a cash funding scenario is not considered for the storm drainage utility because of legal limitations on the ability to raise rates for this utility. Cash and Debt Funding Assumes that the water, wastewater, and storm drainage utilities use near-term debt to meet critical and essential capital needs, but implements a long-term cash funding strategy for its capital replacement program. The water, wastewater, and storm drainage utilities are currently not in a financial position to issue debt due to minimal available reserves. The first assumed bond issuance is projected to occur in FY 2012/13 as reserves become sufficient to meet on-hand liquidity requirements. Capital expenditures in FY 2011/12 are assumed to be cash funded through rates. Given the Department s need for each utility and the potential effects of not sufficiently increasing its revenue needs, we recommend the following rate revenue scenarios for each utility. Water Utility Scenario We recommend that the utility move forward in executing Scenario 3: Cash and Debt Funding. Although this is the most costly long-term alternative for the utility, this scenario reduces its financial and capital risk by meeting its fiscal policy targets and providing sufficient resources to fund its critical and essential capital projects. The use of debt in Scenario 3: Cash and Debt Funding also spreads capital costs over a longer time frame and allows for the City to mitigate rate spikes. Conversely, Scenario 1: Baseline does not fund the utility s critical and essential capital needs and Scenario 2: Cash Funding allows for immediate and significant rate impacts. The near term water rate increases are driven by the upcoming water treatment plant rehabilitation. Delay in the construction of the treatment facility would alter this forecast; however, it is our understanding that the City is nearing completion of pre-design facility report and is on track for the projected construction timing. The five year rate plan illustrated below is designed to meet expenditure and bond coverage requirements in FY 2015/16 while also considering the rate requirements through FY 2017/18. Alternatively, the City could reduce rate increases over the five year schedule below but would require dramatic increases in FY 2016/17. It our opinion that the phased rate increases outlined below are more politically palatable and financially prudent. Since the recommended rate plan below is based on the specific timing and costs of capital projects, the City should periodically revisit the necessary increases based on the final construction cost of the treatment plant, bond market conditions, bond structure, projected debt needs, and capital needs.

11 March, 2011 page / / / / /16 Rate Adjustment 9.00% 9.00% 9.00% 9.00% 9.00% New Rate* $ $ $ $ $ Compounded Rate Difference* $ 3.10 $ 6.48 $ $ $ CIP $ 13.7 m $ 34.5 m $ 35.1 m $ 36.3 m $ m Debt Proceeds - $ 50.6 m - - $ m Ending Unrestricted Working Capital $ 10.6 m (66 days) $ 22.1 m (121 days) $ 23.1 m (120 days) $ 23.7 m (120 days) * New Rate and Compounded Rate Difference assume a flat single family residence (unmetered) 6-9 rooms $ 27.5 m (121 days) Wastewater Utility Scenario Similar to the water utility, we recommend that the utility move forward in executing Scenario 3: Cash and Debt Funding. Again, although this is the most costly long-term alternative, this scenario reduces the utility s financial and capital risk by meeting fiscal policy targets and providing sufficient resources to fund its critical capital projects. The use of debt in Scenario 3: Cash and Debt Funding also spreads capital costs over a longer time frame and allows for the City to mitigate rate spikes. The other scenarios either do not fund the critical capital needs of the utility ( Scenario 1: Baseline ) or allow near-term rate spikes ( Scenario 2: Cash Funding ). 2011/ / / / /16 Rate Adjustment 15.00% 15.00% 15.00% 15.00% 15.00% New Rate* $ $ $ $ $ Compounded Rate Difference* $ 2.21 $ 4.75 $ 7.68 $ $ CIP $ 1.8 m $ 19.7 m $ 35.3 m $ 17.9 m $ 31.5 m Debt Proceeds - $ 58.8 m - - $ 80.0 m Ending Unrestricted Working Capital $ 7.0 m (150 days) $ 7.1 m (120 days) $ 8.3 m (120 days) * New Rate and Compounded Rate Difference assume a flat single family residence 6-7 rooms $ 8.5 m (120 days) $ 11.9 m (145 days)

