Revenue Requirement

What are the components of a reasonable revenue requirement for a municipally-owned water utility?

Under Wisconsin law, it is well established that a municipality, in owning and operating a water public utility, is not performing a governmental function, but rather the municipality is conducting a public service in its proprietary capacity. The entire concept of regulation of municipal water utilities as expressed by statutory requirements places municipal utilities in the position of business enterprises. As such, business concepts with respect to operating expenses, depreciation, taxes, and return on investment are followed in the determination of revenue requirement and rates for water utility service. The utility is provided with an opportunity to earn revenues sufficient to support its operation over the long term by basing the components of the revenue requirement on a forward looking test year, typically the first calendar year for which the rates are expected to be in effect.

The major components of the forecast revenue requirement are:

• Operation and maintenance expenses,

• Depreciation as a recovery of capital investment,

• Taxes; and,

• Return on average net investment rate base.

How are operation and maintenance expense projections developed?

When judging what constitutes a reasonable expense for ratemaking purposes, DWURA staff examines the operating expenses for the most recent accounting period, compare them with the experience of several years, and consider changes in operations that might require an adjustment for the test year period. An example of such an adjustment is the normalization over a seven to twelve year period of the cost of preparing and painting an elevated water tank.

How does the Commission treat depreciation expenses?

The cost of depreciation is recognized by the Commission as a cost of the utility doing business. Depreciation is the expense associated with the value utility property loses over time until eventually it is no longer serviceable. Depreciation assigns a portion of a property unit’s net cost to each year of its life, so over the life of the property unit, its full net cost will have been recovered. Depreciation rates express, for each utility plant account, the percent of value lost through wear and tear in an average year during the life of the property unit. To develop depreciation rates based on costs, it is necessary to estimate the service life of utility property, its salvage value, and the cost of removal. Commission staff has specified a benchmark range of depreciation rates for each plant account. Utilities can choose depreciation rates from within the benchmark ranges, provided the total annual depreciation expense is between 2.0% and 2.5% of the total value of utility plant.

 Benchmark Depreciation Spreadsheet

What taxes are included in the revenue requirement?

Taxes consist primarily of the “tax equivalent," sometimes referred to as a “Payment in Lieu of Taxes” (PILOT), FICA, and the PSC Remainder Assessment. PILOT, typically the largest component of this category, is an expense that must be recorded, per Wis. Admin. Code ch. 109. PILOT is calculated by applying the gross book value of water utility plant (excluding plant outside the municipal limits) times the assessment ratio times the net local and school tax rate. The other above-mentioned tax items are recorded along with the PILOT in Account 408, Taxes. To learn more about PILOT, see Commission staff's 2013 report on the topic.

PILOT Report

What is return on rate base, and how is it calculated?

Return on Net Investment Rate Base (NIRB) is defined as gross utility financed plant less accumulated depreciation, less the regulatory liability for pre-2003 depreciation on contributed plant, plus utility materials and supplies. The Rate of Return on rate base (ROR) expresses the utility’s return on investment as a percentage of the NIRB. Determination of rate base and rate of return are two of the most important and challenging aspects of establishing an appropriate revenue requirement. A fair ROR should result in a net operating income that provides for the utility’s cost of debt and also provides a fair return on equity capital. In making this determination for an investor-owned utility, consideration is normally given to several factors, including: ability to attract capital; economic risk; quality of service provided; and cost of capital. The PSC applies similar criteria, adjusted for tax differences, in establishing the level of return for municipally-owned utilities.

For introductory purposes, it is sufficient to recognize that the return component for a municipal utility should provide for debt interest coverage and a reasonable return on equity capital. The utility should attempt to maintain a balanced capital structure which will allow it to attract the new capital needed for plant replacement and expansion. The optimum capital structure is generally considered to be 50 percent equity and 50 percent debt. The long-term financial and operational integrity of the utility is dependent on establishing and maintaining a balanced capital structure and earning a reasonable return on the municipality’s investment in the utility.