By Sharlene Leurig, water financing expert with Ceres
Water utilities across the United States are planning major infrastructure investments in the coming decades. How much? The Environmental Protection Agency estimates about $300 billion will need to be spent by 2030 to keep our drinking water systems safe.
When it comes to economic investment, there are few services more worthy than water. And yet this investment will be coming at a time when water utilities find themselves in a precarious position: while water utilities finance their infrastructure using revenues from selling water, American households are using less and less of it. Take for example, North Carolina’s Orange Water and Sewer Authority, which saw its number of customer accounts grow more than 60 percent from 1992 to 2012 while water use stayed flat.
This isn’t the story of just one water system—household demand has fallen in Texas by an average of 8 percent over the past decade. Viewed from a conservation angle, this decline in household water use is a great success story. But from the perspective of water utility managers and the investors who buy their bonds, the trend of declining water use raises some sobering questions.
Water systems’ financial projections are often based on assumption of rising demand—but how confident should investors be in these projections? How responsive are water utility customers to pricing, and how resilient are water systems’ revenues to customers reducing their use?
These are questions every credit analyst should be asking of the water systems they are evaluating.
They are also questions that water utility managers should be asking of their staff, and questions they should be using to educate their boards and city council members, who in most communities are responsible for approving water rates.
How to approach these questions is the subject of a new Ceres paper, “Assessing Water System Revenue Risk: Considerations for Market Analysts.” This paper is a joint effort with the Environmental Finance Center at the University of North Carolina, which has spent the past two years poring through data from utilities in Colorado, Texas, and North Carolina to understand what has been happening to utility revenues in a new era of declining demand. The paper analyzes current challenges water utilities are facing to fund infrastructure and operating costs. It also presents metrics that analysts can use to perform their own diagnosis of a water system’s financial strength based on its pricing structure and demand base.
As it turns out, key aspects of water utility pricing structures are being overlooked by traditional credit analysis. One of them is the proportion of the customer bill that is fixed—the higher the fixed portion of the bill, the less variable the revenue. For water systems, the dependability of their revenue is critically important, as on average about 80 percent of their costs are fixed, no matter how much water their customers use.
As is clear from looking at North Carolina, the fixed charge on customers’ bills are all over the map, from $1 to more than $25 a month. Water systems with a higher proportion of their revenue coming from a fixed charge independent of water use are less vulnerable to revenue downturns from customers using less water, whatever the reason: such as a rainy season, emergency watering restrictions induced by drought, or water conservation programs.
But while it may seem like water systems should simply switch to high-fixed component pricing, the consequence would be a muted pricing signal to customers of the real cost of high consumption: bigger pipes, bigger treatment plants, more expensive supplies. What’s truly driving infrastructure costs is “peak demand”—the peak of year, high seasonal use that in most places comes with summertime lawn watering, which can account for more than half of a utility’s total water use. Failure to control peak demand, which is driving costly construction of new mega infrastructure needed for only small durations of the year, can lead to out-of-control water rates. As much as city councils detest near-term rate increases that can come with water conservation, the result can be avoidance of far bigger rate increases that are required to finance infrastructure to meet peak demand.
Finding a more balanced medium between a stable revenue stream and a strong conservation-oriented pricing signal is one of the most important challenges facing the water sector today. This is a challenge not just of economic efficiency, but of affordability for our most essential service. As UNC found, the cost of water services is already stretching the resources of some communities’ most vulnerable populations. In some places in North Carolina, households at the poverty level are paying as much as 8 percent of their income for water services.
This new reality of declining demand is driving actions in pricing and financial management that would have been unthinkable a decade ago. Just last month, Baltimore’s Department of Public Works won approval of a 41 percent water rate increase spread out over the next three years—a necessary action for the city to finance replacement of its crumbling infrastructure with revenue from lower water sales (the result of increased customer efficiency and the loss of some of its larger industrial customers). Although the city’s water rates are still in line with the national average, the rate hike met stiff political resistance.
The city addressed these concerns by establishing a Customer Assistance Program to help the lowest income households to pay for their water services. This thoughtful approach to water pricing helped the city to raise its artificially and unsustainably low rates, while also protecting lower-income customers. Other cities can learn from this strategy as they work to protect and improve critical water infrastructure.
In the coming months, Ceres and UNC will be working with water systems around the country to identify effective pricing structures that can recover costs while promoting conservation and affordability. With innovation, we can protect safe, affordable drinking water for future generations, and ensure that the investors who help us build these systems maintain their confidence in the sector.
Sharlene Leurig is a water financing expert and senior manager in Ceres’ water program.