A utility financial policy: guiding forecasts of long-term capital financing needs.

• Author: Barnett-Moore, Jerri

In Kalamazoo, Michigan, the water and wastewater utilities are strengthening their financial performance at a minimal cost to customers through a formal utility financial policy.

Publicly owned water systems and wastewater treatment facilities are critical components of the wide variety of services provided by local governments. These two services directly impact the health and well-being of all citizens, both at home and at work. The distribution and treatment of the water supply not only protects the health of citizens and the environment but is also a critical economic development tool. Management of these systems is becoming more sophisticated with the need to plan effectively for growth, to meet environmental regulations, to maintain fair and economical rates, and to assure the long-term financial viability of these capital-intensive operations.

In order to provide an effective financial management framework for these utilities, the City of Kalamazoo has developed a water and wastewater financial policy in conjunction with its computerized rate modeling program. This policy, which was adopted in November 1995, and the rate model guide the forecasting of the city's long-term capital financing requirements, including bond financing needs, assuring compliance with bond covenants, and establishing reasonable reserve and cash requirements while maintaining fair, economical rate structures. This article describes the policy's major components and the advantages of establishing a financial policy for utility operations.

The Kalamazoo Service Area

Located in Kalamazoo County in lower southwest Michigan, the City of Kalamazoo is a well-established, core city encompassing 26 square miles with a population of more than 80,000. The area includes two major universities, two regional hospitals, and a diverse commercial and industrial base. Local pharmaceutical and paper processing operations require high-quality, high-volume, and reliable water supplies and specialized industrial waste treatment. Kalamazoo has experienced modest but sustained growth during the past two decades. Future growth opportunities will be concentrated in the outlying areas of the county.

The department of public services provides water supply and wastewater treatment services for the city and the surrounding metropolitan area. Deep wells in and around the city supply water to sufficiently meet customer demand, and wastewater treatment occurs at the water reclamation plant More than 150,000 customers - located inside and outside the city limits - are served by the utilities. Service is provided on a retail basis to residential, commercial, and industrial customers and on a wholesale basis to several surrounding communities. The combined assets of the two separate utilities are in excess of $220 million, and the combined annual budgets exceed $45 million.

Kalamazoo utilities have a strong reputation for quality service and sound financial management, as indicated through consistently solid bond ratings. Rate levels for both the water and wastewater utilities reside in the low to moderate range, and, as seen in Exhibit 1, typical bills for customers fall in the low range of similar utilities. During the past decade, a period in which costs generally exceeded inflation for the water and wastewater industry, Kalamazoo's rates remained relatively stable. Water rates increased at a pace well below inflation, and the current average wastewater rate is only 1 percent higher than in 1985.

The Need for a Formal Policy

The stabilization of rates while maintaining a sound financial position was achieved without a formal financial policy. As was the case with many businesses and municipal entities, however, financial decisions made in the late 1980s and early 1990s focused on minimizing short-term revenue needs. Although requirements and covenants set forth in bond ordinances and informal management targets were maintained, the primary emphasis in the financial planning process was to hold down utility rates.

By 1993, several warning signs alerted financial officers that focusing almost exclusively on minimizing short-term revenue needs would yield long-term financial decline for the utilities. A major warning sign was the decrease in retained earnings. While the current system provided enough revenue to meet cash needs, the utilities experienced losses on annual income statements. A second signal was evidenced in debt service coverage levels. Coverage is defined as the ratio of annual net revenues (operating charges less operation and maintenance expenses) to annual revenue bond principal and interest. Debt service coverage had been relatively level and stayed above the required minimum but was low, which can cause future borrowing expenses to rise.

Kalamazoo utilities also experienced a rising debt load, which was attributable, at least in part, to a decreasing amount of revenue funds being used for routine capital improvements. Meanwhile, the demand for major capital improvements had not subsided and, in fact, had increased. The city's utilities participated in the city's overall efforts to develop and maintain a 10-year capital improvement program to guide its capital planning efforts. This plan is updated annually and includes detailed 10-year projections, detailed debt service schedules, and a debt management policy as well as a revenue policy and comprehensive plan that are under development. Despite...