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Water Rates

AWWA MANUAL M1

Fourth Edition

FOUNDED 1881

American Water Works Association

Copyright (C) 1999 American Water Works Association All Rights Reserved

Copyright 1954, 1972, 1983, 1991 American Water Works Association 6666 West Quincy Ave. Denver, CO 80235 Printed in USA ISBN 0-89867-574-X
Printed on recycled paper.

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Copyright (C) 1999 American Water Works Association All Rights Reserved

Contents
Foreword, iv Acknowledgments, vi Introduction, vii Chapter 1 Revenue Requirements . . . . . . . . . . . . . . . . . 1

Cash-Needs Approach, 1 Utility Approach, 3 Revenue-Requirement Projections, 4 Chapter 2 Allocation of Costs of Service to Cost Components . . . . . BaseExtra Capacity Method, 11 CommodityDemand Method, 16 Special Considerations, 19 Chapter 3 Distribution of Costs to Customer Classes . . . . . . . . . Customer Classes, 20 Units of Service, 23 Unit Costs, 26 Distribution of Costs to Customer Classes, 28 Chapter 4 Development and Design of Rate Schedules . . . . . . . . Basic Cost-of-Service Rate Philosophy, 32 Rate-Design Example, 38 Other Rate-Design Considerations, 46 Chapter 5 Rate Design for Small Water Utilities . . . . . . . . . . . Information and Data Requirements, 54 Revenue Requirements, 54 Rate Design, 59 Appendix A Bill Tabulation Methodology . . . . . . . . . . . . . . Introduction, 63 Bill Tabulation, 64 Glossary, 73 Index, 79 63 53 32 20 9

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Copyright (C) 1999 American Water Works Association All Rights Reserved

Foreword

In 1954, the American Water Works Association (AWWA) prepared and published a report titled Determination of Water Rate Schedules, which later was issued as the first AWWA manual on water rates. The most recent edition of the manual (third ed.) was published in 1983 to update the 1972 edition (second) and to better reflect the current water rate-making philosophy. Dramatic changes in economic conditions that have taken place in the years since the 1972 edition was published have had a continuing and far-reaching influence on water utility operational and financial management during that period. Inflation and resulting cost impacts on water utility customers, as well as increased public awareness of the need for conservation and more effective use of natural resources, together with the need to provide proper price signals, have challenged utility managers to continue providing high-quality service to water utility customers on an equitable and fair cost basis. While the rate of inflation has somewhat declined in magnitude in recent years from the previous decade, pressures to maintain low rates and provide better use of water resources have continued to present challenges to utility management. It is also important to note that none of these forces and pressures have presented any reasons to modify the traditional cost-ofservice principles outlined in this manual as a policy of AWWA. In view of these factors, it is essential that water utility management have a basic understanding of the fundamental cost-of-service principles involved in the evaluation and allocation of water system revenue requirements, the importance of short- and long-term revenue adequacy and stability, and the measuring of revenue requirements and design of water rates to achieve the utilitys objectives while reflecting cost-of-service principles. Current economic conditions and continuing pressures on infrastructures of municipalities and private companies emphasize the obvious fact that a water utility, whether government-owned or investor-owned, must consistently provide adequate income to successfully meet its obligations to the public it serves. The basis for the rates, including rate of return, must reflect anticipated future conditions as well as historical costs. It follows that the financial health of the utility as well as equitability among customers should be primary objectives of the cost allocation and design of rates to meet revenue requirements. Cost-of-service-based rates achieve both of these goals in the most efficient way possible. Development of an adequate revenue requirement to meet both current and expected future cost is essential. Establishment of revenue requirements based solely on current costs without considering elements of expected future expenditures may result in inadequate revenue to meet the utilitys needs. This fourth edition of AWWA Manual M1, Water Rates, contains the traditional and proven rate-making concepts and methodologies endorsed by AWWA in previous editions; discussion of topics relevant to the evaluation and design of equitable rates; and editorial changes, clarifications, and updates to reflect current thinking and to conform to the recent publication of new rate-related manuals, including AWWA Manual M35, Revenue Requirements, and AWWA Manual M26, Water Rates and

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Related Charges. Chapter 1 presents a condensed description of the development of revenue requirements based on M35, Revenue Requirements. Chapters 2 and 3, which present methodologies for allocation of total costs of service to various classes of customers served, present the primary considerations in determining the cost of serving customers. Chapter 4 discusses and illustrates the design of a schedule of water rates to derive the allocated costs of service. In addition, this chapter includes some discussion of alternative rate forms that have been proposed during past decades as a result of inflationary, conservation, and social concerns. Chapter 5 addresses the simplified development of water rates for small utilities. An appendix is attached that briefly sets forth a bill tabulation methodology. A glossary of terms is included in this edition of the manual.

Copyright (C) 1999 American Water Works Association All Rights Reserved

Acknowledgments

The AWWA Management Division Board of Trustees gratefully acknowledges the contribution made by members of the Rates and Charges Subcommittee in preparing this edition of the water rates manual. Appreciation is extended to those members of the subcommittee who updated and drafted the manuscript. All members of the committee reviewed the manuscript and made constructive recommendations for revision. Issues involving final changes in organization and content were mutually resolved by an editorial committee. Rates and Charges Subcommittee A.J. Potochney* (Chair), South Central Connecticut Regional Water Authority, New Haven, Conn. T.R. Stack* (Vice Chair), Public Utilities Division, Illinois Commerce Commission, Springfield, Ill. R.F. Banker* (Chair, Editorial Subcommittee), Black & Veatch, Kansas City, Mo. D.M. Clark, Gannett Fleming Valuation & Rate Consultants, Inc., Pittsburgh, Pa. M.D. Day, Dallas Water Utilities, Dallas, Texas F.P. Griffith Jr., Fairfax County Water Authority, Merrifield, Va. C.R. Harrison,* Clackamas Water District, Clackamas, Ore. O.K. Loen, City of Kalamazoo, Kalamazoo, Mich. J.R. McKinley, Black & Veatch, Kansas City, Mo. T.G. McKitrick, American Water Works Service Company, Inc., Voorhees, N.J. F. Moriarty, Jackson, Samson & Associates, Dallas, Texas J.R. Palko, Associated Utility Services, Inc., Moorestown, N.J. V.F. Pennacchio, Guastella Associates, Weymouth, Mass. G.A. Raftelis, Ernst & Young, Charlotte, N.C. J.E. Robinson, University of Waterloo, Waterloo, Ont. G.S. Saleba, Economic & Engineering Services, Bellevue, Wash. R.S. Schierry, Northern Illinois Water Corporation, Champaign, Ill. D.E. Simpson, St. Louis County Water Company, St. Louis, Mo. R.A. Smith,* General Motors Corp., Detroit, Mich. J. Tolan, City of Pasadena, Pasadena, Calif. M.O. Vann, Water Works and Sewer Board, Birmingham, Ala. C.P.N. Woodcock, Camp Dresser & McKee, Inc., Boston, Mass. AWWA Management Division Liaison Representative G.W. Johnstone, American Water Works Service Company, Inc., Voorhees, N.J.

*Member, Editorial Subcommittee

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Copyright (C) 1999 American Water Works Association All Rights Reserved

Introduction

The American Water Works Association (AWWA) statement of policy regarding Financing and Rates, adopted by the AWWA Board of Directors on Jan. 25, 1965, revised on Jan. 31, 1982, and reaffirmed on Jan. 25, 1987, states in part: The AWWA believes the public can be served best by self-sustained enterprises adequately financed with rates based on sound engineering and economic principles. This manual outlines the basic elements involved in the determination and allocation of the costs of service to the various classes of customers, as well as the development of rates to equitably recover the costs of service from each class of customer. The identification of the value of the rate base, whether it be the net book value or an established fair market value, must reflect the utilitys need to maintain and meet future customer needs. The concepts and procedures described in this manual are based on principles that are generally accepted and widely followed throughout the industry. This manual describes in detail two methods for preparing cost-allocation studies and presents a variety of generally accepted forms for rate structures. The acceptability of variations in allocation methods or rate designs that are cost-based and nondiscriminatory is recognized. A methodology that properly allocates costs to various classes of customers and then recovers these costs through a rate structure to maintain a self-sustaining enterprise and that is not unduly discriminatory to any class of customer is the objective of AWWA. Generally, the development of water rates involves the following procedures: 1. Determination of the total annual revenue requirements for the period for which the rates are to be effective. 2. Allocation of the total annual revenue requirements to the basic functional cost components. 3. Distribution of the component costs to the various customer classes in accordance with their requirements for service. 4. Design of water rates that will recover from each class of customer, within practical limits, the cost to serve that class of customer. A simplified diagram of these procedures is presented in Figure I-1 to which reference can be made as the manual is read and used. Scope. The subject matter is presented in five chapters, which are briefly summarized in the following paragraphs. Chapter 1, Revenue Requirements. The amount of revenue required may be determined by either the cash-needs approach or the utility approach. The applicability of each approach is discussed, and illustrative applications are presented. The reference to rate-base value is intended to recognize that either net book value or an established fair market value may be used in determining the revenue requirements. The value must reflect the financial needs of the utility. The reader of this manual is referred to AWWA Manual M35, Revenue Requirements, for a more comprehensive discussion of revenue requirements. Chapter 2, Allocation of Costs of Service to Cost Components. The allocation of annual revenue requirements, or costs of service, to functional cost components is

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Copyright (C) 1999 American Water Works Association All Rights Reserved

presented using both the baseextra capacity and commoditydemand methods. The application of the general theory involved in making each type of allocation is presented with illustrative examples. Chapter 3, Distribution of Costs to Customer Classes. The distribution to customer classes of component costs is shown for both the baseextra capacity and commoditydemand methods, and a discussion of the theory and means of distributing costs is presented. Illustrative examples are offered for both cost-distribution methods. Chapter 4, Development and Design of Rate Schedules. This chapter discusses the design of water rates that will recover the allocated costs of serving each customer class. It should be recognized that rates may be adjusted to recognize past practices, local policy, and other special circumstances. Chapter 5, Rate Design for Small Water Utilities. Simplified procedures for developing rates for small water utilities are presented to assist the smaller water utilities in preparing rate schedules without the need for relatively complex engineering and economic analysis. Purpose. Rate design for a water utility is a process of matching the costs of service to be recovered to the unique economic, political, and social environments in which the utility provides service. The AWWA Rates and Charges Subcommittee does not endorse any substantial departure from cost-of-service-based rates to achieve social objectives. When special situations require that factors other than the cost of providing service be considered in the final determination of water rates, steps should be taken to minimize any discriminatory effect. It should be recognized that the results of a cost-of-service study are highly dependent on the accuracy and reliability of the record-keeping systems that furnish the basic information for the study. Record-keeping practices are, therefore, critical to the credibility of the rate study. Those persons responsible for conducting rate studies must continually communicate their information requirements to engineering, operating, and accounting staffs to ensure that the necessary information is available on a timely basis. This manual is not intended, nor should it be considered, as a complete text of specific rate making. The complexities of any system require consideration of many factors not included in this simplified presentation. Specific rate making for any particular water utility, based on sound engineering and economic principles, may require the services of consultants experienced in rate matters. This manual provides a basic outline of the rate-making process and serves as a resource that the policymaker or manager may draw on to guide the analysis of the validity of rates and the basis on which they are founded. For small water systems, this manual may suffice with minimum supplemental expertise. Larger utilities with complex system configurations will require more detailed analysis than illustrated in this manual. If the utility does not have necessary in-house expertise to cope with the added complexities, outside independent experts should be called in to ensure that the rates developed are truly cost-based. Even where in-house expertise is available, an independent review may provide insights not perceived by personnel with limited exposure related to a single system. An outside independent study also provides the advantage of different judgments and additional credibility where public support of the resulting level and structure of rates is important. For investor-owned utilities, local regulatory agencies frequently require such independent review, whereas for government-owned systems, many bond agreements require such outside examination and certification.

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Copyright (C) 1999 American Water Works Association All Rights Reserved

AWWA MANUAL

M1

Chapter

1 Revenue Requirements
In providing adequate water service to its customers, every water utility must receive sufficient total revenue to ensure proper operation and maintenance (O&M), development and perpetuation of the system, and maintenance of the utilitys financial integrity. The first step in utility rate making is to determine the total annual operating revenue requirements for the period in which the rates are to be effective. The revenue requirements are the costs of service to be derived from rates. AWWA Manual M35, Revenue Requirements, presents an extensive discussion of considerations and illustrative tables regarding revenue requirements and their projections as they relate to water utilities. The reader is referred to that manual, which was published in 1990, for a more complete discussion of revenue requirements; the discussion of revenue requirements in this chapter parallels, in condensed form, elements of M35. Numerical examples in this manual are derived from the examples developed in M35 to provide continuity from one manual to the other. The two generally accepted and practiced approaches to projecting total revenue requirements of a water utility are the cash-needs approach and the utility approach. Each has a proper place in utility practice and each, when properly used, can provide for sound utility financing.

CASH-NEEDS APPROACH __________________________________


The essence of the cash-needs approach is that the revenues of the utility must be sufficient to cover all cash needs, including debt obligations as they come due, for the period over which the rates are intended to be adequate. The cash-needs approach of determining revenue requirements has been generally used by government-owned utilities and is basically an extension of the cash-oriented budgeting and accounting system traditionally used by government entities. Revenue-requirement studies prepared using the cash-needs approach are, therefore, generally more easily understood by the governing bodies than studies using the utility approach. Another factor encouraging the use of the cash-needs approach by government-owned utilities is the use of bond financing, which requires periodic payment toward liquidation of the debt.

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WATER RATES

Basic revenue-requirement components considered under the cash-needs approach generally include O&M expense, debt-service requirements, and capital expenditures not debt-financed. The O&M expense component of revenue requirements is based on actual expenditures derived from accounting records with adjustments to reflect the level of expenditure anticipated to be incurred during the period that rates are to be effective. Pro forma adjustments to historical O&M expenses are determined by incorporating all known and measurable changes into expense levels or by using well-considered estimates of future expenses. Those revenue requirements of the utility that are generally classified as O&M expenses include salaries and wages, employee fringe benefits, purchased power, other purchased services, rent, chemicals, other materials and supplies, smaller items of equipment that do not extend the useful life of major facilities, and general overheads. In a government-owned utility, an additional element of O&M expense might also include payment to a citys general fund for support services rendered, e.g., use of the citys computer facilities, assistance in collecting water bills, rent on office space provided for water utility operations, and the like. Since inclusion of expenses for such services in the total revenue requirements would be proper if the utility were operating independently, it is also appropriate when the services are furnished by an associated government entity. The debt-service components of the revenue requirements in the cash-needs approach consist of principal and interest requirements on bonds outstanding during the period that rates are effective. In addition, there may be obligations to debt-service reserves. The amount of cash required to pay principal and interest on outstanding debt is obtained from established debt-service schedules. In addition to debt principal and interest expense and payments to reserve accounts established by bond covenants, some utilities may also be required to generate sufficient revenues to provide coverage on bonded debt. Coverage requirements typically specify that utility revenues in excess of O&M expense be sufficient, as a minimum, to equal or exceed by a stated percentage annual debt principal and interest payments, in order to provide a measure of security to bond holders. As such, coverage requirements must also be evaluated in determining total annual revenue requirements to prevent the utility from failing to meet its bond covenant agreements. The establishment of the cash requirement for future plant improvements or additions is a decision generally affected by the nature of investment and utility financing policies. Capital expenditures are generally classified into three broad categories: replacement of existing facilities, normal extensions and improvements, and major capital improvements and replacements. It is a generally accepted practice to finance normal replacements and extensions and minor improvements from current revenue, but some utilities also use current revenue to finance a portion of major capital improvements and replacements. To the extent that capital expenditures are financed from current revenues, they constitute another component of revenue requirements under the cash-needs approach. However, most major capital projects are financed from serially funded debt because the repayment of the debt over a number of years distributes the capital costs, to some extent, over the useful life of the facility. This debt-financing approach results in a better matching of the customers charges from year to year with the use of the facilities (i.e., existing customers will not be paying 100 percent of the initial cost of facilities to be used by future customers). Other cash revenue requirements that may be required to be financed from water system revenues might include payment to the general fund for items such as

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REVENUE REQUIREMENTS

payment in lieu of taxes, gross-receipts taxes, or a dividend payment. Such additional requirements depend on each local situation and should be considered where applicable.

UTILITY APPROACH ________________________________________


The utility approach to determining revenue requirements is mandated for all investor-owned water utilities and for most government-owned (municipal) systems under the jurisdiction of state commissions or other regulatory bodies. It is also an appropriate method for determining the costs of service applicable to customers served outside of the corporate limits by a government-owned water utility. It is often used in the allocation of costs among customer classes within the corporate limits. When a government-owned utility provides service to customers outside the corporate limits, whether at retail or wholesale, the situation is similar to the relationship of an investor-owned utility to its customers since the owner (municipality) provides service to non-owner customers (customers outside corporate limits). In this situation, the government-owned utility, like an investor-owned utility, is entitled to a reasonable return from non-owner customers based on the value of its plant required to serve those customers. The use of the utility approach can reduce controversy since it generally results in more stable rates, which are not so immediately affected by the level of system capital expenditures as are rates developed under the cash-needs approach. For a government-owned utility, the total level of annual revenue required is the same under either the cash-needs or the utility approach. The O&M expense component of total revenue requirements is usually identical under both approaches. The annual cash requirement for capital-related costs under the utility approach of revenue-requirement determination consists of two components: depreciation expense and return on rate base. Depreciation is a real part of the cost of operating a utility, whether governmentor investor-owned. Depreciation is the loss in value of facilities, not restored by current maintenance, that occurs due to wear and tear, decay, inadequacy, and obsolescence. The annual depreciation expense component of revenue requirements provides for the recovery of the utilitys capital investment over the anticipated useful life of the depreciable assets. It is, therefore, proper that this expense be borne by the customers benefiting from the use of these assets. The proper level of depreciation expense to be included in the total revenue requirement should be based on the cost of the depreciable plant in service during the period for which rates are being established. The funds resulting from the inclusion of depreciation expense in the annual revenue requirements are the property of the utility and are available for use as a source of capital for replacement, improvement, or expansion of its system or for repayment of debt. The return component is intended to pay the annual interest cost of debt capital and provide a fair rate of return for the total equity capital employed to finance physical facilities used to provide water service. The annual cost of outstanding debt can be determined from the accounting records of the utility. The cost of equity capital is more difficult to determine. The return to the equity owner should be commensurate with the return from other enterprises having corresponding risks. The return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise so as to maintain its credit and to attract and hold capital. The utility approach of determining revenue requirements requires the establishment of a rate base, defined to be the value of the assets on which the utility is entitled to earn a return, and the fixing of a fair rate of return on the rate base. The

Copyright (C) 1999 American Water Works Association All Rights Reserved

WATER RATES

rate base is primarily composed of the value of the utilitys plant and property useful in serving the public. In addition, it is proper to include an allowance in the rate base for materials and supplies, working capital, and construction work in progress. On the other hand, contributions in aid of construction and customer advances for construction are generally deducted from utility plant in service for rate-base determination. The total annual revenue requirements of an investor-owned utility include O&M expenses, depreciation expense, income taxes, other taxes, and a return on rate base. Operation-and-maintenance expense, depreciation expense, and return on rate base for an investor-owned utility involve the same considerations discussed above for a government-owned utility using the utility approach. Federal and state income taxes must be paid by an investor-owned water utility and are, therefore, properly included in the determination of total revenue requirements. Other taxes, such as general property taxes and gross receipts taxes, must also be included. Each state commission and regulatory body has its own rules, regulations, and policies for determining total revenue requirements. In preparing for any rate matter within a specific jurisdiction, it is essential that the procedures and policies of the regulatory body be determined and that the utility be guided by them in the determination of its revenue requirements.

REVENUE-REQUIREMENT PROJECTIONS_______________________
Among the more significant financial problems confronting government-owned and investor-owned utilities in recent years has been the impact of inflation. Rapidly escalating costs have affected every component of revenue requirements, whether determined using the cash-needs approach or the utility approach. One of the most effective methods used to cope with the problem of rapidly increasing costs is the use of a forward-looking, or prospective, rate period, whereby rates are established to meet projected revenue requirements for a specified future period. This procedure has been used frequently by government-owned utilities, and it is gaining increasing acceptance by state commissions regulating investor-owned utilities. The prospective procedure develops the revenue requirement for costs, both capital and operating, that are anticipated for the period the rates will be in effect. It is essential to first develop adequate historical data to serve as a basis for projecting future requirements. Historical data also provide the basis for the bridge between the actual costs of the past and the projected costs of the future. Although the use of a prospective basis for determining revenue requirements for rate making may be desirable from the utilitys viewpoint, it has not always been accepted in certain jurisdictions subject to regulatory review. In the past, it has been the general practice of regulatory commissions to establish rates based on an actual historical test year, with certain adjustments to historical costs being allowed for known and measurable changes. Typically, such adjustments might include increases in salary and wage expenses resulting from a negotiated labor agreement, known increases in costs for purchased water and electric power, fringe benefit adjustments, and the like. Frequent rate adjustments are likely to be needed when a historical year is used as the basis for establishing revenue requirements, particularly in periods of rapid inflation, because future cost levels will most certainly exceed those incurred in the past. For purposes of illustrating the various principles and techniques of rate making discussed in this and the following chapters, an elementary example for a

Copyright (C) 1999 American Water Works Association All Rights Reserved

REVENUE REQUIREMENTS

Table 1-1 Projected Revenue RequirementsGovernment-Owned Utility


Projected Years Line No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Expenditure Component 1 $86,000 243,000 185,000 116,000 151,000 125,000 25,000 149,000 12,000 70,000 235,000 43,000 186,000 171,000 130,000 256,000 __________ 2,183,000 710,000 30,000 375,000 __________ 1,115,000 (75,000) __________ 1,040,000 $3,223,000 2 $90,000 259,000 193,000 121,000 157,000 130,000 26,000 155,000 13,000 72,000 247,000 44,000 194,000 177,000 135,000 266,000 __________ 2,279,000 860,000 60,000 380,000 __________ 1,300,000 (79,000) __________ 1,221,000 $3,500,000 3 $93,000 375,000 200,000 202,000 283,000 135,000 27,000 161,000 13,000 75,000 259,000 45,000 201,000 224,000 141,000 276,000 __________ 2,710,000 860,000 60,000 385,000 __________ 1,305,000 (83,000) __________ 1,222,000 $3,932,000 4 $97,000 399,000 208,000 211,000 294,000 140,000 28,000 167,000 14,000 78,000 272,000 46,000 209,000 233,000 146,000 288,000 __________ 2,830,000 860,000 60,000 390,000 __________ 1,310,000 (87,000) __________ 1,223,000 $4,053,000 5 $101,000 425,000 217,000 221,000 306,000 146,000 29,000 174,000 15,000 82,000 286,000 47,000 218,000 242,000 152,000 299,000 __________ 2,960,000 860,000 60,000 395,000 __________ 1,315,000 (91,000) __________ 1,224,000 $4,184,000

O&M Expense: Source of supply Pumping: Purchased power Other Water Treatment: Chemicals Other Transmission and Distribution: Mains Storage Meters and services Hydrants Other Customer Accounting: Meter reading and collection Uncollectible accounts Administrative and General: Salaries Employee benefits Insurance Other

17 Total O&M expense 18 19 20 Capital Requirements: Debt service Debt-service reserve Capital improvements

21 Total capital requirements 22 Less: other revenue 23 Net capital requirements 24 Total revenue requirements from rates

hypothetical utility has been developed. The example is oriented toward governmentowned utilities; however, the concepts and tables presented throughout the manual are equally applicable to investor-owned utilities, with the exception of the development of revenue requirements shown in Table 1-1. The revenue requirements for the utility in the example, as shown in Table 1-1, are derived from AWWA Manual M35.* They reflect prospective projection of the cash revenue requirements of the utility for a future five-year period and include O&M expense, debt-service requirements, debt-service reserve requirements, and capital improvements not debt-financed.

