Coordinating the Timing and the Financing of the Water System Capital Improvement Program

• By not using capital project funding in an expeditious manner, the Public Utilities Commission incurs significant debt interest expense and loses buying power through inflation. For example, approximately five to seven years after initial appropriation in FY 1997-1998 through FY 1999-2000 by the Board of Supervisors, $5.2 million of the $77.7 million in 1996 revenue bond proceeds remain unencumbered, amounting to 6.7 percent of the total amount of the appropriation. Combined debt interest expense and inflation have resulted in the unexpended funds of $5.2 million declining in value by an estimated 4 percent per year, equal to approximately $208,000 per year or approximately $1.04 million over five years.
  
  
• These circumstances occur because the Public Utilities Commission does not effectively manage the timing of financing and construction of capital projects. In other examples, capital projects totaling $2.8 million had unencumbered balances equal to 65 percent to 100 percent of the original appropriation two to five years subsequent to when the funds were originally appropriated.
  
  
• The Public Utilities Commission is planning the largest issuance of revenue bonds in the Commission's history to finance the Water System Capital Improvement Program. The Water Enterprise will issue up to approximately $3.6 billion in revenue bonds to finance the Water System Capital Improvement Program, which is ten times the amount of revenue bonds issued by the Water Enterprise in the twelve year period from 1991 through 2002. Without well-coordinated information on the planning and timing of the Capital Improvement Program projects, the Financial Services Section staff cannot efficiently time cash flow requirements for constructing the Water System Capital Improvement Program projects with the issuance of revenue bonds.
  
  
• If the Public Utilities Commission does not efficiently manage the planning and timing of issuance of revenue bonds and appropriation and expenditures of the revenue bond proceeds for the $3.6 billion Water System Capital Improvement Program, the additional costs which would be imposed on ratepayers resulting from interest payments on unencumbered and unexpended balances could be significant.

Long Term and Short Term Debt to Finance the Water System Capital Improvement Program

The Public Utilities Commission is planning the largest issuance of revenue bonds in the Commission's history. The proposed issue of $3.6 billion in revenue bonds, of which $1.7 billion will be the City retail ratepayers' share of debt, far exceeds the Water Enterprise Fund's previous bond issuance. During the twelve-year period from 1991 through 2002, the Water Enterprise issued three series of revenue bonds with total principal amounts of $376.15 million, approximately one-tenth of the proposed revenue bond issuance of $3.6 billion of the Water System Capital Improvement Program.

The Public Utilities Commission can issue both long term and short term debt to fund the Water System Capital Improvement Program. Under Propositions A and E, approved by City voters in November, 2002, the Public Utilities Commission can issue revenue bonds to fund the City's share of costs for the Water System Capital Improvement Program. Either the Public Utilities Commission or the San Francisco Bay Area Regional Water System Financing Authority, pursuant to Senate Bill 1870, can issue revenue bonds to cover the suburban wholesale customers' share of costs for the regional Water System Capital Improvement Program.

The Public Utilities Commission Financial Services Section staff use the Water System Capital Improvement Program's cash flow requirements to form the basis of the Water Enterprise's long range financial projections. The timeframe for planning and constructing the Water System Capital Improvement Program projects will determine the Water Enterprise's cash flow requirements and the timing of debt issuance. The Financial Services Section has proposed issuing short term debt to smooth out the timing of longer term debt issuance. The Water Enterprise's long range financial projections assume that the first series of revenue bonds will be issued in FY 2005-2006, and capital financing needs prior to that time will be met with commercial paper.

Short Term Debt to Finance the Capital Improvement Program

The Board of Supervisors authorized the Public Utilities Commission to issue up to $250 million in commercial paper, which are short-term loans up to 270 days at low interest rates. Commercial paper will provide interim funding to reduce the risks of insufficient capitalized interest¹ to meet debt service payments during construction of capital projects and to better time the issuance of debt to correspond with construction of capital projects.

The Public Utilities Commission's Financial Policies

In May, 2002, the Public Utilities Commission adopted several financial policies regarding the funding of the Water System Capital Improvement Program and the impact on water rates, including:

• · The Water Enterprise's annual net revenues (operating revenues less operating expenses) must equal 125 percent of annual revenue bond debt service payments. This policy will require a larger increase in the water rates than the existing requirement imposed by the Water Enterprise's bond indentures on its outstanding revenue bonds, in which net revenues plus the unappropriated fund balance must equal 125 percent of annual debt service payments.
• · Both the City Charter and the Water Enterprise Fund's bond indentures on its outstanding bonds require that the Water Enterprise Fund maintain an operating reserve. The Public Utilities Commission proposes to increase water rates to maintain a 25 percent operating reserve, although the Public Utilities Commission will consider an operating reserve of less than 25 percent if the impact of increasing rates is too high.
• · One-time revenues from the sale of surplus properties should be applied to capital projects in lieu of acquiring debt in order to reduce the magnitude of water rate increases that would otherwise be required.

Because the January, 2005, long range financial projections estimate annual retail water rate increases of 15 percent annually, rather than 11 percent annually as estimated in the August, 2004, long range financial projections, as discussed in Section 1 of this report, the Public Utilities Commission may want to consider revising its policy to maintain debt service coverage equal to 125 percent of net revenues plus the unappropriated fund balance in order to reduce the impact of retail water rates.

Efficient Timing of Debt Issuance and Capital Construction

The Water Enterprise pays debt service on the revenue bonds once they are issued. Increases in debt service payments are met through increases in retail water rates. For example, in FY 2002-2003, the retail water rate increased by 8.8 percent, from $1.37 per unit of water to $1.49 per unit of water², to fund an increase in annual debt service payments from $27.7 million in FY 2001-2002 to $36.5 million in FY 2002-2003.

