Policy Documents: Using Charges and Credits for Tap Rentals in Water Rates

Introduction

The design of this rate structure started as an attempt to simultaneously address six goals for a water utility, like the City of Boulder's, in an area of scarce and expensive water, and that has a large existing customer base who have paid for the utility’s capital plant and water rights through tap fees/plant investment fees (PIFs):

• The rate structure should be equitable and economically efficient in that it accurately reflects both capital and operating costs associated with each individual customer, not just the “average” customer in a given class.
• Rates should provide an economically accurate incentive for conservation for all customers, big and small, that includes long term capital costs as well as variable operating costs,
• Plant Investment Fees should be accurate to current individual consumption levels and/or water budgets, not just to some class average consumption levels at some time in the past,
• The rate structure should eliminate inequities that occur between larger and smaller users within a class when using increasing block rates,
• The rate structure should have a logical and automatic adjustment for dry year forecasts to both increase incentives to conserve and to ensure adequate revenues to the utility, and
• The rate structure and its associated methodology should be both simple and transparent, in that the assignment of costs and thus the rates themselves make logical sense to the customer, both qualitatively and quantitatively.

The Tap Rental Charge/Credit (TRCC) rate structure, as I have chosen to name it, achieves these goals by charging (in addition to the more typical charges collected for operations, maintenance, capital improvements programs and administrative costs), a “tap rental charge” for water use in excess of the amount of water allocated for a given tap size and providing a “tap rental credit” for use of less than that amount.

This approach is both more equitable and more efficient than traditional block rates. It also addresses equity issues that emerge with respect to tap fees when an existing community or district converts from class based rates to an individualized “water budget” rate structure. Additionally, it provides an automatic mechanism for adjusting rates for dry years both to increase conservation and to maintain revenues.

This paper reviews the concepts behind this alternative rate structure and discusses its potential advantages and disadvantages.  In addition, an example calculation is provided using data from Boulder CO.

Why Consider Tap Rental Charges and Credits as an alternative to Block Rates?

Block rates have come into favor as ways to promote water conservation in arid areas where water is both expensive and scarce. But block rates by themselves can be economically inefficient in that larger customers within a class face higher marginal rates than smaller customers, even though these larger customers may actually be using water more efficiently. In addition, a certain amount of arbitrariness is inevitable both in setting the break points between blocks and the rates within blocks.

Water budgets attempt to correct these failures by tailoring the block break points to the individual customer. But this individualization raises an equity issue in that customers who paid the same tap fees/PIFs may be given widely disparate budgets, a concern especially significant for communities with large amounts of existing development that are considering converting to water budgets from a more traditional rate structure.

In addition, strongly conservation oriented block rates can force consumption below that paid for with the tap fee, which would possibly invalidate the tap fee calculation itself and create significant legal liabilities. And high marginal rates can create budgetary issues for the utility in periods where demand is lower than average.

What is the concept behind the TRCC structure?

In its simplest form, the design of this rate structure starts by identifying the “capacity right” for each class, which is the level of consumption from which the PIF for that class is calculated, and by definition is the same number for all customers in a given class. Consumption above that amount is charged at a rate that is proportional to the “rental” cost of a tap, and consumption below that amount receives an equivalent credit. If the tap fees are properly calculated and the calculations kept up to date, this rental rate should be equal to the resource cost, i.e. the long term marginal cost. So that it is clear, this rate structure assumes that a normal class based tap fee is paid, and the tap rental charge or credit only adjusts for consumption above or below the level that was paid for with the tap fee, and that operating costs are collected in addition.

The extra payment by customers who use more than their “capacity right” then goes to reimburse or credit the customers that are not fully utilizing their allotted capacity.  In other words, a customer who consumes one extra unit over and above their “capacity right” must rent a portion of a tap to cover that consumption; the amount they pay for that extra capacity is used to reimburse or credit the customer that uses one unit less than their “capacity right.”

All other utility costs are charged as accurately as possible, with fixed and variable costs charged separately, with no block structure being used. This ensures economic accuracy and transparency.

How is the Tap Rental Charge/Credit Rate Structure developed?

The starting point for the development of the TRCC rate structure is the typical segregation of costs into categories, including:

• Administration
• Capital Improvements Program (CIP)
• Operation & Maintenance (O&M)

and a new category:

• Tap Rental Charge/Credit

Administration costs are a fixed charge to the customer; they include customer accounting costs and are differentiated by class.

Capital Improvement Program (CIP) costs are assessed as a fixed charge to the customer, and include 100% of long term capital replacement costs. The logic behind this being a fixed charge is that these expenditures maintain the asset value of the utility, a portion of which is “owned” by each customer through the payment of their PIF. So in effect, each customer is paying for the long term replacement and rehabilitation of his or her portion of the utility’s system based on their percentage interest in the system. Thus this charge is the same for all customers in a given class. (Paying for the CIP through the variable charge, as is frequently done, allows those customers whose usage is temporarily low to avoid paying for their share of the long term capital improvements that they benefit from, and conversely overcharges the rest of the customer base. Thus, it is both inequitable and inefficient from an economic perspective.)