*Table 6-1, Flow of Funds, pg. 42.

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WATER RATES

The example in M35 illustrates that revenues under existing rates are adequate to meet cash requirements in Year 1 but that revenues under existing rates are insufficient in subsequent years. Such an illustration reflects prudent planning in that Year 1 could well be the current year, for which projections show that revenues will be adequate to meet revenue requirements but that projections for next year, Year 2, show a need for additional revenues. In allocation of costs to customer classes and design of rates, a period for which the initial rate change is to be adequate is usually considered to be the test year. For this example, it is assumed that rates are to be designed for a one-year period, Year 2, with subsequent rate changes possibly necessary to meet the requirements in Years 3, 4, and 5. The projections of O&M expense shown on lines 117 in Table 1-1 are separated into various expenditure components. The accounting system format maintained by utilities varies considerably; however, the categories of O&M expense shown in Table 1-1 are considered to be representative of the type of accounting detail available in most utilities. Projection of expense in the detail shown in Table 1-1 is important for two reasons. First, it provides for small elements of expense to be more accurately analyzed and projected. Second, the total requirement for O&M expense is separated into cost elements that are readily assignable to appropriate functional cost components in the cost-of-service allocation phase of the rate study analysis. The debt-service requirements on outstanding debt during the rate period, shown in Table 1-1, total $860,000 in the test year. This total consists of $560,000 on existing revenue bond debt and $300,000 on proposed new debt, the latter being a $3,000,000 issue with approximately equal annual principal and interest payments over 20 years at an average annual interest rate of nearly 8 percent. In the example, necessary contributions to debt-service reserve are estimated to be $60,000 per year as shown on line 19. Another item of revenue requirements included in the example is the expenditure for capital improvements consisting of replacements, extensions, and improvements not debt-financed. Because such expenditures are generally of a recurring nature, it is proper that they be financed directly from annual revenues rather than through debt-financing. The appropriate level of normal annual improvements certainly varies with the size and average age of a particular utility. Prior to years of relatively high inflation, a general rule of thumb for projecting an adequate allowance for such costs is that they should amount to between 1 and 2 percent of total depreciable gross plant investment. However, if marked cost increases are experienced, an allowance in excess of 2 percent may be justified, and the level of expenditures established based on careful examination of historical trends and anticipated future conditions. An estimate of $380,000 for normal annual capital improvements is used for the utility in the example and is shown on line 20 of Table 1-1. While most revenue requirements usually need to be met from rates applicable to water service, some other revenue is derived from miscellaneous income items such as rentals and interest on invested capital. In the example, the estimates of such other revenue is shown on line 22, and for the test year, Year 2, is $79,000. It is reflected as a deduction from total capital requirements in deriving the total revenue requirements of the utility. The total test-year cash requirement for the government-owned utility in the example amounts to $3,500,000, as shown on line 24 in the second column in Table 1-1. This represents the total annual cost of service to be derived from rates

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REVENUE REQUIREMENTS

anticipated to be incurred by the utility in the test year for providing service during the period for which rates are being designed. If provisions for coverage on bonded debt are applicable to determining revenue requirements, a comparison needs to be made between these provisions and planned capital expenditures to be financed from current revenues. Only the greater of the two amounts should be included in the determination of total revenue requirements. Generally, revenue-bond covenants prescribe a minimum coverage level with the frequent provision that revenue amounts in excess of that required for operating expenses and debt service can be spent only for capital improvements or early debt retirement. The projected revenue requirements shown in Table 1-1 reflect the cash-needs determination of revenue requirements referred to at the beginning of this chapter. In Table 1-2, this same level of total annual revenue requirements is shown for a government-owned utility on both the cash-needs and the utility approach, indicating the relationship of the two methodologies. Table 1-2 also shows the revenue requirements for a similar investor-owned utility. As shown in Table 1-2, the O&M expense component of the total test-year revenue requirement is the same for the investor-owned utility as for the government-owned utility using either the cash-needs or the utility approach. Using the utility approach, the annual depreciation expense component of total revenue requirements, shown on line 5 in Table 1-2, is $414,000. This is determined by applying a proper schedule of depreciation rates to the total depreciable plant investment in service. In the example, the composite depreciation rate is about 1.89 percent of the total depreciable plant investment of $21,904,000. Under the utility approach, the annual depreciation expense allowance is the same for either an investor-owned or a government-owned utility. For a government-owned utility to meet the total cash-revenue requirements under the utility approach, the level of return to be derived from rates in the example is required to be $807,000 ($886,000 $79,000), as shown on lines 8 and 9 of Table 1-2. Assuming a rate base of $16,186,000, the overall rate of return for the hypothetical government-owned utility is about 4.99 percent. In any particular

Table 1-2 Summary of Test-Year Revenue Requirements


Investor-Owned Utility Utility Approach $2,279,000

Government-Owned Utility Line No. 1 2 3 4 5 6 7 8 9 O&M expense Debt service Debt-service reserve Capital improvements Depreciation expense Taxes other than income tax Income taxes Return (operating income) Other revenue Cash-Needs Approach $2,279,000 860,000 60,000 380,000 Utility Approach $2,279,000

* 414,000

10 Total revenue requirements from rates

(79,000) ___________ $3,500,000

886,000 (79,000) ___________ $3,500,000

* 414,000 360,000 469,000 1,451,000 (31,000) ___________ $4,942,000

*Annual cash requirements for this item are met from depreciation expense and return. Includes interest on debt.

Copyright (C) 1999 American Water Works Association All Rights Reserved

WATER RATES

government-owned utility, the magnitude of existing debt service and policy regarding the amount of revenue financing of capital improvements will influence the required level of return and may result in an indicated need for an overall rate of return markedly different from the example. For the same example utility on an investor-owned basis, income taxes and other taxes must be recognized in the determination of annual revenue requirements. The element of other taxes, shown on line 6 of Table 1-2, amounts to $360,000 and could include business, occupational, gross receipts, and other types of taxes. The income tax element of the investor-owned utilitys cost of service is based on the application of a composite tax-rate allowance for both federal and state income taxes to total taxable income. In this example, taxable income is equivalent to total revenue less O&M expense, depreciation expense, other taxes, and interest expense. Income tax is shown on line 7 to be $469,000. For the investor-owned utility, the rate base is less than that for the government-owned utility by the amount of accumulated deferred income taxes. An overall rate of return of 10.5 percent on the rate base of $13,820,000 was assumed, resulting in a requirement for return (operating income) of $1,451,000. The higher return for the investor-owned utility assumed in the example shown in Table 1-2 results from the weighted cost of debt and equity capital. This return would be expected to be greater than the resulting overall 4.99 percent rate of return shown for the government-owned utility in the example, the latter of which in this example is adequate only to provide for cash needs beyond O&M expense and capital requirements covered by depreciation expense. Where a government-owned utility is serving customers who are outside its jurisdictional boundaries and who are considered to be non-owners, the applicable rates of return may properly reflect a differential between owners and non-owners. For a government-owned utility providing service to non-owners, development of an appropriate rate of return may reflect imbedded interest cost and return on system equity. Once established, the rate of return assigned to system owners would be developed to recognize remaining cash needs. Consideration of differential rates of return is addressed in a subsequent chapter of this manual. From the example shown in Table 1-2, it is apparent that the overall revenue requirement to be obtained from water rates varies with the type of ownership and other requirements of the system. In the example, the overall level of revenue requirements varies from $3,500,000 for the government-owned utility paying no income taxes, financed with tax-free bonds, and in which the customers have made the equity investment for which no return is required, to $4,942,000 for an investor-owned utility paying all taxes, having no tax-free financing available, and having to pay a fair and reasonable return to equity investors who provided a portion of the investment requirements.

Copyright (C) 1999 American Water Works Association All Rights Reserved

AWWA MANUAL

M1

Chapter

2 Allocation of Costs of Service to Cost Components


The total annual cost of providing water service is the annual revenue requirements applicable to the particular utility, as discussed in chapter 1 of this manual and more extensively in AWWA Manual M35, Revenue Requirements. Consistent with the exercise of appropriate conservation considerations in providing service, a water utility is required to supply water in total amounts and at such rates of use as desired by the customer. A utility incurs costs in relationship to the various expenditure requirements caused by meeting those customer needs. Since the needs for total volume of supply and peak rates of use vary among customers, the costs to the utility of providing service also vary among customers or classes of customers. In seeking equitability in charges to the different customers, the basic premise in the establishment of adequate rate schedules is that they should reflect the cost of providing water service. A sound analysis of the adequacy of charges requires allocation of costs among the customers commensurate with their service requirements in order to recognize differences in costs of furnishing service to different types of customers. For example, a customer with a high peak rate of use as compared with an average rate of use requires larger capacity pumps, pipes, and certain other system facilities than a customer who has an equal total volume of use but takes water at a uniform rate. Accordingly, cost-allocation procedures should recognize the particular service requirements of the customers for total volume of water, peak rates of use, and other factors. The total annual revenue requirements discussed in chapter 1 are the total costs of service to be derived from water rates and may be considered in the two broad categories of operation-and-maintenance (O&M) expenses and capital costs. For

Copyright (C) 1999 American Water Works Association All Rights Reserved

10

WATER RATES

government-owned utilities, payments in lieu of taxes may also be a part of revenue requirements. Operation-and-maintenance expenses include both the costs of operating the system and the costs of maintaining system facilities and equipment. Utility records generally show these expenses broken down into costs related to supply, pumping, treatment, transmission and distribution, customer meter reading, billing and collection, and administrative and general. Such cost breakdowns also usually show separation of salaries and wages, materials and supplies (including power and chemicals), and other categories of expense. Such expenses are of a similar nature, whether the utility is government-owned or investor-owned. Capital costs may be expressed as annual costs associated with plant investment. Under the cash-needs approach, these costs would include such investment-related cash requirements as debt service, contributions to debt-service reserve, capital requirements not debt-financed, and, in some cases, payments in lieu of taxes. Under the utility approach, capital costs would include depreciation expense and return on rate base, and income taxes and other taxes if applicable. In allocating costs of service to customer classes, whether for a governmentowned utility or an investor-owned utility, revenue requirements may be apportioned among customer classes on a utility basisthat is, in terms of O&M expense, depreciation expense, return on rate base, and, where appropriate, taxes. For a government-owned utility such as the one illustrated in Table 1-2, the total depreciation expense and return are equal to the total cash requirements, beyond O&M expense and other revenues, to be recovered from rate-related revenues to meet capital-related costs. The purpose of cost allocation is to express the total utility cost of service, including O&M expense, depreciation expense, and return, in terms of costs associated with supplying: (1) both the customers average and peak rates of use or demands; (2) costs related to customer meters, services, and accounts; and (3) direct costs incurred to provide for fire protection. Those costs by functions, in turn, are further distributable to customer classes on the basis of their particular requirements for service. The allocation of water utility costs have, over the years, gone through an evolution in the application of a variety of bases or methods. In most cases, the costs are allocated, or assigned, in two steps: first to appropriate cost components, then to customers. The cost components vary, depending on the basis of allocation used. The two most widely used methods of cost allocation are the baseextra capacity method and the commoditydemand method. In their respective ways, both of these methods of cost allocation recognize the fact that costs of serving customers are dependent not only on the total volume of water used but also on the rate of use, or peaking requirements. In addition, the methods each recognize customer-related costs as a valid cost function. Another method of cost allocation, the functional-cost method, has been used in the past but is little used today because of its limitations relative to the two previously mentioned factors, volume and rate of use. Other methods of cost allocation, involving incremental, marginal, or special-use service, are of limited applicationthat is, they apply only in special situations. Cost allocation under the baseextra capacity and commoditydemand methods includes:

Allocation of costs applicable to the functional cost components of base, extra


capacity, and customer costs in the baseextra capacity method, and to commodity, demand, and customer costs in the commoditydemand method.

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ALLOCATION OF COSTS OF SERVICE

11

Distribution of costs by the various cost components to respective classes of


customers in accordance with the respective responsibility of the customer classes for each of the component costs. The allocations of costs to cost components by the baseextra capacity method and the commoditydemand method are discussed and illustrated in the remainder of this chapter. Distribution of component costs to customer classes is discussed in chapter 3. It is useful to consider the distinctions between variable and fixed cost categories in performing baseextra capacity or commoditydemand cost allocations. Variable costs are those costs that tend to vary directly with the volume of water produced. Examples of variable costs include chemicals used in treatment and the energy portion of the costs of power used in pumping. Water purchased on a charge per unit of volume basis is also considered to be a variable cost. Fixed costs are those capital and operating costs that remain relatively unchanged over a given operating period, such as a year. Examples of fixed costs would include virtually all capital costs such as debt service or depreciation expense and return, as well as costs of O&M for system facilities. Such a categorization provides a useful understanding and insight into the way costs are incurred by the utility. The impact on revenues of significantly changing volumes of production and the potential resultant revenue instability can be more easily recognized with this data available. Moreover, minimum required revenue levels, based on fixed-cost needs, can be evaluated with respect to each customer class. Contractual charges to large customers, which include a fixed-cost component, can be appropriately evaluated. Finally, the evaluation process itself provides a useful consideration of a utilitys revenue requirements, potentially leading to improved record keeping, budgeting, and recognition of the nature of the utilitys costs.

BASEEXTRA CAPACITY METHOD ___________________________


In the baseextra capacity method, costs of service are usually separated into four primary cost components: (1) base costs, (2) extra capacity costs, (3) customer costs, and (4) direct fire-protection costs. In detailed rate studies, some of these elements may be broken down further into two or more subcomponents. Base costs are costs that tend to vary with the total quantity of water used plus those O&M expenses and capital costs associated with service to customers under average load conditions, without the elements of cost incurred to meet water use variations and resulting peaks in demand. Base costs include O&M expenses of supply, treatment, pumping, and distribution facilities, as well as capital costs related to water plant investment associated with serving customers to the extent required for a constant, or average, annual rate of use. Extra capacity costs are costs associated with meeting rate-of-use requirements in excess of average and include O&M expenses and capital costs for system capacity beyond that required for average rate of use. These costs may be subdivided into costs necessary to meet maximum-day extra demand, maximum-hour demand in excess of maximum-day demand, or other extra-demand criteria appropriate for a particular utility. Customer costs comprise those costs associated with serving customers, irrespective of the amount or rate of water use. They include meter reading, billing, and customer accounting and collecting expense, as well as maintenance and capital costs related to meters and services. In detailed studies, the costs for meter reading and billing and for customer accounting and collecting may be considered as one

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12

WATER RATES

subcomponent, and maintenance and capital costs on customer meters and services may be considered as another subcomponent. Direct fire-protection costs are those costs that are applicable solely to the fire-protection function. Usually, such costs are simply those directly related to public fire hydrants and related branch mains and valves. It should be noted that the costs allocated to the direct fire-protection cost component are usually only a small part of the total cost of fire protection. As more fully described and illustrated in chapter 3, a significant portion of extra capacity costs is also allocable to fire protection in the distribution of costs to customer classes. In the baseextra capacity method, care must be taken in separating costs between base costs and extra capacity costs. The appropriate allocation factors between base and extra capacity usually vary among systems and should be determined on the basis of the actual operating history or design criteria for each system. For example, if a system has an annual average-day use of 7.5 mgd and a maximum-day use of 11.55 mgd, the maximum-day to average ratio would be 1:1.54. Facilities designed to meet maximum-day requirements, such as a treatment plant, may be allocated 65 percent (1/1.54) to the base cost component and 35 percent (0.54/1.54) to the maximum-day extra capacity cost component. If the system also has a maximum-hour use of 16.65 mgd, the maximum-hour to average ratio would be 1:2.22. Facilities designed to meet maximum-hour requirements, such as distribution mains, inherently meet both maximum-day and maximum-hour requirements and may appropriately be allocated to the base maximum-day extra capacity and maximum-hour (in excess of maximum-day) extra capacity cost components. The base cost component would be allocated 45 percent (1/2.22); the maximum-day extra capacity cost component would be allocated approximately 25 percent (0.54/2.22); and the maximum-hour extra capacity component would be allocated approximately 30 percent (0.68/2.22). It is cautioned that ratios must be developed with care, and sound judgment must be exercised in their development. As previously discussed, total costs of service are represented by three principal elements: (1) O&M expense, (2) depreciation expense, and (3) return. In some instances, payment in lieu of taxes must be included as an element in cost of service. Operation-and-maintenance expense and depreciation expense are annual amounts directly allocable to cost components as subsequently illustrated. Return is the balance of annual capital costs not derived through depreciation expense and is expressed as a percentage of rate base. Thus, return is allocated on the basis of the distribution of rate base to appropriate cost components as a basis for subsequent distribution of responsibility for return to the various customer classes. Payment in lieu of taxes may be allocated similarly. Table 2-1 presents an example of the allocation of rate base to cost components under the baseextra capacity cost-allocation method. For purposes of this illustration, the various elements of rate base shown in the table are the net book value (original cost less accrued depreciation) of the water system, based on the accounting records of the utility as projected for the test period. Investment in source of supply, land, land rights, and impounded reservoir structures in this example is allocated 100 percent to the base cost component in recognition of the fact that such facilities are sized principally to meet annual supply requirements in total, whether or not variations in daily needs are experienced. In some cases, reservoirs may function to provide not only total annual supply requirements but also to provide for fluctuations in use on a seasonal or daily basis. Evaluation of each particular local situation will indicate if some portion of the impounded reservoir-related costs should be allocated to the extra capacity cost function. The source of supply for many utilities may also

Copyright (C) 1999 American Water Works Association All Rights Reserved

ALLOCATION OF COSTS OF SERVICE

13

Table 2-1 Allocation of Rate BaseBaseExtra Capacity Method (Test Year)


Extra Capacity Line No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Maximum Day $1,000 Maximum Hour* $1,000 Customer Meters and Services $1,000 Direct FireProtection Service

Item

Total

Base $3,000 423,000 407,000 15,000 240,000 244,000 102,000 277,000 2,491,000 4,000 5,000 102,000 2,628,000

Intangible Plant: Organization $6,000 Source of Supply Plant: Land 423,000 Reservoir 407,000 Pumping Plant: Land 23,000 Structures 369,000 Electric pumping equipment 376,000 Other pumping equipment 157,000 Water Treatment Plant: Structures 426,000 Water treatment equipment 3,832,000 Transmission and Distribution Plant: Land 35,000 Structures 48,000 Distribution storage 1,020,000 Mains 5,842,000 Services 2,264,000 Meters 996,000 Hydrants 404,000 General Plant: Land 4,000 Structures 190,000 Other 129,000 ___________ Net plant in service 16,951,000 Plus: Materials and supplies 291,000 Cash working capital 285,000 Construction work in progress 104,000 Less: Contributions and advances (1,445,000) ___________ Test-year rate base $16,186,000

8,000 129,000 132,000 55,000 149,000 1,341,000 31,000 43,000 918,000 1,753,000 2,264,000 996,000 $404,000

1,461,000

1,000 80,000 55,000 __________ 7,077,000 122,000 119,000 47,000 __________ $7,365,000

1,000 37,000 25,000 __________ 3,339,000 57,000 56,000 26,000 __________ $3,478,000

1,000 31,000 21,000 __________ 2,799,000 48,000 47,000 31,000 __________ $2,925,000

1,000 37,000 25,000 __________ 3,324,000 57,000 56,000

5,000 3,000 ________ 412,000 7,000 7,000

(1,445,000) __________ $1,992,000

________ $426,000

*Maximum-hour demand in excess of maximum-day demand.

include well supply. In these instances, a portion of the rate base for source of supply may be allocated to maximum-day and/or maximum-hour extra capacity, depending on the basis of design or usage characteristics associated with the well supply. Raw- and treated-water pumping and treatment facilities are allocated 65 percent to base and 35 percent to the maximum-day extra capacity cost components since these facilities are designed to meet maximum-day demands. It is noted that if the example were to separately identify reservoir intake facilities and/or raw-water transmission mains, these facilities also would be allocated 65 percent to base and 35 percent to the maximum-day extra capacity cost components. Treated-water transmission and distribution mains are allocated 45 percent to base, 25 percent to maximum-day extra capacity, and 30 percent to the maximum-hour extra capacity cost components in recognition of the fact that mains provide maximum-day and maximum-hour service to all customers. Distribution-storage-related facilities, such as elevated storage tanks, serve principally to assist in meeting maximum-hour extra capacity requirements of the system, and are, therefore, in this example, allocated

Copyright (C) 1999 American Water Works Association All Rights Reserved

14

WATER RATES

90 percent to the maximum-hour extra capacity cost component. In recognition that distribution storage provides some element of system reliability, the base cost component is assigned 10 percent of such facilities. The percentage factor used in the allocation of distribution storage is largely dependent on engineering judgment as well as the operating and design characteristics of the reservoirs in each particular system. Meters and services are allocated to the customer cost component. Fire hydrants are allocated to the direct fire-service cost component. The value of office buildings, furniture and equipment, vehicles, and other general plant is allocated to cost components on the basis of the resulting allocation of other plant facilities. The allocation to base and extra capacity components depends on conditions controlling the design of any given system and facilities within the system. It must be recognized that each system requires separate analysis for proper allocation to cost components. Construction work in progress is allocated to cost components on the same basis as similar elements of plant in service. In the example, it is assumed that all construction work in progress is transmission and distribution mains. In many water utility systems, the accounting records will show contributions in aid of construction that ordinarily are deducted from the rate base before applying rate-of-return percentages. Contributions should be deducted from plant value in accordance with the purposes for which the contributions were made. The example illustrated in Table 2-1 assumes that all contributions in this instance are related to customer meters and services. The results of the allocation of rate base to the various cost components, as illustrated in Table 2-1, provide a basis for subsequent distribution of capital costs to these components and then to the customer classes, as further explained in chapter 3. Table 2-2 illustrates the allocation of annual depreciation expense to cost components. The categories of items of depreciation expense are allocated to cost components in the same manner described in the allocation of rate base. Table 2-3 presents an example of the allocation of O&M expense to cost components under the baseextra capacity method. In general, O&M expense for each facility is allocated to cost components in a manner similar to that for rate base. Expenses that tend to vary directly with water usage are assigned directly to the base cost component. Chemical costs are an example of such an expense. Power costs are allocated principally to the base cost component. The demand portion of power costs should be allocated to extra capacity to the degree that it varies with demand pumping requirements. In the illustration, pumping power is allocated 10 percent to the maximum-day extra capacity cost component in recognition of this factor, with the balance of power costs, or 90 percent, being allocated to base cost. The extent to which power costs are allocated to the extra capacity cost component depends on the variations in electric demands incurred in pumping and the energy/demand electric rate structure applicable to pumping. Expenses other than power, chemical, and customer-related costs are allocable to cost components on the basis of the design capacity requirements of each facility. Such expenses, if designed to meet maximum-day requirements, are allocated 65 percent to base cost and 35 percent to maximum-day extra capacity cost. Expenses related to facilities designed to meet maximum-hour requirements are allocable 45 percent to base cost, 25 percent to maximum-day extra capacity cost, and 30 percent to maximum-hour extra capacity cost. Expenses related to distribution storage are allocated in the same manner as for rate basethat is, 10 percent to base cost and 90 percent to maximum-hour extra capacity costs.

