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HomeMy WebLinkAboutStaff Report 107-07City of Palo Alto C ty Manager’s Report TO: ATTN: HONORABLE CITY COUNCIL FINANCE COMMITTEE FROM:CITY MANAGER DEPARTMENT: UTILITIES DATE: SUBJECT: JANUARY 17, 2007 CMR:107:07 UTILITIES ADVISORY COMMISSION RECOMMENDATION ON CHANGES TO CERTAIN UTILITIES RESERVE GUIDELINES RECOMMENDATION Staff and the Utilities Advisory Commission (UAC) recommend that Council approve changes to certain Utilities reserve fund guidelines. Specifically, staff and the UAC recommend that the development of an assessment of the risks facing each fund be undertaken as part of the annual budget and retail rate development and approval process. This annual assessment will be compared to the established guideline levels to assist in the determination of the Rate Stabilization Reserve level target for each fiscal year. Additionally, minor changes to the guidelines of the following Utilities Fund Reserves are recommended are noted below: For the Electric, Gas, Water and Wastewater Collection Emergency Plant Replacement Reserves, establish a minimum guideline level equal to the greater of: 1) the City’s liability insurance coverage deductible or 2) the amount that covers the most expensive item of equipment which, if lost, would cause interruption in the normal activity of that utility; 2.For the Electric Supply Rate Stabilization Reserve, change the minimum and maximum guideline levels equal to 50% and 100% of the annual supply purchase cost, respectively; For the Gas Supply Rate Stabilization Reserve, change the minimum and maximum guideline levels equal to 35% and 75% of the annual supply purchase cost, respectively; and CMR:107:07 Page 1 of 3 For the Electric Distribution, Gas Distribution, Water and Wastewater Collection Rate Stabilization Reserves, change the minimum and maximum guideline levels equal to 20% and 50% of the annual sales revenue, respectively; The table below summarizes the proposed changes to the Emergency Plant Replacement (EPR) and Rate Stabilization Reserve (RSR) guidelines. Electric, Gas, Water and Wastewater Collection EPRs Electric Supply RSR Gas Supply RSR Electric Distribution RSR No minimum (maximum, as stated in the City Charter, is = 5% of the book value of the fund’s capital in service) .Maximum = 103% of purchase cost Minimum = half of maximum Maximum = 75% of purchase cost Minimum = half of maximum Maximum = 38% of sales revenue Minimum = half of maximum Gas Distribution Maximum = 40% of sales revenue RSR Minimum = half of maximum Water RSR Wastewater Collection RSR All RSRs Maximum = twice the minimum Minimum = sum of: 1) 15% of sales revenue; plus 2) sales revenue decline due to abnormal weather Maximum = twice the minimum Minimum = sum of: 1) 15% of sales revenue; plus 2) sales revenue decline due to abnormal weather Target = midpoint between minimum and maximum Minimum = greater of: 1) the City’s liability insurance coverage deductible or 2) an amount covering the most expensive critical item Maximum = 100% of purchase cost Minimum -- 50% of purchase cost Maximum = 75% of purchase cost Minimum = 35% of purchase cost Maximum = 50% of sales revenue Minimum = 20% of sales revenue Maximum -- 50% of sales revenue Minimum -- 20% of sales revenue Maximum = 50% of sales revenue Minimum -- 20% of sales revenue Maximum = 50% of sales revenue Minimum = 20% of sales revenue Target to be established following an annual evaluation of risks to each fund as part of budget preparation BACKGROUND On September 19, 2006, the Council Finance Committee directed staff to work with the Utilities Advisory Commission (UAC) to develop recommendations for changes to the policies, guidelines, or purposes of the following Utilities Fund Reserves [CMR:358:06]: 1. Emergency Plant Replacement Reserve for the Water, Electric, Gas, and Wastewater CMR:107:07 Page 2 of 3 Collection Funds; 2. Supply Rate Stabilization Reserve for the Electric and Gas Funds; 3. Distribution Rate Stabilization Reserve for the Electric and Gas Funds; and 4. Rate Stabilization Reserve for the Water and Wastewater Collection Funds. The attached memorandum to the UAC contains staff’s recommendations for the selected reserves and the rationale for the development of the recommendations, which were presented to the UAC at its December 6, 2006 meeting. COMMITTEE