Wisconsin law establishes that, in owning and operating a water public utility, a municipality is not performing a governmental function, but rather a public service in its proprietary capacity. The regulation of municipal water utilities as expressed by statutory requirements places municipal utilities in the position of a business enterprise.
Accordingly, the PSC uses standard business concepts when determining the revenue required for a water utility to provide safe, reliable, affordable, and environmentally responsible service over the long term. Within the context of a rate case, this necessary revenue is referred to as the revenue requirement. A revenue requirement is the amount of money that a public utility must receive from its customers on an annual basis to cover its operating costs, applicable taxes (including PILOT), debt payments, and earn a reasonable return (profit). The Commission bases the revenue requirement on a forward looking test year, typically the first calendar year for which the rates are expected to be in effect.
For more information about accounting, see Accounting
The major components of the forecasted 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?
To determine what constitutes a reasonable expense for ratemaking purposes, the PSC examines the operating expenses for the most recent accounting period, compares them with the experience of several years, and considers changes in operations that might require an adjustment for the test year period. An example of such an adjustment is the normalization over a ten to twenty year period of the cost of repairing and painting an elevated water tank.
How does the Commission treat depreciation expenses?
The Commission recognizes the cost of depreciation as a utility's cost of doing business.
Depreciation is the expense associated with the value that 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. Over the life of the property unit, the utility will recover its full net cost. 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 specifies a benchmark range of depreciation rates for each plant account. Utilities can choose depreciation rates from within the benchmark ranges. If a Utility wants to use a depreciation rate outside of the benchmark range, it needs Commission approval. Benchmark Depreciation Spreadsheet
What taxes are included in the revenue requirement?
Taxes consist primarily of the “tax equivalent" (also referred to as a “Payment in Lieu of Taxes" or PILOT), FICA, and the PSC Remainder Assessment. PILOT, typically the largest component of this category, is an expense that must be paid to the municipality and recorded per Wis. Stat. 66.0811(2). Per Wis. Admin. Code ch. 109, the 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. Under the statute, the governing body of a municipality is allowed to authorize a lower PILOT expense than calculated under PSC 109. 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. Each year, the Commission establishes a benchmark ROR for municipal utilities. For most water utilities that file a conventional rate case, the benchmark ROR is usually recommended by Commission staff and approved by the Commission.
For introductory purposes, it is sufficient to recognize that the return component for a municipal utility should provide for interest coverage on debt 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.
Why is the benchmark rate of return so important?
Often, utilities consider a ROR lower than the benchmark as a way to minimize rate increases. A lower ROR does have the effect of lowering rates, but only in the short term. The utility will experience decreased cash flow that can stunt future capital investment in the long term.