Copyright (C) 1999 American Water Works Association All Rights Reserved

ALLOCATION OF COSTS OF SERVICE

15

Table 2-2 Allocation of Depreciation ExpenseBaseExtra Capacity Method (Test Year)


Extra Capacity Line No. 1 Maximum Day Maximum Hour* Customer Meters and Services Direct FireProtection Service

Item

Total

Base $11,800 6,200 6,900 2,700 7,100 54,500 100 2,900 72,500

2 3 4 5 6 7 8 9 10 11 12 13 14 15

Source of Supply Plant: Reservoir $11,800 Pumping Plant: Structures 9,600 Electric pumping equipment 10,600 Other pumping equipment 4,200 Water Treatment Plant: Structures 11,000 Water treatment equipment 83,800 Transmission and Distribution Plant: Structures 1,200 Distribution storage 28,500 Mains 161,100 Services 48,900 Meters 21,500 Hydrants 12,300 General Plant: Structures 4,900 Other 4,600 _________ Total depreciation expense $414,000

$3,400 3,700 1,500 3,900 29,300 $1,100 25,600 48,300 $48,900 21,500 $12,300

40,300

2,000 1,900 _________ $168,600

1,000 900 ________ $84,000

800 800 ________ $76,600

1,000 900 ________ $72,300

100 100 ________ $12,500

*Maximum-hour demand in excess of maximum-day demand.

Table 2-3 Allocation of O&M ExpenseBaseExtra Capacity Method (Test Year)


Customer Costs Extra Capacity Line No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Maximum Day Maximum Hour* Meters and Services Direct Billing Fireand Protection Collecting Service

Item

Total

Base $90,000 233,100 125,400 121,000 102,000 58,500 2,600

Source of Supply $90,000 Pumping: Purchased power 259,000 Other 193,000 Water Treatment: Chemicals 121,000 Other 157,000 Transmission and Distribution: Mains 130,000 Storage 26,000 Meters and services 155,000 Hydrants 13,000 Other 72,000 Customer Accounting: Meter reading and collection 247,000 Uncollectible accounts 44,000 Administrative and General: Salaries 194,000 Employee benefits 177,000 Insurance 135,000 Other 266,000 ___________ Total O&M expense $2,279,000

$25,900 67,600

55,000 32,500 $39,000 23,400 $155,000 $13,000 2,900 $247,000 7,700 44,200 40,400 200 60,700 _________ $400,200

13,600

7,200

13,900

34,400

20,800 70,300 64,000 77,600 96,300 __________ $1,075,200

6,300 29,100 26,500 36,300 39,900 _________ $326,300

2,800 13,700 12,500 19,700 18,700 _________ $143,700

5,900 33,900 31,000 1,200 46,500 _________ $307,900

500 2,800 2,600 3,900 ________ $25,700

*Maximum-hour demand in excess of maximum-day demand.

Copyright (C) 1999 American Water Works Association All Rights Reserved

16

WATER RATES

Expenses for meters and services and for customer billing and collecting are allocated directly to the customer cost components. Administration and general expense, in the example, is allocated to cost components in three parts. Salaries and employee benefits are allocated on the basis of the allocation of salaries and wages. Insurance is allocated on the basis of test-year rate base in Table 2-1. Other administration and general expense is allocated on the basis of the allocation of all other expenses, exclusive of power and chemical costs.

COMMODITYDEMAND METHOD __________________________


In the commoditydemand method, costs of service are separated into four primary cost components: (1) commodity costs, (2) demand costs, (3) customer costs, and (4) direct fire-protection costs. In detailed rate studies, some of these elements may also be broken down further into two or more subcomponents. Commodity costs are costs that tend to vary with the quantity of water produced. They usually include costs of chemicals, a large part of power costs, and other elements that increase or decrease almost directly with the amount of water supplied. Costs related to impounded reservoir source of supply or other costs that vary with average daily demands, such as raw-water transfer pumping costs, may also be considered as commodity costs. Purchased-water costs, if water is bought on a unit volume basis, would also be considered as commodity costs. However, recognition of recent practices to include a demand charge in addition to commodity charge in purchased-water agreements may dictate that demand portions of purchased-water costs be allocated to demand components. Demand costs are associated with providing facilities to meet the peak rates of use, or demands, placed on the system by the customers. They include capital-related costs on plant designed to meet peak requirements plus the associated O&M expenses. This cost component may be broken down into costs associated with meeting specific demands, such as maximum-day, excess maximum-hour, or other periods of time that may be appropriate to the utility that has to meet these demands. The definition of customer costs for this method is the same as for the baseextra capacity method. Direct fire-protection costs are also the same as under the baseextra capacity cost method. Table 2-4 presents an example of allocation of rate base under the commodity demand method. In this example, rate base for each facility is the same as in the baseextra capacity method presented in Table 2-1. Each element of utility plant is assigned to commodity, demand, customer, or direct fire-service functions. Pumping plant and treatment plant, which meet maximum-day demands, are allocated 100 percent to the maximum-day demand component. Treated-water mains, which serve maximum-hour demands, are allocated 70 percent to the maximum-day demand component and 30 percent to the maximum-hour demand cost component. Rate base for distribution storage is allocated 100 percent to the maximum-hour demand component. The results of the allocation of rate base to the various cost components, as illustrated in Table 2-4, provide a basis for subsequent distribution of rate base, and capital costs related thereto, to customer classes, as further explained in chapter 3. Table 2-5 presents an example of the allocation of depreciation expense to cost components under the commoditydemand method. The categories of items of depreciation expense are allocated to cost components in the same manner as described in the allocation of rate base. Table 2-6 presents an example of allocation of O&M expense under the commoditydemand method. In general, O&M expense for each facility is allocated to

Copyright (C) 1999 American Water Works Association All Rights Reserved

ALLOCATION OF COSTS OF SERVICE

17

Table 2-4 Allocation of Rate BaseCommodityDemand Method (Test Year)


Demand Line No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Maximum Day $4,000 $423,000 407,000 23,000 369,000 376,000 157,000 426,000 3,832,000 35,000 48,000 1,020,000 1,753,000 2,264,000 996,000 $404,000 2,000 106,000 73,000 __________ 9,457,000 162,000 159,000 73,000 __________ $9,851,000 1,000 33,000 22,000 __________ 2,913,000 50,000 49,000 31,000 __________ $3,043,000 1,000 37,000 25,000 __________ 3,324,000 57,000 56,000 Maximum Hour* $1,000 Customer Meters and Services $1,000 Direct FireProtection Service

Item

Total

Commodity

Intangible Plant: Organization $6,000 Source of Supply Plant: Land 423,000 Reservoir 407,000 Pumping Plant: Land 23,000 Structures 369,000 Electric pumping equipment 376,000 Other pumping equipment 157,000 Water Treatment Plant: Structures 426,000 Water treatment equipment 3,832,000 Transmission and Distribution Plant: Land 35,000 Structures 48,000 Distribution storage 1,020,000 Mains 5,842,000 Services 2,264,000 Meters 996,000 Hydrants 404,000 General Plant: Land 4,000 Structures 190,000 Other 129,000 ___________ Net plant in service 16,951,000 Plus: Materials and supplies 291,000 Cash working capital 285,000 Construction work in progress 104,000 Less: Contributions and advances (1,445,000) ____________ Test-year rate base $16,186,000

4,089,000

9,000 6,000 _________ 845,000 15,000 14,000

5,000 3,000 ________ 412,000 7,000 7,000

_________ $874,000

(1,445,000) __________ $1,992,000

_________ $426,000

*Maximum-hour demand in excess of maximum-day demand.

cost components in a manner similar to that for rate base. However, chemical costs, which tend to vary with the amount of water produced, are assigned 100 percent to the commodity cost function. Pumping power costs are allocated 71 percent to commodity cost and 29 percent to maximum-day demand cost in recognition of the fact that power costs vary with demand. Administration and general expense is allocated to cost components in a manner similar to that described for the baseextra capacity methodthat is, in three parts in the example. Employee benefits are allocated on the basis of the allocation of salaries and wages. Insurance is allocated on the basis of test-year rate base in Table 2-4. Other administration and general expense is allocated on the basis of all other expenses, exclusive of power and chemicals. In comparing allocations under the baseextra capacity and commoditydemand methods, base costs in the baseextra capacity method include commodity costs plus that portion of demand costs in the commoditydemand method related to providing services at average annual rates of water use. In the example, base cost includes all

Copyright (C) 1999 American Water Works Association All Rights Reserved

18

WATER RATES

Table 2-5 Allocation of Depreciation ExpenseCommodityDemand Method (Test Year)


Demand Line No. 1 Maximum Day Maximum Hour* Customer Meters and Services Direct FireProtection Service

Item

Total

Commodity $11,800

2 3 4 5 6 7 8 9 10 11 12 13 14 15

Source of Supply Plant: Reservoir $11,800 Pumping Plant: Structures 9,600 Electric pumping equipment 10,600 Other pumping equipment 4,200 Water Treatment Plant: Structures 11,000 Water treatment equipment 83,800 Transmission and Distribution Plant: Structures 1,200 Distribution storage 28,500 Mains 161,100 Services 48,900 Meters 21,500 Hydrants 12,300 General Plant: Structures 4,900 Other 4,600 _________ Total depreciation expense $414,000

$9,600 10,600 4,200 11,000 83,800 $1,200 28,500 48,300 $48,900 21,500 $12,300 200 200 ________ $12,200 2,800 2,600 _________ $237,400 800 800 ________ $79,600 1,000 900 ________ $72,300 100 100 ________ $12,500

112,800

* Maximum-hour demand in excess of maximum-day demand.

Table 2-6 Allocation of O&M ExpenseCommodityDemand Method (Test Year)


Customer Costs Demand Line No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Maximum Day Maximum Hour* Meters and Services Direct Billing Fireand Protection Collecting Service

Item

Total

Commodity $90,000 183,900

Source of Supply $90,000 Pumping: Purchased power 259,000 Other 193,000 Water Treatment: Chemicals 121,000 Other 157,000 Transmission and Distribution: Mains 130,000 Storage 26,000 Meters and services 155,000 Hydrants 13,000 Other 72,000 Customer Accounting: Meter reading and collection 247,000 Uncollectible accounts 44,000 Administrative and General: Salaries 194,000 Employee benefits 177,000 Insurance 135,000 Other 266,000 ___________ Total O&M expense $2,279,000

$75,100 193,000

121,000 157,000 91,000 $39,000 26,000 $155,000 20,300 14,400 34,400 $247,000 7,700 44,200 40,400 200 60,700 _________ $400,200 $13,000 2,900

9,000 16,100 14,700 8,200 22,100 _________ $465,000

18,000 82,800 75,300 103,600 113,300 _________ $929,400

2,900 14,200 13,000 21,800 19,500 _________ $150,800

5,900 33,900 31,000 1,200 46,500 _________ $307,900

500 2,800 2,600 3,900 ________ $25,700

*Maximum-hour demand in excess of maximum-day demand.

Copyright (C) 1999 American Water Works Association All Rights Reserved

ALLOCATION OF COSTS OF SERVICE

19

commodity costs plus 65 percent of the maximum-day demand costs. The maximumday extra capacity costs include the balance of the costs allocated to the maximumday demand component, or in the example, the maximum-day extra capacity costs are 35 percent of the maximum-day demand costs for such facilities. Consideration of the merits of the baseextra capacity method relative to the commoditydemand method of allocation is presented in chapter 4 of this manual.

SPECIAL CONSIDERATIONS _________________________________


In some water utility systems, there are customers with certain water-use characteristics that require special consideration in allocating costs. Customers provided with firm water service, that is, unlimited service in the amounts and at such times as desired, should be charged rates adequate to recover the full cost to the utility of providing such service. In establishing charges for nonfirm service, such as off-peak or interruptible service, consideration should be given to charging special rates that are less than the rates for firm service. Such rates might consist of those direct additional costs, such as for power and chemicals, associated with providing water from existing facilities; however, charges should reflect a recognition of capacity-related and other costs, in addition to purely incremental costs. In some areas where irrigation or other seasonal uses impose significant demands on the system, consideration may be given to separate charges for such use. Costs associated with seasonal use might be recovered through rates applied to separate metering for such services or through surcharges applied to consumption over and above an established normal use. The allocation of the costs of service between inside-city and outside-city customers of a government-owned utility system should include special consideration of factors such as facilities required, extent and nature of service, ownership, risk, and other special items. A general approach to this situation is the use of the utility basis for assigning cost responsibility to outside customers. This method is presented in more detail in chapter 3 of this manual. Except in specific instances, such as for a metropolitan service approach, discussed in chapter 3, it is reasonable to establish separate inside-city and outside-city cost factors in order to properly allocate costs related to serving a particular group of customers. In certain utility systems, the service area may be subdivided into pressure zones or districts due to the geophysical characteristics of the area. Under these conditions, it may be desirable to assign the costs related to specific facilities to each pressure district in order to determine the cost responsibility of each section of the system. The results of such detailed studies will indicate whether there are significant differences in the costs of providing service to each pressure district. In some instances, consideration should be given to the responsibility for reserve capacity in the system. A typical example would be where a significant portion of the system is being held for the future growth needs of a specific customer or class of customers. Means of recognizing this factor vary from one situation to another but, where warranted, are vital to an equitable allocation of costs.

Copyright (C) 1999 American Water Works Association All Rights Reserved

AWWA MANUAL

M1

Chapter

3 Distribution of Costs to Customer Classes


Preceding chapters of this manual have dealt with the determination of revenue requirements and the allocation of both operating- and capital-related costs to the functional components of cost of service. This chapter presents the third element in the rate-making processdistribution of component costs to customer classes. The theoretically ideal solution to developing rates for water utility customers would be to assign cost responsibility to each individual customer served and develop rates to derive that cost. It is not economically practical nor often possible to determine the cost responsibility and applicable rates for each individual customer served. However, the cost of providing service can reasonably be determined for groups or classes of customers that have similar water-use characteristics and for special customers having unusual water-use or service requirements. It is an objective of rate making to assign costs to classes of customers in such a manner that rates can be designed that are nondiscriminatory and meet as nearly as possible the cost of providing service to such customer classes.

CUSTOMER CLASSES _____________________________________


In establishing customer classes for a water utility, consideration is given to service characteristics, demand patterns, and whether service is provided both inside and outside the city (jurisdiction) limits. Service-characteristic differences may be illustrated by recognizing that customers using treated water require facilities not needed by raw-water customers. Similarly, large-volume industrial customers, wholesale customers, and other large users tend to be served directly from major treated-water transmission mains, whereas smaller users are served by both large and small mains. This factor will, in some cases, warrant recognition in establishing customer classes and their costs of service. Demand patterns of various customers differ, depending on their peak-day and peak-hour rates of demand relative to average demands. For example, the residential

20

Copyright (C) 1999 American Water Works Association All Rights Reserved

DISTRIBUTION OF COSTS

21

customer class that places summertime lawn irrigation loads on the system typically has a much higher peak-demand requirement, relative to the average demand, than does a petroleum refinery, which may require water on a relatively uniform basis throughout the year. The classification of water customers as to whether they are inside or outside the city limits is related to each major groups responsibility for overall costs. As explained later in this manual, this factor is of major importance to governmentowned utilities and may, in some instances, have a bearing on investor-owned utilities. Legal requirements or customs may require recognition of certain customer classifications from an accounting standpoint, and such requirements can be accommodated in rate studies. However, general service characteristics, demand patterns, and location with regard to city limits are generally the principal considerations in customer classification.

General Classes
The three principal customer classes typical of most water utilities are (1) residential, (2) commercial, and (3) industrial. Definition of these general customer classes differs among utilities, but in very broad terms, the following definitions are common: ResidentialOne- and two-family dwellings, usually physically separate. CommercialMultifamily apartment buildings and nonresidential, nonindustrial business enterprises. IndustrialManufacturing and processing establishments. For specific utilities, there may be a breakdown of these general classes into more specific groups. For example, the industrial customer group may be subdivided into small industry, large industry, and special, the latter typified by a petroleum refinery. In many systems, particularly larger ones, frequently there are customers having individual water-use characteristics, service requirements, or other reasons that set them apart from other customers with regard to cost responsibility. These customers should, therefore, have a separate class designation. Such classes may include large hospitals, universities, military establishments, and other such categories.

Special Classes
In addition to the general classes of service previously described, water utilities often provide service to certain special classes of customers. Four of those considered here are (1) wholesale service, (2) fire-protection service, (3) lawn irrigation, and (4) air conditioning and refrigeration. Wholesale service. Wholesale service is usually defined as a situation in which water is sold to a customer at one or more major points of delivery for resale to individual retail customers within the wholesale customers service area. Treatedwater service is provided in most cases, but on occasion raw water is provided to wholesale customers. Usually, the wholesale customer is a separate municipality or water district adjacent to the supplying utility, but it may be in an area within the jurisdiction of the supplying utility. Fire-protection service. Fire-protection service has characteristics that are markedly different from other types of water service. The service provided is principally of a standby naturethat is, readiness to deliver relatively large quantities of water for short periods of time at any of a large number of points in the

Copyright (C) 1999 American Water Works Association All Rights Reserved

22

WATER RATES

water distribution system while the total annual quantity of water delivered is relatively small. There are two principal approaches to the determination of fire-protection service costs that differ widely in both theory and application. One approach proposes that the costs of fire-protection service, other than those of the direct cost related to the hydrants themselves, be determined on the basis of the potential demand for water for fire-fighting purposes in relationship to the total of all potential demands for water. A second approach proposes that fire-protection-service costs be allocated as an incremental cost to the costs of general water service. This second approach is based on the premise that the prime function of the water utility is to supply general water service and that fire-protection service is a supplementary service. Each approach has advocates among water utility professionals. For the purposes of illustration in this manual, the first approach discussed above is used. Costs allocated to fire-protection service as a class can be subdivided into those related to public fire-protection service and private fire-protection service. The specific methodology for such subdivision is presented in chapter 4. The reader of this manual is referred to chapter 2 of AWWA Manual M26, Water Rates and Related Charges, for further discussion of fire-protection rates and charges. Lawn irrigation. Residential lawn irrigation is characterized by the relatively high demands it places on the water system, usually during the late afternoon and early evening hours. In most of the United States, lawn irrigation is very seasonal in nature, being most pronounced during the summer months and virtually nonexistent during the winter months. In most instances, lawn irrigation service is not separate from other service; therefore, the high-peaking characteristics of lawn irrigation need to be recognized as a part of residential-class water-use characteristics. However, where separate metering for lawn irrigation is provided, as is sometimes the case for automatic lawn sprinkling systems, parks, and golf courses, and where such loads are significant in the system, a separate class designation is warranted. Air conditioning and refrigeration. In the 1950s and 1960s, there was a trend away from water-cooled air conditioning and refrigeration. Subsequent to the rapid increase in electric-power and natural-gas costs in the 1970s, commercial and industrial customers have reconsidered the economics of alternative cooling methods. In some cases, it has been found that higher initial outlays for water-cooled units can be more than offset by the operating economies of water costs versus power requirements. In many communities, however, city codes prohibit the use of water-wasting units. The use of recirculating units needing only make-up water is a proposed alternative. Make-up water requirements will vary, but a common rule of thumb for make-up water due to evaporation, quality control, and other causes is estimated as 20 gpd/ton of air conditioning. A survey of the magnitude of water-cooled air conditioning and refrigeration service provided or expected could determine the need or advisability of recognition of such service as a separate class.

Service Outside City Limits


Many government-owned utilities recognize in their rate structures the differences in costs of serving water users located outside the corporate limits of the supplying city or jurisdiction compared with those located within the corporate limits. A government-owned utility may be considered to be the property of the citizens within the city. Customers within the city are owner customers, who must bear the risks and

Copyright (C) 1999 American Water Works Association All Rights Reserved

DISTRIBUTION OF COSTS

23

responsibilities of utility ownership. Outside-city customers are non-owner customers and, as such, bear a different responsibility for costs than do owner customers. The costs to be borne by outside-city (non-owner) customers are similar to those attributable to the customers (non-owners) of an investor-owned utility. Such costs include operation-and-maintenance (O&M) expense, depreciation expense, and an appropriate return on the value of property devoted to serving the outside-city customers. Those who are responsible for designing or reviewing water rates do not always have a clear understanding of the relationship of the cash-needs approach to measuring total revenue requirements to the utility basis of cost allocation with regard to government-owned water systems, and why both elements are used in many rate studies. A government-owned utility, in most cases, where not regulated by a state public utility commission, determines its total revenue requirements, or costs of service, on a cash-needs basis; that is, it must develop sufficient revenue to meet cash needs for O&M expense, debt-service requirements, capital expenditures not debt-financed, and possibly other cash requirements as described in chapter 1. Such cash needs must be met by the utility as a whole. However, when that utility serves outside-city, non-owner customers, it is most appropriate to measure the costs of such service on a utility basis; that is, assign costs to outside-city customers for O&M expense, depreciation expense, and an appropriate return on the value of property devoted to serving them. It is then the responsibility of the inside-city customers to meet all remaining cash requirements not derived from outside-city customers. Thus, if total utility revenue requirements are relatively low, perhaps due to a major part of the bonded indebtedness having been retired which resulted in a large amount of paid-up equity, the inside-city customers have relatively low rates, benefiting from having invested in and owning paid-up equity in the system. The reverse situation could also occur. If the rate of return is properly set, the utility basis of allocating cost of service is fair to both the supplier and the outside-city customer. In some instances, as a matter of policy, a government-owned utility might choose to waive the distinction between owner and non-owner customers, considering the utility to be metropolitan in nature, where differences in costs between owners and non-owners are not recognized in cost allocation and rate making. This generally would require the owner customers to subsidize the non-owner customers to some degree. Such a policy is a choice to be made by the governing body of the utility.

UNITS OF SERVICE_________________________________________
As a step toward rate design, component costs may be distributed among customer classes in the proportion that the respective class responsibility for those costs bears to the total cost responsibility of all customer classes served by the system. This applies for each of the component costs of service. Responsibility for each component may be expressed in terms of the number of units of service required by each class of customer. The sum of all component costs attributable to a customer class is the total cost of service to be recovered from it. The total cost of each component, such as base cost, may be divided by appropriate total customer requirements or units of service to express a unit cost for each component. The unit costs of each component serve as a basis for designing rates. As a basis for distributing component costs to customer classes, it is essential that the units of service attributable to the respective classes be established for the test year. This involves determining or estimating the total quantity of water to be used by each class in the test year and the peak rates of use by the class, usually for

Copyright (C) 1999 American Water Works Association All Rights Reserved

24

WATER RATES

both maximum-day and maximum-hour rates of use. (In some systems, maximumweek or other periods may be appropriate.) In addition, a determination needs to be made of the number of equivalent meters and services by class, as well as the number of bills by class. Maximum rates of use may be expressed in terms of capacity factorthat is, a percentage relationship of the class maximum rate of use to average annual rate of use. Thus, if a customer class maximum-day rate of use is 2.5 times its average rate, it is said to have a maximum-day capacity factor of 250 percent. All pertinent sources of information need to be investigated and studied in estimating customer-class capacity factors. Such data should include daily and hourly pumpage records, recorded rates of flow in specific areas of the system, studies and interviews of large users regarding individual and group characteristics of use, special-demand metering programs, and experience in studies of other utilities exhibiting like characteristics. Sound and logical inferences can be drawn from customer metering information, provided billing periods are sufficiently short to reflect seasonal differences, usually not to exceed three-month periods. The total annual quantity of water attributable to fire service is usually considered to be negligible, at least in relation to that of other classes. However, peak requirements for fire service can be quite significant. The periodic reports of the Insurance Services Office, New York, N.Y., in which desired rates of flow for fire service are defined, are a very good source of maximum-capacity requirements for fire service. Such data must be applied with judgment and care to achieve practical cost allocations. Customer-related costs for meters and services may be properly distributed among customer classes by recognizing factors that are generally responsible for those costs being incurred. As an example, a method for distributing meter-and-service costs to customer classes is in proportion to the investment in meters and services installed for each customer class, based on the number of equivalent meters. Distribution of customer costs by equivalent meter-and-service ratios recognizes that meter-and-service costs vary, depending on considerations such as size of service pipe, materials used, locations of meters, and other local characteristics for various-sized meters as compared to 58-in. meters and services. For purposes of this example, typical customer meter-and-service equivalent ratios based on investment are as follows:
Meter Size in.
58 34

Equivalent Meterand-Service Ratio 1.0 1.1 1.4 1.8 2.9 11.0 14.0 21.0 29.0

1 1 12 2 3 4 6 8

Customer meter-and-service costs are sometimes distributed among customer classes based on factors other than investment. Equivalent ratios based on meter capacity or other measures may be appropriate in some circumstances. Selection of appropriate measures for distributing such costs should be considered on an individual utility basis.

