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Regulation 101

Regulation 101. A Primer for the Edmonton City Council. Today’s Topics. Understand regulatory accounting Principles Terminology and reports How the SU develops rates, increases Understand the choices to be made Questions to ask Alternatives to consider Impacts High level questions

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Regulation 101

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  1. Regulation 101 A Primer for the Edmonton City Council

  2. Today’s Topics • Understand regulatory accounting • Principles • Terminology and reports • How the SU develops rates, increases • Understand the choices to be made • Questions to ask • Alternatives to consider • Impacts • High level questions • Goals and process of regulation • Utility fiscal policy

  3. What We Will Analyze • Concentrate on the Sanitary Utility • Larger, older utility • Can discuss Land Drainage Utility if desired • Initial focus on budget for 2006 • Basis for approving current rates • Note that process involves longer-term view • See how different assumptions affect the results • Review budget vs. actual 2005 results • Understand the financial reports • Think about the implications

  4. The Financial Fundamentals

  5. Basic Accounting Statements • Operating statement (or “income statement”) • Revenues and expenses for an accounting period • Usually for a calendar year • Balance sheet • Assets equal liabilities + equity • Stated as of a date, usually end of the year • Cash position • Change over the year (like operating statement) • Includes financing (+) and investment (-)

  6. Operating Statement - 2005

  7. Revenues

  8. Operation & Maintenance Expenses • Labour • Supplies • Chemicals • Power • Insurance • Central management fees • Billing expense

  9. Depreciation Expense • Applies to expenditures on assets • Items that will be used over several years • Written off (expensed) over their useful life • Electronic and lab equipment: 5 years • Office equipment & furniture: 6.67 years • Buildings, wastewater treatment plant: 44 years • Mains, pump stations: 75 years • Land: Not depreciated • Annual amount called “depreciation”/”amortization”

  10. Calculating Depreciation Expense

  11. Calculating Depreciation Expense

  12. Why Depreciation is a “Non-Cash Expense” The cash was spent in this year An expense is recorded in each of these years—but there is no cash outlay

  13. Calculating Depreciation Expense

  14. Calculating Depreciation Expense

  15. Calculating Depreciation Expense

  16. Balance Sheet • Assets = Liabilities + Equity • Assets are “things owned” • Facilities, equipment (net of depreciation write-off) • Cash • Receivables (cash not yet received) • Liabilities are “things owed” • Debt (to debt holders) • Payables (bills not yet paid) • Equity is the owner’s value • Retained earnings • Contributed capital (including SSSF)

  17. Financed and Contributed Assets • “Financed” assets • Financed by debt and retained earnings • “Contributed” assets • Assets transferred from the City in 1954 • Assets funded by contributions

  18. Balance Sheet: Assets

  19. Balance Sheet: Liabilities + Equity

  20. Sanitary Servicing Strategy Fund • SSSF is a separate fund • Separate board • Funds used only for designated projects • SSSF plans through 2074 • SSSF collects mostly from developers • SU interaction with SSSF • SU pays $2.6 million to SSSF • SSSF pays SU for some projects • $1.9 million in 2004 • $23.0 million budgeted for 2005 • $7.0 million in 2005

  21. SSSF Funding - 2004

  22. SSSF 2004 Revenues Source: SSSF 2004 Annual Report

  23. Capital Structure • Split of capital between debt & equity (2005) • Typical regulated: 65%/35% to 50%/50% • Wider variation for municipal utilities

  24. Return on Equity (RoE) Definition: Net income ÷ Retained earnings UFP uses retained earnings at start of year Usual definition is average retained earnings Details of definition UFP uses earnings after dividend payment Usual definition is before dividend payment UFP states RoE before SSSF payment Comparison with others Typical regulated value is 8.5% - 11.5% Most drainage utilities have no stated target

  25. Return on Equity Calculations

  26. Income vs. Cash • Operating income  “cash income” • Not all cash receipts are income • Borrowed money is not income • Not all cash payments are expenses • Repayment of borrowing is not an “expense” • Asset purchases only partly expensed • Timing differences • Revenue booked before cash received (billed in Dec., paid Jan.) • Expenses booked before bills paid • These are end of year differences, usually small