REVIEW AND RECOMMENDATIONS At its December 6, 2006 meeting, the UAC considered staff’s recommendations on changes to the Utilities Reserves Policies and Guidelines. After discussion, Commissioner Dawes made a motion to accept staff’ s recommendation with the proviso that, for the rate stabilization reserves, if the target balance resulting from the risk assessment is below the minimum guideline level, that appropriately conservative risk assumptions should be used. This motion died for the lack of a second. After further discussion, the UAC unanimously approved staff’s recommendations. ENVIRONMENTAL REVIEW Approval of the recommended changes to the Utilities reserves does not constitute a project that would require environmental review. NEXT STEPS If the recommendations are approved, staff will provide the annual risk assessment for each fund and make ,recommendations regarding the reserve levels for each reserve fund during the budget and retail rate development process as described in the report to the UAC. ATTACHMENTS 1. Report to the UAC for its December 6, 2006 meeting: Changes Reserve Guidelines 2.Excerpt of December 6, 2006 Utilities Advisory Commission notes PREPARED BY: to Certain Utilities DEPARTMENT HEAD: CITY MANAGER APPROVAL: City Manager CMR:107:07 Page 3 of 3 ATTACHMENT 1 TO: MEMORANDUM UTILITIES ADVISORY COMMISSION 4 FROM:UTILITIES DEPARTMENT DATE: SUBJECT: DECEMBER 6, 2006 CHANGES TO CERTAIN UTILITIES RESERVE GUIDELINES REQUEST Staff recommends that the UAC recommend that the Council approve changes to certain utilities reserve fimds. Specifically, staff recommends that the development of an assessment of the risks facing each fund be undertaken as part of the annual budget and retail rate development and approval process. This annual assessment will be compared to the established guideline levels to assist in the determination of the Rate Stabilization Reserve level target for each fiscal year. Additionally, staff recommends the following minor changes to the guidelines of the following Utilities Fund Reserves: For the Electric, Gas, Water and Wastewater Collection Emergency Plant Replacement Reserves, establish a minimum guideline level equal to the greater of: 1) the City’s liability insurance coverage deductible or: 2) the amount that covers the most expensive item of equipment which, if lost, would cause interruption in the normal activity of that utility; 2.For the Electric Supply Rate Stabilization Reserve, change the minimum and maximum guideline levels equal to 50% and 100% of the annual supply purchase cost, respectively; 3.For the Gas Supply Rate Stabilization Reserve, change the minimum and maximum guideline levels equal to 35% and 75% of the annual supply purchasecost, respectively; and For the Electric Distribution, Gas Distribution, Water and Wastewater Collection Rate Stabilization Reserves, change the minimum and maximum guideline levels equal to 20% and 50% of the annual sales revenue, respectively; The table below summarizes the proposed changes to the Rate Stabilization Reserve (RSR) guidelines. UAC December 6, 2006: Changes to Reserve Guidelines Page 1 of 14 Rate Stabilization Reserve Electric Supply . Existing Guidelines : i ’ ¯ Maximum = 103% of purchase cost Minimum = half of maximum Gas Supply Maximum = 75% of purchase cost Minimum = half of maximum Electric Maximum = 38% of sales revenue Distribution Minimum = half of maximum Gas Distribution Maximum = 40% of sales revenue Water Wastewater Collection Proposed New Guidelines Maximum = 100% of purchase cost Minimum = 50% of purchase cost Maximum = 75% of purchase cost Minimum = 35% of purchase cost Maximum = 50% of sales revenue Minimum = 20% of sales revenue Maximum = 50% of sales revenue Minimum = 20% of sales revenue Maximum = 50% of sales revenue Minimum = 20% of sales revenue Minimum = half of maximum Maximum = twice the minimum Minimum = sum of: 1) 15% of sales revenue; plus 2) sales revenue decline due to abnormal weather Maximum = twice the minimum Minimum -- sum of: 1) 15% of sales revenue; plus 2) sales revenue decline due to abnormal weather Target = midpoint between minimum and maximum Maximum = 50% of sales revenue Minimum = 20% of sales revenue All Target to be established following an annual evaluation of risks to each fund as part of budget preparation BACKGROUND On September 19, 2006, the