Rate Setting – The Small System Challenge

April 6, 2021 | Drinking Water, General RCAP News, Rates

By Jean Holloway, Delaware and Maryland State Manager, SERCAP 

Small water and wastewater utilities face many challenges in structuring user rates that are fair and equitable to the customer and provide sufficient revenue for the utilities’ operations and future needs. Government and quasi-government owned systems are particularly prone to setting rates based on political expediency rather than on the real cost of operation, often subsidizing a utility fund with the general fund, usually tax-derived dollars. Private systems, while not immune to these same pressures, are more apt to have a systematically designed rate structure because they don’t usually have a general fund to tap into and have no choice but to run the utility as a business enterprise.  

Utility rates that are not designed to include adequate cost of present service will eventually threaten the system’s ability to sustain itself. Lack of sufficient revenue often prohibits sound management activities that are necessary to the utility’s long-term health and stability. Activities such as planned equipment maintenance or replacement, system improvements that could increase efficiency or treatment quality, and increases in staff compensation to stay competitive in the hiring market are some examples of sound utility management practices. Lack of ability to perform these activities can lead to equipment failure, process failure, treatment standards violations, and lack of continuity of operations due to staff turnover.  

Utility rates that are not designed to include adequate costs of future service through sound planning and forecasting can also threaten a system’s ability to sustain itself. If new rate structures are imposed in order to pay for major repairs, it often means that present customers are paying for the cost of serving future customers. Conversely, the present customers may really be paying for the actual cost of having served past customers who were not paying rates sufficient to cover maintenance and/or replacement of the system’s components in the last few decades.  

Small utilities, both public and private, seldom have the resources themselves to conduct a full-fledged, cost-of-service rate study. The cost of having an outside consultant perform such a study is usually prohibitive, so that detailed rate studies, if they are done at all by small systems, are only done every few years. Decision-makers are then left to set rates based on whatever they have been for the last several years or on what surrounding communities charge for the same type of service. The problem with both of these methods is that they do not reflect the true cost of providing service, and neither is based on data that is defensible or “saleable” to the consumer. Most people do not want to pay more for anything than they have to, especially not for public water supply. Rate setting procedures that include objective rate analysis methodologies prepare officials and staff to present rate proposals in an understandable fashion that can foster public understanding and improve acceptance of proposed changes.  

Many utilities make the mistake of assuming what is budgeted reflects the total cost of operation. This can overlook reserves as a genuine cost of operating the system, since it is not a current year cash expense. Contributions to any reserve fund, whether it be for replacement, debt service, emergencies or capital improvement activities, should be reflected in the rate design. Current users should be covering at least a portion of the costs of the system’s wear and tear that their use is causing, and this cost should be considered in structuring rates.  

All governing bodies must perform a balancing act with virtually every decision they make. That is never more evident than in system rate setting. All in all, system decision-makers need to remember that rate increases alone are no substitute for good overall financial management practices. Proper planning, adequate reserves, preventive maintenance, and strategic asset management can go a long way to ensure that a utility is sustainable over time. Costs of operation must be offset by adequate, equitable user fees that, along with non-rate revenue, fully recover the costs of operating the system now and in the future. RCAP TAPs in each region can perform this analysis and can help a governing body or board explain and defend their proposed rate structure to their utility customers and to the taxpaying public.