Copyright (C) 1999 American Water Works Association All Rights Reserved

DISTRIBUTION OF COSTS

25

Costs related to billing and collecting may be distributed among customer classes based on the total number of bills rendered to the respective classes in a test year. In some instances, it is appropriate to recognize, through billing ratios, that billing and collecting for larger services may incur more cost than for smaller services. An illustration of the development of the test-year units of service for the hypothetical utility, using the baseextra capacity method of cost allocation and distribution, is presented in Table 3-1. Test-year units of service reflect the prospective average annual customer water-use requirements during the test-year study period considered in this example. For the example, it is assumed that retail service and fire-protection service are provided inside the city to residential, commercial, and industrial classes. Outsidecity service is provided on a wholesale basis. For each customer class, under the heading of Base in Table 3-1, the total annual water use in thousand gallons is shown, as well as the average rate in thousand gallons per day. Maximum-day capacity factors are applied to average-day rates of flow to develop total capacity by class. Extra capacity is the difference between total capacity and average rate of use. Fire-protection service is considered to require negligible flow on an average basis but 960 thou. gpd on a maximum daily basis. Maximum-hour extra capacity is developed similarly. Maximum-hour fireprotection service reflects the assumption that flow for fires is concentrated in a four-hour period. Equivalent meters and services are derived by applying equivalent ratios to the number of meters of each size by class. The number of bills is simply the total number of bills rendered annually for each class. Table 3-2 shows the development of the units of service applicable to the commoditydemand method of cost allocation. It differs from Table 3-1 only by the fact that the maximum-day extra capacity column is excluded. It should be recognized that the maximum total capacity on both a maximumday and maximum-hour basis for the total system (shown in Tables 3-1 and 3-2) is the estimate of the sum of noncoincidental peaking requirements on the system; that is, it is the sum of the peaks for each class, regardless of the day or hour in which such

Table 3-1 Units of ServiceBaseExtra Capacity Method (Test Year)


Base Maximum Day Maximum Hour

Customer Class

Annual Average Total Extra Total Extra Equivalent Use Rate Capacity Capacity Capacity Capacity Capacity Capacity* Meters thou. thou. Factor thou. thou. Factor thou. thou. and gal gpd % gpd gpd % gpd gpd Services

Bills

Inside-City: Retail service Residential 968,000 2,652 Commercial 473,000 1,296 Industrial 1,095,000 3,000 Fire-protection service __________ ______ Total inside-city 2,536,000 6,948 Outside-City: Wholesale service Total system 230,000 630 __________ ______ 2,766,000 7,578

250 200 150

6,630 2,592 4,500 960 ______ 14,682 1,418 _______ 16,100

3,978 1,296 1,500 960 ______ 7,734 788 ______ 8,522

400 325 200

10,608 4,212 6,000 5,760 _______ 26,580 2,363 _______ 28,943

3,978 1,620 1,500 4,800 ______ 11,898 945 _______ 12,843

15,652 1,758 251

185,760 14,640 420

_______ ________ 17,661 200,820 34 48 _______ ________ 17,695 200,868

225

375

*Maximum-hour demand in excess of maximum-day demand.

Copyright (C) 1999 American Water Works Association All Rights Reserved

26

WATER RATES

Table 3-2 Units of ServiceCommodityDemand Method (Test Year)


Commodity Annual Use thou. gal Average Rate thou. gpd Maximum Day Total Capacity Capacity thou. Factor % gpd Maximum Hour Total Extra Equivalent Capacity Capacity Capacity* Meters thou. thou. Factor and % gpd gpd Services

Customer Class Inside-City: Retail service Residential Commercial Industrial Fire-protection service Total inside-city Outside-City: Wholesale service Total system

Bills

968,000 473,000 1,095,000 __________ 2,536,000 230,000 __________ 2,766,000

2,652 1,296 3,000 ______ 6,948 630 ______ 7,578

250 200 150

6,630 2,592 4,500 960 ______ 14,682 1,418 ______ 16,100

400 325 200

10,608 4,212 6,000 5,760 _______ 26,580 2,363 _______ 28,943

3,978 1,620 1,500 4,800 _______ 11,898 945 _______ 12,843

15,652 1,758 251 _______ 17,661 34 _______ 17,695

185,760 14,640 420 ________ 200,820 48 ________ 200,868

225

375

*Maximum-hour demand in excess of maximum-day demand.

peaks may occur. Thus, the total system capacity shown, as related to the average rate, is not to be confused with the coincidental maximum-to-average ratio used in system design.

UNIT COSTS______________________________________________
Component costs can be directly distributed to respective customer classes in proportion to the respective units of service applicable to each class. For instance, costs of service are distributed among customer classes by application of unit costs of service to respective service requirements. Unit costs of service are based on total costs previously allocated to functional components and the total number of applicable units of service for the test year. The development of unit costs of service for the baseextra capacity method is presented in Table 3-3. Unit costs are determined simply by dividing the test-year functionally allocated O&M and capital costs by the respective total system units-of-service requirements in the test year. For example, under the baseextra capacity method, the base unit cost for O&M expense of $0.3887/thou. gal may be derived by dividing the allocated base O&M expense of $1,075,200 by the total base-component units of service of 2,766,000 thou. gal. Similar computations are made to determine unit costs for all other O&M expense and depreciation expense. Under the utility-basis method of cost allocation, the resulting average unit costs for O&M expense and depreciation expense are applicable to all customers, both inside and outside the city. Allocation of O&M expense and depreciation expense to functional cost components is presented in chapter 2. The determination of unit return on rate base is made by first calculating unit rate base. The functionally allocated total rate base is divided by respective total system units of service to yield unit rate base. Subsequently, unit return on rate base is derived by applying appropriate inside- and outside-city rates of return to the unit rate base. As discussed in chapter 1, for the government-owned utility to meet total cash revenue requirements under the utility approach, the level of return in the example would be $807,000. Based on a total rate base of $16,186,000, the overall rate of

Copyright (C) 1999 American Water Works Association All Rights Reserved

DISTRIBUTION OF COSTS

27

Table 3-3 Unit Costs of ServiceBaseExtra Capacity Method (Test Year)


Customer Costs Extra Capacity Line No. 1 2 Total Cost Maximum Day 8,522 thou. gpd Maximum Hour* 12,843 thou. gpd Meters and Services 17,695 equiv. meters $307,900 17.4004 $72,300 4.0859 $1,992,000 112.5742 5.2659 10.1317 26.7522 31.6180 1.9924 1.9924 Direct Billing Fireand Protection Collecting Service 200,868 bills

Item Total System Units of Service: Number Units

Base 2,766,000 thou. gal

3 4 5 6 7 8 9 10 11 12

O&M Expense: Total $2,279,000 Unit cost ($/unit) Depreciation Expense: Total $414,000 Unit cost ($/unit) Rate Base: Total rate base $16,186,000 Unit rate base ($/unit) Unit Return on Rate Base: Inside-city ($/unit) Outside-city ($/unit) Total Unit Costs of Service: Inside-city ($/unit) Outside-city ($/unit)

$1,075,200 0.3887 $168,600 0.0610 $7,365,000 2.6627 0.1246 0.2396 0.5742 0.6893

$326,300 38.2907 $84,000 9.8573 $3,478,000 408.1372 19.0915 36.7323 67.2394 84.8803

$143,700 11.1888 $76,600 5.9643 $2,925,000 227.7479 10.6534 20.4973 27.8065 37.6504

$400,200 1.9924

$25,700

$12,500

$426,000

19,900

*Maximum-hour demand in excess of maximum-day demand. At 4.68 percent return on $15,033,000 rate base. At 9.0 percent return on $1,153,000 rate base.

return is equivalent to about 4.99 percent. In this example, it is assumed that the utility provides service to both inside- and outside-city customers. Generally, where inside-city owners provide service to outside-city non-owners, a differential rate of return is appropriate. In this example, a rate of return of 9.0 percent is assumed and applied to component unit rate base in order to determine the outside-city unit return on rate base. Although it is not presented in Table 3-3, total outside-city return may be calculated by determining total outside-city rate base and applying the 9.0 percent rate of return to it. For the baseextra capacity method, total outside-city rate base is derived by applying the unit rate base from Table 3-3 to the respective outside-city units of service presented in Table 3-1. Application of the 9.0 percent rate of return to outside-city rate base of about $1,153,000 results in an outside-city return of approximately $103,800. Once outside-city return is determined, the inside-city rate of return is established at a level sufficient to derive the balance of total returnthat is, $807,000 less the outside-city return of $103,800, or $703,200, which is not derived from the outside-city customers. Determination of the inside-city rate of return is made by dividing the balance of total return of $703,200 by the inside-city rate base. The inside-city rate base is calculated in a manner similar to that described for developing the outside-city rate base and totals $15,033,000. Total inside-city rate of return is determined to be 4.68 percent. Returning to the unit-cost approach presented in Table 3-3, inside-city unit return on rate base is developed by applying the 4.68 percent rate of return to the unit rate base. The differential in inside- versus outside-city rates of return reflects, in part, the municipalitys risk in the ownership of facilities constructed to serve

Copyright (C) 1999 American Water Works Association All Rights Reserved

28

WATER RATES

Table 3-4 Unit Costs of ServiceCommodityDemand Method (Test Year)


Customer Costs Demand Line No. 1 2 Total Cost Maximum Day 16,100 thou. gpd Maximum Hour* 12,843 thou. gpd Meters and Services 17,695 equiv. meters $307,900 17.4004 $72,300 4.0859 $1,992,000 112.5742 5.2685 10.1317 26.7548 31.6180 1.9924 1.9924 Direct Billing Fireand Protection Collecting Service 200,868 bills

Item Total System Units of Service: Number Units

Commodity 2,766,000 thou. gal

3 4 5 6 7 8 9 10 11 12

O&M Expense: Total $2,279,000 Unit cost ($/unit) Depreciation Expense: Total $414,000 Unit cost ($/unit) Rate Base: Total rate base $16,186,000 Unit rate base ($/unit) Unit Return on Rate Base: Inside-city ($/unit) Outside-city ($/unit) Total Unit Costs of Service: Inside-city ($/unit) Outside-city ($/unit)

$465,000 0.1681 $12,200 0.0044 $874,000 0.3160 0.0148 0.0284 0.1873 0.2010

$929,400 57.7277 $237,400 14.7456 $9,851,000 611.8738 28.6357 55.0686 101.1090 127.5419

$150,800 11.7418 $79,600 6.1979 $3,043,000 236.9384 11.0887 21.3245 29.0285 39.2642

$400,200 1.9924

$25,700

$12,500

$426,000

19,900

*Maximum-hour demand in excess of maximum-day demand. At 4.68 percent return on $15,018,000 rate base. At 9.0 percent return on $1,168,000 rate base.

outside-city customers, as well as a return on paid-up equity in system facilities to inside-city customers. Total unit costs of service are comprised of the O&M, depreciation, and return on rate base unit costs of service and are shown at the bottom of Table 3-3 for inside- and outside-city customers. Also included in the table are the costs of service that are directly allocated to fire-protection service, as discussed previously. The development of unit costs of service for the commoditydemand method is made similarly to that used for the baseextra capacity method. Total unit costs of service for inside- and outside-city customers under the commoditydemand method are summarized at the bottom of Table 3-4.

DISTRIBUTION OF COSTS TO CUSTOMER CLASSES__________


BaseExtra Capacity Method
The distribution of the costs of service to the utilitys customer classes is accomplished by applying unit costs of service to individual customer-class units of water service. The total units of service and the unit costs of service for the test year, from Tables 3-1 and 3-3, respectively, are summarized in Table 3-5. As discussed previously, base costs are costs that would be incurred in supplying water at perfect load factor (that is, at a continuous, uniform rate), without costs incurred in providing extra plant capacity for variation in the rate of use beyond a uniform rate. The resulting distribution of cost responsibility for base costs is simply a function of the volume of water used by each class.

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DISTRIBUTION OF COSTS

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Table 3-5 Cost Distribution to Customer ClassesBaseExtra Capacity Method (Test Year)
Customer Costs Extra Capacity Line No. 1 Maximum Maximum Day Hour 67.2394 per thou. gpd 27.8065 per thou. gpd Meters and Services 26.7522 per equiv. meter Direct Billing Fireand Protection Collecting Service 1.9924 per bill Total Cost of Service

Item Inside-City: Unit costs of service ($/unit)

Base 0.5742 per thou. gal

2 3 4 5 6 7 8 9 10

Retail Service: Residential: Units of service Allocated cost of service Commercial: Units of service Allocated cost of service Industrial: Units of service Allocated cost of service Fire-Protection Service: Units of service Allocated cost of service

968,000 $555,900 473,000 $271,600 1,095,000 $628,900

3,978 $267,500 1,296 $87,100 1,500 $100,900 960 $64,500

3,978 $110,600 1,620 $45,000 1,500 $41,700 4,800 $133,500

15,652 $418,700 1,758 $47,000 251 $6,700

185,760 $370,100 14,640 $29,200 420 $800

$1,722,800

$479,900

$779,000

$58,100 ___________ $256,100 $3,237,800

11 12 13 14

Total inside-city allocated cost of service Outside-City: Unit costs of service ($/unit) 0.6893 Wholesale: Units of service 230,000 Allocated cost of service $158,500 __________ Total system allocated cost of service $1,614,900

84.8803 788 $66,900 _________ $586,900

37.6504 945 $35,600 _________ $366,400

31.6180

1.9924

34 48 $1,100 $100 _________ _________ $473,500 $400,200

$262,200 ________ ___________ $58,100 $3,500,000

As shown in Table 3-5, residential customers are projected to use 968,000 thou. gal of water in the test year; commercial customers, 473,000 thou. gal; and industrial customers 1,095,000 thou. gal. Applying the inside-city unit base cost of $0.5742/thou. gal to the respective units of service yields the distributed customer-class base cost of service. By definition, the unit base cost is the minimum rate at which water could be sold (if perfect load-factor use could be achieved) after customer costs are recovered. Outside-city distributed base costs are derived from the application of the unit base cost of $0.6893/thou. gal to the outside-city base unit-of-service requirements. The higher unit base cost reflects the rate-of-return differential discussed previously. Extra capacity costs for maximum-day and maximum-hour service are incurred in providing facilities to furnish water at varying rates above the average. Customer-class responsibility for extra capacity costs is determined by applying the unit costs of service to the individual customer-class units of service in a manner similar to that used for determining customer-class base costs. Customer costs, which include the category of meters and services and the category of billing and collecting, are generally treated separately in rate studies. Customer costs associated with meters and services (both capital and O&M costs) may be distributed to customer classes on the basis of equivalent meter-and-service cost factors. Meter-and-service costs are based on the total number of equivalent 58-in. meters and are applied to customer-class equivalent meter units of service in order to determine allocated cost of service. Units based on equivalent 58-in. meters

Copyright (C) 1999 American Water Works Association All Rights Reserved

30

WATER RATES

are used to allow for the fact that customer costs will vary and tend to increase with the size of the customer meter and service. Billing and collecting costs may be related to the number of bills issued and, in turn, distributed to customer classes on the basis of the number of bills rendered to customers within each class. For the example, customer-class responsibility is determined by applying the billing and collecting unit cost to the total estimated number of bills in each customer class rendered for the average rate year. The base, extra capacity, and customer costs, summarized by customer classes, constitute the costs of service to be recovered from the respective classes of customers involved. This summation also provides identification of the responsibility of each class for the functional costs.

CommodityDemand Method
The distribution of costs to customer classes under the commoditydemand method is accomplished in the same manner used for distributing baseextra capacity costs. Table 3-6 summarizes the application of units of service to unit costs of service, as developed in Tables 3-2 and 3-4 for the commoditydemand method. In the commoditydemand method, commodity costs are distributed to customer classes on the basis of total annual use. Demand-related costs are distributed to the various classes in proportion to the class total demand responsibility, and customer costs are distributed based on equivalent meter and billing requirements.

Table 3-6 Cost Distribution to Customer ClassesCommodityDemand Method (Test Year)


Customer Costs Demand Line No. 1 Maximum Maximum Day Hour 101.1090 per thou. gpd 29.0285 per thou. gpd Meters and Services 26.7548 per equiv. meter Direct Billing Fireand Protection Collecting Service 1.9924 per bill Total Cost of Service

Item Inside-City: Unit costs of service ($/unit)

Commodity 0.1873 per thou. gal

2 3 4 5 6 7 8 9 10

Retail Service: Residential: Units of service Allocated cost of service Commercial: Units of service Allocated cost of service Industrial: Units of service Allocated cost of service Fire-Protection Service: Units of service Allocated cost of service Total inside-city allocated cost of service Outside-City: Unit costs of service ($/unit) Wholesale: Units of service Allocated cost of service Total system allocated cost of service

968,000 $181,300 473,000 $88,500 1,095,000 $205,100

6,630 $670,300 2,592 $262,000 4,500 $454,900 960 $97,000

3,978 $115,400 1,620 $47,000 1,500 $43,500 4,800 $139,300

15,652 $418,700 1,758 $47,000 251 $6,700

185,760 $370,100 14,640 $29,100 420 $800

$1,755,800

$473,600

$711,000

$58,100

$294,400 $3,234,800

11 12 13 14

0.2010 230,000 $46,200 $521,100

127.5419 1,418 $180,800 $1,665,000

39.2642 945 $37,100 $382,300

31.6180 34 $1,000 $473,400

1.9924 48 $100 $400,100 $58,100

$265,200 $3,500,000

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DISTRIBUTION OF COSTS

31

Commodity costs, which tend to vary with the annual quantity of water produced, are distributed to inside-city customer classes by applying the inside-city commodity unit cost of $0.1873/thou. gal to the respective inside-city class units of service. Likewise, demand-related costs for maximum-day and maximum-hour service requirements are distributed to the classes based on the application of total estimated class service demands and the unit costs of demand. Customer costs to be distributed for meters and services and for billing and collecting are the same under both the baseextra capacity and commoditydemand methods and are distributed similarly in both methods. Meter-and-service costs are distributed to classes in proportion to the number of equivalent 58-in. meters, whereas billing and collecting costs are distributed on the basis of the number of bills rendered. Cost of service for outside-city wholesale service may also be derived by applying the outside-city unit costs of service to outside units of service. A summation of the distributed costs for each component of cost for inside- and outside-city customers yields the total distributed customer class cost-of-service responsibility and appears in the right-hand column of Table 3-6. A word of caution should be added that may prevent misinterpretation of the commodity cost of $0.1873/thou. gal. Under no circumstances is this the cost of water. Even with perfectly uniform use, demand or capacity costs must be added. The baseextra capacity method avoids the possibility of such a misconception.

Copyright (C) 1999 American Water Works Association All Rights Reserved

AWWA MANUAL

M1

Chapter

4 Development and Design of Rate Schedules


The preceding chapters have discussed general procedures for determining total costs of service and assigning these costs to classes of utility customers in accordance with their respective service requirements. This chapter presents the final step in a cost-of-service rate studynamely, the development of a schedule of rates to recover, as nearly as possible, the allocated costs of service from customers. The initial portion of this chapter discusses several considerations to be addressed during the rate-design process and is followed by an illustration of the development of a cost-of-service schedule of rates based on costs identified and allocated in chapters 1 through 3. The final portion of this chapter is devoted to a review and general discussion of alternative rate considerations, some of which may deviate from cost-of-service principles. The circumstances under which such alternatives may find acceptance for meeting social, special service, or other requirements are also discussed. When a deviation from cost-related rates is made, the reason for such modification should be explicitly understood so that the responsibility for such deviation is placed on legal and policy-making factors, and the public is not misled into believing that the resulting rates are fully cost-related when they are not.

BASIC COST-OF-SERVICE RATE PHILOSOPHY ________________


General Considerations
A primary consideration in the derivation of water-rate schedules is the establishment of equitable charges to customers commensurate with the costs of providing that service. As previously discussed, the only method of assessing entirely equitable

32

Copyright (C) 1999 American Water Works Association All Rights Reserved

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33

rates would be the determination of each customers water bill, based on his or her particular service requirements. Since this obviously is impractical, if not impossible, when dealing with thousands of customers, rates are normally designed to fit average conditions for groups of customers having similar service requirements. Chapter 3 developed a basis for categorizing customers into classes having similar service requirements and presented a methodology for identifying the costs of serving each customer group. Adherence to the results of the cost-of-service determinations presents a practical basis for determining equitable water rates. However, before cost-of-service rates can be designed, several policy considerations, which may ultimately affect the actual development of rates, should be addressed. These are discussed below. Once costs of service by class are established, based on the overall level of needed revenue requirements, characteristics of the rate-schedule format may be analyzed for their adequacy in recovering costs of service. While rates designed on the basis of cost of service should be the principal consideration in rate making, judgment must be exercised in the final decision as to revisions to be made in the existing rate structure. Various factors may affect the decision as to recommended rate modifications. Factors such as general public reaction to changes in rates; consideration of the impact of shifts in the cost burden from a group of customers that has been overcharged to a group that has been subsidized under existing rates; reluctance to depart from rate forms that have existed for so long that they have almost become traditional despite inequities; pressure of special interest groups; and similar factors may require consideration as revisions in existing rate structures are made. Therefore, the basic objective of a rate study should be the development of a rate structure that will attain the maximum degree of equitability among customers, will be consistent with local practice and conditions, and will be in the best interest of both the community and the utility. Departure from rates based on cost of service is generally a decision made for political, legal, or other reasons. Consideration of rates deviating from cost of service, therefore, is made by politicians, not the rate designer. A factor that may have some bearing on the rate-design process is consideration of metering requirements associated with various rate formats. There are certain limitations in designing water rates that relate to existing and economically available water meters. For instance, water rates having both demand and volume elements are practicable only for very large users because demand-metering equipment is generally too expensive for most customers. Routine reading of water meters, many of which are located indoors, often presents administrative and logistical problems. Often water meters are only read quarterly or semiannually. Such factors can seriously affect the practicality of seasonal types of rates. Thus, water rates should be designed with metering practicalities in mind and with the thought that they may be revised if and when future technology and costs permit.

