1 regulation 101 a primer for the edmonton city council

1

Regulation 101Regulation 101

A Primer for the

Edmonton City Council

2

Today’s Topics

• Understand regulatory accounting– Principles– Terminology and reports– How the SU develops rates, increases

• Understand the choices to be made– Questions to ask– Alternatives to consider– Impacts

• High level questions– Goals and process of regulation– Utility fiscal policy

3

What We Will Analyze

• Concentrate on the Sanitary Utility– Larger, older utility– Can discuss Land Drainage Utility if desired

• Initial focus on budget for 2006– Basis for approving current rates– Note that process involves longer-term view – See how different assumptions affect the results

• Review budget vs. actual 2005 results– Understand the financial reports– Think about the implications

4

The Financial Fundamentals

5

Basic Accounting Statements

• Operating statement (or “income statement”)– Revenues and expenses for an accounting period– Usually for a calendar year

• Balance sheet– Assets equal liabilities + equity– Stated as of a date, usually end of the year

• Cash position– Change over the year (like operating statement)– Includes financing (+) and investment (-)

6

Operating Statement - 2005

Budget

Revenues $93.8

Expenses

Operations 46.0

Depreciation 10.7

Franchise fee 7.1

Interest 9.7

Subtotal 73.5

Net income $20.3

7

Revenues

2005

Rates

Rate charges* $85.1

Other charges* (e.g., overstrength)

3.5

Outside revenue 5.2

Total $93.8* Subject to Franchise Fee

8

Operation & Maintenance Expenses

• Labour

• Supplies

• Chemicals

• Power

• Insurance

• Central management fees

• Billing expense

9

Depreciation Expense

• Applies to expenditures on assets– Items that will be used over several years

– Written off (expensed) over their useful life

• Electronic and lab equipment: 5 years

• Office equipment & furniture: 6.67 years

• Buildings, wastewater treatment plant: 44 years

• Mains, pump stations: 75 years

• Land: Not depreciated

• Annual amount called “depreciation”/”amortization”

10

Calculating Depreciation Expense

Year Investment / life 1954 1955 1956 1957 ... 2006 2007

1954 $1 500 000

1954

1955

1955

1956

1956

…

2005

2005

2006

2006

2007

2007

Total

11



1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000

1954

1955

1955

1956

1956

…

2005

2005

2006

2006

2007

2007

Total

12

Why Depreciation is a “Non-Cash Expense”


1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000

1954

1955

1955

1956

1956

…

2005

2005

2006

2006

2007

2007

Total

An expense is recorded in each of these years—

but there is no cash outlay

The cash was spent in this

year

13



1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000

1954 $120 000 / 10 12 000 12 000 12 000 12 000 -- --

1955

1955

1956

1956

…

2005

2005

2006

2006

2007

2007

Total $32 000

14



1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000

1954 $120 000 / 10 12 000 12 000 12 000 12 000 -- --

1955 $600 000 / 75 8 000 8 000 8 000 8 000 8 000

1955 $40 000 / 8 5 000 5 000 5 000 -- --

1956

1956

…

2005

2005

2006

2006

2007

2007

Total $32 000 $45 000

15



1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000

1954 $120 000 / 10 12 000 12 000 12 000 12 000 ... -- --

1955 $600 000 / 75 8 000 8 000 8 000 ... 8 000 8 000

1955 $40 000 / 8 5 000 5 000 5 000 ... -- --

1956 $3 825 000 / 75 51 000 51 000 … 51 000 51 000

1956 $160 000 / 10 16 000 16 000 … -- --

…

2005 $6 000 000 /75 80 000 80 000

2005 $240 000 / 8 30 000 30 000

2006 $15 000 000 / 75 200 000 200 000

2006 $1 380 000 / 10 13 800 13 800

2007 $12 000 000 / 75 160 000

2007 $830 000 / 20 41 500

Total $32 000 $45 000 $68 250 $94 560 $9 256 023 $9 386 228

16

Balance Sheet

• Assets = Liabilities + Equity • Assets are “things owned”

– Facilities, equipment (net of depreciation write-off)– Cash– Receivables (cash not yet received)

