Section 1

Suburban Wholesale Water Rates, Long Range Financial Planning, and Revenue Funded Repair and Replacement Projects

  • In FY 2003-2004, suburban wholesale water customers paid the Public Utilities Commission $15 million more than necessary because water rates were based in part on the projected cost of several large capital projects that were not completed within the year. Between July 1, 2000, and June 30, 2005, suburban wholesale customers will have overpaid an estimated $27 million to the Public Utilities Commission, resulting in the need to decrease the suburban wholesale customers' water rates by 30 percent in FY 2005-2006, followed by a proposed increase in suburban wholesale customers' water rates of 40 percent in FY 2006-2007 to meet FY 2006-2007 revenue requirements.

  • Because the Public Utilities Commission has failed to accurately plan and time the completion of capital projects, contributing to volatile suburban wholesale customer rates and revenues, the Public Utilities Commission can not adequately plan for the Water Enterprise's finances, causing difficulties for customers. For example, in the five month period between August, 2004, and January, 2005, the Financial Services Section significantly revised its long range financial projections and estimates of retail rate increases for City customers, from the August, 2004, estimated retail rate increase of 11 percent per year to the January, 2005, estimated retail rate increase of 15 percent per year.

  • Also, the January, 2005, Water Enterprise long range financial projections suggest that the Public Utilities Commission will be unable to meet its eleven year goal of allocating $506 million in operating revenues to fund capital repair and replacement projects that have not been included in the Water System Capital Improvement Program. To complete critical projects, such as the replacement of aging water pipelines, the Public Utilities Commission will need to develop an effective asset management program to determine its most critical capital repair and replacement needs and to set other priorities for its resources.

City Retail and Suburban Wholesale Water Rate Revenues

Suburban and City water rate revenues pay most of the Water Enterprise's operating and capital costs. In FY 2003-2004, water rate revenues were an estimated $176.6 million.1 City residential, municipal, commercial, and industrial customers paid $71.1 million in retail water rates and suburban wholesale customers paid $101.4 million in wholesale water rates. The Water Enterprise also received $4.1 million in retail water rate revenues from suburban customers, including the San Francisco International Airport, and suburban commercial and residential customers.

Table 1.1

FY 2003-2004 Suburban and City Water Accounts and Rate Revenues

 

Total Accounts

Total Revenue

City Retail Accounts

169,069

$71,094,337

Suburban Retail Accounts

337

4,135,833

Suburban Wholesale Accounts

77

101,386,296

 

169,483

$176,616,466

Source: Customer Services Section Billing and Collections Data, as of June 30, 2004

Setting City Retail Rates

The Public Utilities Commission determines the Water Enterprise's revenue requirements to operate and maintain the water system each year, and sets retail and wholesale water rates to meet these annual revenue requirements. The Public Utilities Commission sets City retail rates to cover debt service costs and the City's customers' share of the operating, maintenance, and administrative overhead costs of the Water Enterprise. In 1998, the San Francisco voters approved Proposition H, which freezes City retail water rates through July 1, 2006. Under Proposition H, the Public Utilities Commission has been able to adopt incremental rate increases to cover increased costs of debt service. The FY 2004-2005 retail water rate of $1.49 per unit of water2 was set in FY 2002-2003 and has not increased since that time.

In November of 2002, the San Francisco voters approved Proposition A, authorizing the Public Utilities Commission to issue up to $1.628 billion in revenue bonds to pay for capital improvements to the City's water system. Under Proposition A, the Public Utilities Commission may increase City retail rates to pay for increased debt service costs of the new revenue bonds. The Public Utilities Commission Financial Services Section anticipates a 15 percent retail water rate increase in FY 2005-2006 to pay costs of voter approved debt, including funding reserves and prospective costs of future debt issues.

Setting Suburban Wholesale Rates

The Water Enterprise provides wholesale water to 29 suburban customers represented by the Bay Area Water Supply and Conservation Agency. The 1984 Settlement Agreement and Master Water Sales Contract, which expires on June 30, 2009, provides the terms and conditions, including the methodology for setting suburban wholesale water rates, by which the Water Enterprise delivers water to suburban purchasers. Under the Settlement Agreement and Master Water Sales Contract, the rate-setting method differs significantly from the method used to set City retail water rates.

The suburban wholesale rates are based on the suburban customers' share of the Water Enterprise's operating, maintenance and administrative overhead costs, and the suburban customers' allocation of property taxes levied against San Francisco Water Enterprise properties in San Mateo, Santa Clara, and Alameda Counties. Suburban wholesale rates do not include the costs of debt service on outstanding debt. Rather, the suburban wholesale rates include the cost of capital once the construction on the capital asset has been completed and the capital asset has been placed in service. The costs of capital include a rate of return on the suburban customers' allocation of the Water Enterprise's wholesale utility plant and working capital, and depreciation on the Water Enterprise's capital assets allocable to the suburban customers. Suburban wholesale water rates are adjusted annually.