The Operation & Maintenance (O&M) costs are primarily related to operating and maintaining the water storage facilities, pumps, water treatment and distribution system. To the extent that these costs are truly variable, they are charged on a per 1,000-gallon rate applied to all customers equally, since the utility cannot distinguish who gets which piece of water. (Note that this portion of the rate can be made more economically accurate by adjusting it to reflect seasonal cost differentials.)

The final, and most significant, component of the rate is the Tap Rental Charge/Credit. The most simplistic way to calculate this portion of the rate is to divide the net asset value of the utility’s system by its projected annual yield to come up with a capital value per 1,000 gallons of annual yield, which is then multiplied by an appropriate interest rate, typically the long-term municipal bond rate.  (This is a common methodology for converting a capital value to rental rate and is easy to understand if one thinks of interest as the cost of renting capital.) This would then generate a rate that would apply year-round to all customers.

The Tap Rental Charge/Credit rate is the same for all classes and for all customers within a class, thereby avoiding any possibility of discrimination between classes. The argument for not trying to charge different rates to different classes is that the utility cannot, at any moment, distinguish between customers as to who is the “marginal user”, a subject much discussed in utility rate-making literature.

What variations on the Tap Rental Charge/Credit Rate Structure are there?

The tap rental charge/credit calculation may be made more sophisticated by having it vary by season (or month) to reflect the changes in use of the major elements of the system’s capital components (e.g. water rights, storage rights, treatment plants and pumping facilities.) The per unit tap rental charge/credit would then be different during different times of the year. The charge may also be differentiated between classes, but this can cause perceptions of inequality as it will lead to differences between classes in the resulting rates.

Additionally, the asset value used to calculate these charges and credits may have to be corrected to account for assets that are held in reserve for future growth and have not been paid for by existing tap owners.

Under either the simplistic or more sophisticated versions of this approach, the price for the tap rental charge/credit is a per-unit rate that is invariant at any point in time regardless of the amount of total consumption over or under a customer’s capacity rights.  This rate stays fixed because the charge or credit is based only on the costs to the system; these costs are the same whether created by one customer consuming a lot or a number of customers consuming a little.

The utility could also justifiably lower the tap rental rate by removing capital items that are not expected to vary as consumption increases, such as the value of certain delivery pipes or the value of the land around a treatment plant.

How is the Break Point between Tap Rental Charges and Credits calculated?

The next-to-final step in calculating the tap rental charge/credit is to determine the “break point” between charges and credits for each customer class. This break point number is the same as the allocation per tap that is used to calculate the PIF for each class. If this is the average consumption for the class, then, at least for the test year, the total of tap rental charges will equal the tap rental credits for that class and net revenue from charges and credits will be zero.

If the average consumption for a class exceeds the PIF number, then charges will exceed credits. This, of course, indicates that, as a whole, the tap fees for the class were based on an underestimate of average consumption. The excess revenues thus generated should be used to reduce the fixed charges for the other classes who, in effect, subsidized that “over-consuming” class, or could be spent to enhance the utility’s water supply. But the tap rental charge/credit to each individual customer is still accurate, being based on the tap fee numbers themselves.

I should point out that this rate structure doesn’t rely on actually knowing how the PIFs were calculated for customers whose PIF information is lost in the distant past, but simply treats them the same as other customers in the class who purchased more recently. In other words, it is a viable rate structure all on its own.

How is the actual Tap Rental Charge or Credit calculated?

The final step is to multiply the difference between the actual consumption and the break point by the rental rate. This will give a charge if actual consumption is over the break point and a credit if under the breakpoint.

How does the Tap Rental concept relate to resource efficiency?

The TRCC approach ensures resource efficiency (insofar as rates can ever do this) because the charge/credit rate is equal to the long term marginal cost of the water supply system. (This assumes that the tap fee, on which the charge/credit is based, is calculated using the present, not historical, value of the system, as it should.)

How does the Tap Rental concept adjust for dry year forecasts?

The TRCC rate structure automatically adjusts for forecasted dry years by both increasing conservation incentives and increasing per unit revenues, thereby reducing consumption while at the same time maintaining utility solvency. This occurs because, on the one hand, for a forecasted dry year, the calculations for the tap rental rate would divide the system value by the decreased yield projection, increasing the tap rental rate. And, on the other hand, the calculations for the tap fee “capacity right” would produce a lower break point number for the dry year, because a lowered yield forecast is divided by the same number of taps as in a normal year.

These calculations result in two synergistic effects: (1) they increase the tap rental charge/credit rate, and (2) they lower the break point between charges and credits. Increasing the rate creates an economically justified incentive for additional conservation, and lowering the break point ensures that revenue collections remain relatively stable in spite of decreased consumption.

How would this be calculated for a real world example?

Based upon the above discussion, the overall rate structure may be graphed as a sum of components, each of which is a straight line in a graph of total bill against consumption:

• Fixed costs (Administrative Costs, CIP, and fixed O&M): a horizontal line.
• Variable costs (variable O&M): slope equal to the variable cost rate, intercept at 0.
• Tap rental charge/credit: slope equal to the tap rental rate, intercept at the class break point.