• Liabilities are “things owed”– Debt (to debt holders)– Payables (bills not yet paid)

• Equity is the owner’s value– Retained earnings– Contributed capital (including SSSF)

17

Financed and Contributed Assets

Actual at 2005-Dec-31 Financed Contributed

Original cost $524.2 $386.7

Accum. depreciation 137.5 52.9

Net book value $386.7 $333.8

• “Financed” assets – Financed by debt and retained earnings

• “Contributed” assets– Assets transferred from the City in 1954– Assets funded by contributions

18

Balance Sheet: Assets

As of December 31 (actual) 2004 2005

Investment in facilities

Facilities - financed (net cost) $352.3 $386.7

Facilities - contributed (net cost) 294.5 333.8

Cash and deposits 52.5 44.6

Cash in SSSF 42.5 51.9

Accounts receivable 11.5 18.5

Misc. (inventory, etc.) 1.7 1.9

Total assets $755.0 $837.4

19

Balance Sheet: Liabilities + EquityAs of December 31 (actual) 2004 2005

Liabilities

Long-term debt $167.8 $176.1

Accounts payable 11.2 15.7

Miscellaneous 3.2 4.7

Total liabilities 182.2 196.5

Equity

Contributed capital 294.5 333.8

Retained earnings - reinvested 183.2 210.7

Retained earnings - to be invested 52.5 44.6

SSSF balance 42.5 51.9

Total equity

Grand total $755.0 $837.4

20

Sanitary Servicing Strategy Fund

• SSSF is a separate fund– Separate board– Funds used only for designated projects

• SSSF plans through 2074• SSSF collects mostly from developers • SU interaction with SSSF

– SU pays $2.6 million to SSSF– SSSF pays SU for some projects

• $1.9 million in 2004• $23.0 million budgeted for 2005• $7.0 million in 2005

21

SSSF Funding - 2004

Balance at year-end 2003 $30.2

Funds received from others 10.9

Payment from SU 2.6

Interest earned 0.8

Capital expenditures -1.9

Balance at year-end 2004 $42.5

22

SSSF 2004 Revenues

Source: SSSF 2004 Annual Report

23

Capital Structure

• Split of capital between debt & equity (2005)

$M %

Debt $176.1 42%

Equity 255.3 58%

Total $403.5 100%

• Typical regulated: 65%/35% to 50%/50%• Wider variation for municipal utilities

24

Return on Equity (RoE)

• Definition: Net income ÷ Retained earnings– UFP uses retained earnings at start of year– Usual definition is average retained earnings

• Details of definition– UFP uses earnings after dividend payment– Usual definition is before dividend payment– UFP states RoE before SSSF payment

• Comparison with others– Typical regulated value is 8.5% - 11.5%– Most drainage utilities have no stated target

25

Return on Equity Calculations

UFP Method Standard Method

2005 2006 2005 2006

Net income $20.3 $18.9 $20.3 $18.9

Less SSSF (2.6) (2.6)

After SSSF 17.7 16.3

Dividend (5.0) (5.5)

After dividend 12.7 10.8

Retained earnings $235.7 $255.3 $235.7 $255.3

Return on equity 5.4% 4.2% 8.6% 7.4%

26

Income vs. Cash

• Operating income “cash income”• Not all cash receipts are income

– Borrowed money is not income

• Not all cash payments are expenses– Repayment of borrowing is not an “expense”– Asset purchases only partly expensed

• Timing differences– Revenue booked before cash received (billed in Dec.,

paid Jan.)– Expenses booked before bills paid– These are end of year differences, usually small

27

Cash Statement - 2005

BudgetNet income $20.7

+ Depreciation expense 10.3

- Dividend -5.0

= Cash from operations $26.1

- Paid into SSSF -2.6- Debt repayment -13.8

+ Contributions (incl. SSSF) 31.8

+ New debt 35.2

- Investment in facilities -81.2

Change in cash balance -$4.6

28

Financial Statements - Review

• Income statement– Shows the operating profit for the year– Shows the depreciation write-off amount for the year