The Public Utilities Commission's Settlement Agreement and Master Water Sales Contract with the Suburban Customers

Each year, the Public Utilities Commission's Financial Services Section staff calculate the Water Enterprise's suburban wholesale revenue requirements. Suburban wholesale customers pay approximately two-thirds of the costs of the Water Enterprise's regional water system and City retail customers pay approximately one-third. The suburban customers' share of costs are allocated among five categories, as follows:

  • Operating and maintenance expenses,
  • Administrative and general expenses,
  • Property taxes,
  • Return on the rate base, and
  • Depreciation on the capital assets.

The suburban share of costs also includes the charge assessed by the Public Utilities Commission for delivering water from the Hetchy Hetchy Enterprise's water system. The Hetch Hetchy Enterprise's assessment consists of the same five cost allocation categories as the Water Enterprise's cost allocation. The suburban wholesale customers pay only for their percentage allocation of water facilities costs and of the water-related portion of joint power and water facilities.

Many of the costs that make up the suburban customers' revenue requirements are on a cash basis. Operating and maintenance expenses, administrative and general expenses, and Water Enterprise property taxes paid to San Mateo, Alameda and Santa Clara Counties are included in the annual Water Enterprise Fund budget. Two components of the suburban customers' cost allocations, the rate of return of the Water Enterprise's rate base, including its utility plant and working capital, and depreciation of capital assets, require additional calculations.

Estimated and Actual Annual Suburban Revenue Requirements

Prior to the beginning of the fiscal year, the Public Utilities Commission Financial Services Section staff estimate the suburban revenue requirement for the year, based upon projected costs and water usage. Actual suburban revenue requirements are calculated after the close of the fiscal year, based on the actual costs incurred and actual water usage data. The Public Utilities Commission Financial Services Section staff make interim calculations of the suburban revenue requirement, based upon actual costs and water usage, within three months after the close of the fiscal year.

Under the Settlement Agreement and Master Water Sales Contract, the City's Controller selects an independent auditor to conduct an annual compliance audit. The compliance auditor reviews the recorded operating, maintenance, administrative, property tax, and other expenses to determine if the recorded expenses reasonably reflect the actual expenses incurred. The auditor also reviews the supporting documentation for calculation of the return on the rate base and depreciation to determine if the calculations are reasonable. Table 1.2 shows the suburban revenue requirements for FY 1998-1999 through FY 2001-2002, based on the audited financial statements. Audited financial statements for FY 2002-2003 and FY 2003-2004 are not yet available.

Table 1.2
Annual Suburban Revenue Requirements
FY 1998-1999 through FY 2001-2002

 

FY 1998-1999

FY 1999-2000

FY 2000-2001

FY 2001-2002 1

Operating and Maintenance

$22,729,731

$23,667,621

$21,114,791

$30,241,603

Citywide Overhead

343,090

347,102

339,657

387,810

Public Utilities Commission Administration

4,433,852

5,277,667

4,868,126

4,433,806

Other Administration

4,462,499

4,281,210

3,792,542

4,204,513

Contract Administration

86,749

90,437

92,722

95,758

Compliance Audit

61,370

64,434

74,100

77,805

Property Taxes

784,685

801,880

807,770

815,815

Return on the Rate Base

10,417,677

10,612,065

10,493,727

11,897,492

Depreciation

7,048,815

7,727,447

8,233,083

8,575,463

Hetch Hetchy Assessment

13,896,947

17,049,793

18,973,171

15,082,134

 

$64,265,415

$69,919,656

$68,789,689

$75,812,199

Source: Audited Financial Statements

1 Increased operating and maintenance expenses in FY 2001-2002 resulted from one time revenues from the sale of Public Utilities Commission properties that were appropriated for Water Enterprise Department capital repair and replacement projects.

Suburban Wholesale Revenues Balancing Account

The Settlement Agreement and Master Water Sales Contract establishes a "balancing account" to reconcile differences between estimated and actual suburban revenue requirements each year. If the estimated suburban revenue requirement exceeds the actual revenue requirement, the suburban customers receive a credit in the balancing account. If the estimated suburban revenue requirement is less than the actual requirement, the suburban customers receive a debit in the balancing account.

Under the Settlement Agreement and Master Water Sales Contract, the Public Utilities Commission attempts to clear the accumulated suburban wholesale account balance when setting wholesale water rates for the next fiscal year. If the suburban customers have a balancing account credit, the suburban wholesale rates for the next fiscal year are adjusted downward. If the suburban customers have a balancing account debit, the suburban wholesale rates for the next fiscal year are adjusted upward.