Council Finance Committee directed staff to work with the UAC to develop recommendations for changes to the policies, guidelines, or purposes of the following Utilities Fund Reserves [CMR:358:06]: 1. Emergency Plant Replacement Reserve for the Water, Electric, Gas, and Wastewater Collection Funds; 2. Supply Rate Stabilization Reserve for the Electric and Gas Funds; 3. Distribution Rate Stabilization Reserve for the Electric and Gas Funds; and 4. Rate Stabilization Reserve for the Water and Wastewater Collection Funds. This memorandum is responsive to that direction. DISCUSSION This section describes the existing reserves and identifies any issues that may prompt further review and analysis. Article VII, Section 2 - Public utilities revenue, of the City Charter states: The revenue of each public utility shall be kept in a separate fund from all other receipts and shall be used for the purposes and in the order as follows: (a)For the payment of the operating and maintenance expenses of such utility, including the necessary contribution to retirement of its employees. UAC December 6, 2006: Changes to Reserve Guidelines Page 2 of 14 (b)For the payment of interest on the bonded debt incurred for the construction or acquisition of such utility. (c)For the payment of the principal of said debt, as it may become due. (d)For capital expenditures of such utility. (e)For the annual payment into a reservefund for contingencies, of an amount not to exceed ten percent of the expenditure for capital outlay for the year, exclusive of bond fund expenditures. The total accumulated in this reserve for contingencies shall at no time exceed five percent of the book value of the utility’s capital in service. This reserve fund shall be available for use by the utility, only for replacements or emergency repairs and after special appropriation by the council. (f) The remainder shall be paid into the general.fund by quarterly allotments. Emergency Plant Replacement (EPR) Reserves These reserves are established by the City Charter for the Electric, Water, Gas, and Wastewater Collection Funds for unplanned emergencies only. AS stated above, the Charter directs that EPR reserve balances are not to exceed 5 percent of the net book value of the fixed assets of the fund. In 1988, Council approved minimum funding of the EPR reserves to be 5 percent of the annual increase in the net book value of the fixed assets of the fund. At that time, Council also directed that the balance of the reserve should be equal to an amount that covers the most expensive item of equipment which, if lost, would cause interruption in the normal activity of that utility. As required by the City Charter, these funds are available for use only for replacement or emergency repairs of damaged equipment; and such uses require special appropriation by Council. The City has rarely tapped these reserves. The EPRs have onlybeen tapped once in the last ten years. The last time was in 1998 when the Electric EPR was used to cover the cost to replace a blown transformer. Damage to facilities due to disasters is covered by the City’s property loss insurance policies. One of these policies is liability insurance, for which the City is currently self-insured up to $1 million for disasters. This means that the first $1 million~in costs must be covered by the City before the liability insurance coverage would begin. Liability insurance is insurance coverage to protect against claims alleging that the City’s negligence or inappropriate action resulted in bodily injury or property damage. In addition, the City has property loss insurance, .which protects the City’s property against physical loss or damage by theft, fare or other means. The City’s property loss insurance covers certain property and equipment identified in an annual appraisal done for this. purpose. The appraisal provides a statement of each item covered and the limit of coverage for each item. The limit is generally equal to the replacement cost of the item although some small exclusions may apply. Not all of the City’s assets are listed in this appraisal. For example, the water, gas, and wastewater collections pipes and the electric wires are not included. For items that are listed in the appraisal, the coverage extends to the limit less the deductible. Currently, the deductible for property loss is $10,000 