• Cash statement– Shows investments, financing for the year– Part of financing comes from year’s income

• Balance sheet– Shows the total of all past results at a given date

(Income, investments, financing, accrued depreciation)

– Changes in balance sheet totals reflect above two reports

29

Setting Next Year’s Rates

30

The Basic Income Equation

Revenues

- Operating expenses

= Net income

31

The Basic Regulatory Equations

Operating expenses

+ Target net income

= Revenue requirement

(also called “cost of service”)

Revenue requirement

- Revenue at present rates

= Rate increase

#1

#2

32

Revenue Requirement - 2006

Expenses Budget

Operations $48.3

Depreciation 11.2

Franchise fee 7.3

Interest 11.3

Subtotal 78.1

Target net income ??

Revenue requirement ??

33

What Determines Target Net Income?• Past investments (current book value)

– Equity investors require a market-based return• Fairness• Need to attract future equity capital

– Debt holders require safety and repayment

• Future investment– Muni, Crown: cannot raise outside equity– Not all investment can be funded by debt– Borrowing restrictions– Not wise to borrow to the hilt

• Cushion and smoothing– Cover unfavourable variances– Keep annual changes smooth and moderate

34

Determining Required Earnings

• Utility boards focus on existing investment– Most experience with investor-owned utilities– Fair return determined by market– Future investment can be financed externally– Hard for them to change methods– Current ≈ 10% return on equity

• Other WW utilities have wide range of earnings• City Council approach

– Utility Fiscal Policy– Based on needs of each utility

35

Current Utility Fiscal Policy

A. 6% return on opening equity

B. 40% of earnings paid as dividend by 2014

C. Up to 35% of additions financed by earnings

• A + B = 10% return on equity

• C gives different answer than A + B

36

Earnings Required By UFP

• 6% return (after 40% dividend) = $28.1 M

• 35% financing from retained earnings = $39.1 M

37

Revenue Requirement - 2006

Expenses

Operations $48.3

Depreciation 11.2

Franchise fee 7.3

Interest 11.3

Subtotal 78.1

Target earnings 18.9

Revenue requirement $97.0

Revenue @ present rates 93.8

Increase needed $3.2

38

Revenues

Previous Rates

New Rates

%

Change

Rate charges* $85.1 $87.4 2.7%

Other charges* (e.g., overstrength)

3.5 3.5 ―

Outside revenue 5.2 6.1 17.3%

Total $93.8 $97.0 3.4%* Subject to Franchise Fee

39

Questions

40

What Do PUBs Regulate?

• Operating expenses– Allowed operation and maintenance costs– Depreciation rates

• Investment– Investment on which return is allowed

• Earnings– Capital structure– Return on equity

• Rate structure

41

What Does Council (Want to) Regulate?

• Budget• Capital program

– Timing of some programs– Affects future costs

• Interest• Depreciation

• Earnings– Net income– Dividend

• Capital structure• Timing of rate increases (?)• Rate structure (?)

42

Setting Rates – The Long Term View

• Review– Have examined revenue requirement for 1 year– Investment and financing decisions affect future

• Looking only at next year can cause problems– Rates not predictable– Large increases in some years– Less financing flexibility

• SU has used 20 year forward look– More sophisticated than most other utilities– Gives SU and Council more flexibility

43

Overview of Rate Setting Process

Construction,Capital Needs

Expenses + Net Income = Required Revenue Rate Increases

Target Net Income(Retained earnings)

44

Steps in Rate Setting ProcessConstruction

Operating costs

Capital Required

Funded by debt

Funded by earnings

+

Required revenue=

Rate increaseIncrease too big?