The gap between estimated and actual suburban revenue requirements has varied widely from year to year, resulting in large shifts in suburban wholesale water rates. The wholesale rate volatility has not only impaired the ability of the Public Utilities Commission to plan adequately for future revenue and operating funding requirements, but impacts the suburban wholesale customers' ability to plan for their own finances.

Table 1.3
Estimated and Actual Suburban Wholesale Revenue Requirements and the Impact on the Balancing Account
FY 2000-2001 through FY 2003-2004

 

FY 2000-2001 1

FY 2001-2002 1

FY 2002-2003 2

FY 2003-2004 2

 

Audited financial statement

Audited financial statement

Based on Unaudited Final Calculation

Based on Unaudited Interim Calculation

Beginning Balancing Account on June 30 3

$2,384,424

($4,838,236)

($9,354,685)

($4,433,851)

Suburban Revenues

(76,156,486)

(76,388,220)

(74,951,668)

(99,987,601)

Suburban Revenue Requirement

68,789,688

75,812,199

80,107,254

84,778,040

Interest on Balancing Account on June 30 3

144,138

(204,754)

(234,752)

(117,376)

Arbitration Settlement Adjustment

0

(3,735,674)

0

0

Ending Balancing Account on July 1 4

($4,838,236)

($9,354,685)

($4,433,851)

($19,760,788)

Source: Public Utilities Commission Financial Services Section

1 FY 2000-2001 and FY 2001-2002 information is based on the audited financial statements.

2 FY 2002-2003 and FY 2003-2004 information is based on the Financial Services Section staff's calculations. Audited financial statements are not yet available for these years.

3 FY 2002-2003 and FY 2003-2004 balancing account interest amounts are estimated.

4 The positive balance in the beginning balancing account on June 30, 2000 (FY 2000-2001) represents credits to the Public Utilities Commission. The negative balances in the FY 2001-2002 through FY 2003-2004 balancing accounts represent credits to the suburban customers.

As shown in Table 1.3, the suburban wholesale customers' balancing account has a $19.76 million credit in FY 2003-2004, which is projected to increase to $27 million in FY 2004-2005.

The actual suburban revenue requirement in FY 2003-2004 varied significantly from the estimated suburban revenue requirement, resulting from increased demand for water and delays in completing capital projects. This variation between estimated and actual suburban revenue requirements resulted in a $15.3 million increase in the suburban balancing account credit in FY 2003-2004.

In FY 2003-2004, the Public Utilities Commission Financial Services Section staff had anticipated that several capital projects would be completed and placed into service during the fiscal year. The estimated suburban revenue requirement had included rate of return and depreciation calculations on these capital projects which were expected to be completed. Because the projects were not completed in the projected timeframe, the suburban revenue requirement was recalculated to exclude the rate of return and depreciation calculations.

  • The Financial Services Section staff had projected that FY 2003-2004 suburban revenue requirements would be approximately $96.7 million and had adjusted wholesale rates upward by 25.7 percent to meet this revenue requirement projection.
  • The actual suburban revenue requirement was approximately $84.8 million, or almost $12 million less than projected.
  • Actual FY 2003-2004 suburban revenues received by the Public Utilities Commission were $99.99 million. This $3.29 million increase between actual revenues of $99.99 million and the projected revenue requirement of $96.7 million resulted largely from increased water volume purchased by the suburban customers.

Impact of the Suburban Balancing Account on FY 2005-2006 and FY 2006-2007 Suburban Wholesale Rates

The Settlement Agreement and Master Water Sales Contract requires the Public Utilities Commission to adjust suburban wholesale rates to clear the balancing account each year. To clear the suburban balancing account credit, which is expected to be $27 million in FY 2004-2005, the Public Utilities Commission projects a 30 percent reduction in suburban wholesale rates in FY 2005-2006, followed by a 40 percent suburban wholesale rate increase in FY 2006-2007 to meet FY 2006-2007 suburban revenue requirement.

Impact of the Variation in Suburban Wholesale Revenue Requirements on Long Range Financial Planning

The Public Utilities Commission Financial Services Section has developed a long range financial plan in conjunction with the Water System Capital Improvement Program, and presents annual updates to the Public Utilities Commission. The long range financial plan provides an overall description of the Water Enterprise 's financial structure, the Water System Capital Improvement Program financing plan, and a description of the Public Utilities Commission's capital funding sources.

The Public Utilities Commission presents the Water System Capital Improvement Program long range financial plan to the State Legislature's Joint Legislative Audit Committee, the Seismic Safety Commission, and the State Department of Health Services, in accordance with Assembly Bill 1823, which imposed planning, reporting and operating requirements on the Public Utilities Commission in managing the regional water system.

