Funding Utility Infrastructure
June 14, 2017
Category: Guest Author , Public Works Finance , Utilities
The facilities that make up your utility infrastructure won’t last forever. Once you’ve funded and constructed a project, the clock is ticking on its eventual replacement. Every year is one year closer to funding replacement for every part of the system. While a year-to-year, pay-as-you-go funding philosophy was, at one time, a manageable approach for some utilities, the rising cost of infrastructure and reduced, low-cost funding options have required utilities to look at more long-term options.
The old adage applies that if you fail to plan, you plan to fail–or more specifically–you will likely experience rate increase spikes and an increasing debt load. In order to avoid significant funding challenges or impacts to ratepayers, there is a push in the industry for utilities to begin more actively engaging in asset management.
Asset Management Options
Asset management involves a range of activities including the development of asset inventory records, a condition assessments of existing facilities, and an analysis to target the lowest risk versus cost balance of servicing and repairing assets to extend useful life and determine optimal replacement timing. Regardless of the outcome, the result is an ongoing cost that requires a funding source.
While asset management is optimal, utility management doesn’t need to wait until an asset management plan is in place to begin asset management funding. In the absence of such a plan, the following policy options target varying levels of funding system repair and replacements (R&R).
Booked Asset Schedule
The most readily available information to measure the accumulating replacement liability is the booked asset schedule. For example, when a utility installs a pipe, the cost and expected useful life are recorded. If the pipe cost is $50,000 and the useful life is 50 years, annual depreciation is $1,000.
Depreciation measures one year of asset value loss as it moves toward zero value at replacement. Accumulated depreciation shows the depreciation that has accumulated since the asset was placed in service. Cash-based utilities are encouraged to develop and maintain asset inventory records for managing both the physical infrastructure and the funding policy.
One way to begin funding future R&R is to reserve from rates each year, an amount equal to annual depreciation. Reserve funding is often referred to as rate-funded system reinvestment.
If a system reinvestment policy is in place from year one of operation, the utility will accumulate the original cost of the asset by the time the replacement is required, along with any interest earnings reserved over that time. The limit of a depreciation-based funding policy is that, even fully funded, the reserve will not accumulate the replacement cost of the asset.
The $50,000 pipe will be replaced for a projected $220,000 at the end of the 50 years (assuming 3% annual construction cost inflation), leaving a $170,000 funding deficiency. Assuming 2% annual interest earnings on the reserve, the deficiency reduces to an estimated $135,000.
Even this suggested minimum level of funding can have significant rate impacts if a utility has no reserve policy in place. Often a phase-in strategy is a useful tool to set in place a plan for policy achievement. A phase-in strategy can smooth rate impacts by building up the target funding level over 3 to even 10 years, depending on the policy goals of the Board or Council.
Replacement Cost Funding Policy
While the depreciation basis is introduced as a minimum for consideration, on the other end of the spectrum is a replacement cost-based funding policy. If the policy goals of a utility include borrowing only for expansion or improvement projects and cash-funding repair and replacements, a replacement cost funding policy should be in place.
In this case, the current year replacement value is estimated using the Engineering News Record and the Construction Cost Index historical annual inflation from the year placed in service to the current year. The current replacement value is then projected forward to the end of the useful life using an average of the historical inflation values. The annual funding policy is set so that the targeted reserve balance is available in time to fund asset replacement. Often this includes an assumption for interest earnings on the reserve balance contributing to the target.
The following graphic illustrates the policy spectrum for the $50,000 pipe and resulting replacement funding level.
In conclusion, having an asset management plan is ideal, but when reserving for infrastructure replacement, something is surely better than nothing. Replacement liability denial can set a utility up for significant financial impacts from accumulating deferrals. A reinvestment funding policy should consider the utility’s funding goals and philosophy, sensitivity to rate impacts, and a strategy for implementation.
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