Interest cost increases operating expense

Reconsider construction plans or UFP

Contributions, SSSF

-

=

=

-

45

Construction Forecast

• Forecast of project additions by year• 20-year forecast• Some investment required by legislation• Council policy determines some timing

– Mature neighbourhood program– Planned rehab vs. emergency rehab

46

Construction Financing

• Sources of capital– SSS Fund (Sanitary Utility)– Contributions and grants– Debt (debentures)– Retained earnings (retained cash)

• Debt subject to constraints – Certain assets don’t qualify (design, equipment)– Financial tests

• Current year decisions affect future flexibility

47

Construction Expenditure ForecastProject Fund

Source

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Gold Bar WWTP rehab SLD $0.5 $1.1 $4.6 $.2 $.1 $-- $-- $-- $-- $--

RET 1.2 2.2 1.9 1.9 1.9 2.0 2.0 2.1 2.1 2.1

Gold Bar Upgrade SLD 10.5 17.8 8.6 1.4 .2 .2 0 0.4 1.4 7.7

“ “ “ RET 0.8 0.1 -- -- -- -- -- -- -- --

Mature Neighbourhood rehab SLD .9 1.2 5.1 5.7 9.3 7.6 8.0 8.4 6.5 5.5

“ “ “ RET 5.0 7.2 6.0 6.0 3.0 0 0 0 2.3 3.8

Flood Prevention RET 5.2

“ “ Schg 1.7 4.7 .6 2.2 3.5 3.5 3.6 3.7 3.7

WESS Stage 1 SSSF 10.3 6.0 . . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

Total $96.4 $89.2 $82.2 $67.4 $57.4 $41.3 $34.7 $44.1 $67.9 $69.5

48

Construction Financing Plan

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Total project expenditures $96.4 $89.2 $82.2 $67.4 $57.4 $41.3 $34.7 $44.1 $67.9 $69.5

Funded by contributions/

SSS Fund

33.5 28.0 18.9 20.2 22.5 8.5 2.6 3.3 20.1 19.9

Financed by debt 43.9 42.4 42.9 31.6 20.9 19.5 19.4 27.8 32.0 32.5

Financed by earnings $18.9 $18.7 $19.3 $15.5 $14.0 $13.3 $12.8 $13.0 $15.8 $17.1

49

Debt Financing Constraints

• Constraints on borrower– ACFA constraints– Borrower is the City

• Constraints based on type of investment– Only certain projects/costs qualify – Not for design, equipment

• Constraints created by cash needs– Interest– Debt principal repayments

50

Debt Constraints

• ACFA constraints on City– Debt principal < 2 times revenue– Debt service (interest + principal payment) < 35% of revenue– Utility can exceed because City borrowing is low

• Difference between debt life and asset life

– Some assets depreciated over 44-75 years

– Associated debt has maximum 25 year term

– Debt being paid off faster than recovery of cost

– Can create cash flow problem

51

Variables for Council to Decide

• Return on equity• Dividend to City• % funding from debt vs. retained earnings• Target capital structure • Pattern of rate increases• Cash balances• Let’s look at some scenarios

– #1: Current SU plan– #2: Increase dividend to 50%– #3: Maximize use of debt

52

Financial Results – Current Plan

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Revenue $97.7 $106.3 $110.9 $115.7 $120.7 $126.0 $131.4 $137.0 142.8 148.9

Expenses 78.1 84.0 87.8 90.7 93.0 95.0 97.1 99.3 101.1 104.1

_________ _________ _________ _________ _________ _________ _________ _________ _________ _________

Net income 19.6 22.2 23.1 25.0 27.7 30.9 34.3 37.7 41.7 44.7

Dividend payment $5.8 $6.1 $6.2 $6.1 $6.3 $8.5 $9.5 $14.0 $15.6 $16.9

Debt service/revenue 24.8% 25.1% 26.7% 28.6% 29.4% 29.4% 29.4% 30.1% 30.8% 31.0%

Debt/revenue 2.2X 2.3X 2.5X 2.5X 2.4X 2.3X 2.2X 2.1X 2.1X 2.0X

Cash balance $41.3 $34.3 $26.6 $22.6 $21.3 $20.7 $22.0 $20.1 $15.7 $12.1

Cash needed

for construction$18.3 $18.9 $19.5 $13.8 $14.1 $12.9 $12.7 $13.1 $16.9 $17.2

53

Financial Results - Dividend @ 50%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Revenue $97.7 $106.3 $110.9 $115.7 $120.7 $126.0 $131.4 $137.0 $142.8 $148.9