The Water Enterprise's Long Range Financial Projections

The Financial Services Section staff revised the Water Enterprise's long range financial projections significantly during the five-month period from August, 2004, when the Financial Services Section presented the Water Enterprise's long range financial projections to the Public Utilities Commission as part of the annual Water System Capital Improvement Program status report and update, and January, 2005, when the Financial Services Section presented the Water Enterprise's long range financial projections to the Public Utilities Commission as part of the annual budget hearing.

Table 1.4
The Water Enterprise's Long Range Financial Projections
FY 2004-2005 through FY 2009-2010

 

FY 2004-2005

FY 2005-2006

FY 2006-2007

FY 2007-2008

FY 2008-2009

FY 2009-2010

Average

Annual Increase/ (Decrease)

Total revenues

$188,244,000

$168,768,729

$209,456,525

$227,169,123

$253,904,404

$295,756,504

10%

Total operating and maintenance expenditures

(142,649,089)

(145,143,211)

(151,424,463)

(155,245,158)

(159,176,703)

(163,222,356)

3%

Net revenue

45,594,911

23,625,518

58,032,062

71,923,965

94,727,701

132,534,148

39%

Annual debt service

(38,376,106)

(38,444,973)

(38,517,056)

(50,844,673)

(72,023,606)

(92,488,635)

20%

Net revenue after debt service

7,218,805

(14,819,455)

19,515,006

21,079,292

22,704,095

40,045,513

(89%)

Beginning fund balance, July 1

92,220,829

70,818,634

35,999,179

34,514,185

33,543,477

33,095,072

(16%)

Net revenue plus beginning fund balance

99,439,634

55,999,179

55,514,185

55,593,477

56,247,572

73,140,585

(3%)

Total revenue funded capital

(28,621,000)

(20,000,000)

(21,000,000)

(22,050,000)

(23,152,500)

(24,310,125)

5%

Ending fund balance, June 30

$70,818,634

$35,999,179

$34,514,185

$33,543,477

$33,095,072

$48,830,460

(2%)

Debt service coverage (ratio of net revenues to annual debt service)

119%

61%

151%

141%

132%

143%

 

Operating and maintenance reserve

65%

49%

24%

22%

21%

20%

 

Source: Public Utilities Commission Financial Services Section

Impact of Project Delays on Revenue Projections

Revisions to long range financial projections result from revised projections of operating expenditures and of completion dates or planning timelines for capital projects. For example, the Financial Services Section staff revised projections for operating expenditures due to the Controller's Office revised estimates of mandatory fringe benefit costs.

Revisions to the planning and implementation of capital project construction can significantly alter the Water Enterprise's long range financial projections. Specifically, revisions to the expected timeframe to complete capital projects can change the projected revenue requirement from suburban customers, impacting both funds available for operating and revenue funded capital budgets and the unappropriated fund balance.

Delays in completing capital projects in FY 2003-2004 and revisions to future timelines for commencing capital project construction contributed to the revised long range financial projections.

  • Several Water System Capital Improvement Plan projects that were scheduled for completion in FY 2003-2004 were delayed, including the seismic rehabilitation of two terminal storage reservoirs located in San Francisco, which reduced the actual suburban revenue requirement compared to the estimated suburban revenue requirement by $15.3 million.
  • The commencement of construction of other Water System Capital Improvement Plan projects has been moved out to future years to allow for a programmatic rather than project-specific environmental impact report. The postponement of construction results in lowered suburban revenue projections in the next few fiscal years, impacting the amount of funding that is expected to be available to fund operating and revenue funded capital budgets in future years.

These timing revisions to completing existing capital construction projects or planning and commencing future capital construction projects have resulted in several key changes to the long range financial forecast. When the Financial Services Section presented the long range financial plan to the Public Utilities Commission in August, 2004, the Financial Services Section staff projected that:

  • City retail water rates would increase by 11 percent annually in FY 2005-2006 through FY 2008-2009 and by 9 percent in FY 2009-2010.
  • Suburban wholesale water rates would increase annually, ranging from 6.7 percent to 8.8 percent, in FY 2005-2006 through FY 2009-2010.
  • Operating revenues would be sufficient to increase funding for repair and replacement projects by $20 million in FY 2006-2007, and by 5.5 percent each subsequent year, in accordance with Public Utilities Commission policies.
  • Annual debt service coverage and operating and maintenance reserves would meet the Public Utilities Commission's financial targets in FY 2005-2006 through FY 2009-2010.

The January, 2005, Water Enterprise financial projections differ from the long range financial projections presented to the Public Utilities Commission in August, 2004, in several ways.