12 March, 2011 page 10 Storm Drainage Utility Scenario Given the constraint on raising storm drainage rates due to Proposition 218 voting requirements, we recommend that the utility at least move forward with a plan for considering Scenario 2: Cash and Debt Funding ; however, funding options should further be explored in the Department s upcoming storm drainage rate review study. The rate increases projected under this scenario assumes the full funding of the utility s critical and essential capital needs and the deferment of capital needs until the year it can raise rates. It is assumed that a voter approved rate increase would go into effect in FY 2013/14. At the City s current rate levels, the storm drainage utility cannot fund the projected FY 2011/12 and FY 2012/13 critical capital needs. The scenario below is for illustrative purposes only. The scenario identifies the rate requirement necessary to issue a utility revenue backed bond that funds the utility s deferred critical capital needs. The City will be examining available funding sources to meet storm drainage requirements and comply with Proposition 218 voting requirements. Because the funding source is yet unknown, the FY 2013/14 rate increase as shown in the table below illustrates the order of magnitude revenue increases necessary to fund the City s identified storm drainage program. It is likely that critical capital projects would be further delayed in order to phase in the necessary rate and funding increases. 2011/ / / / /16 Rate Adjustment* 0.00% 0.00% 70.00% 9.00% 9.00% New Rate** $ $ $ $ $ Compounded Rate Difference*** - - $ 7.92 $ 9.65 $ CIP**** n/a n/a $ 23.8 m $ 24.7 m $ 25.5 m Debt Proceeds - - $ 48.5 m - - Ending Unrestricted Working Capital $ 9.0 m (89 days) $ 3.3 m (31 days) $ 14.1 m (122 days) $ 16.6 m (130 days) $ 17.8 m (133 days) * FY 2011/12 and FY 2012/13 rates levels are not projected to meet the utility s debt coverage objectives. ** FY 2013/14 rate is for illustrative purposes and based on fully funding FY 2013/14 critical capital needs. *** New Rate and Compounded Rate Difference assume a flat single family residence (unmetered) 6-9 rooms **** Amounts reflect no CIP funding in FY 2011/12 and FY 2012/13 Solid Waste Utility Scenario We recommend that the utility adopt Scenario 3: Flat Cash Funding. Unlike the other scenarios, this scenario will fund the utility s existing capital needs, meet its fiscal policy objectives over time, and establish a predictable rate schedule for its customer base.

13 March, 2011 page / / / / /16 Rate Adjustment 4.00% 4.00% 4.00% 4.00% 4.00% New Rate* $ $ $ $ $ Compounded Rate Difference* $ 1.55 $ 3.14 $ 4.81 $ 6.53 $ 8.33 CIP $ 2.1 m $ 1.5 m $ 1.6 m $ 1.7 m $ 1.8 m Debt Proceeds Ending Unrestricted Working Capital $ 9.0 m (60 days) $ 16.3 m (113 days) $ 22.7 m (150 days) $ 23.4 m (150 days) $ 25.4 m (150 days) * New Rate and Compounded Rate Difference assume a single family rate (includes garbage, garden refuse, recycling, and street sweeping); garbage service is assumed to be 96 gallons, garden refuse is assumed to be containerized. Utility Comparison Survey As a part of the study, a comparison survey was developed to benchmark the Department against several surrounding municipal agencies, chosen based on proximity to the City, similarities in size and demographics, or is a regional water or wastewater provider. It should be noted that it is difficult to compare one agency to another. System attributes such as age of infrastructure, density and topography of service area, and regulatory compliance issues can vary vastly by area and agency. Consequently, while end user rates are ubiquitously used to benchmark an agency s performance, using rates as an isolated metric does not provide a strong basis for comparison. Rather, an agency s pursuit and achievement of best practices is the most appropriate measure. Data was collected from direct conversations with the surveyed agencies, from previous or ongoing rate studies performed by FCS Group, and from public information available through each agencies website. In some cases, the results are subject to self-reporting of the agencies and were not corroborated with other sources to determine the accuracy of statements made. The following figure provides the overall rate comparison across the utilities. It is important to note that not all agencies listed provide all three of the offered services. Generally, the City s utility rates fall in the middle of those surveyed, given the usage assumptions used in the comparison analysis. That being said, under a different set of assumptions the City may compare better or worse to other cities. Rates reflect recovered costs at a point in time and cannot be used in isolation to determine how effectively a utility is being run. The report provides further detail on the nature of the comparison.