  27. Cash Statement - 2005

  28. Financial Statements - Review • Income statement • Shows the operating profit for the year • Shows the depreciation write-off amount for the year • Cash statement • Shows investments, financing for the year • Part of financing comes from year’s income • Balance sheet • Shows the total of all past results at a given date (Income, investments, financing, accrued depreciation) • Changes in balance sheet totals reflect above two reports

  29. Setting Next Year’s Rates

  30. The Basic Income Equation

  31. The Basic Regulatory Equations #1 #2

  32. Revenue Requirement - 2006

  33. What Determines Target Net Income? • Past investments (current book value) • Equity investors require a market-based return • Fairness • Need to attract future equity capital • Debt holders require safety and repayment • Future investment • Muni, Crown: cannot raise outside equity • Not all investment can be funded by debt • Borrowing restrictions • Not wise to borrow to the hilt • Cushion and smoothing • Cover unfavourable variances • Keep annual changes smooth and moderate

  34. Determining Required Earnings • Utility boards focus on existing investment • Most experience with investor-owned utilities • Fair return determined by market • Future investment can be financed externally • Hard for them to change methods • Current ≈ 10% return on equity • Other WW utilities have wide range of earnings • City Council approach • Utility Fiscal Policy • Based on needs of each utility

  35. Current Utility Fiscal Policy • 6% return on opening equity • 40% of earnings paid as dividend by 2014 • Up to 35% of additions financed by earnings • A + B = 10% return on equity • C gives different answer than A + B

  36. Earnings Required By UFP • 6% return (after 40% dividend) = $28.1 M • 35% financing from retained earnings = $39.1 M

  37. Revenue Requirement - 2006

  38. Revenues

  39. Questions

  40. What Do PUBs Regulate? • Operating expenses • Allowed operation and maintenance costs • Depreciation rates • Investment • Investment on which return is allowed • Earnings • Capital structure • Return on equity • Rate structure

  41. What Does Council (Want to) Regulate? • Budget • Capital program • Timing of some programs • Affects future costs • Interest • Depreciation • Earnings • Net income • Dividend • Capital structure • Timing of rate increases (?) • Rate structure (?)

  42. Setting Rates – The Long Term View • Review • Have examined revenue requirement for 1 year • Investment and financing decisions affect future • Looking only at next year can cause problems • Rates not predictable • Large increases in some years • Less financing flexibility • SU has used 20 year forward look • More sophisticated than most other utilities • Gives SU and Council more flexibility

  43. Overview of Rate Setting Process Construction, Capital Needs Target Net Income (Retained earnings) Expenses + Net Income = Required Revenue Rate Increases

  44. Steps in Rate Setting Process Reconsider construction plans or UFP Construction - Contributions, SSSF = CapitalRequired - Interest cost increases operating expense Funded by debt = Funded by earnings + Operating costs = Required revenue Increase too big? Rate increase

  45. Construction Forecast • Forecast of project additions by year • 20-year forecast • Some investment required by legislation • Council policy determines some timing • Mature neighbourhood program • Planned rehab vs. emergency rehab

  46. Construction Financing • Sources of capital • SSS Fund (Sanitary Utility) • Contributions and grants • Debt (debentures) • Retained earnings (retained cash) • Debt subject to constraints • Certain assets don’t qualify (design, equipment) • Financial tests • Current year decisions affect future flexibility

  47. Construction Expenditure Forecast

  48. Construction Financing Plan

  49. Debt Financing Constraints • Constraints on borrower • ACFA constraints • Borrower is the City • Constraints based on type of investment • Only certain projects/costs qualify • Not for design, equipment • Constraints created by cash needs • Interest • Debt principal repayments

  50. Debt Constraints • ACFA constraints on City • Debt principal < 2 times revenue • Debt service (interest + principal payment)< 35% of revenue • Utility can exceed because City borrowing is low • Difference between debt life and asset life • Some assets depreciated over 44-75 years • Associated debt has maximum 25 year term • Debt being paid off faster than recovery of cost • Can create cash flow problem

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