  • City retail water rates would increase by 15 percent annually in FY 2005-2006 through FY 2009-2010, resulting in a cumulative rate increase of 101 percent. The water rate would increase from $1.49 per unit of water in FY 2003-2004 to $3.00 per unit of water in FY 2009-2010. Under the August, 2004 financial projections, the cumulative rate increased between FY 2005-2006 through FY 2009-2010 would be 66 percent, resulting in FY 2009-2010 retail water rate of $2.47 per unit of water.
  • Suburban wholesale water rates are expected to decrease by 30 percent in FY 2005-2006 and increase by 40 percent in FY 2006-2007. These volatile rates result from adjustments to the suburban revenue requirements to account for the $15 million surplus in suburban revenues in FY 2003-2004.
  • Operating revenues would not be sufficient to increase funding for repair and replacement projects by $20 million in FY 2006-2007, in accordance with Public Utilities Commission policies.
  • In FY 2006-2007 through FY 2009-2010, operating and maintenance reserves would be less than the Public Utilities Commission's financial target of 25 percent of operating and maintenance expenditures.

Because the planning and implementation of the Water System Capital Improvement Program, including the timing of construction projects, has significant financial impacts on the Water Enterprise, the General Manager needs to report regularly to the Public Utilities Commission on the status of the Water System Capital Improvement Program, the plan to finance the capital projects, and the current long range financial projections. The report should include:

  • Summary of the Infrastructure Division and Financial Services Section's coordination of planning and implementing construction projects and the timing of debt issuance.
  • Impact of Water System Capital Improvement Program project planning and implementation on projected revenues and the Public Utilities Commissions financial targets.

Impact of Suburban Wholesale Revenues on the Revenue Funded Capital Budget

The suburban wholesale water rates will decrease by 30 percent in FY 2005-2006 to clear the suburban customers' $27 million balancing account credit, resulting in FY 2005-2006 suburban wholesale revenues of $69 million, which is a decrease of approximately $28.3 million, or 29 percent, from projected FY 2004-2005 revenues of $97.3 million. As shown in Table 1.5, total estimated FY 2005-2006 operating revenues, including the reduced suburban wholesale revenues, will be insufficient to pay operating and maintenance and debt service expenses. Therefore, the Water Enterprise will draw down $14.8 million from the unappropriated fund balance in FY 2005-2006 to meet operating and maintenance and debt service expenditures.

Table 1.5
Estimated Water Enterprise Revenues and Expenditures
FY 2004-2005 through FY 2006-2007

 

FY 2004-2005

FY 2005-2006

FY 2006-2007

Retail rate revenues 1

$74,270,000

$85,410,500

$98,222,075

Wholesale revenues

97,374,000

69,060,671

97,094,138

Interest income, fund balance

4,000,000

1,697,558

1,540,312

Other miscellaneous income

12,600,000

12,600,000

12,600,000

Total revenues

188,244,000

168,768,729

209,456,525

Total operating and maintenance expenditures

(142,649,089)

(145,143,211)

(151,424,463)

Net revenues

45,594,911

23,625,518

58,032,062

Annual debt service

(38,376,106)

(38,444,973)

(38,517,056)

Net revenues, less debt service

7,218,805

(14,819,455)

19,515,006

Beginning fund balance, July 1

92,220,829

70,818,634

35,999,179

Net revenue plus beginning fund balance

99,439,634

55,999,179

55,514,185

Total revenue funded capital

(28,621,000)

(20,000,000)

(21,000,000)

Ending fund balance, June 30

$70,818,634

$35,999,179

$34,514,185

Source: Public Utilities Commission Financial Services Section

1 FY 2005-2006 and FY 2006-2007 retail rate revenues are based on 15 percent retail rate increases in each year.

Reduced Rate Revenues and the Revenue Funded Capital Budget

The Water Enterprise's annual budget includes monies for revenue funded capital projects. Capital projects funded from operating revenues generally consist of maintenance, repair, replacement, and rehabilitation of existing capital assets.

The Public Utilities Commission's financial policies, adopted in May, 2002, specifically addressed revenue funded capital projects. The Public Utilities Commission proposed that water rates be set at a level to provide sufficient revenues to pay the recurring costs of maintaining the water system's capital assets in order to pay for ongoing capital asset repairs and replacement with revenues rather than debt financing.

According to the Public Utilities Commission's May, 2002, financial policies, the Water Enterprise's revenue funded repair and replacement projects should receive annual block funding. The Public Utilities Commission proposed to increase the amount of annual funding for capital repair and replacement projects, which currently ranges from approximately $20 million to $30 million annually, by $20 million in FY 2006-2007, the year in which the Proposition H rate freeze expires, and by 5.5 percent each subsequent year.