The Financial Services Section and the Infrastructure Division will need to carefully coordinate the issue of debt with the commencement of capital projects to ensure that bond proceeds are spent effectively on capital projects.

A review of capital projects funded by 1996 revenue bonds shows several instances of bond monies that were appropriated but not spent fully or in a timely manner. The total appropriation for the 1996 revenue bonds was $77.7 million, most of which was appropriated in FY 1997-1998 through FY 1999-2000. The unencumbered balance as of June 30, 2004 was $5.2 million, or 6.7 percent of the total appropriation. Specific capital projects funded by the 1996 revenue bonds, totaling approximately $2.8 million, had unencumbered balances equal to 65 percent to 100 percent of the original appropriation, two to five years later, as shown in Table 3.1.

Table 3.1
1996 Revenue Bond Capital Projects with More than 50 Percent of Appropriation Unencumbered as of June 30, 2004

	Appropriation
Project	FY 1998-1999 and Prior Years	FY 1999-2000 and FY 2000-2001	FY 2001-2002	Total	Total Expenses	Unencumbered Balance as of June 30, 2004	Percent of Appropriation Remaining Unencumbered
CUW 124 Bay Division Pipeline 1 and 2 Joint Rehabilitation	$51,583	$0	$0	$51,583	$0	$51,583	100%
CUW 178 Skyview/Aqua Vista Pump Station - Modify Piping & Valving	$775,296	$0	$0	$775,296	$268,493	$506,803	65%
CUW 198 Stone Dam Rehabilitation	$345,000	$0	$0	$345,000	$109,084	$235,916	68%
CUW 850 New Feeder Mains	$0	$0	$2,000,000	$2,000,000	$0	$2,000,000	100%

Source: Controller's Office

Because the Water Enterprise is paying interest on the revenue bond debt, when the monies remain unexpended and unencumbered for up to five years after the appropriation, debt interest payments as well as inflation cut into the monies available to fund capital projects. Although the Water Enterprise receives interest earnings on the unexpended revenue bond monies deposited in the City Treasury, which currently equals 1.855 percent annually, interest earned is less than interest payable on revenue bond debt, resulting in the unexpended funds declining in value by an estimated 3 to 5 percent per year. Therefore, the combined interest expense and inflation on the outstanding balance of $5.2 million, which remains unspent approximately five years after the initial $77.7 million appropriation of 1996 revenue bond proceeds, have resulted in the unexpended funds declining in value by an estimated 4 percent per year, equal to an estimated $208,000 per year or an estimated $1.04 million over five years.

If the Public Utilities Commission does not efficiently manage the issuing of revenue bonds and appropriation and expenditures of the revenue bond proceeds for the $3.6 billion Water System Capital Improvement Program, the costs to the ratepayers from interest payments on unencumbered and unexpended balances could be significant.

Conclusion

The Public Utilities Commission is planning the largest issuance of revenue bonds in the Commission's history to finance the Water System Capital Improvement Program. Without well coordinated information on the planning and timing of the Capital Improvement Program projects, the Financial Services Section staff cannot efficiently time cash flow requirements for constructing the Capital Improvement Program projects with the issuing of revenue bonds.

The Public Utilities Commission does not effectively manage the timing of financing and constructing capital projects. A review of capital projects funded by 1996 revenue bonds shows several instances of bond monies that were appropriated but not spent fully or in a timely manner. The total appropriation for the 1996 revenue bonds is $77.7 million, most of which was appropriated in FY 1997-1998 and FY 1999-2000. The unencumbered balance as of June 30, 2004 was $5.2 million. Specific capital projects funded by the 1996 revenue bonds had unencumbered balances equal to 65 percent to 100 percent of the original appropriation, two to five years later.

The Public Utilities Commission General Manager needs to ensure that the Financial Services Section and Infrastructure Division managers are coordinating financial and capital planning and should report monthly to the Public Utilities Commission and quarterly to the Board of Supervisors on the status of the Water System Capital Improvement Program planning and financing.

Recommendations

The Public Utilities Commission General Manager should:

3.1 Develop a formal coordinating team within the Public Utilities Commission, in which the Infrastructure Division and the Financial Services Section coordinate capital program and financial planning for the Water System Capital Improvement Program, including:

(a) Regular and frequent disclosure of information from the Infrastructure Division on the planning and timing of construction of the Water System Capital Improvement Program projects, and

(b) Regular reports to the General Manager on the status of Water System Capital Improvement Program projects, current revenue requirement forecasts, estimated suburban and wholesale water rate increases to meet these requirements, and debt financing plans.

3.2 Report monthly to the Public Utilities Commission and quarterly to the Board of Supervisors on the status of the Water System Capital Improvement Program, the plan to finance the capital projects, and the current long range financial projections, including:

(a) The summary of the Infrastructure Division and Financial Services Section's coordination of planning and implementing construction projects and the timing of debt issuance, and

(b) The impact of Water System Capital Improvement Program project planning and implementation on projected revenues and the Public Utilities Commissions financial targets.

Costs and Benefits

Implementation of the Budget Analyst's recommendations would ensure better coordination of capital and financial planning. Such coordination would provide more precise information on the timing of revenue bond issues, reducing the risk of the City rate payers incurring unnecessary debt service costs, and would provide more reliable financial projections, contributing to more predictable and uniform City retail and suburban wholesale water rates.

¹ Revenues from the capital assets funded by revenue bonds pay the principal and interest of the revenue bonds. During construction of the capital project, prior to the Water Enterprise Fund receiving revenues from the completed capital asset, a portion of bond proceeds are set aside as "capitalized interest" to pay interest on the bonds.

² One unit of water equals 100 cubic feet or 748 gallons.