Thus the total bill is a linear function of consumption (a straight line) with the slope equal to the sum of the variable cost rate and the tap rental rate.

The numbers for this example are taken from the City of Boulder, CO. Certain approximations were made for ease of calculation, and the simplest form of the TRCC rate structure was used.

Physical assets: $700,000,000

System yield: 35,000 Acre-feet per year

Long term municipal bond rate: 5%

(1 Acre-foot = 325,851 gallons = 325.851 kgal)

The calculated values then are:

System annual yield: 35,000 x 325.851 kgal = 11,404,785 kgal.

Asset value per 1000 gal/year of capacity: $700,000,000 / 11,404,785 = $61.37/kgal

Rental price for 1000 gallons/year capacity at 5%: $61.37 x 0.05 = $3.07

Thus, the uncorrected tap rental rate is $3.07 per kgal. Assume that, after corrections for invariant capital costs, the tap rental rate is $2.50 per kgal.

For this example, assume that the single family residential PIF has been calculated based on 10 kgal/month average consumption. Thus, 10 kgal/month is the break point between tap rental charges and credits for this class. (10 kgal/month is equivalent to 0.368 Acre-feet per year, very slightly more than the number in fact used by Boulder’s water utility).

Total fixed charges (Admin Costs plus CIP plus fixed O&M) are assumed to be $20/month, and true variable O&M charges (chemicals plus electricity) are assumed to be $0.50/kgal.

Thus if a residential customer uses 12 kgal/month, they would pay

$20 + 12 x $0.50 + 2 x $2.50 = $31.00/month.

If they use 7 kgal/month, they would pay

$20 + 7 x $0.50 + (-3) x $2.50 = $16.00/month.

If they used no water at all in a particular month, they would pay

$20 + 0 x $0.50 + (-10) x $2.50 = -$5.00, i.e. a credit of $5.00 for that month.

How would the calculation be made more sophisticated?

The City of Boulder CO provides an example of how the TRCC system might be made more sophisticated. Boulder has distinct seasons from a water supply perspective.  The first period, which is generally May and June, is a “direct flow” period when the excess water in the streams are used, and no storage is required. At the end of the “direct flow” period and for the rest of the year, the city relies primarily upon storage facilities for water supply, but the supply mix and treatment plant capital (and operating) costs may change in proportion to how much water is coming from various sources. In addition, the direct flow period and the rest of the summer is irrigation time, leading to higher daily consumption and thus more treatment capacity being needed relative to the rest of the year.

During the “direct flow” period, the storage component of the tap rental charge/credit would then be zero, since the city is using Boulder Creek and is in a “use it or lose it” stream flow period. Also, because this water is coming directly from the mountains above Boulder and is cleaner and requires little pumping, the treatment and pumping infrastructure costs are much lower.  As the year progresses, Boulder shifts toward more stored water as well as increases its water use from low lying reservoirs and less clean sources. Thus the price of the tap rental charge/credit would increase seasonally to reflect the increased costs associated with storage and more costly treatment plants and pumps.

What are the pros and cons of TRCC approach?

In comparison with typical increasing block rate structures, the tap rental rate structure will provide a larger financial conservation incentive for most customers but possibly a slightly smaller financial incentive for the very largest customers, depending on the actual blocks and rates to which it is being compared.

While a uniform marginal cost based tap rental charge/credit may not convey the same message as a block rate structure, the notion of receiving a credit may create a unique incentive to encourage conservation.

The tap rental rate structure does address certain issues that are unaddressed in typical increasing block rate structures:

·         The “rights” that come with the purchase of a tap are defined, and rates are set based on that number.

·         All customers face the long term marginal cost of water at all times, and thus are provided with an accurate economic incentive for conservation and efficiency.

·         The calculation of the rates requires no arbitrary decisions, such as where to set the break points between blocks, how much revenue should be collected from each block, or how much to collect from the fixed or variable portion of the rates.

·         The TRCC structure corrects for the capital cost associated with over and under use relative to the typical class average based tap fee, and thus prevents intra or inter class subsidies.

An important concern is that of revenue accuracy to the utility’s costs when demand is above or below that of the test year or test season. It is worth noting that increasing block rate structures in which the customer faces high prices in the tail (excess use) block may make revenues more volatile and sensitive to weather than a rate structure that has more moderate rates at that point (such as the tap rental approach). And in addition, the automatic adjustment of both the break point and the actual tap rental rate further ensures that the tap rental system will produce more accurate revenue receipts. (An additional non-utility benefit is that, since the process for adjusting rates can be well defined in advance, ad hoc legislative action can be kept to a minimum.)

The tap rental concept avoids the “arbitrage” situation created by block rates when similar customers face different rates. “Arbitrage” situations are economically inefficient, since, except for physical constraints, the customer facing a higher rate would be better off buying from the customer facing a lower rate than buying more from the utility.

The tap rental rate structure provides a legally defensible way to implement the use of “water budgets”, since it corrects tap fees to match budgets when the budgets allow more or less consumption than was paid for with the original tap fee. (It is perhaps worth pointing out that conceptually water budgets are a way to allocate water and rate structures are a way to charge for water, two separate activities.)

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