General Service Rates


For reasons of practicality of application, administration, and customer acceptance, it is common practice in the water industry to provide water service to all general service customers within a given jurisdiction through a single rate schedule comprised of a two-part rate. This two-part rate includes an initial charge to generally recover customer-related and possibly some volume-related costs, together with a volumetric charge to recover remaining volume costs. This is quite different from the practice of other utility services (such as electricity, gas, and telephone), for

Copyright (C) 1999 American Water Works Association All Rights Reserved

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WATER RATES

which separate rate schedules are used for residential, commercial, industrial, and other classes of customers. The design of a water-rate schedule that requires each customer class to pay its full cost of service takes into consideration unit costs applicable to the level of service rendered. Unit costs for each major component of service have been described and illustrated in chapter 3. Recognition of the degree to which each component is involved in providing the level of service rendered provides a basis for design of a schedule of rates. Recovering customer costs. The method of recovering customer costs, such as meter reading and billing-and-collecting, should reflect factors such as different frequencies of meter reading and billing among customers, and it may consider the greater cost of billing for large meters and other factors. Customer costs related to meter reading and billing-and-collecting are incurred regardless of the amount of water, if any, that is used. These costs are generally recovered through either a minimum charge or a service charge. The minimumcharge format is usually designed to recover all customer-cost elements and both the volume and extra-capacity-related costs associated with an allowance for a specified quantity of water usage. The water use included in the minimum charge can be established at a level such that some nominal percentage of all the residential bills will be rendered under this charge, perhaps on the order of 5 to 15 percent. The percentage selected for this purpose should not be so high, and the water allowance so great, that it effectively approaches a flat rate for a large number of customers. This would encourage waste of water by those customers who normally would use a smaller quantity of water than that included under the minimum charge. Another criterion that might be considered is to base the water allowance included in the minimum charge on the winter time (nonirrigation) use of very small households. The water allowance under the schedule of minimum charges may be uniform for all customers, or it may be graduated, based on meter size. Another form of minimum charge is a disappearing charge, which fixes the minimum amount of dollars to be collected from the customer and incidentally allows the customer a given amount of water under the minimum charge. The amount of water allowed is simply determined by the quantity that the customer could buy under the applicable volume rates. Under this type of rate, the minimum charge is disappearing in that when use exceeds the amount allowed under the minimum charge, the regular rate schedule prevails. Rather than preparing a minimum bill that includes an allowance for some water use, the rate schedule can be designed to provide for a service charge, or readiness-to-serve charge, which would be an initial charge that provides no water-use allowance. The service charge is designed to recover customer-related costs and possibly some capacity-related costs associated with readiness to serve, and, consequently, all water use would be billed under subsequent rate blocks. From the standpoint of cost recovery, either a minimum bill or a service charge can be used, if properly designed. As with the minimum charge, the service charge may be graduated by meter size, based on an analysis of metering, billing, and other associated costs for customer services of varying sizes. Recovering costs related to volume and extra capacity. An important issue to be determined in rate design is whether the water rate schedule will consist of (1) a single rate per unit of volume, irrespective of the volume of use, or (2) two or more rate blocks. Because of load-factor effects, the rates for subsequent blocks generally decline for larger rates of use. Such a schedule is often referred to as a declining-block schedule. In some instances, there may be an inverted rate structure,

Copyright (C) 1999 American Water Works Association All Rights Reserved

DEVELOPMENT/DESIGN OF RATE SCHEDULES

35

whereby the charge for use beyond the first block would be priced at higher rates rather than at declining rates. Contrary to usual lay opinion, a declining-block water-rate schedule may be designed to recover the costs of serving different classes of customers while maintaining reasonable equitability between the customer classes. In the design of rates, declining blocks do not reflect quantity discounts or lower rates simply because water is sold in large amounts. Such rates do provide a mechanism for recovering costs from residential, commercial, and industrial users based on the differing water-use and demand characteristics associated with providing their service. It has been found that the larger users, as a class, characteristically have a much lower peak-to-average demand factor with correspondingly lower extra capacity requirements and related costs than do the smaller users, as a class. Accordingly, a properly designed block-rate schedule having a decreasing level of unit charges will ordinarily recover revenue for each class in accordance with the cost of providing service to the respective classes. Where all customer classes are served under a single water-rate schedule, it is necessary that several rate blocks be used. As an approach to the design of a schedule of rates, recognition of costs associated with various levels of customer usage, in general, provides a basis for the selection of usage blocks and the development of rates for respective blocks. An initial block may be designed to recover customer and other costs associated with use of the smallest users. This block is normally associated with the allowance included in the minimum charge. Subsequent rate blocks may be designed to recover costs, beyond those of the smallest users, associated with use and capacity requirements of residential and small commercial customers. In special cases, an additional block may be warranted for an extremely large industry having nearly uniform demand requirements. Each subsequent block should be designed to recover that part of the total cost of service that has not been recovered through rates for water use in prior blocks. In order to design rate blocks and to estimate revenues to be obtained through the designed rates, an analysis of the number of bills rendered to various customer classes at various use levels is necessary. The blocks that ultimately control the charges for any particular system should be designed on the basis of customer-class water usage information derived from billing records of that system. Such information can be provided in the form of a bill tabulation showing, by meter size and customer classification at each level of use, the number of bills rendered and the use, as well as the cumulative use and bills rendered at each of the various levels of use. This information can then be depicted graphically by means of curves showing the relative percentage of total use by meter size or customer class at various levels of usage per month. Appendix A presents procedures for tabulating bills and usage based on hypothetical water billing records. Figure 4-1 shows examples of curves prepared to express the various levels of monthly water use per customer in a class as a percentage of the total water use by that class. The cumulative percentage of total water use by class is shown on the vertical scale, and monthly water use per customer is shown on the horizontal scale. For residential customers, a usage of 10,000 gal/month intersects the curve at 88 percent. The 88 percent figure for residential customers represents total water used by those customers using a total of less than 10,000 gal/month, together with the first 10,000 gal used by customers with greater than 10,000 gal total monthly use. Similarly, the curves indicate that only 12 percent of commercial use and only a very small percentage of industrial use occurs in the 010,000 gal or less monthly usage range.

Copyright (C) 1999 American Water Works Association All Rights Reserved

36

WATER RATES

Copyright (C) 1999 American Water Works Association All Rights Reserved

Figure 4-1 Metered water-use condition (example).

DEVELOPMENT/DESIGN OF RATE SCHEDULES

37

Such curves provide a basis for selection of usage blocks in rate design and a means of estimating total annual revenues by customer class that would be derived from rate schedule designs. For various water systems, the curves are usually similar in configuration, often of an ogee type, but the slope and relative locations of the curves for any particular utility will depend on the type and mixture of customers served by the utility. For instance, the amount of lawn sprinkling that occurs significantly affects the location and shape of the residential curve. The commercial class curve for a large city would represent a composite usage pattern of numerous stores, office buildings, hotels, and other commercial establishments, whereas for a smaller town, the pattern may be more subject to the possible influence of one particular business or customer.

Fire-Protection Service
Consideration of the costs of service related to fire protection should normally be included in a cost-of-service study. The development of rates to recover the costs of service are often separated into public and private fire-protection categories. Public fire-protection service would consist of the costs for fire hydrants and the backup facilities required to provide an adequate water supply in the event of fire. Private fire-protection service would consist generally of the costs for backup facilities and separate connections to the water system for the purpose of providing water to fire sprinkler systems, fire standpipes, and private fire hydrants located on customer premises. Customers with private fire-protection-service connections are generally large industrial, commercial, and governmental buildings and facilities. The division of fire-protection-service costs that are common to both public and private fire-protection service may be accomplished in several ways. A relatively simple method is to base the division of costs related to common facilities between public and private fire protection on the number of equivalent 6-in. public fire hydrant branches and the number of equivalent 6-in. private fire connections. Equivalent 6-in. connections can be determined on the basis of cross-sectional area, or it may be appropriate to consider relative potential fire flows. Charges for fire-protection service are based on costs not only of direct facilities, such as public hydrants and fire-service connections, but also the allocated share of costs for backup facilities in the water system, including transmission and distribution mains, storage facilities, pumps, and other facilities. The backup facilities normally constitute a much larger share of the cost of providing fire-protection service than the costs directly related to fire-service connections. Rates for public fire protection are generally expressed as a total annual charge and may be expressed as an annual charge per hydrant. In some cases, a separate charge is made for the water mains and backup facilities on an inchfoot (in.ft) basisthat is, the footage of main multiplied by the inches in diameter. By this method, an annual charge is made in cents per inchfoot of main, and an additional charge is made per hydrant. Both unit charge methods are founded on sound principles and have the merit that the total annual charge for fire-protection service increases with the amount of fire-protection facilities installed. In some instances, the cost of public fire-protection service is collected as part of the basic water rates applicable to retail customers, rather than through a separate charge to the municipality or fire-protection district served. In this case, public fire-protection allocated cost of service must be distributed to customer classes benefited by public fire protection. While there are often legal or other reasons for such a practice, the preferred method is to charge the municipality directly for fire-protection service.

Copyright (C) 1999 American Water Works Association All Rights Reserved

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WATER RATES

As previously noted, the reader is referred to chapter 2 of AWWA Manual M26, Water Rates and Related Charges, for further discussion of fire-protection rates and charges.

Wholesale Service Rates


Where wholesale or sale-for-resale service is provided, a careful analysis should be made of the cost-of-service elements entering into such service. For example, where wholesale customers are served directly from major transmission facilities, an allocation of small distribution mains may not be appropriate since they provide little service to such customers. For service to large-use customers, it may be desirable to design a two-part volumedemand rate with one part applicable to the volume of water used and the other to measured demands imposed on the system by the customer. This type of rate requires demand-metering equipment, a more costly installation than straight volume metering; however, it may benefit both the utility and the customer to have such a demand rate since it is directly responsive to the service requirements of the wholesale customer. It is important to carefully define and evaluate the cost of providing water on a wholesale basis and to design the rates accordingly. A demand-type rate will encourage the wholesale customer to either install storage on the system or to adjust operations so as to minimize peak demands to the fullest extent practicable. Such incentives benefit the customer and the water utility in terms of reducing peak water demands and costs.

Customer Resistance and Lag


Two additional considerations that can be incorporated into the rate-design process are recognition of customer water-use resistance and lag. When a substantial increase in rates is indicated or when the differential increase among classes of service is somewhat drastic, it is wise to consider in the design of the rates possible customer conservation of water use as a resistance to increased charges. In general, reduction in customer water usage following a rate increase is usually temporary in nature, particularly with modest increases. However, when rates reach such a level that once-through use is not economical, business and industry will initiate more stringent reuse practices with resulting permanent reductions in water requirements. Similarly, when water is no longer considered an inexpensive service, residential customers will take action to conserve on their usage. The extent of potential customer water conservation with increased charges warrants careful consideration in rate design if the utility is to actually realize the required additional revenues. Another factor sometimes overlooked in considering a rate adjustment is a possible lag between the date of rate increase and actual receipt of additional funds. The degree of lag can depend on billing frequency, accounting procedures, or other factors. Failure to recognize lag in receipt of additional funds can create a revenue cash-flow problem, particularly in the initial year of an increase, with the result being a shortfall in revenues due to the timing of water revenue receipts.

RATE-DESIGN EXAMPLE ____________________________________


The development of a schedule of rates to recover costs of service allocated to customer classes in chapters 2 and 3 is presented to illustrate rate-design procedures discussed previously. Development of rates in the example is prepared from cost information determined under the baseextra capacity method. It is noted that if all

Copyright (C) 1999 American Water Works Association All Rights Reserved

DEVELOPMENT/DESIGN OF RATE SCHEDULES

39

elements of cost are properly allocated, use of either the baseextra capacity or the commoditydemand method will result in comparable charges. One particular advantage in using the baseextra capacity method is that it identifies in the base cost element the minimum unit volume cost of service. Such a unit cost would be applicable as a rate only if perfect load factor or constant rate of use could be achieved. Therefore, the unit base cost provides a measure of the lowest potential charge in a schedule of rates for delivery of uniform service. As such, the unit base cost establishes an important guide in preventing the potential for establishing a charge that could result in the sale of water below cost. For purposes of this example, the design of a rate form having a service charge with block rates is illustrated. In addition, a minimum charge is also designed to illustrate an alternative type of initial charge.

Service-Charge Design
Customer costs, which are comprised of meter-and-service and billing-and-collecting related costs, may be recovered from customers through a service charge. In addition, a portion of distribution-main costs as well as a portion of demand-related costs are sometimes included in the determination of service charges. In this example, however, only customer-related costs of meter-and-service and billing-and-collecting related costs are included in the determination of service charges. As discussed, no allowance for water usage is included in the development of the service charge, and, therefore, the base and extra capacity costs are recovered in the volume portion of the rate illustrated subsequently. Table 4-1 presents the development of a monthly service charge for inside-city retail service customers. Unit customer costs for meter-and-service and billing-andcollecting related costs are presented in column 1. Examples of unit costs are as developed in Table 3-3. Since the meter-and-service unit cost of $26.7522/equivalent meter is an annual cost, it is divided by 12 to derive the monthly unit cost of $2.2294/equivalent meter/month. The unit billing-and-collecting cost of $1.9924/bill is based on the total number of bills projected to be issued annually during the rate

Table 4-1 Design of Inside-City Monthly Service Charges (Test Year)


(1) Line No.
58-in.

Unit Cost Service Charge: Meter-and-service-related costs Billing-and-collecting-related costs $2.2294/meter $1.9924/bill*

(2) Equivalent Meter-andService Ratio* 1.0

(3)

Cost $2.23 1.99 ______ 4.22 4.20

1 2 3 4 5 6 7 8

Total Total (rounded) 2-in. Service Charge: Meter-and-service-related costs Billing-and-collecting-related costs Total Total (rounded) $2.2294/meter $1.9924/bill 2.9

6.47 1.99 ______ 8.46 $8.45

*Ratio of investment in this size meter and related service relative to investment in a 5/8-in. meter and related service per chapter 3. $26.7522 annually/equivalent meter / 12 bills/year = $2.2294/month/equivalent meter per chapter 3.

Copyright (C) 1999 American Water Works Association All Rights Reserved

40

WATER RATES

year. Column 2 presents the equivalent meter-and-service ratio, which reflects the relative ratio of meter-and-service investment as compared to a 58-in. meter. As shown in column 2, a 2-in. meter is assigned a factor of 2.9, indicating the relative difference in cost incurred by the utility to buy, install, and service this meter as compared to a 58-in. meter. For purposes of this example, it is assumed that billing-and-collecting costs do not vary substantially from smaller to larger customer accounts, and all accounts are billed at a uniform rate of $1.9924/bill/month. Application of the equivalent meter-and-service ratio to the unit meter-and-service cost results in the total meter-and-service cost portion of the service charge. In the case of the 2-in. meter, a ratio of 2.9 is applied to the unit cost of $2.2294, and a total cost of $6.47 is determined, as shown in column 3. A billing-and-collecting cost of $1.99 is added to the meter-and-service cost of $6.47 to derive the total 2-in. service charge of $8.46, which is rounded to $8.45. Similar determinations would be made for each meter size to determine the total service charge. Service charges for outside-city retail service would be developed in a manner similar to that used for inside-city retail service, except that outside-city unit costs would be substituted for inside-city unit costs. Once the service charge is established for each meter size, the charge can be applied to the total number of customer-class bills to determine total service-charge revenue for each customer class. Total service-charge revenue by class is considered subsequently in conjunction with customer-class revenues from volume-related charges to verify that total water charges generally recover allocated costs of service from each customer class.

Block-Rate Design
Block rates provide a means of recovering costs for general service classes of residential, commercial, and industrial users under a single rate schedule by recognizing the differing water-use and associated cost characteristics for each class of service. The blocks that ultimately control the charges for any particular system should be designed on the basis of customer-class water-use information derived from historical billing records for that system. As previously discussed, billing information is tabulated by customer class to establish quantity of usage and number of bills rendered at various usage levels. The results of the bill tabulation are then graphically depicted for each customer class in the form of curves to allow selection of appropriate usage blocks. The curves depicted in Figure 4-1 are used in this example of rate design and express levels of monthly water use by retail customer classes. Comparison of individual customer-class curves reveals the distinct differences in the use patterns of the classes of customers. These patterns afford a basis for design of a rate structure, through proper selection of usage blocks, under which revenues can be derived in accordance with the cost responsibility of each class. An example of rate-block selection is indicated at the top of Figure 4-1. Examination of the figure indicates that an initial block of 15 thou. gal would include a large portion of the total residential use but relatively little commercial or industrial water use. Accordingly, most residential costs of service would need to be recovered in this first block, and water-use and cost characteristics of this type of service would serve as the predominant basis for the design of rates for the initial block. The next 1485 thou. gal, beyond 15 and up to and including 1500 thou. gal, would include a major part of the total commercial water use and only a small portion of industrial water use. The rate for this block would need to be adequate to recover a large part of the costs of providing commercial service. Water-use and related

Copyright (C) 1999 American Water Works Association All Rights Reserved

DEVELOPMENT/DESIGN OF RATE SCHEDULES

41

demand cost characteristics of commercial customer service would be included in the basis of design of the rate. Figure 4-1 indicates that a final block, including water use over 1500 thou. gal/month, would encompass essentially all the industrial service and the use by commercial customers not covered in earlier blocks. Accordingly, rates for this block would be designed to recover primarily the industrial-class costs of service, based principally on the cost characteristics associated with industrial service. In addition to providing a basis for the initial selection of appropriate limits for block rates, information in Figure 4-1 also affords a means of estimating revenues that would be derived from each class of service for any particular schedule of blocks and rates. Such curves provide a basic tool for use in testing whether or not proposed rates derive revenues from the various customer classes in accordance with the respective class costs of providing service. After selection of the usage blocks, the next step becomes one of designing an appropriate schedule of block rates. The design of a water-rate schedule that requires each customer class to pay its full cost of service takes into consideration unit costs applicable to the level of service rendered. Unit costs for each major component of service associated with water usage of base cost and maximum-day and maximumhour extra capacity costs are developed in Table 3-3. Recognition of the degree to which each component is involved in providing the level of service rendered provides a basis for design of a schedule of rates. Table 4-2 shows the derivation of the typical costs per thousand gallons for inside-city service, including the elements of base cost and maximum-day and maximum-hour extra capacity costs. The total cost for each block reflects the cost characteristics of the predominant class of water use that occurs within the respective blocks. The base cost per thousand gallons by water-usage block is shown in column 2. Base cost, by definition, is the cost for constant, uniform, or perfect load-factor use, and the unit cost is the same for all levels of use or classes of inside-city service. Accordingly, the variation in the total cost per thousand gallons between levels of usage reflects solely the difference in extra capacity requirements for classes of service representative of the various levels of use. The first 15-thou.-gal-per-month block includes 94 percent of the residential use, 15 percent of the total commercial use, and practically no industrial use. Accordingly, the maximum-day and maximum-hour capacity factors in excess of average-day use

Table 4-2 Derivation of Typical Inside-City Cost per Thousand Gallons by Water-Use Blocks (Test Year)
(1) Water-Use Block Line thou. No. gal/month 1 2 3 First 15 Next 1485 Over 1500 (3) (4) Extra Capacity Factor Extra in Excess of Capacity Base Cost Average Day Cost* $/thou. gal % $/thou. gal 0.5742 0.5742 0.5742 150 100 50 0.2763 0.1842 0.0921 (2) (5) (6) Extra Capacity Factor Extra in Excess of Capacity Maximum Day Cost % $/thou. gal 150 125 50 0.1143 0.0952 0.0381 (7)

Total Cost $/thou. gal 0.9648 0.8536 0.7044

*Based on maximum-day extra capacity unit cost of $67.2394 /year/thou. gpd divided by 365 days/year (or $0.1842/thou. gal) applied to the extra capacity factor shown in column 3. Based on a maximum-hour extra capacity unit cost of $27.8065/year/thou. gpd divided by 365 days/year (or $0.0762/thou. gal) applied to the extra capacity factor shown in column 5. Total cost per thou. gal is equal to sum of values shown in columns 2, 4, and 6.

Copyright (C) 1999 American Water Works Association All Rights Reserved

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for the block are shown on line 1 in columns 3 and 5 and are representative of residential service. The next 1485-thou.-gal-per-month block is predominantly a commercial-class block. Therefore, the extra capacity factors on line 2 of Table 4-2 used in development of the average cost for water use in this block principally reflect commercial-service characteristics. The last block of over 1500 thou. gal/month includes primarily industrial water use. Accordingly, the extra capacity factors listed on line 3 in the derivation of the average costs for the last block of the rate schedule are considered representative of large-volume customer water-use characteristics. The resulting total costs per thousand gallons are derived in column 7 by adding costs developed in columns 2, 4, and 6 and provide an initial basis for selection of potential rates. The costs indicate that for monthly water use a schedule of rates for inside-city service of $0.96, $0.85, and $0.70 per thousand gallons, respectively, for each of the three blocks might be proposed. However, the designed rates are subject to further testing to determine if revenues of each class meet costs of service. Costs for outside-city service would be developed in a similar manner, using customer-class characteristics and unit costs appropriate for those customer classes. For the purpose of simplicity in illustration, the development of total costs per thousand gallons developed in Table 4-2 is based on a single set of water-use characteristics selected as a representative composite of all customer use within each block. Actually, the amount and characteristics of use will vary among customers within each block. Detailed design studies would involve examination of the costs for a range in both amount and characteristics of water use for various potential users within each block and might indicate the selection of extra capacity factors that reflect a combination of factors from more than one class. Actual rate-design practice would also recognize that because of the relatively high capacity factors associated with water use in the initial rate blocks, charges in these blocks may recover costs in excess of the requirements representative of usually better load-factor users in subsequent rate blocks. The calculated charges for subsequent rate blocks may need to be adjusted downward to recognize costs recovered in prior blocks. In this example, the rate applicable to wholesale service is derived simply by dividing the total allocated cost of service of $262,200 from Table 3-5 by the total annual use of 230,000 thou. gal, resulting in a uniform volume rate of $1.14/thou. gal. Declining-block rates are usually not appropriate for wholesale service because large-use wholesale customers do not necessarily have more favorable peaking factors than do small wholesale users. In other words, quantity of use is no indication of load characteristics for this type of customer. The calculated rates should be tested by application to customer-class water usage to determine if revenues will be derived from each class in accordance with the cost of service. At this point in the development of the rate schedule, comparison of revenue using designed rates with costs of service by customer class may indicate that designed rates may not adequately recover costs of service from one or more customer classes while recovering more than cost from other classes. Selection of slightly different rate blocks or redesign of rates for selected blocks using modified excess capacity factors may be warranted in order to more closely recover total allocated costs of service. Normally, if designed rates recover total system costs of service and individual customer-class costs of service to within 2 to 3 percent, the rates may be considered adequate.

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Table 4-3 shows a test for the rate schedule developed for all classes of service. It is noted that final block rates designed for inside-city service are slightly different than reflected in the initial schedule of rates developed in Table 4-2 in order to more closely recover total customer-class costs of service. Columns 1 through 3 present the development of the total annual water use by rate blocks for each class of service. The percent of use by rate blocks shown in column 2 is derived from the customer-class curves presented in Figure 4-1. Application of these percentages to the total average annual class for the rate year results in the projected water use by block shown in column 3. The resulting revenues under proposed rates after application of the proposed schedule of charges to water usage in each block is shown in column 5. The costs of service by customer class developed in Table 3-5 appear in column 6. The revenues, expressed as a percentage of costs and shown in column 7, indicate that the proposed schedule of rates derives revenues from all customer classes in accordance with the costs of providing service. Indicated deviations from allocated costs for all classes are less than 2 percent and are well within practical design allowances. Service charge revenues, also shown in the table, are derived by applying designed service charges by meter size to the total projected average test-year number of bills rendered by meter size to each customer class.

Table 4-3 Summary of Customer Water Use by Rate Block and Application of Proposed Rates (Test Year)
(1) (2) (3) (4) (5) Revenue Under Proposed Rates $ 785,300 882,600 50,000 0 _________ 1,717,900 76,100 68,900 321,400 19,300 _________ 485,700 7,500 2,100 129,900 640,400 _________ 779,900 256,400 1,200 262,200 _________ 263,400 _________ 3,503,300 (6) Allocated Cost of Service $ (7) Revenue as a Percent of Cost of Service %

Line No. Customer Class 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Industrial Commercial Inside-City: Residential

Monthly Usage Block thou. gal Service charge First 15 Next 1485 Over 1500 Total Service charge First 15 Next 1485 Over 1500 Total Service charge First 15 Next 1485 Over 1500

Percent of Use %

Annual Water Use thou. gal

Proposed Rates $/thou. gal

94.0 6.0 ______ 100.0 15.0 79.0 6.0 ______ 100.0 0.2 13.8 86.0

909,900 58,100 _________ 968,000 71,000 373,700 28,400 _________ 473,100 2,200 151,100 941,700 _________ 1,095,000

0.97 0.86 0.68

1,722,800

99.7

0.97 0.86 0.68

479,900

101.2

0.97 0.86 0.68

Total Public fire-protection-service annual charge 1155 hydrants @ $222 per hydrant Outside-City: Wholesale Service charge All usage

778,900 256,200

100.1 100.1

17 18

100.0

230,000

1.14

19

Total

262,200 __________ 3,500,000

100.5 ______ 100.1

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In practice, the development of rates that result in revenue meeting costs within limits indicated in the illustration may involve adjustments to the number of rate blocks, usage allowances in each of the various blocks, and the individual block rates within the schedule. It should be recognized that satisfactory results on a first-try basis would be a marked oversimplification of the problems usually involved in the development of an appropriate schedule of rates.