14 March, 2011 page 12 Overall Utility Rate Comparison: FY 2010/11 Rates $90.00 $80.00 $70.00 $60.00 $50.00 $40.00 $30.00 $20.00 $10.00 $ Water Wastewater Solid Waste Note: A quantitative comparison of storm drainage rates could not be made at the time of this study due to the highly varying degrees of rates and the methods of their implementation.

15 March, 2011 page 13 SECTION I: INTRODUCTION The City of Sacramento (City) Department of Utilities (Department) provides and maintains water, wastewater, solid waste, storm collection, storm drainage, and flood control services and facilities. These services and facilities are provided for its customers are in place to safeguard the health and safety of the public, contribute to economic development, and improve the quality of life. The Department works in conjunction with other City departments, Sacramento County, regional, state and federal agencies in the development and rehabilitation of urban utility infrastructure. Further, the Department develops longrange financial plans to evaluate alternatives for funding its capital and operational needs related to its water, wastewater, drainage and solid waste systems. The Department engaged FCS Group to perform a Utility Rates Study (study) for s (FY) 2011/12 through 2015/16 for the City s water, wastewater, solid waste, and storm drainage funds. In addition, the Department requested a regional rate comparison for each utility service. To meet these goals, FCS Group collected and reviewed a variety of documents from the City, including accounting records, City policies and procedures, utility operating budgets, debt service payments, and capital improvement program costs. These sources were used to prepare budget projections and assess revenue requirements to develop proposed utility rates. An enterprise fund is a government facility or service that is self-supporting through the fees associated with operating that particular service. As noted, the following enterprise funds are a part of this study: water, wastewater, storm drainage, and solid waste. The following provides a brief description of these City funds: Water Service The Water Fund is used to account for the activities associated with the production, distribution, and transmission of potable water by the City to its users. The Water Fund supports both the capital and operating costs of providing potable water throughout the city including production, treatment, DEPARTMENT OF UTILITIES MISSION To provide high quality, cost effective, reliable and environmentally sensitive water, wastewater, drainage and solid waste services for today and tomorrow. VISION We are a high performance organization, providing excellent service and reliable infrastructure. VALUES Integrity and honesty Innovation and commitment Communication We are dedicated to serving them our customers and community Our employees are our most important resource and essential to our success and distribution systems. Revenues are generated by user fees. In addition, the fund receives revenues from development fees, which are used for system improvements necessitated by growth. Wastewater Service The Sewer Enterprise Fund provides for the maintenance, repair and replacement of facilities for collecting, conveying and pumping sanitary and combined sewage to the interceptor sewers of the Sacramento Regional County Sanitation District. User fees finance both operating costs and capital improvements to the existing system. A combined sewer system impact fee funds development related improvements to the combined system.

16 March, 2011 page 14 Storm Drainage Service The Storm Drainage Enterprise Fund supports the operations, maintenance, repair, and rehabilitation of the storm drainage system, which consists of a collection system and drainage pump stations, ditches, channels, and secondary levees. Primarily user fees generate revenues. Solid Waste Service Through the Solid Waste Enterprise Fund, the utility provides garbage, recycling, and green waste collection and disposal services for the City. It also manages the City s closed (legacy) landfills, provides street sweeping services, programs to assist with disposal of household hazardous waste, batteries, light bulbs, bulky waste and e-waste, and composting information. The following report provides sections related to a review of financial policies for the Department and the assumptions, methodologies, budget projections, sources of data, and recommendations associated with the revenue requirement analysis.