Expenses 78.1 84.0 87.8 90.7 93.0 95.0 97.1 99.3 101.1 104.1_________ _________ _________ _________ _________ _________ _________ _________ _________ _________

Net income 19.6 22.2 23.1 25.0 27.7 30.9 34.3 37.7 41.7 44.7


Debt service/revenue % 24.8% 25.1% 26.7% 28.6% 29.4% 29.4% 29.4% 30.1% 30.8% 31.0%


Cash balance $38.6 $27.9 $16.1 $7.0 ($0.6) ($6.8) ($11.9) ($17.3) ($25.6) ($33.5)

Cash needed

for construction

$18.3 $18.9 $19.5 $13.8 $14.1 $12.9 $12.7 $13.1 $16.9 $17.2

•Dividends 2007-2015 increase from $90.2 M to $132.0M

•But not enough cash for construction by 2008

•Will need larger increases

54

Financial Results – Maximum Debt Use2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Revenue $97.7 $106.3 $110.9 $115.7 $120.7 $126.0 $131.4 $137.0 $142.8 $148.9

Expenses 78.1 84.5 89.0 92.5 95.1 97.4 99.6 102.0 103.9 107.1_________ _________ _________ _________ _________ _________ _________ _________ _________ _________

Net income 19.6 21.7 21.9 23.2 25.6 28.5 31.8 35.0 38.9 41.8


Debt service/revenue % 24.8% 26% 28.9% 32.1% 33.7% 34.6% 35.5% 36.7% 37.9% 38.6%


Cash balance $50.0 $54.8 $58.1 $61.3 $65.8 $69.3 $73.0 $72.0 $69.5 $67.9

Cash needed

for construction

$5.9 $6.2 $6.2 $4.1 $3.2 $3.3 $3.2 $4.5 $4.9 $5.0

•Dividends 2007-2015 decrease from $90.2 M to $72.9 M

•Cash balance very high; suggests a possible rate decrease

BUT

•Debt service expense > 35% of revenue

•Debt to revenue ratio stays too high

55

Questions

56

Reviewing the Results

57

Reviewing the Results

• How did the utility perform?– Satisfactory results?– Relative to budget

• Review accounting reports– Operating statement (revenues & expenses)– Cash flow– Balance sheet

• Improve regulatory oversight– Better understanding– More confidence

58

Operating Statement - 2005

Budget Actual

Revenue $93.8 $99.8

Expenses

Operations 46.0 46.5

Depreciation 10.7 10.1

Franchise fee 7.1 7.1

Interest 9.7 8.8

Subtotal 73.5 72.5

Net income $20.3 $27.3

59

Cash From Operations - 2005

Budget Actual

Net income $20.3 $27.3

+ Depreciation expense +10.7 +10.1

- Debt repayment -17.3 -13.8

- Dividend -5.0 -5.1

- Paid into SSSF -2.6 -2.6________________________ ________________________

Cash from operations $6.1 $15.9

60

Questions

61

Looking Ahead

62

High Level Issues

• Council’s regulatory process– Goals – Aspects of regulation

• Reviewing the Utility Fiscal Policy

63

Goals of Regulation

• Equity and efficiency– Reasonable total costs– Allocation of costs among customers

• Accountability– Utility decisions and proposals– Regulators’ decisions

• Transparency– Information– Process

64

Aspects of Regulation

• Structure – who evaluates utility proposals and suggests Council action?

– City Council as a whole?– City Council committee? TPW?– Oversight board?

• Criteria – what are the criteria for decisions?– Financial: main criterion is cost of service– Economic: impact on customers

• Process – what procedures are used?– Information flow– Public participation

65

Reviewing the UFP

• What are the goals?– Level of rates– Income to City– Appropriate financing of future investment

• Suggestions– UFP should be specific to needs of SU and LDU– There is no one “best” UFP

• Different for SU, LDU• Results will depend on interest rates, capital needs

– Have Drainage Services evaluate impacts

66

Practice in Other Cities

• Most are similar Edmonton in structure

• Some have advisory councils

• Few use long-term planning like SU

• Details in the notebook

67

Questions

1 regulation 101 a primer for the edmonton city council

Documents