Rate Design for Fire-Protection Service


In the cost-of-service allocations, fire-protection service has been included as a class of service separate from regular retail service customers. Fire protection, like any other class of service, imposes on the utility certain demands and facility requirements with associated costs, and charges can be designed to recover costs for this service. The costs distributed to fire-protection service in Table 3-5 include extra capacity costs associated with potential demands on the system by public fire-protection requirements and direct costs related to investment in, and maintenance of, public fire hydrants. In this example, public fire-protection-service charges are stated simply as a cost per hydrant. Based on an allocated cost of service of $256,200 and 1155 fire hydrants, an annual hydrant charge of $222 would be assessed to the proper authority. Revenue under proposed rates for public fire protection is summarized in Table 4-3.

Minimum-Bill Design
Rather than utilizing a service charge that allows no water use, an alternative minimum charge that provides a customer with some volume of water for the charge may be designed as a part of the rate schedule. The initial block may be designed to recover customer costs and costs associated with use and capacity requirements of the smallest users. The remaining blocks are designed in the same manner shown previously to recover costs beyond those of the smallest users. Table 4-4 presents the design of the minimum monthly charge for an inside-city retail customer with a 2-in. meter. The total customer-cost component of the minimum charge is derived in the same manner presented for the development of service charges shown in Table 4-1 and is shown in lines 1 and 2 of Table 4-4. Costs for quantity of water use and capacity requirements are also recognized, and it is assumed the minimum bill would allow 1 thou. gal of water usage per month. Examination of the customer-class usage curves presented in Figure 4-1 indicates that this block encompasses approximately 10 percent of the total residential use, less than 3 percent of the total commercial use, and only a very small percentage of industrial use. For the example, the maximum-day and maximum-hour extra capacity factors in excess of average day of 150 and 150, respectively, are assumed to be representative of residential customers and are used to design the minimum charge. Application of the base and extra capacity unit costs of service to the assumed minimum-user conditions is shown in lines 4 through 6 of Table 4-4. The resulting total base costs of $0.57, maximum-day extra capacity costs of $0.28, and maximum-hour extra capacity costs of $0.11, together with customer costs, represent a total cost of $9.42 for the minimum allowed usage of 1 thou. gal. This may reasonably be rounded to $9.40. The design of rates for water use in blocks beyond the minimum would include recovery of costs associated with the requirements of the larger residential, commercial, and industrial customers. The design of a rate for each block would be made in the same general manner discussed previously.

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Table 4-4 Design of Inside-City Minimum Monthly Bill for 2-in. Meter (Test Year)
Line No. 1 2 3 Customer Costs: Meter-and-service-related costs ($2.2294/meter) 2.9 equivalent meter-and-service ratio Billing-and-collecting-related costs Assume 1.0 thou. gal monthly allowance, 150% maximum-day extra capacity factor, and 150% maximum-hour extra capacity in excess of maximum day Base Costs: @ $0.5742/thou. gal $0.5742/thou. gal 1.0 thou. gal Extra Capacity Costs: Maximum day @ 67.2394/year/thou. gpd = $0.1842 per thou. gal $0.1842/thou. gal 1.5 extra capacity factor 1.0 thou. gal Maximum hour @ 27.8065/year/thou. gpd = $0.0762 per thou. gal $0.0762/thou. gal 1.5 extra capacity factor 1.0 thou. gal Total minimum charge for 1.0 thou. gal allowance Rounded 0.57 Monthly Cost 2-in. Meter

$6.47 1.99

4 5 6 7 8

0.28 0.11 _____ 9.42 $9.40

BaseExtra Capacity Versus CommodityDemand Rate Design


The design of rates in the foregoing example is based on cost allocations made in accordance with the baseextra capacity method. Similar computations would also be made in designing rates using allocations based on the commoditydemand method. The use of costs derived by either the commoditydemand or the baseextra capacity method as a basis for rate design will result in comparable charges if all elements of cost are properly treated. As previously discussed, the baseextra capacity method directly identifies through the base-cost element the minimum unit cost of service after recovery of customer cost, and this would ordinarily be applicable only if perfect load-factor use could be achieved. The unit base cost provides a measure of the lowest potential rate in a schedule of rates for firm service, an important guide in preventing possible establishment of rates that could result in the sale of water by the utility at below cost. The principal difference between the commoditydemand method and the baseextra capacity method of cost allocation is in the effect of system diversity on cost. This difference may be illustrated by considering the allocation of costs to a perfect, or uniform, load-factor customer. Such a customer, exercising a constant demand 100 percent of the time, does not contribute to diversity in peak-demand requirements and should not receive benefits in cost that result from such diversity. In the commoditydemand cost method, the demand costs are allocated among users on the basis of their total diversified peak demands. Accordingly, the perfect load-factor customer is assigned a portion of the diverse peak-demand costs, thus receiving the benefits of system diversity of peak-demand requirements. In the baseextra capacity cost method, the perfect load-factor customer is assigned only base cost, which is allocated among customers on an average,

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nondiversified-use basis. Such a customer is then assigned the full cost incurred in providing his or her share of the nondiversified system load. The effect of the difference in the handling of system diversity in the two methods of cost allocation may be further illustrated by examining the allocation of costs to the opposite type of use by the totally standby customer. In the commoditydemand method, the potential demand of such a customer would be a part of the total diversified-system peak demand, the same as the demand of the perfect load-factor customer. The totally standby customer would share in the benefits in cost that result from diverse use only to the same extent as the perfect load-factor customer, who does not contribute to diversity of peaking water use. In the baseextra capacity method, the totally standby customers would only be assigned extra capacity cost, which is allocated among customers on the basis of the diversified extra demands created by only those customers contributing to the system diversity of peak water use. The baseextra capacity method provides a better means of cost allocation by recognizing the customer contribution to diversity in system peak water use. The conditions of a perfect load-factor customer and a totally standby customer illustrate the maximum differences in the two cost-allocation methods. The degree of difference in the cost allocations reduces progressively as requirements of the customer approach the total-system average requirements. Consequently, for many utilities the degree of difference will not be large by using either the commoditydemand or the baseextra capacity cost method.

OTHER RATE-DESIGN CONSIDERATIONS _____________________


Preceding portions of this chapter presented general considerations regarding the design of rates, recognizing traditional factors and rate forms, and included an example illustrating the derivation of cost-of-service rates in the form of a service charge and block-rate schedule. The remainder of this chapter describes other water-pricing practices through discussions of alternative water-rate forms. It is emphasized that these discussions are meant to be quite general. Considerations in specific situations may dictate procedures and influences quite different from those described herein. In every case, rate making must be based on reasonableness under specific conditions prevailing in the affected utility. American Water Works Association policy provides that water rates be developed in accordance with sound economic and engineering judgment and cost-of-service principles. In instances where the disparity between the existing level of charges and cost-based rates is great, a gradual movement toward cost-based rates is acceptable to moderate the impact of the change in rates on affected customers. In addition, departure from full cost-of-service approaches may be required in order to address special social, environmental, or other considerations as dictated by legal or policy-making bodies. Discussion of both cost-based and non-cost-based rate forms is included in this section. Departure from rates based on cost of service is not recommended by the AWWA Water Rates and Charges Subcommittee. It is, therefore, suggested that if deviation from cost-of-service concepts is to be considered, the consequences of such approaches should be brought out so that there is full knowledge and understanding of the effects of such a decision.

General Information
It is characteristic of the development of utility rates, including water rates, that when the average costs of serving customers are relatively low, systems of charges are

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justifiably simple. Rapidly increasing costs have generally prompted additional attention to equitability in the development of utility charges. At the same time that utilities are facing higher costs, there has been recent emphasis by certain groups for recognition of socioeconomic, environmental, and other considerations in the development of rates, considerations that may not be directly related to the utilitys cost of providing service. The philosophy of water utility rate determination has undergone dramatic changes over the past century. At the turn of the century, flat-rate (unmetered) charges that gave little recognition to the amount of service provided a given customer were utilized for most water customers. With the development of the water meter in the early 1900s, many water utilities adopted volume-related block-rate structures to better recognize customer-service requirements and the associated responsibility for costs. More recently, water utilities have been considering other rate structures, including those that try to recognize peak responsibilities in a more sophisticated manner. Rates designed to charge customers for the peak or seasonal demand that they place on a system may be viewed as simply a normal evolution in the increased sophistication in structuring rates to more equitably recover costs from those individual customers creating them. To recover water utility costs of service from customer classes, several alternative rate forms can be utilized, such as commoditydemand rates, seasonal excess-use charges, other forms of seasonal rates, and uniform volume charges by customer class. Some rate forms, such as commoditydemand rates, are theoretically better than others in recognizing individual customer requirements that deviate from the customer-class average requirements, but these rate forms have their practical drawbacks. Other rate forms, such as uniform rates for all customers, inverted block rates, lifeline rates, and other special rate forms, although not necessarily consistent with the cost-of-service concept, still may need to be considered for particular legal or policy reasons. The remainder of this section discusses, to a limited extent, these rate forms and other considerations that generally affect the selection and development of rates designed to recover total costs. It is noted that the AWWA Rates and Charges Subcommittee is developing a separate manual to provide a more complete discussion of alternative rate methodologies and forms than is provided in this manual.

Uniform Rate by Customer Class


The majority of investor-owned and government-owned water systems in the United States today provide water service to all general-service customers under a single declining-block rate schedule. This practice is quite distinct from electric and gas utilities, which often provide service to different customer classes under separate rate schedules. One advantage of providing for separate rate schedules by customer class is that each schedule can be designed based on the demand, use, and other characteristics of the customer class using a single rate for all customers in the class. Such schedules require up-to-date identification and classification of individual customers into rate classes having common characteristics. A list of such rate classes might include single-family residential, multifamily residential, commercial, industrial, public authority, and resale or wholesale. Separate rates for each class may complicate rate administration and cost and perhaps enhance the chances of controversy. Many public water systems have separate rates for retail customers residing outside the jurisdictional limits. In some instances, the same customer classifications might be used for retail service both inside and outside of the city. An initial step in

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considering separate rate schedules for outside-city customers is the practicability, identification, and classification of customers by customer classes. Where uniform rates by customer class are to be designed, they may basically be developed by dividing allocated class costs of service, less customer costs, by projected class water use.

Seasonal Rates
In most water systems, the peak demand for water service occurs in the summertime, when lawn irrigation and other outdoor water uses are more prevalent. This fact has given rise to consideration of seasonal rates, whereby higher rates are charged for water used in the summer, or peak season, than for the non-peaking portion of the year. Seasonal rates have received greater attention the last several years due, in part, to localized water shortages. In addition, the recognition of peaking requirements as a significant element of cost has opened the way to seasonal rates. There are several types of seasonal water rates. The simplest type is merely to charge a higher unit price for water used in the summer than for water used the rest of the year. A more sophisticated method is to develop a system of excess-use charges. Excess-use charges are characterized by having one schedule of charges for winter-season level of use, with an additional charge for use in excess of the base amount during a peak water-using period. Excess use is usually determined from the usage patterns of individual customers. The added charge is developed from an analysis of costs during peak and off-peak periods. For example, if a customers average monthly usage during the winter period is 10,000 gal and usage during a given month during the summer period is 25,000 gal, then the excess above-average winter-period monthly use of 15,000 gal would be charged at a higher rate than the rate for the first 10,000 gal, which would be at the lower winter rate. One consideration in developing excess-use charges is the determination of a suitable definition for excess use. In the broadest sense, excess use is that volume of use over a given period of time that exceeds some base figure. As a practical matter, excess use must be related to the period of time in which the volume of use can be measured in order to establish a sound basis for establishing excess usage. The definition of excess use selected will affect the magnitude of both the rate of charge for excess use and the base rate of charge (that is, the charge for off-peak usage). Before adopting any one definition of excess use, the potential quantitative and subjective impacts should be carefully considered. Particular emphasis should be placed on practicality of application, customer understanding, and potential administrative constraints and added costs related to metering, billing, and data processing. One beneficial aspect of an excess-use charge, even though it is a more sophisticated form of charge, is that it does tend to result in a more equitable bearing of costs by individual customers of the system. The costs incurred in meeting peaking requirements can be derived from among those customers using the extra capacity, while customers exerting relatively uniform requirements on the system bear only the costs related to such service. Each water system should consider seasonal rates on their individual merits after first determining the objectives to be accomplished through such rates. There are a number of unknowns regarding the effect of seasonal rates on peak system demands. Further experience and study are needed to determine whether or not and to what extent such rates do, in fact, moderate peak demands.

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CommodityDemand Type Rates


Commoditydemand rates. A commoditydemand rate can be developed for water service whereby the total charge consists of a customer charge to generally recover metering, billing, and collection costs; a commodity charge based on the total volume of water used; and a demand charge based on the maximum rate of water use. The commodity-charge portion of the rate usually takes the form of a uniform rate. The demand charge is based on a customers peak load imposed on the water system. If it were possible to meter and measure each customers volume-use and maximum-demand units of water service, it would be a relatively simple matter to apply the cost-of-service unit costs to customer-service requirements to determine each customers cost responsibility. Commoditydemand rates offer a sound means of recovering the costs of providing service to those customers with water-use characteristics that vary significantly from the class average. However, where demand rates are used, a recording metering device must be installed to record both volume of use and the maximum rate of flow. Although the commoditydemand form of rate is, in many respects, more equitable for all concerned, its application is not practical because demand meters, to the limited extent to which they are available, are relatively expensive to install and maintain, and benefits generally do not justify the added costs. As a result, commoditydemand rates are not commonly used in the water industry today. Generally, they are applicable only for large wholesale and industrial users where it is cost-effective to meter both total use and rate of demand. Peak-load pricing rates. Peak-load pricing and commoditydemand pricing are similar in that each method consists of a multiple-part rate structure in which charges are based on both the quantity of water used and the maximum rate at which it is used. However, peak-load pricing may recognize two types of demand: (1) customers demand that is coincidental with the system peak demand, and (2) customers noncoincidental demands (each of these demands are priced separately). Although this method of pricing for variations in the load factor overcomes some of the objection to demand pricing based on maximum noncoincidental demand only, it still requires the installation of expensive demand meters, and its administration is apt to be complex and costly. Off-peak rates. Off-peak rates for delivery of utility service are common in the electric utility industry and are occasionally considered in the water utility industry. Where used, separate rates or rates lower than average are applied to water delivered during off-peak periods. Such deliveries may be advantageous to a water utility whereby the overall system load factor is improved. As a practical matter, outside of possible industrial application, it has been found that few customers consider worthwhile the potential savings that may result from limiting their use to the off-peak service and the potentially lower rates related thereto.

Marginal Cost Rates


Marginal cost is usually defined as the cost of water from the most recent or next increment of plant capacity and supply. Some economists assert that the price of water should reflect the marginal cost. Thus, if a water utility needed to develop a new source of supply at considerable expense, the charge for all water sold should reflect that cost even though the average could be less. The contention is that only through such pricing is the customer given the proper signal as to the true price of

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water and the opportunity to make an economic decision concerning his or her desire for additional service. Although the economic theory behind marginal cost pricing is sound, the application of the theory to water rates lacks considerable practicality. Pricing all water at the marginal cost could result in the collection of revenue from customers considerably in excess of current needs. It has been suggested by some that such excess revenues should be utilized to lower rates to customers whose use is relatively inelastic, such as low-use customers. Marginal cost rates have some value in theory, but their practical applicability needs to be thoroughly studied before adoption.

Inverted-Block Rates
The inverted- or increasing-block rate structure is the counterpart to declining-block rates. Under such rates, the unit price rises with each successive block, resulting in both the incremental and average cost of water increasing with increased customer usage. The use of inverted rates is a relatively recent development in water pricing. The concept of an increasing price per unit of use frequently arises from the desire for conservation in total water use. Increased concern for conservation of resources has led to limited acceptance of inverted rates in several areas, particularly those facing immediate and recognizable water supply problems. It is not possible to design each rate step in an inverted rate schedule based on the results of a traditional cost-of-service study. In the traditional cost-of-service study, customers are allocated cost responsibility based, in part, on their demand for extra capacity. Declining-block rates are used to recognize that the average cost of water decreases with the volume used, due to improved peaking factors. Invertedblock rates, which charge a higher price for water as usage increases, do not recognize the generally better load factors of the large-use customers. It is possible to use some elements of a cost-of-service study as a guide in the design of inverted rates. For example, for the residential class, high irrigation use during the summer season is generally a cause indicative of a poor load factor. A peak-use-period inverted-block rate schedule could function to charge for such peak use. Inverted rate schedules would not likely be appropriate for all customer classes. Some large-volume commercial and industrial customers have very uniform wateruse patterns with a resultant lower unit cost of service than residential customers. A very practical objection to inverted rates is that higher use per customer does not necessarily indicate a higher cost per unit of use. Thus, only in special circumstances could inverted rates be considered as cost-of-service related. Such circumstances should be documented and carefully evaluated before inverted rates are proposed.

Uniform Rate
The uniform rate is a constant unit price for water, regardless of the amount used, and is applicable to all customers served. A uniform rate for all customers implies that each unit of water costs the same. The same rate is paid by all users, irrespective of user class, amount of water use, patterns of water use, or size of meter and service. Since the rate is generally established by dividing total anticipated costs by total anticipated water sales, it is easy to understand and administer. This type of rate may be appropriate where the predominance of water customers have similar water-use characteristics and, consequently, there is little

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need for more than a single charge. For example, a uniform rate might be appropriate in a suburban community with generally similar residential use only.

Unmetered or Flat Rates


Flat rates refer to charges utilized where customer use is not metered. Such rates are applied to certain measures of customer service, such as the number of rooms, the number of plumbing fixtures, the size of irrigated areas, and other such elements. Such rates have been common in the past and continue to be used in some water utilities. In specific instances where water conservation is not a significant consideration and the installation of meters is impractical, such rates can be designed to generally recover estimated costs of service, but they may contribute to excessive use of water with attendant higher total costs.

Lifeline Rates
Consumer-advocate groups sometimes propose programs to reduce utility charges for residential customers who are senior citizens, poor, or on fixed incomes. Such assistance is often described by the single category of lifeline rates. Lifeline rates seek to assure that each qualifying customer may obtain his or her theoretically minimum requirements for service at a lower-than-cost rate. Revenues not recovered from this minimum-usage allowance would need to be recovered by increasing the rates charged for use above the minimum, increasing the rates charged to other customers, or relying on revenue from other sources, such as general tax revenues. The lifeline concept of rate design is frequently proposed as an aid to economically disadvantaged and elderly residential customers who might not be able to pay their bills. Proponents of lifeline rates argue that (1) such rates are easy to understand and to implement and require no additional tax revenues; (2) the inverted form of rate will encourage conservation, since lifeline rates provide favorable rates for minimal conservative use and increasing rates for greater use; and (3) the poor and elderly, who are thought to be the low-use customers, will be the chief beneficiaries. Opponents of lifeline rates argue that the concept is essentially similar to a single schedule of inverted rates and has serious drawbacks. The first problem is that providing reduced rates to low-volume residential users can discriminate unfairly within a class of customers being provided essentially similar service. The subsidizing of one part of a class of customers by other classes of customers may be ruled unlawful discrimination except in those states that have enacted laws supporting the lifeline concept. In addition, a correlation between water use and income level generally has not been proven to exist. Consequently, lifeline rates may, in fact, unduly benefit customers who have low water-use requirements but who have the ability to pay for their full cost of service. Extensive discussion of the theory and practice of lifeline rates is beyond the scope of this manual. The institution of lifeline rates, which are not based on cost-of-service principles, should not be advocated by those responsible for rate design, except where legislative authority mandates such a policy. In the absence of such direction, rates should be based on nondiscriminatory cost-of-service principles.

Water Connection Charges


Many water systems require a connection charge for a new customer joining the system. The water connection charge is frequently based on a capital contribution by the customer for the purpose of financing initial capital investment attributable to the

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new service. Such charges can be valid, but are not considered as water rates in the ordinary sense of the term. Therefore, the concept is beyond the scope of this manual, which addresses general water-service rates. To the extent that such charges are used, development of appropriate charges should proportionately recover the costs incurred by the utility in providing the water service connection.

Other Considerations
The reader is referred to AWWA Manual M26, Water Rates and Related Charges, for further discussion of the rate and charge matters set forth in this manual. Each water utility should maintain adequate records to provide for periodic rate design. These include individual customer billing records for which a history of at least one fiscal year should be maintained. The billing records should be maintained so that they can be used to develop a bill-frequency tabulation (an example of which is shown in the appendix). Such records provide information as to the quantity of water sold at various levels of use and are used for rate-block design. In addition, accurate records of total daily raw- and treated-water produced as well as maximum-day and maximum-hour production at water treatment and major booster pumping facilities should be maintained so that they can be used to develop a bill-frequency tabulation (an example of which is shown in the appendix). Such records provide information as to the quantity of water sold at various levels of use and are used for rate-block design. Each utility should also maintain a careful record of all expenditures, including classified cost data regarding investment in the physical plant and equipment. Suggested accounting practices are set forth in the AWWA publication Water Utility Accounting (2nd ed., 1980). The information in this publication is not only vital for a rate-design study but is useful as a management tool.

Copyright (C) 1999 American Water Works Association All Rights Reserved

AWWA MANUAL

Chapter

5 Rate Design for Small Water Utilities

The allocation of the total cost of service to cost functions and the design of water rates to recover these costs using the somewhat complex techniques described in earlier chapters of this manual requires information not always available to small water utilities. Also, the cost of preparing relatively detailed studies may not be justified for a small utility. As the term is used in this chapter, a small utility may generally be defined as one having fewer than about 5000 customers. The purpose of this chapter is to provide a simplified cost-based method for the preparation of rates for a small utility. Use of the small-utility method, or simplified method, of rate design described in this chapter may be considered when the estimated cost of preparing a full rate-design study exceeds approximately 5 percent of the utilitys annual revenue. However, if a utility has substantial industrial or other special sales, it may be prudent to conduct a full study, even if the cost exceeds 5 percent of the revenue or if the utility is facing significant changes in costs. Such a study can demonstrate the changes in costs and how those costs can be reflected in rates. Generally, the simplified method is most appropriate for small water utilities with customers who are either mostly or entirely residential with a few commercial users, and who have no significant industrial or other special-use customers. It should be noted that many of the elements of a rate study presented in chapters 1 through 4 provide the background for suggested rate-making procedures presented in this chapter and should be reviewed and used as appropriate.

53

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INFORMATION AND DATA REQUIREMENTS


Small water utility data requirements for determining cost-of-service rates are quite similar to those required for larger water utilities. The following information, as a minimum, is required to develop the simplified rate design described in this chapter: 1. The revenue requirements of the water utility for the projected rate period in sufficient detail to permit allocation to cost categories. 2. A bill-frequency analysis of metered water use by customer class and meter size. 3. The number and size of meters by customer class.