17 March, 2011 page 15 SECTION II: FINANCIAL POLICIES Financial policies are fundamental to good financial management and provide a standard for assessing fiscal performance. These policies can serve as guidelines for operational and strategic decision-making that identify acceptable and unacceptable courses of action. Further, establishing financial policies can promote standardization, stability, continuity, and financial balance. This section provides background and guidance on financial policies for the Department s consideration, including minimum target balances and prudent financial management practices. A. DEFINING REVENUE NEEDS The Department, like most municipal utilities, operates under an enterprise business model, and generally does not intend to generate profits above its current needs (with surplus reserves to assist with responsible financial planning). With that in mind, what is the correct level of funding and annual revenues? The following cash flow and bond coverage sufficiency tests are universally used to determine the amount of annual revenue that must be generated from utility rates. Both tests are embedded into the analysis developed for the utility rate study as well as programmed into the Department s utility rate models. A.1 Cash Flow Sufficiency Test The cash flow test defines the amount of annual revenues that must be generated in order to meet annual expenditure obligations of the utility. These needs can include direct cash expenditures as well as planned transfers or additions to reserves. For example, chemical costs are a cash expense, but depreciation funding, while represented by a non-cash expense, is a policy-based funding decision which requires the generation of cash flow in order to be fulfilled. Notably, debt service coverage is excluded from this test. In order to adequately segregate capital and operational resources, the cash flow test focuses on operational requirements, while a separate capital funding analysis determines capital program resources and constraints. Cash Flow Test: The cash flow obligations for the Department s rate analysis include: Operating, maintenance and various non-operating expenses Debt service payments Rate-funded capital expenditures System reinvestment funding Reserve funding Offsetting these obligations are various sources of revenue, including: Interest earnings on reserve balances The cash flow test defines the amount of annual revenues that must be generated in order to meet annual expenditure obligations of the utility. These needs can include direct cash expenditures as well as planned transfers or additions to reserves.

18 March, 2011 page 16 Miscellaneous operating and non-operating revenues Charges to other departments for services Use of surplus reserve balances Impact fees (specifically used for debt service obligations) User rate revenues Resources such as bond proceeds are not considered available for meeting these operational cash flow needs, but become part of the resources used for capital project funding. In setting user rates, rates must be sufficient to meet annual cash flow requirements. While typically the largest single financial resource, note that rates are listed last in the above summary. This is due to the fact that rates (or monthly service charges) are controlled by the City Council and should be set at a level necessary to fulfill financial objectives, whereas the other sources of revenue are typically either externally constrained, limited in scale, or subject to significant annual fluctuations (as is the case with impact fees). A.2 Bond Coverage Sufficiency Test When an agency issues Certificates of Participation (revenue bonds), it agrees to certain terms and conditions related to the repayment of those bonds, such as bond coverage. Bond coverage refers to the collection in revenues to meet all operating expenses and debt service obligations plus an additional multiple of that debt service. A minimum bond coverage ratio of 1.25 is common for rate revenue backed bonds, meaning that the agency would collect expenses plus 1.25 times debt service as a minimum legal level of revenues. Many utilities establish higher policy targets (such as coverage ratios of ) to retain or attain high bond ratings with correspondingly lower interest costs. Historically, the City s General Fund has served as the backstop for several of the bond issuances for the Department. Additionally, the coverage factors have varied between issuances. Consequently, historic coverage and security requirements might not serve as the appropriate benchmark for future security requirements, which are assumed to be wholly secured by the revenue of the issuing utility. Given the Department s future need to issue more debt for its capital needs, it should consider targeting a coverage Bond Coverage: factor of 1.50 times debt service. 4 This ratio can be Bond coverage refers to the collection in revenues to meet all operating expenses and debt service obligations plus an additional multiple of that debt service. A minimum bond coverage ratio of 1.25 is common for rate revenue backed bonds. achieved over time, as rate increases permit. A target debt coverage ratio of 1.50 times debt service will also help to protect the utility from adverse bond compliance consequences of annual fluctuations in revenues and/or expenditures. Surplus revenues generated to comply with coverage requirements may be used for capital purposes once operating and debt service payments are satisfied, and may reduce the amount of revenue needed to meet cash needs in subsequent years. These excess revenues can also be used to meet future capital funding needs, thus reducing future borrowing. However, such revenues cannot be held over to reduce coverage needs in subsequent years, except as they are dedicated to the bond rate stabilization 4 Standard and Poor s has informally stated that a minimum 1.50 coverage ratio is typically required in order to achieve a AA bond rating. Achieving this ratio does not guarantee that rating, but is rather considered a minimum.