The anticipated costs of the local and regional water system repair and replacement projects over a ten-year period were approximately $506.1 million for the eleven-year period from FY 2003-2004 through FY 2014-2015. Although the August, 2004 Water Enterprise long range financial projections presented to the Public Utilities Commission as part of the Water System Capital Improvement Program status report and update anticipated meeting this funding goal, the projections presented to the Public Utilities Commission five months later in January, 2005, no longer included the $20 million in additional block funding for capital repair and replacement projects, commencing in FY 2006-2007.

  • In August, 2004, the Financial Services Section presented Water Enterprise long range financial projections to the Public Utilities Commission for the ten-year period from FY 2004-2005 through FY 2013-2014, with projected capital repair and replacement funding for the four-year period from FY 2006-2007 through FY 2009-2010 of $166,845,329.
  • In January, 2005, the Financial Services Section presented Water Enterprise long range financial projections to the Public Utilities Commission for the six-year period from FY 2004-2005 through FY 2009-2012, with projected capital repair and replacement funding for the four-year period from FY 2006-2007 through FY 2009-2010 of $90,512,625.

Under the January, 2005, long range financial projections, capital repair and replacement funding will be $76.3 million, or 46 percent less, for the four-year period from FY 2006-2007 through FY 2009-2010 than in the August, 2004, long range financial projections.

Much of the water system capital repair and replacement funding was to be allocated to replacing aging water pipelines. These projects are not included in the revenue bond funding for the Water System Capital Improvement Program.

Funding the Capital Repair and Replacement Program

The Financial Services Section staff, in conjunction with Clean Water, Water, and Hetch Hetchy Enterprise staff, have begun planning for an asset management program to better identify capital repair and replacement needs and the required annual funding. Currently, in setting the annual operating budget, the Water Enterprise requests funding for capital repair and replacement projects based on available operating revenues after operating and maintenance expenditures have been met. Monies drawn down from the unappropriated fund balance supplement operating revenues to fund the annual capital repair and replacement program. Between FY 1999-2000 and FY 2003-2004, the revenue funded capital program appropriation ranged from approximately $20 million to $31 million annually.

Table 1.6
Water Enterprise Actual Expenditures
FY 1999-2000 through FY 2003-2004

 

FY 1999-2000

FY 2000-2001

FY 2001-2002

FY 2002-2003

FY 2003-2004

Cumulative Annual Growth Rate

Operating and maintenance expenditures

$111,595,505

$110,891,404

$110,926,766

$119,426,274

$126,338,122

3%

Annual debt service

20,032,939

19,989,020

27,733,212

36,497,590

38,177,573

14%

Capital repair and replacement

19,982,450

28,180,000

146,031,450

28,680,000

31,041,000

9%

Total

$151,610,894

$159,060,424

$284,691,428

$184,603,864

$195,556,695

5%

Source: Public Utilities Commission Financial Services Section

The Water Enterprise does not have a formal process to identify which capital projects should be funded from operating revenues. The annual capital repair and replacement budget, funded by operating revenues, is a function of the funds available for such projects rather than a formal process of determining funding needs. Additionally, not all revenue funded capital projects are distinctly repair and replacement of existing capital assets. Revenues can also be allocated to projects that are capital improvement projects rather than capital repair and replacement projects. In FY 2001-2002, the Water Enterprise included $146 million in the revenue funded capital budget, resulting from the sale of Public Utilities Commission property, which were allocated to the Water System Capital Improvement Program projects.

Developing an Asset Management Program

The asset management program's goal is to develop comprehensive cost and life-cycle data on the enterprise departments' capital assets, including evaluating the risks and costs of maintaining, repairing, and replacing existing capital assets, to better determine allocation of funds to repair and replacement projects. In the absence of a coordinated asset management program, the Water Enterprise has not had a systematic method for identifying, planning for, and meeting its ongoing capital repair and replacement needs. The Budget Analyst will review the Public Utilities Commission's proposed asset management program in Phase IV of the management audit.

The State Department of Finance Audit

In November, 2003, the State Department of Finance audited the Water Enterprise's maintenance policies and procedures for the regional water system, and issued a final audit report in June, 2004. State Assembly Bill 1823 required the State Department of Finance to audit the Public Utilities Commission's regional water system to assess the adequacy of the Commission's procedures and resources for (a) identifying water system maintenance needs, (b) planning, budgeting, scheduling, and completing maintenance projects, and (c) maintaining maintenance records.

The State Department of Finance audit noted that identification of capital repair and replacement projects is based upon the Hetch Hetchy and Water Enterprises' staff's experience, rather than more formal criteria. Managing capital repair and replacement projects (such as planning, scheduling, completing, and record keeping) has been decentralized among the various Public Utilities Commission's departments and divisions and can be unique to the specific department or division.