REVENUE REQUIREMENTS
Development of revenue requirements to reflect annual cash needs of the utility is the first step in the development of rates and maybe incorporated as an extension of cash budgeting and accounting techniques practiced by most utilities. The objective of developing revenue requirements is to determine the cash needs and general timing of utility expenditures in order that adequate funds may be made available as requirements come due. Basic revenue requirements of a small government-owned utility would normally include operation-and-maintenance (O&M) expense, debt service on borrowed funds, allowances for normal annual repairs and replacement of existing facilities, possibly some small capital additions to the system, and other cash requirements for items such as payment in lieu of taxes and payments for services provided to the utility by other municipal departments. Revenue requirements for investor-owned utilities would include provisions for O&M expense, depreciation expense, income and property taxes, and return on rate base. In order to minimize potential cash-flow shortages during the period rates are to be effective, a forward-looking, or prospective, rate year should be used in developing revenue requirements. Projections of anticipated expenditures based on historical expense trends of anticipated growth in sales of water and of potential increases in costs of materials, supplies, and labor would be made for one or more years in the future. Recognition of factors such as the effect of inflation and growth on expenses will reduce the need for frequent rate adjustments likely to be needed if a historical test year is used as the sole basis for establishing revenue requirements. This is particularly true in periods of rapid inflation since the current and projected costs being incurred by the utility will generally exceed those incurred in the past. This procedure has been used frequently by government-owned utilities, and it is gaining increasing acceptance by state commissions regulating investor-owned utilities. Chapter 1 presents a more comprehensive presentation of the development of revenue requirements on the cash-needs basis, including provisions for recognizing cost escalation. As mentioned previously, revenue requirements must be identified in sufficient detail to permit development of cost-of-service rates. Generally, utility costs for O&M would be identified in accordance with specific operational areas or cost centers of the utility. Costs might be separated to include costs of O&M for source of supply, treatment, pumping, transmission and distribution; costs of customer metering, billing, and collecting; and costs of general administration. In addition, separate identification of power-related expense for treatment and distribution pumping as well as treatment-related chemical expense is recommended. Investment in utility plant and equipment should also be separated, based on operational areas, to the extent available.

Copyright (C) 1999 American Water Works Association All Rights Reserved

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Functional Cost-Allocation Components


In any utility, service provided to customers must include provision for meeting average water-use or volume needs as well as peak-demand requirements. In order to properly distribute revenue requirements, or costs of service, to customers in accordance with water-service requirements, utility costs must be identified as being related to particular levels of service. Costs related to levels of service provided may be categorized as either commoditydemand, customer, or public fire-protection costs. Costs allocated to the commodity cost component include those costs that tend to vary with the quantity of water produced. Commodity costs usually include costs of chemicals and power and other costs that increase directly with the, amount of water supplied. In the example presented in this chapter, chemical and power costs are allocated to the commodity cost component. Other costs that may be allocated to the commodity cost component include costs related to impounded reservoir source of supply and purchased water since these costs tend to vary with average daily usage requirements. Demand costs are associated with providing facilities to meet peak rates of use by system customers. Generally, all transmission and distribution system pumping and all treatment, transmission, and distribution mains and storage facilities are sized to meet peak demands. Consequently, costs associated with these facilities are allocated to the demand cost component. Source of supply costs related to groundwater sources are generally sized to meet maximum-day demand. Therefore, associated costs would be allocated to the demand component. For purposes of this example, supply is assumed to be from groundwater sources. Consequently, related costs are allocated to the demand component. Customer costs include costs incurred to serve customers, irrespective of the amount or rate of water use. Customer costs include meter and service maintenance, meter reading, billing, and customer accounting and collection costs.

Allocation of Public Fire-Protection Costs


Public fire-protection costs are related to provision of public fire-protection services and are directly allocated to the public fire-protection component. It may be difficult for small utilities to determine the full cost of public fire-protection service without performing comprehensive studies. Even though a utility may not charge its customers for public fire-protection service separately, a fire-protection-service cost allocation is desirable. Public fire-service costs are primarily demand-related. An estimate of the cost to provide fire service can be based on the results of cost-allocation studies made for other larger utilities where such information is available. In the absence of other data, an estimate can be developed using Figure 5-1. Based on the number of customers served, the curve indicates the amount of the fire-service cost as a percentage of the total revenue. This curve is an adaptation of a curve developed by the Maine Water Utilities Association, Gorham, Maine, and has been used by the Maine Public Utilities Commission, Augusta, Maine, as a basis for estimating the required fire-service cost when a detailed fire-service allocation study is not feasible. The results obtained from Figure 5-1 can be modified to reflect the results of other studies for other pertinent considerations as may be known. Fire-service costs derived from the figure may be considered to be the cost of service for public fire protection.

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Figure 5-1 Percentage of total revenue allocated as fire-protection-service cost.

Copyright (C) 1999 American Water Works Association All Rights Reserved

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Allocation of Revenue Requirements


Table 5-1 shows the allocation of plant value to cost functions using a simplified version of the commoditydemand method described in chapter 2. In the case of a government-owned utility, capital expense is assumed to include debt service as well as normal annual repairs and replacement expenditures. For an investor-owned utility, capital-related costs would include depreciation expense, income and property taxes, and return on rate base. Table 5-2 presents the allocation of O&M expense to functional cost components. Cost allocations to the commodity component include pumping power and treatmentrelated chemical expenses. Costs allocated to the demand component include labor, materials and supplies, and other expense for O&M of source of supply, pumping, treatment, and transmission and distribution expense for mains and storage facilities. Customer costs include expense related to services, meters, and customer accounting and collecting. Hydrant maintenance expense is allocated to the public fire-protection cost component. Administrative and general expenses are generally allocated to all cost components, based on the subtotal allocation of all other O&M expense, excluding power and chemicals, since relatively little general administration is required to monitor consumption of power and chemicals. Total costs of service for the test year to be recovered from general service rates are presented in Table 5-3. Total allocated O&M expense developed in Table 5-2 is restated in line 2 of Table 5-3. Capital-related expenses are allocated to cost components, based on total allocated plant value and are shown in line 3. Total utility costs of service are summarized in line 4 and are offset by revenue from public fire-protection service shown in line 5. The revenue to be obtained from public fire-protection service is estimated from the curve shown in Figure 5-1. In the example, 22.5 percent of the total revenue requirement, or $67,500, is allocated to fire-protection service based on the system having 2500 customers. In line 5, fire-protection service revenues are deducted to entirely offset costs allocated to the direct fire-protection cost component, with remaining revenues deducted from costs allocated to the demand cost component in recognition of the fact that fire service, other than hydrant expense, is predominantly

Table 5-1 Small UtilitiesAllocation of Plant Value Using the CommodityDemand Method

*Assumes groundwater source of supply. Allocated based on overall weighted allocation of all other plant.

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Table 5-2 Small UtilitiesAllocation of O&M Expense Using the Commodity-Demand Method

*Power for pumping only. Chemicals only. Allocated based on overall weighted allocation of all other expenses, excluding purchased power and chemicals.

Table 5-3 Small UtilitiesAllocation of Costs of Service Using the Commodity-Demand Method (Test Year)

*Allocation on basis of allocated plant value, line 1. Line 2 plus line 3. Line 4 less line 5.

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related to peak rates of use. The small amount of commodity cost that might be allocable to fire service is negligible in comparison to total system water use, and therefore, no cost is allocated to the commodity component. Total costs of service to be recovered from general water service rates are summarized in line 6 of Table 5-3.

RATE DESIGN
General
Two types of rate structures are recommended for consideration by small water utilities. A schedule consisting of an initial charge related to customer costs and a single-block rate structure is best suited for water utilities with primarily residential use and little commercial use. Utilities with significant commercial use should use an initial customer service charge and a two-block rate structure. Fire-service charges should also be considered and are discussed subsequently. Generally speaking, water utilities serving fewer than 500 customers are likely candidates for a single-block rate structure, whereas utilities serving from 500 to 5000 customers should probably use a two-block rate structure. It should be noted, however, that many water utilities at the upper end of this range could have significant industrial users, and a two-block rate structure may be unduly discriminatory. In such a case, the preparation of the detailed studies described in earlier chapters should be considered. A comparison of average water use for residential and commercial customers can serve as a guide to the number of rate blocks to be used. If the average use of residential and commercial customers is close, a one-block structure can be adequate. If the average commercial use is substantially higher than the average residential use, by perhaps three times or more, a two-block structure may be needed to provide equitability between the classes.

Single-Block Rate Design


If a single-block rate structure is to be used, the entire revenue requirement less customer costs will be recovered through a volumetric charge. This is calculated by dividing the revenues to be recovered by the total water sales, as shown in the following example:

To recover customer costs, a service charge with no water allowance can be developed. Table 5-4 demonstrates how to calculate the number of equivalent 5/8-in. meters. If the 2587 equivalent 5/8-in. meters calculated in Table 5-4 are to recover the $76,500 of customer costs calculated in Table 5-3, an annual charge of $29.57, or a monthly charge of $2.46, is indicated for an equivalent 5/8-in. meter. Development of a suitable monthly service charge for any size meter is accomplished by multiplying the appropriate equivalent meter and service ratio shown in Table 5-4 by the $2.46/month equivalent 5/8-in. meter service charge. For example, the monthly service charge for a 1-in. meter would be 1.8 times the 5/8-in. charge, or $4.43.

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Table 5-4 Small UtilitiesEquivalent 5/8-in. Meters

A minimum charge consisting of the service charge plus the volume cost of an amount of water allowed under the minimum is also acceptable. Details for calculating minimum charges are shown in chapter 4.

Two-Block Rate Design


If a two-block rate schedule is considered appropriate, it is necessary to establish the first-block water usage limit. This limit is needed in order to determine the total volume of water use in each rate block and to allocate the commodity and demand costs between the first and second rate blocks. One method for selecting rate blocks is to develop a bill-frequency analysis and prepare curves depicting the percentage of total water use by customer class and the total water use by the class. The appendix to this manual illustrates procedures for developing a bill-frequency analysis and curves. Once the curves are prepared, the initial usage block would be selected to include about 80 to 90 percent of residential usage. The second usage block would include all usage beyond the first block. In the absence of a bill-frequency analysis, a generally accepted practice is to set the water usage limit of the first rate block so that it will include almost all of the residential use. Generally, a first-block water usage limit of two to three times the average residential customers use is reasonable. Once established, a check of the customer bills for several months to determine the total use within the first block would be made in order to evaluate the percentage of annual water use that would be billed at the first-block rate. All other water would then be billed at the second-block rate. If less than a full years bills are analyzed, selection of bills should be for periods when a customers average water usage is not abnormally high or low, i.e., an all-winter period or an all-summer period. The next step is the allocation of the commodity and demand costs between the two rate blocks. A simple approach suitable for small water utilities is as follows: 1. Allocate the commodity costs between the first and second blocks based on the percentage of the volume of water sold in each block. 2. Allocate the demand costs between the first and second blocks based on the volume of water sold in each block but giving twice the weight to water sales in the first block. This assumes that water sales in the second block have a peaking factor of one half that of water sales in the first block, indicating a more uniform usage of water at higher use levels. Commodity and demand costs allocated to each rate block are then divided by total estimated water sales in each block to produce the block rate for each block. This calculation is illustrated in Table 5-5.

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Table 5-5 Small UtilitiesAllocation of Costs of Service to Rate Blocks and Calculation of Water Rates (Test Year)

If a study of the usage patterns in a particular utility indicates that a peaking-factor ratio different from that used in Table 5-5 is appropriate, then such a ratio should be used in the allocation of demand costs.

Unmetered Rates
Procedures for designing water rates for unmetered customers are included because many small water systems serve unmetered customers. In cases where the water utility has both metered and unmetered customers, an allocation of the revenue requirement between these types of customers must be made. For a small utility, it is an acceptable procedure to design metered rates and unmetered rates to produce about the same average revenue per customer from similar classes of customers. Unmetered rates should potentially reflect the greater costs required to serve these customers because they generally exhibit higher water use. However, the rates should also reflect lower customer costs resulting from the fact that the unmetered customers do not incur costs related to the increment of meter ownership and maintenance and meter reading expense. After determining the revenue requirements for unmetered customers, it is necessary to design rates to produce this revenue. Because the water use is unknown, the rates must be based on estimates of such customers demand for water. A commonly used basis for establishing rates of charge is the number of water-using fixtures in the structure served. This requires an inventory or count of all the fixtures and an estimation of their demand - capability. The demand characteristics of various water-using fixtures is published information, but it must be remembered that as the number of fixtures increases, the probability of using all fixtures coincidentally diminishes. Therefore, a customers first faucet is given substantially more weight and a higher charge than the balance of the customers fixtures. Thus, the first-faucet charge can become the minimum charge. The first-faucet or minimum charge should produce a substantial (25 to 50) percent of the total revenue requirements from these customers. Additional fixtures owned by the same customers are generally assigned a lower charge, which should be related to their rated capacity use.

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The following example demonstrates a method used to calculate unmetered or flat rates:
Assume the total test-year annual revenue requirements from 2500 flat-rate residential customers is $232,500. Assuming that 40 percent of the revenue requirement is to come from the first faucet, the first-faucet annual rate will be: $232,500 40% = $37.20/year 2500 first faucets Assuming an average of 12 fixture units per customer in excess of the first faucet, which indicates the relative water-demand potential of all water-using devices installed per customer, the rate per fixture unit would be: $232,500 60% = $4.65/year per fixture unit 2500 12 If a fixture has a weighting of 3 due to its rate of water use, the fixture rates for this type of fixture would be $4.65 3, or $13.95/year.

Fixture rates are difficult to establish and administer because they require frequent fixture counts for all customers. Alternative rate-setting methods should be explored. Family units or equivalent family units are often used as a basis for charges. Nonresidential customers can be billed on the basis of equivalent family units, eliminating the need for a large number of fixture rates. It is the general policy of the American Water Works Association that all customers be metered, and this simplified discussion of flat rates should not be considered as a waiver of the advisability of this policy.

Public Fire-Protection Rates


Perhaps the simplest method for recovering fire-protection costs is on a per-hydrant basis. This is accomplished by dividing total fire-protection costs by the total number of hydrants. The direct per-hydrant charge would then be billed to a fire district or other governmental agency. In some instances, the cost of public fire-protection service is collected as part of the basic water rates rather than through a separate charge. In this case, public fire-protection costs of service maybe distributed to all customers benefitted by public fire protection as an addition to the customer service charge. While there are occasional reasons for such practice, the preferred method is to charge separately for fire-protection service.

Copyright (C) 1999 American Water Works Association All Rights Reserved

AWWA MANUAL

Appendix

A
Bill Tabulation Methodology

INTRODUCTION
The summarization or tabulation of customer bills provides a useful basis for identifying and analyzing customer usage patterns, selecting water-usage rate blocks, and determining utility billing revenue under any rate schedule. Tabulation of customer bills and usage, commonly referred to as a bill-frequency distribution analysis or simply a bill tabulation, may be accomplished either manually or by data processing. Normally, it is best to initiate bill tabulation procedures during the early stages of a cost-of-service rate study due to the potentially time-consuming work involved in summarizing billing data and in testing the completeness and accuracy of the results of the bill tabulation. If the utility billing system is computerized, the time required for the preparation of the bill tabulation may be relatively short, perhaps only one or two weeks. The computer staff may, however, be required to develop specific programs to extract and summarize data in the form required, and delays are often encountered because computer time is not readily available when needed. By beginning the bill tabulation early in the cost-of-service study, the results should be available to avoid delay both in the design of rates and in the evaluation of the adequacy of proposed rates to recover allocated costs of service from customer classes. A bill tabulation shows the number of customer bills rendered at various levels of water usage during a specified period of time for each customer class served by the utility. The tabulation of bills for a historical period provides the basis for identifying typical customer-class usage patterns and aids in the development of rates recognizing such usage patterns. Rate schedules that are intended to be applicable throughout an entire year generally require a bill tabulation for a historical 12-month period in order that annual usage patterns are properly identified. On the other hand, if a seasonal rate schedule is to be developed, separate bill tabulations would need to be made to coincide with the periods for which each part of the seasonal rates are to be effective. For instance, if a summerwinter seasonal rate were to be developed with one rate applicable for usage during the 6-month summer period and another for the 6-month winter period, the bill tabulation would need to be made in two parts so as to coincide with the summer and winter periods as defined. This permits recognition of customer usage patterns and variations in use between seasons. In the example presented here, bills are tabulated for one customer class for a continuous 12-month period. Tabulating bills for a continuous 12-month period is strongly recommended in order to properly account for seasonal variations in customer water-usage patterns. In addition, the selection of the 12-month period

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should coincide as closely as possible with the utilitys fiscal accounting period so that the accuracy of the bill tabulation in generating revenue can be more easily ascertained. The possibility that the period selected for study may represent a year in which water usage was abnormally high or low, due to climatic or other conditions, should be considered when utilizing the bill tabulation for rate-design purposes. If possible, the selection of bills for tabulation should reflect a year in which average conditions prevail.

BILL TABULATION
Bill Summarization
The first step in tabulating customer bills is to separate billing records into customer classes, if available, and into meter sizes. Next, a manual bill-tabulation process involves entering individual customer usage for each billing period on summary sheets that are separated into various levels of usage. If a computer is utilized for the summarization of bills, the manual process described herein would be simulated on the computer. For small utilities, each customers usage may be tabulated for the 12-month period. However, for larger utilities, a sample tabulation of the residential class, on the order of 10 to 20 percent of the total number of customers in the class, may be adequate to establish usage patterns for that class. It is suggested that a 100 percent tabulation be made for other customer classes, because the use per customer in other classes is likely to be much more variable than for the residential class. A less than 100 percent sample, particularly for large customers, may not provide a representative distribution of water-usage patterns. If a sample of customers is to be made, random sampling procedures should be used. The bill-tabulation process is initiated by selecting the smallest meter size for a particular customer class and tabulating identified individual customer usage onto the summary sheet for that meter size and class. This procedure is continued for each meter size until all customer bills in the class have been summarized. The same process would be repeated for every other customer class. It is important to summarize bills for each identified customer in all customer classes unless a sample for the class, as previously discussed, has been selected. Bills issued to inactive accounts should be excluded. Bills issued to active customer accounts with zero usage during any billing period should be included as zero-usage bills. To illustrate the bill summarization procedure, hypothetical customer-billing account records and a bill tabulation sheet are shown in Figures A-1 and A-2, respectively. Figure A-1 shows two customer billing accounts, presenting each customers monthly water use and the amount billed. Both customers are inside-city residential customers with 5/8-in. meters, as indicated on the billing record. Figure A-2 shows an example of the type of sheet on which the usage for each monthly bill is tabulated when a manual bill tabulation is necessary. As indicated at the top of the sheet, the usage for inside-city residential customers with 5/8-in. meters is to be summarized on this sheet. In the left-hand margin of the tabulation sheet appear the various possible levels of customer usage for each billing period in terms of hundred cubic feet (Ccf). Thus, in the example in Figure A-2, the number 2 is equal to a monthly usage of 200 ft3. It is noted that usage levels or use blocks should be established to cover the largest monthly usage in each class. Several summary sheets may be required for a given customer class and meter size in order to accommodate the range of monthly usage by customers in the class.

Copyright (C) 1999 American Water Works Association All Rights Reserved

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Figure A-1 Hypothetical customer-account billing records.

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Figure A-2 Example of a water-bill tabulation sheet.

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Beginning with customer account number 115147, shown in Figure A-1, a tick mark is made on the line in Figure A-2 that corresponds to the usage billed in a given month. Each tick mark is equivalent to one bill. From Figure A-1, for the January billing period, the usage for customer account 115147 is indicated to be 5 Ccf. Therefore, a tick mark is made on the usage-block line marked 5 on Figure A-2, as shown. A tick mark is made for each monthly usage quantity on the appropriate line on Figure A-2 for both customers monthly usage quantities. This procedure would be repeated for all 5/8-in. residential inside-city accounts billed during the 12-month period. Similarly, a separate tabulation sheet or sheets for each meter size by customer class would be completed. Once the bill tabulation is complete for each meter size by class, the number of tick marks or bills is totaled for each usage block and summarized at the bottom of the appropriate column on each sheet. Usage associated with the bills tabulated in each usage block is determined by multiplying the number of bills by the usage amountshown in the left-hand column of each line. If the two hypothetical customers shown in Figure A-1 were the only 5/8-in. residential inside-city customers, the total number of bills and usage would be those shown in Figure A-2 at the bottom of the two right-hand columns. After all bills and associated usage have been summarized for each meter size and class, total customer-class usage and bills would be determined by adding the bills and usage for all meter sizes for a given customer class. The selection of the period for which bills are to be summarized to coincide with the utilitys fiscal accounting period greatly enhances the ability to check the accuracy of the bill tabulation since cumulative data as to the number of bills, total water sales, and revenue for that period would be readily available. The final check as to the accuracy of the bill tabulation is based on the revenue that the tabulation generates when applied to the existing schedule of rates.

Development of Cumulative Billed Usage


After tabulating the number of bills and usage for each customer class by meter size, the next step is to determine the cumulative billed water usage by various usage blocks or increments for each customer class and meter size. The procedure includes several steps and is best accomplished by using a computation table similar to the one shown in Figure A-3. The data summarized in Figure A-3 are for a hypothetical residential customer class. Column 1 shows the usage blocks for which water-usage and bill data are summarized. Selection of usage blocks for summarizing cumulative billing data does not need to set forth all usage blocks used in the bill-tabulation sheet described earlier. The usage blocks used in summarizing cumulative billed usage are generally established to include single-unit increments at the lower usage levels to coincide with the use of smaller users and larger increments or groupings of several unit increments at the higher usage levels. As shown in Figure A-3, increments of usage from 1 Ccf up to 10 Ccf are used, and larger increments are utilized thereafter. For example, the bills and usage recorded for the unit increments of 11 through 15 Ccf from the bill tabulation sheet (see Figure A-2) would be combined for the purposes, of Figure A-3 and would be recorded on the line opposite the usage-block category marked 1115 in columns 2 and 4, respectively. The numbers entered on this line would represent the total number of bills and associated usage for customer usage of 11 through 15 Ccf per billing period. Usage blocks summarized should be selected in part to coincide with the existing rate blocks. This will result in a readily identifiable cumulative level of usage in each rate block against which existing rates may be applied for purposes of checking the

Copyright (C) 1999 American Water Works Association All Rights Reserved

Copyright (C) 1999 American Water Works Association All Rights Reserved

Figure A-3 Development of cumulative billed usage residential classannual number of bills and usage5/8-in. meters.