19 March, 2011 page 17 reserve. Introducing a higher coverage standard may induce additional near-term rate increases, but it may lower long-term rates through this generation of funds for capital. Recommendation Discussion: The Department s historical rate model has defined rate revenue requirements based on a cash flow sufficiency test only. As a part of our current study and our utility rate model development, we have incorporated a coverage sufficiency test into the Department s analysis. Given that the Department will likely issue bonds to fund its future capital needs, incorporating the coverage sufficiency test into the rate analysis becomes integral to defining future rate needs and maintaining legal compliance with bond covenants. Both the cash flow and bond coverage test must be satisfied independently. We recommend that the Department target bond coverages of 1.50 times annual debt service, with a minimum coverage ratio of It should be noted that the 1.25 times coverage test does not provide sufficient annual revenues to protect against for fluctuations in revenues and expenditures. Therefore, we also recommend that the Department establish a bond rate stabilization reserve (discussed below) at the time of its next issuance. The sizing of this reserve will depend upon the size of the issuance, reasonably anticipated fluctuations in revenues and expenditures, and market requirements for securing a favorable bond rating. Recommendation We recommend that the Department target bond coverages of 1.50 times annual debt service, with a minimum coverage ratio of We also recommend that the Department establish a bond rate stabilization reserve (discussed below) at the time of its next issuance. B. UTILITY RESERVES The City does not currently have formalized policies to fund reserves for its water, wastewater, storm drainage, and solid waste funds. 5 Utility reserve policies are intended to create a measure of safety and security for the uncertain events of the future that impact a utility s financial health. Reserves can address variability and timing of expenditures and receipts of revenues, as well as occasional disruptions in activities, costs, or revenues. The general objectives of these policies are to facilitate stable and predictable rates and funding sources, along with equitable recovery of costs from customers. Overall, a utility s reserve policies are a collection of rules and guidelines. The collective use of individual reserves will allow the utility to minimize its exposure to revenue shortfalls and bond coverage defaults. A collection of fiscal policies were developed in collaboration with staff, input from the City s financing team, and based on best industry practices. 6 These policies build on those evaluated as part of the 2009 rate adoption process. A detailed description of each of the recommended reserves is provided below. The following provides a summary of the best practice recommendations: 5 City staff recommended funding reserves for operational requirements and rate stabilization during the 2009 rate setting process. However, the final adopted 2009 and 2010 rate package eliminated these recommended reserve contributions. ( Amendment of the FY 2009/10 Operating and Capital Improvement Program Budgets and Approval of Two Year Water, Sewer and Solid Waste Service Rates ; Staff Report; June 23, 2009) 6 As of the writing of this report, Goldman Sachs is assisting the Department of the Treasurer to evaluate bond financing alternates.