The State Department of Finance made several recommendations regarding the Public Utilities Commission's procedures for identifying and reporting capital repair and replacement needs and developing annual repair and replacement budgets.

Improving Repair and Replacement Program Procedures

The State Department of Finance found that repair and replacement program procedures needed improvement. Although identifying the need and requesting funds for repair and replacement projects originates within the various Public Utilities Commission enterprise departments and divisions, the Public Utilities Commission has assigned oversight of capital repair and replacement projects to the Infrastructure Division. The State Department of Finance recommended that the Public Utilities Commission:

(a) Re-assign responsibility for overseeing capital repair and replacement projects from the Assistant General Manager of Infrastructure to another senior manager to ensure that capital repair and replacement projects received focused attention; and

(b) Develop project management system tools that are specifically designed for recurring repair and replacement projects rather than incorporated into the Capital Improvement Program project management system.

The Public Utilities Commission did not concur with these recommendations in their written response to the State Department of Finance audit report. Rather, the Public Utilities Commission stated that the repair and replacement program would be incorporated into the framework developed for the Water System Capital Improvement Program, which would include a new management team and project control system. According to the Public Utilities Commission, the Assistant General Manager, Infrastructure would ensure that the repair and replacement program would be implemented in full coordination and with the same priority as the Water System Capital Improvement Program.

The State Department of Finance also recommended that the Public Utilities Commission report to the Commissioners, the Board of Supervisors and other constituents and stakeholders on the status of all repair and replacement projects, including projects completed during the year, the status of open projects, project expenditures, and any budgeted funds carried froward from the previous year. Although the Public Utilities Commission concurred with this recommendation, detailed capital repair and replacement program information has not been included in the Water System Capital Improvement Program status reports and updates. The Public Utilities Commission should implement the State Department of Finance audit recommendation to provide the Commissioners and the Board of Supervisors detailed capital repair and replacement program information. The Public Utilities Commission should provide a report to the Board of Supervisors during the FY 2005-2006 budget review, the status of the Water Enterprise's repair and replacement projects, and the Infrastructure Division's management support of the capital repair and replacement program.

Improving Repair and Replacement Program Budget Development Procedures

The State Department of Finance recommended that the Public Utilities Commission should:

(a) Develop formal budget criteria for repair and replacement projects in advance of the annual budget process and provide managers with an opportunity to develop appropriate maintenance budgets based on the stated criteria, and

(b) Consider a budget process that better recognizes asset management priorities.

The Public Utilities Commission concurred with the two recommendations in their written response to the State Department of Finance audit report. The Public Utilities Commission has not yet developed formal criteria for the FY 2005-2006 capital repair and replacement program but has begun developing an asset management program. According to the Director of Financial Services, the asset management program will develop formal criteria for the FY 2006-2007 capital repair and replacement program. The Public Utilities Commission should provide a report to the Board of Supervisors during the FY 2005-2006 budget review on the implementation of the asset management program.

Expiration of the Settlement Agreement and Master Water Sales Contract in 2009

Although the Settlement Agreement and Master Water Sales Contract with the 29 suburban wholesale customers will expire on June 30, 2009, the Public Utilities Commission should negotiate with the suburban customers, represented by the Bay Area Water Supply and Conservation Agency, to renegotiate the terms of capital cost recovery included in the Settlement Agreement and Master Water Sales Contract at an earlier date.

Suburban wholesale water rates and revenues have been volatile in recent years. The complexity of the suburban wholesale rate calculation under the Settlement Agreement and Master Water Sales Contract and the Water System Capital Improvement Program's difficulty in establishing a firm project-sequencing schedule contribute to this volatility. The Public Utilities Commission and the suburban customers, represented by the Bay Area Water Supply and Conservation Agency, could reduce the financial uncertainty that results from the existing Settlement Agreement and Master Water Sales Contract wholesale rate calculation methodology by early negotiation of the terms of capital cost recovery included in the Settlement Agreement and Master Water Sales Contract.

The Bay Area Water Supply and Conservation Agency commissioned a study on alternatives for paying for the regional Water System Capital Improvement Program and the impact on wholesale rates, which was completed in September, 2004. The study determined that the current methodology by which the wholesale customers pay for capital costs under the Settlement Agreement and Master Water Sales Contract is not appropriate for financing the $3.6 billion Water System Capital Improvement Program, of which $1.9 billion would be costs incurred by the suburban wholesale customers. According to the study, under the current suburban wholesale rate methodology, City retail payers would have to make up future revenue shortfalls, which would occur prior to the completion of the Water System Capital Improvement Program projects and placement of capital assets into service, through increased retail rates. The study noted that the suburban revenue requirements over the life of the Water System Capital Improvement Program under the existing suburban rate setting methodology, and the alternative cash or "pay as you go" methodology, would be approximately equal. Therefore, the study recommended that, under the new water sales contract to be negotiated between the City and the suburban customers in 2009, the suburban wholesale customers pay for water under the cash or "pay as you go" methodology, comparable to the methodology applied to the City's retail water rates.