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69

accuracy of revenue generated by the bill tabulation. Other usage blocks should be summarized in sufficient detail to prepare a representative graphical curve. The number of bills issued for water usage corresponding to the various consumption blocks is shown in column 2. The number of bills issued for each usage block would be taken directly from bill tabulation sheets similar to the one shown in Figure A-2. In this example, total bills represent the summation of bills issued to residential-class customers with 5/8-in. meters. For example, during the 12-month period represented by the bill tabulation, 24,317 bills were issued to the group of customers having a monthly usage of 3 Ccf. Bills for each usage block are summarized in this manner for each customer class and each meter size individually. Once the number of bills is summarized by usage block, the bills are accumulated up in column 3 of Figure A-3 by starting with the bills in the largest usage block and adding the next above usage blocks number of bills to it. As shown in Figure A-3, beginning with the 251 and over Ccf usage block and summing up the number of bills, a total of 187,836 bills issued to the residential class is represented in the figure. The number of cumulative bills in any particular usage block represents the number of bills issued for the amount of water use shown in that block or more. For instance, at the 3 Ccf consumption block, 154,158 bills have been issued for usage of 3 Ccf or more. Column 4 represents the total use of bills stopping in each usage block and corresponds to the number of bills listed in column 2. These numbers are taken from the far right-hand column of each bill-tabulation sheet (an example of which is shown in Figure A-2). In the example in Figure A-3, 24,317 bills are issued for the 3 Ccf usage block for a total of 72,951 Ccf in total water use. The total water use of bills stopping in each usage block shown in column 4 is accumulated, beginning with the 0 Ccf usage block, as shown in column 5. The value in column 5 for a given usage block represents the cumulative billed usage of all bills with monthly usage less than or equal to the usage represented by the usage block. Consequently, the summarization of usage for all usage blocks yields the total use of the customer class for the meter size during the bill tabulation period. In the example, 5/8-in. residential-class customers used 1,254,308 Ccf during the 12-month bill tabulation period, as shown in the last line of column 5. While the accumulated usage shown in column 5 provides a measure of total customer-class water use, it does not indicate the quantity of water used in a given usage block by bills that exceed that usage level. That is, at the 3 Ccf usage block, column 5 indicates that a total of 120,508 Ccf of water was used by those customers billed for 0, 1, 2, and 3 Ccf. This quantity does not include water used by customers who use more than 3 Ccf. For rate-design purposes, the total quantity of water used at a particular usage block needs to be determined, including the usage in the block by customers whose usage exceeds the block. Therefore, the next step is to determine the total use in the block of all billed usage passing beyond each block. This quantity may be determined from data in columns 1 and 3 and is summarized in column 6. The values shown in column 6 are calculated for each usage block by multiplying the usage block value in column 1 by the number of cumulative bills through block corresponding to the next larger usage block, as shown in column 3. For example, the column 6 value for the 3150 Ccf usage block is calculated by multiplying 50 Ccf by the number of cumulative bills for the 51100 Ccf block of 645 and totals 32,250 Ccf. The 32,250 Ccf of water use is the quantity of usage in the 3150 Ccf block of monthly use for the 645 bills whose usage exceeds this block. The cumulative billed usage of all 5/8-in. residential customers maybe developed at this point by adding the values shown in columns 5 and 6 for each usage block.

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Total cumulative usage for the 5/8-in. residential class is shown in column 7. The cumulative usage figures in column 7 indicate the total usage that would be billed at any given usage block. To determine the usage at interim blocks (for example, the usage between 3 Ccf and 10 Ccf), the cumulative usage corresponding to the smaller block would be subtracted from the cumulative usage of the larger block. In this example, 1,050,229 Ccf less 510,031 Ccf, or 540,198 Ccf, would be the use in a rate block of 410 Ccf. Once the bill tabulation has been completed for all customer classes, the cumulative usage (shown in column 7 of Figure A-3) for each existing rate block would be determined. Application of existing rates to the cumulative usage in each rate block as determined from the bill tabulation would result in the indicated bill-tabulation revenue under existing rates, which is related to existing volumerelated charges. Applying existing service charges to the number of bills by meter size and adding the volume-charge revenue produced from the bill tabulation would yield the total bill-tabulation revenue under existing rates. This revenue figure can then be compared with the billed revenue recorded by the utility to test the accuracy of the bill tabulation. A correlation of bill-tabulation revenue to actual billed revenue of 3 percent or less generally indicates that the bill tabulation is sufficiently accurate for rate-design purposes. Where initial charges in the form of a minimum bill are utilized, precaution must be taken to avoid multiple counting of minimum usage in computing revenues.

Application of Bill Tabulation for Rate Design


The bill analysis, once verified for accuracy, provides a useful tool for rate design. The usage pattern of each class of customers, as determined from bill tabulation, is generally considered to remain relatively stable over a period of several years. In designing rates for future study periods, the usage pattern from the bill tabulation may be applied to projected water usage of various classes to determine estimated water usage applicable to each rate block. If it becomes necessary to change existing blocks in order to more equitably recover allocated costs of service from the various customer classes, the bill tabulation provides a means for selecting alternative rate blocks and the associated amount of water usage with the new blocks. To aid in the selection of the proposed rate blocks, cumulative usage curves may be derived from the bill analysis. To construct the necessary curves, the percentage of cumulative billed usage must be determined. Column 8 of Figure A-3 presents the percent of cumulative billed usage for each usage block and is determined by dividing the cumulative billed usage for each block in column 7 by the total cumulative usage times 100. Construction of a curve for the hypothetical residential customer class is shown in Figure A-4. The curve is constructed on semilogarithmic graph paper with cumulative billed percent usage shown on the vertical linear axis and monthly usage levels shown on the horizontal logarithmic axis. To construct the curve representing cumulative usage for the hypothetical residential class shown in Figure A-3, the cumulative billed percent usage figures from column 8 are plotted for each level of usage, and a line is drawn through all plotted points. The resulting curve may then be used to determine an estimate of the cumulative percent of future water usage that will occur at a given usage level. For example, if a proposed rate block is chosen at a monthly usage of 3 Ccf, from the curve it is determined that approximately 40 percent of the total water use of customers in this class for this meter size would be expected to be billed in the 03 Ccf block.

Copyright (C) 1999 American Water Works Association All Rights Reserved

APPENDIX A

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Similar curves can be developed for each customer class and meter size. In some instances, it may be more desirable to determine the cumulative billed usage and graph the curve for the combination of all meter sizes in each class. This may be accomplished simply by adding together the cumulative billed usages (similar to those shown in column 7 of Figure A-3) determined for each meter size in a class for each respective usage block. In order to add cumulative billed usages for each meter size, the usage blocks established for each meter size must be exactly the same. The value determined from the summation would represent the cumulative billed usage of all customers in the class and would be used to calculate cumulative billed usage percentages and, subsequently, to graph the customer-class curve. It is generally useful to plot all customer-class curves on the same graph as an aid in the selection of proposed rate blocks for rate design. Trial rate blocks may be chosen that effectively separate the majority of the usage for each class into one or more rate blocks simply by visual inspection of the family of customer-class curves. A more complete discussion of the use of curves in rate design is included in chapter 4.

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Glossary
annual operating revenue requirement The total revenues required on an annual basis adequate to meet all expenses and capital requirements of the utility. base costs Costs that tend to vary with the total quantity of water used and operation under average load conditions. Costs included are operation and maintenance expenses of supply, treatment, pumping, and transmission and distribution facilities, and capital costs related to plant investment associated with serving customers at a constant, or average, annual rate of use (100 percent load factor). baseextra capacity The method of cost allocation in which the costs of service are classified to the functional cost components of base, extra capacity, and customer costs. bill frequency analysis A tabulation and summarization of customer bills and usages showing the number of bills rendered at various levels of water usage during a specified period of time. bond covenants Terms of obligations incurred as conditions of the issuance of bonds. bonded debt Indebtedness represented by outstanding bonds. capacity The ability of available water utility resources to meet the quantity, quality, peak loads, and other service needs of the various customers or classes of customers served by the utility. capacity factor Ratio of peak rate of demand to the average rate of demand over a specified period of time (hour, day, etc.) for a customer, class, or system. It is generally greater than 1. capital expenditures Expenditures that result in the acquisition of or addition of fixed assets. cash-needs approach The method of determining annual operating revenue requirements based on all cash needs, including but not limited to, operation and maintenance expense, debt service, and capital expenditures from current revenues. commodity costs (variable costs) Costs that tend to vary with the quantity of water produced, including the costs of chemicals, a large part of power costs, and other elements that follow, or change almost directly with, the amount of water produced. Purchased water costs, if the water is purchased on a unit volume basis without minimum charges or any associated demand charges, may also be considered as commodity costs. commoditydemand The method of cost allocation in which the cost of service is allocated to the functional cost components of commodity, demand, and customer cost. Variable costs are allocated to the commodity component, with the balance of costs being allocated to the demand and customer components. commoditydemand rate A multiple-part rate containing both fixed and variable components, generally requiring the fixed portion (or a percentage of it) to be paid independent of volume of water usage, while the variable portion is based on the volume of water usage. The fixed portion is generally based on the customers peak demand requirements; it may also include customer charges (billing, metering, etc.).

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connection charge The charge made by the utility to recover the cost of connecting the customers service line to the utilitys facilities. This charge is often considered as a contribution of capital by the customer or other agency receiving the service. contribution in aid of construction (CIAC) Any amount of money, services, or property received by a water utility from any person or governmental agency that is provided at no cost to the utility. It represents an addition or transfer to the capital of the utility, and is used to offset the acquisition, improvement, or construction costs of the utilitys property, facilities, or equipment used to provide utility services to the public. It includes amounts transferred from advances for construction representing any unrefunded balances of expired refund contracts or discounts resulting from termination of refund contracts. Contributions received from governmental agencies and others for relocation of water mains or other plant facilities are also included. Contributions are generally carried as equity capital on the balance sheets of government-owned utilities. cost allocation The procedure for classifying or assigning the costs of service to functional cost components for subsequent distribution to respective customer classes. costs of service The operating and capital costs incurred in meeting various aspects of providing water service, such as customer billing costs, demandrelated costs, and variable costs. coverage ratios The margin of safety ratios associated with bonded indebtedness and preferred stocks, reflecting the ratio of the actual or projected net revenue available for debt service to debt service or other costs. These ratios range from debt-service coverage of principal and interest, to interest only, to all fixed charges, including preferred stock dividends and lease payments. Coverage may be expressed as a ratio or as a percentage. customer classification The grouping of customers into homogeneous classes. Typically, water utility customers may be classified as residential, commercial, and industrial for rate-making and other purposes. For specific utilities, there may be a breakdown of these general classes into more specific groups. For example, the industrial class may be subdivided into small industry, large industry, and special. Some water systems have individual customers (large users) with unique water-use characteristics, service requirements, or other factors that set them apart from other general customer classes and thus may require a separate class designation. This may include large hospitals, universities, military establishments, wholesale service districts, and other such categories. construction work in progress (CWIP) The utilitys investment in facilities under construction, but not yet dedicated to service. The inclusion of CWIP in rate base varies from one agency to another. customer costs Costs directly associated with serving customers, irrespective of the amount of water use. Such costs generally include meter reading, billing, accounting, and collecting expense, and maintenance and capital costs related to meters and associated services. debt An obligation resulting from the borrowing of money or from the purchase of goods and services. debt-service requirement The amounts of money necessary to pay interest and principal requirements for a given series of years.

Copyright (C) 1999 American Water Works Association All Rights Reserved

GLOSSARY

75

declining-block rates A schedule of rates applicable to blocks of increasing usage in which the usage in each succeeding block is charged at a lower unit rate than in the previous blocks. Generally, each successive block rate is applicable to a greater volume of water delivery than the preceding block(s). demand costs Costs associated with providing facilities to meet demands placed on the system by customers. They include capital-related costs associated with those facilities plus related operation and maintenance expenses. demand patterns Profiles and characteristics of the demand requirements of the system, specific customer class or classes, or an individual customer, indicating the frequency, duration, and amount of demand placed on the water production and delivery system. depreciation The loss in service value not restored by current maintenance as applied to depreciable plant facilities. Depreciation is incurred in connection with the consumption or prospective retirement of plant facilities in the course of providing service. This depreciation is the result of causes known to be in current operation and against which the utility is not protected by insurance. Among the causes are wear and tear, decay, action of the elements, inadequacy, obsolescence, changes in technology, changes in demand, and requirements of public authorities. The proper level of depreciation expense at any given time should be based on the costs of depreciable plant in service. The funds resulting from depreciation are available for replacements, improvements, expansion of the system, or for repayment of the principal portion of outstanding debt. depreciation rate The annual rate at which capital facilities are depreciated, based on the estimated loss in value of the facilities, not restored by current maintenance, that occurs in the property due to wear and tear, decay, inadequacy, and obsolescence. It provides for the recovery of a utilitys capital investment over the anticipated useful life of the depreciable assets. dividend payment Payment made by an investor-owned water utility to its shareholders, based on its earnings. equity The net worth of a business, consisting of capital stock, capital (or paid in) surplus, earned surplus (or retained earnings), and, occasionally, certain net worth reserves. equivalent meter-and-service ratio The ratio of the cost of investment in larger meters and services to those of a base meter size, such as the 58-in. meter typically used for residential customers. Meter capacities may be used rather than investments. expenditures Amounts paid or incurred for all purposes, including expenses, provision for retirement of debt, and capital outlays. extra capacity costs Costs of capital and operation and maintenance associated with meeting rate-of-use requirements in excess of average rate-of-use requirements. fire-protection charges Charges made to recover the cost of providing fireprotection service to the area served by the utility. firm service Dependable service in the amounts and at times as desired by the customer.

Copyright (C) 1999 American Water Works Association All Rights Reserved

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functional cost components The distinct operational components of a water utility to which separate cost groupings are typically assigned. In the baseextra capacity method of cost allocation, these are usually the components of base, extra capacity, customer, and direct fire-protection costs. In the commoditydemand method, they are the components of commodity, demand, customer, and direct fire-protection costs. government-owned water utility A water utility created by state or other government-agency legislative action, with the mandate that the purposes of the utility are public purposes and that its functions are essential governmental proprietary functions. Its primary purpose is to provide its designated service area with potable water in an adequate supply at reasonable costs so that people of the area may promote their health, safety, and welfare. A government-owned water utility may be part of a municipal government operation, a county agency, a regional authority, or take such other form as is appropriate for its service area. gross receipts tax Payments made to a government entity based on the gross revenues received by the water utility from its revenues. inverted block rates A schedule of rates applicable to blocks of increasing usage in which the usage in each succeeding block is charged at a higher unit rate than in the previous blocks. Generally, each successive block rate may be applicable to a greater volume of water delivery than the preceding block(s). investor-owned water utility A utility owned by an individual, partnership, corporation, or other qualified entity with the equity provided by shareholders. Regulation may take the form of local or state jurisdiction. lifeline rates Rates applicable to usage up to a specified level that are below the cost of service for the purpose of meeting the social goal of providing so-called minimum annual water requirements to qualified customers at a below-cost price. marginal cost rates Rates based on the cost of providing the next unit of production. minimum bill A minimum charge to a customer that includes a fixed volume of water delivered to the customer during the applicable period of time. off-peak rates Rates charged for usage during certain designated off-peak periods. payment in lieu of taxes A payment made to a governmental entity by the government-owned utility instead of taxes. peak-load pricing rates A multiple-part rate structure in which charges vary and are based on the higher costs of providing water during the system peak periods of use and on the lower cost of providing water during the system off-peak periods. rate base The value of a water utilitys property used in computing an authorized return under the applicable laws and/or regulatory policies of the agency setting rates for the utility. rate blocks Elements of a schedule of charges for specific usages within certain defined volume and/or demand boundaries. rate-making process The process of developing and establishing rates and charges. The process is comprised of four phases: (1) determination of revenue requirements; (2) allocation of costs to the functional components of the cost of service; (3) distribution of the function costs of service to customer classes; and (4) development and design of a schedule of rates and charges to recover the revenue requirements.

Copyright (C) 1999 American Water Works Association All Rights Reserved

GLOSSARY

77

rate schedule Schedule of the rates and charges to the various customer classes and customers. raw water Water that is obtained directly from the supply sources, such as wells, reservoirs, rivers, etc., that has not been treated to produce potable water. return on rate base The percentage of earnings on the rate base. seasonal excess-use charges Charges for usage above pre-established levels, typically used during periods of peak use relative to use during off-peak periods. seasonal rates Rates based on the cost of service variations with respect to system seasonal requirements. For example, higher rates may be charged during the summer months when a system peak occurs, which requires facilities not needed to meet lower winter loads. self-sustaining water enterprise A water utility operating without subsidies given to or received from non-water utility operations. service charge A fixed charge usually designed to recover customer costs. standby service Service provided occasionally under certain defined conditions, such as in the event of failure of the customers normal water supply system. Fire protection is another form of standby service. test year The annualized period for which costs are to be analyzed and rates established. treated water Water that has been obtained from supply sources and treated to produce potable water. unit cost The cost of producing a unit of a product or service. An example would be the cost of treating a thousand gallons of potable water for use by the water utilitys customers. unit of service An element of service for which a cost can be ascertained, such as thousand gallons, hundred cubic feet, million gallons per day, monthly bill, etc. uniform volume charge A single charge per unit of volume for all water used. unmetered or flat rate A fixed charge for unmetered service, often simply based on the number of fixtures and water-using devices of the customer. utility approach The method of determining annual operating revenue requirements, which includes operation and maintenance expense, depreciation expense, and return on rate base. wholesale service customers Service in which water is sold to a customer at one or more major points of delivery for resale within the wholesale customers service area. working capital Cash, materials, supplies, and other similar current assets necessary in the operation of the enterprise. It is usually measured by the excess of current assets over the current liabilities, or sometimes as a percentage of annual operation and maintenance expense levels.

Copyright (C) 1999 American Water Works Association All Rights Reserved

Index
NOTE: An f. following a page number refers to a figure; a t. refers to a table. Air conditioning and refrigeration, 22 AWWA Water Rates and Charges Subcommittee, 46 Base cost component, 13, 14 Base costs, 11 and extra capacity costs, 11 Baseextra capacity method, 1011 base costs, 11 and commoditydemand method, 4546 cost components, 11 cost distribution to customer classes, 2830, 29t. customer costs, 1112 depreciation allocation, 14, 15t. direct fire-protection costs, 12 extra capacity costs, 11 O&M allocation, 14, 15t. rate base, 1214, 13t. rate design for, 4546 unit costs of service, 27t. units of service, 25, 25t. Bill tabulation, 6364 bill summarization, 6467 billing records, 64, 65f. cumulative billed usage, 6770, 68f., 70, 71f. and meter size, 64, 65f., 67 and rate design, 7072 tabulation sheet, 64, 66f. Bill-frequency distribution analysis. See Bill tabulation Billing records, 64, 65f. Block-rate design, 4044. See also Rate blocks Capital costs, 10 Capital expenditures and cash-needs approach, 2 Cash-needs approach capital expenditures, 2 Cash-needs approach debt-service requirements, 2 Cash-needs approach described, 1 Cash-needs approach O&M expense, 2 City limits service outside, 2223 Commercial customers, 21 Commodity costs, 16 Commoditydemand method, 1011 and baseextra capacity method, 4546 commodity costs, 16 cost components, 16 cost distribution to customer classes, 3031, 30t. customer costs, 16 demand costs, 16 depreciation allocation, 16, 18t. direct fire-protection costs, 16 in small utilities, 5759, 57t., 58t. O&M allocation, 1619, 18t. rate base, 16, 17t. rate design for, 4546 unit costs of service, 28t. units of service, 25, 26t. Commoditydemand rates, 49 Connection charges, 5152 Construction work costs, 14 Cost allocation baseextra capacity method, 1011, 1116 commoditydemand method, 1011, 1619 and costs of service, 10 functional-cost method, 1011 Cost components related to customer classes, 2326 Cost distribution to customer classes baseextra capacity method, 2830, 29t. commoditydemand method, 3031, 30t. Costs of service components in baseextra capacity method, 11 and cost of allocation, 10 and customer needs, 9 firm water service, 19 inside-city and outside-city users, 19 nonfirm service, 19 pressure zones, 19 principal elements, 12 and rate design, 3233 and rates, 9 reserve capacity, 19 seasonal uses, 19 small utilities, 55 special considerations, 19 unit costs, 2628 Cumulative billed usage, 6770, 68f., 70, 71f. Customer costs, 1112, 16, 34. See also Service charges Customers air conditioning and refrigeration, 22 classes of related to cost components, 2326

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commercial, 21 differences among, 2021 distribution of costs to, 2831 fire-protection, 2122, 24 general classes, 21 industrial, 21 lawn irrigation, 22 meter-and-service costs, 24 residential, 21 special classes, 2122 uniform rates by class, 4748 units of service, 25t., 26t. water use by classes, 3537, 36f. wholesale, 21 Debt-service requirements and cash-needs approach, 2 Declining-block rate schedules, 3435, 47 Demand costs, 16 small utilities, 55 Depreciation, 3, 12 allocation in baseextra capacity method, 14, 15t. allocation in commoditydemand method, 16, 18t. Direct fire-protection costs, 12, 16 Disappearing charge, 34 Excess use, 48 Extra capacity component, 13, 14 Extra capacity costs, 11 and base costs, 11 Fire-protection costs small utilities, 55, 56f., 5759 Fire-protection service, 2122, 24 rate design for, 3738, 44, 62 Flat rates, 51 Functional-cost method, 1011 General plant costs, 14 General service rates, 3334 Government-owned utilities capital improvements, 6 debt-service requirements, 6 O&M expense, 6 and outside-city customers, 23 projected revenue requirements, 5t. Industrial customers, 21 Inverted-block rates, 50 Investor-owned utilities projected revenue requirements, 8 taxes, 4 utility approach to revenue requirements, 3 Lawn irrigation, 22 Lifeline rates, 51 Marginal cost rates, 4950 Meter-and-service costs, 24 Minimum charge, 34, 44, 45t.

O&M expense, 10, 12 allocation in baseextra capacity method, 14, 15t. allocation in commoditydemand method, 1619, 18t. and cash-needs approach, 2 Off-peak rates, 49 Operation and maintenance expense. See O&M expense Peak-load pricing, 49 Prospective rates, 4 Pumping facilities, 13 Rate base, 34 baseextra capacity method, 1214, 13t. commoditydemand method, 16, 17t. Rate blocks. See also Block-rate design and use costs, 4142, 41t., 43, 43t. and water meters, 47 Rate design, 4647 baseextra capacity and commodity demand methods compared, 4546 block rates, 4044 commoditydemand rates, 49 connection charges, 5152 and costs of service, 3233 disappearing charge, 34 factors affecting, 33 for fire-protection service, 3738, 44, 62 flat rates, 51 general service rates, 3334 and income lag, 38 inverted-block rates, 50 lifeline rates, 51 marginal cost rates, 4950 minimum charge, 34, 44, 45t. off-peak rates, 49 peak-load pricing, 49 and record keeping, 52 recovering costs related to volume and extra capacity, 3437 recovering customer costs, 34 seasonal rates, 48 service charges, 3940, 39t. for small utilities. See Small utilities uniform rate by customer class, 4748 uniform rates, 5051 unmetered rates, 51 and user conservation, 38 for wholesale service, 38 Rate schedules declining-block, 3435, 47 single-rate, 35 Rates and costs of service, 9 Record keeping and rate design, 52 Residential customers, 21 Return, 3, 12 Revenue requirements, ixf., 1, 8. See also Cash-needs approach, Utility approach government-owned utilities, 5t.

Copyright (C) 1999 American Water Works Association All Rights Reserved

INDEX

81

projected, 5t. prospective basis, 4 small utilities, 54 Revenues from nonrate sources, 6 Seasonal rates, 48 Service outside city limits, 2223 Service-charge design, 3940, 39t. Small utilities and commoditydemand method, 5759, 57t., 58t. costs of service, 55 costs-of-service allocation, 57, 58t., 60, 61t. customer costs, 55 demand costs, 55 fire-protection costs, 55, 56f., 5759 fire-protection rates, 62 information needed for rate design, 54 meter equivalents, 5960, 60t. O&M allocation, 57, 58t. plant value allocation, 57, 57t. rate design, 5354, 5962 revenue requirements, 54 service charges, 5960, 60t. single-block rate design, 5960 two-block rate design, 6061, 61t. unmetered rates, 6162

Test year, 6 revenue requirements, 7t. Treatment facilities Uniform rates, 5051 by customer class, 4748 Unit costs of service, 2628 baseextra capacity method, 27t. commoditydemand method, 28t. Units of service baseextra capacity method, 25, 25t. commoditydemand method, 25, 26t. Unmetered rates, 51 Utility approach depreciation, 3 and investor-owned utilities, 3 rate base, 34 return, 3 taxes, 4 Water meters and rate design, 47 in small utilities, 5960, 60t. Water use by customer classes, 3537, 36f. Wholesale service, 21 rates, 38

Copyright (C) 1999 American Water Works Association All Rights Reserved