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Setting Water and Wastewater Rates: Defining a Revenue Target  

Written by: Hope Thomson, Senior Project Director at the UNC-Chapel Hill School of Government EFC

As public enterprises, water and wastewater utilities are responsible for bringing in revenues to cover the costs of delivering services. This includes the cost of day-to-day operations and maintenance, as well as long-term investments in physical infrastructure. Different fee types help cover these costs, but most utility revenues will be from service charges, the rates that customers pay to the utility each billing cycle. 

Through technical assistance and teaching efforts, the School of Government Environmental Finance Center has many conversations with utilities about rate options, how they can be structured, and how to calculate what revenues will be produced. Before getting into those details, the first step is to determine what rates need to accomplish financially and operationally. It may be an overused axiom, but in the case of utility rate setting, failing to plan is truly planning to fail.  

Defining a Revenue Target 

A “revenue target” is the amount of revenue that will help the utility reach its goals for service provision. This target will cover known costs, like budgeted expenses, but also expenses not currently included in the budget. If you need to replace a section of water main, for example, but have not planned on how to cover those costs with rate revenues, you could be setting a rate that won’t help you accomplish what needs to be done. Likewise, if you know that you will need to increase pay, hire new positions, or implement a new training program, but have not accounted for these workforce-related items in the most recent budget, rates related to that budget will not support those plans. Setting rates that cover only the past year’s budgeted expenses without considering what that budget may exclude will not help a utility accomplish its goals. 

The phrase “full cost recovery” refers to setting rates that cover all utility expenses needed today and into the future, with minimal to no reliance on grants. Funders and lenders sometimes seek confirmation of rates achieving full-cost recovery as evidence that your utility is financially responsible. Determining your revenue target before you look at rate options will help ensure that you are funding your utility goals and working towards full-cost recovery.  

There are several components to consider when calculating your revenue target. These can be organized into the three main categories below, but you may organize or present them differently depending on your utility.  

Operations and Maintenance Expenses 

Operations and maintenance expenses are the costs to run your utility day-to-day – salaries and benefits, electricity, chemicals, equipment, testing, and more. It can be helpful to think about how your utility has changed over time. Applying an overall inflation percentage is the simplest approach, since costs generally continue to rise over time.  

You can take a more precise approach as well. You can categorize these expenses, calculate trends over time and then apply a line-item inflation percentage relevant to your specific utility costs to predict how costs may rise in the future. Consider which changes may not be reflected by this retrospective analysis. Are there major infrastructure investments that will impact your operations? Will electricity bills change with new treatment infrastructure? If you have implemented new software, how might that affect the time or money spent on billing and collections? Are you hiring or training new staff? Accounting for these changes financially, even with an estimate, will result in a more robust revenue target. 

Thinking carefully about which expenses are even less within your control is critical. If you purchase wholesale water or wastewater services, you may not be able to negotiate lower rates. Other contracts, such as contract operators or testing services, may also be restrictive. In these cases, a conservative approach is protective – expect costs to rise rather than hoping they will fall.  

Long-term Planning and Capital Investments 

The physical system that provides your utility service requires regular investment. One of the most essential tools for planning these investments is a 5- or 10-year capital improvement plan (CIP), which lays out the major necessary infrastructure projects, how much they are expected to cost, and how they will be funded. This last item is especially important for your revenue target calculations – unless you have funding secured for a project, the protective approach is to assume the project will be funded via service charge revenues, whether in a lump sum or a debt service payment. These expenses should be built into your forward-looking revenue targets. 

Additionally, consider your asset management plan and how you anticipate maintaining, rehabilitating, and replacing infrastructure. These activities may involve smaller dollar figures not always captured in a CIP. If they are not sufficiently accounted for in your annual budgets, they are not being captured in the revenue target. Incorporating these activities into the revenue target (and into either the budget or the CIP) ensures they are part of the long-term financial plan. 

Finally, if you have professional services for strategic planning, engineering, or other costs associated with capital improvements, these should also be incorporated into your revenue target. 

Reserve Contributions 

Most utilities understand things rarely go to plan. Having a financial cushion to deal with emergencies big and small is not just helpful; in some cases, it is required. For example, the Local Government Commission in North Carolina closely monitors the cash on hand utilities maintain and may issue formal warnings if financial audits show available cash on hand as less than 60 days’ worth. Other lenders and debtors may also have cash-on-hand requirements as this cushion provides reassurance that debt payments will be made reliably, even with revenue fluctuations or unexpected expenses.  

Internally, your utility may have a reserve fund target to help with unexpected expenses or support known larger expenditures, such as capital improvements. Your reserve fund target will be informed by your risk tolerance, your CIP, and other known plans for your utility. Your utility should factor in how quickly you want to reach your savings goal, so rates generate the revenues needed on the expected schedule. 

Establishing your revenue target is essential preparation before engaging in the nuances of rate setting. You may prepare several revenue targets, each reflecting a different level of utility goals or investment. Know the trade-offs among these various targets, and make sure they are clearly communicated to your team as you work through which rates will help achieve them. 

This blog is part of a series related to rate-setting practices and principles. Stay tuned for forthcoming blogs that will discuss this topic more in-depth. 

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