20 March, 2011 page 18 Maintain a minimum aggregate unrestricted working capital balance at the time of any new bond issuance based on bond market conditions (total funds held collectively amongst all reserves) Establish a working capital (operating) reserve sized based on seasonal fluctuations in revenues and expenditures Establish a bond rate stabilization reserve at the time of debt issuance Establish an unrestricted rate stabilization fund balance based on multi-year fluctuations in revenues and expenditures. Establish a capital reserve for the long-term replacement of the system in order to minimize reliance on debt Maintain a minimum capital/emergency reserve The following is a summary of the reserves suggested and corresponding recommendations. Table 1. Summary of Reserves and Recommendations Reserve Type Purpose Recommendation Operating (or Working Capital) Reserve Rate Stabilization Reserve Capital Emergency Reserve Bond Reserve Provides working capital for day-today operations and absorbs fluctuations in cash balance Provides a revenue source during revenue shortfalls that result from lower than expected customer consumption. A rate stabilization reserve may also be established at the time of debt issuance, setting aside money in a restricted fund can be used to meet the utility s annual debt service coverage obligation. Provides a source of emergency funding for emergency repairs and replacements Provides a means of protecting against the risk of nonpayment of bond covenants The Department should set its operating reserve minimum targets at a range of 60 to 120 days of its annual operating expenses (including general fund transfers). Based on current market conditions, an aggregate, minimum unrestricted working capital balance of 120 days should be maintained between the various reserves. The Department should formalize a rate stabilization reserve policy related to appropriate reserve levels, as well as criteria for replenishing and liquidating the fund. As the Department issues new debt, it should revisit the working capital reserve targets so that both the necessary on-hand liquid cash is available for ongoing operations, as well as the necessary restricted set aside for the purposes of meeting bond coverage obligations. The presence of a rate stabilization reserve can also consequently lower the appropriate target for unrestricted working capital. In the future, the Department should consider establishing and funding a capital reserve minimum in order to be in a position to make short-term emergency repairs and to provide some buffer against capital cost overruns. As of the writing of this report, the Department does not have the user rate capacity to fund a minimum target. The Department should maintain a reserve in compliance with existing bond official statements. Future bond reserve requirements will be defined at the time of each subsequent issuance.

21 March, 2011 page 19 B.1 Operating (or Working Capital) Reserve Operating reserves provide a minimum unrestricted working capital fund balance needed to accommodate the short-term cycles of revenues and expenses. They provide a necessary cushion which can be used to cover cash balance fluctuations on a month-to-month basis. These reserves are intended to address both anticipated and unanticipated changes in revenues and expenses. Anticipated changes might include billing and receipt cycles, payroll cycles, and other payables. Finally, operating reserves can be used to meet short-term cash deficiencies due to unanticipated changes in usage for water utilities, such as water reductions due to wet years in which users consume less for outdoor irrigation. Typically, the operating reserve is not actually a reserved or restricted account balance. Instead, it functions as a minimum year-end unrestricted working capital balance targeted for budgeting. The actual fund balance will vary both upward and downward from this target through the course of a fiscal year. If the actual ending balance is below or is projected to drop below the defined targeted level then rates should be increased in order to replenish the balance. Similarly, projected excesses can, with care, be used to fund a rate stabilization reserve (as discussed below). Appropriate reserve levels: Generally, utilities should target a defined minimum working capital as a beginning cash balance to provide the liquidity needed to allow regular management of payables and payment cycles. When setting this reserve level, the utility should consider the policies of its other reserves. Depending on several factors (including bond requirements, a separate rate stabilization reserve, revenue collection variability, and fiscal prudence), the target level of an operating reserve can range from as little as 30 to as much as 180 days of its annual operating expenses. Replenishing reserves: The reserve should be reviewed and recalibrated through the normal annual budget and rate-setting process. Since expenses typically increase over time, the reserve target should also increase proportionally with increases in expenditures, meaning that rates would incorporate small annual increments of additions to the operating reserve. Recognizing that reserves are intended to stabilize and strengthen utility finances, a policy for replenishing reserves when drawn below targets should require a strategy for recovering target levels, but should allow flexibility in such attainment. In this regard, it is worth an explicit note that any strategy implemented to increase reserves inherently provides an added level of conservatism through the budgeting of this surplus to cash flow needs. In the case of financial underperformance, this intended incremental funding would be consumed (or lost) before any net cash flow impacts would further reduce utility reserves. Liquidating reserves: If the operating reserve exceeds the target balance, it should be brought back to the target level through a sequential decision process, with progress contingent on a surplus remaining. This would include steps such as: Determining whether near-term increases in the operating reserve target would consume all or part of the surplus. Determining whether the rate stabilization fund (discussed below) is at or above its target level. If not, the surplus could be applied toward the rate stabilization reserve target. Determining whether funds would have a designated use for one-time or capital outlays. Make the surplus balance available to meet projected capital expenditures. Current related Department policy: According to the Department, a formalized operating reserve does not exist for any of its utilities; however, the Department has established a prudent reserve concept that is based on having sufficient reserves to cover 45 days of operations. The computation