Administering the Settlement Agreement and Master Water Sale Contract, including the suburban wholesale revenue requirement and rates, would only be simplified under the recommended alternative cash methodology if the suburban customers agreed to pay the Public Utilities Commission the net present value of payments for capital assets currently included in the rate base. If the Public Utilities Commission and the suburban customers, represented by the Bay Area Water Supply and Conservation Agency, were able to negotiate new capital cost recovery terms in the Settlement Agreement and Master Water Sales Contract prior to FY 2009-2010, which applies the cash methodology to suburban wholesale water rates, calculating wholesale water rates would be simplified. The variations in the suburban balancing account, which impact annual suburban wholesale rate adjustments, long range financial projections, and operating and revenue funded repair and replacement budget decisions, would be reduced.

Conclusion

Actual suburban wholesale revenue requirements, which are calculated based on the costs of the regional water system's capital assets, have varied significantly from estimated suburban wholesale revenue requirements over the past two years, largely due to delayed completion of capital projects, resulting in a 30 percent reduction in wholesale rates and a $28 million reduction in estimated revenues in FY 2005-2006. The Public Utilities Commission Financial Services Section cannot prepare accurate long range financial projections and provide reliable financial information to the Public Utilities Commission without accurate capital planning and project timing information from the Infrastructure Division. The Public Utilities Commission General Manager needs to ensure coordination of the Water System Capital Improvement Program financial and capital planning. The General Manager should develop a formal plan for the ongoing exchange of information between the Infrastructure Division's program management team and the Financial Services Section staff, including regular reporting to the General Manager and the Public Utilities Commission, to ensure that the Commissioners, the General Manager, and senior management staff have adequate information on future revenues and expenditures for Water Enterprise programs.

The Public Utilities Commission is in the process of developing a capital asset management program for the three enterprise departments, but in the absence of a coordinated capital asset management program, the Water Enterprise Department has not had a systematic method for identifying, planning for, and meeting its ongoing capital repair and replacement needs. The General Manager should (a) implement findings and recommendations made by the State Department of Finance, in the November, 2003, audit of the Water Enterprise Department's maintenance policies and procedures for the regional water system, including providing the Commissioners and the Board of Supervisors detailed capital repair and replacement program information, and (b) provide a full report to the Board of Supervisors during the FY 2005-2006 budget review on the status of all Water Enterprise repair and replacement projects, and the Infrastructure Division's management support of the capital repair and replacement program.

Also, the Public Utilities Commission should negotiate with the suburban customers, represented by the Bay Area Water Supply and Conservation Agency, to renegotiate the Settlement Agreement and Master Water Sales Contract at an earlier date to revise the terms of capital cost recovery, which would simplify suburban wholesale rate calculations, and reduce the variations in the suburban wholesale revenue requirements and water rates.

Recommendations

The Public Utilities Commission General Manager should:

1.1 Implement the State Department of Finance audit recommendation to provide the Public Utilities Commission and the Board of Supervisors detailed capital repair and replacement program information.

1.2 Provide a report to the Board of Supervisors during the FY 2005-2006 budget review regarding:

(a) The status of all Water Enterprise repair and replacement projects, and the Infrastructure Division's management support of the capital repair and replacement program.

(b) The implementation of the asset management program.

1.3 Develop a formal plan for the ongoing exchange of information between the Infrastructure Division's program management team and the Financial Services Section staff, including regular reporting to the General Manager and the Public Utilities Commission, to ensure that the Commissioners, the General Manager, and senior management staff have adequate information on future revenues and expenditures for Water Enterprise programs.

The Public Utilities Commission should:

1.4 Negotiate with the suburban customers, represented by the Bay Area Water Supply and Conservation Agency, to renegotiate the Settlement Agreement and Master Water Sales Contract at an earlier date to revise the terms of capital cost recovery.

Costs and Benefits

Implementation of our recommendations would provide more detailed and reliable information on the Water Enterprise's future revenues and expenditures, the capital repair and replacement program, and the asset management program to the Board of Supervisors, City residents, suburban wholesale customers, and other stakeholders in the water system.

1 FY 2003-2004 revenues are based on the Customer Services Section's billing system water rate charges as of June 30, 2004.

2 One unit of water equals 748 gallons.