per item. Assets or equipment that are not specifically listed in the appraisal are "unscheduled" and the deductible for "unscheduled" losses is $500,000. Claims for damage due to earthquakes or floods would be made to the Federal Emergency Management Agency (FEMA). UAC December 6, 2006: Changes to Reserve Guidelines Page 3 of 14 1.Water Emergency Plant Replacement Reserve Details about the Water EPR for the last several fiscal years are shown in the table below: Water EPR Reserve (millions of dollars) Net Book Value of Fixed Assets as of end of FY Balance as of end of FY Balance as a fraction of Net Book Value Annual Increase in Net Book Value ~nnual Reserve Funding Annual Reserve Funding as a fraction of Annual Increase in Net Book Value FY 03-04 43.603 1.129 2.6% 3.155. FY 04-05 48.686 1.204 2.5% 5.082 0.075 1.5% FY 05-06 pre-audit 51.730 1.279 2.5% 3.045 0.075 3.9% FY 06-07 budget 1.354 0.075 For the last three fiscal years, the Water EPR reserve balance has been under the 5% of Net Book Value limit established in the Municipal Code and, therefore, is in compliance with that mandate. However, the annual increase in reserve funding has not met the minimum of 5% of the annual increase in Net Book Value. Facilities that could be damaged and would need to be repaired or replaced could consist of large pressure control valves, SCADA control systems, large booster pumps, pump control systems, pump buildings and structures, large electric fire pumps, recirculation and chemical feed pumps, well motors, casings or pumps, electric backup generators or reservoir failures. The most expensive pieces of equipment in the water distribution system that, if lost, would need to be replaced as soon as possible to avoid service interruption are the Mayfield Reservoir and pump station. The cost to replace these facilities could be over $5 million. This amount is much greater than 5% of the Net Book Value, the maximum amount for the reserve fund, It is more likely that the reservoir or pump station would be damaged, not completely destroyed. The repair cost for damage is hard to estimate. Assuming that some of the major equipment components at this plant require replacement due to some unforeseen event, they could be replaced for $1.2 million in FY06/07. This estimate includes materials and labor to replace the damaged pump station components, plus additional operating expenses to cover operating the system while the rebuild effort is occurring. 2.Electric Emergency Plant Replacement Reserve Details about the Electric EPR for the last several fiscal years are shown in the table below: Electric EPR Reserve (millions of dollars) Net Book Value of Fixed Assets as of end of FY Balance as of end of FY Balance as a fraction of Net Book Value Annual Increase in Net Book Value Annual Reserve Funding Annual Reserve Funding as a fraction of Annual Increase in Net Book Value FY 03-04 132.948 2.45! 1.8% 5.029 FY 04-05 137.831 2.509 1.8% 4.884 0.058 1.2% FY 05-06 pre-audit 142.783 2.567 1.8% 4.952 0.058 1.2% FY 06-07 budget 2.625 0.058 UAC December 6, 2006: Changes to Reserve Guidelines Page 4 of 14 For the last three fiscal years, the Electric EPR reserve balance has been under the 5% of Net Book Value limit established in the Municipal Code and, therefore, is in compliance with that mandate. However, the annual increase in reserve funding has been far short of the minimum of 5% of the annual increase in Net Book Value. The most expensive piece of equipment in the electric distribution system that, if lost, would need to be replaced as soon as possible to avoid service interruption is any one of the three transformers at the Colorado substation. Replacement of such a transformer would cost about $1 million. This cost is more than covered by the current balance of this reserve even though funding is below the recommended 5% of the increase in Net Book Value. 3.Gas Emergency Plant Replacement Reserve Details about the Gas EPR for the last several fiscal years are shown in the table below: Gas EPR Reserve (millions of dollars) Net Book Value of Fixed Assets as of end of FY Balance as of end of FY Balance as a fraction of Net Book Value Annual Increase in Net Book Value Annual Reserve Funding. Annual Reserve Funding as a fraction of Annual Increase in Net Book Value FY 03-04 FY 04-05 FY 06-07 budget FY 05~06 pre-audit 59.712 0.972 1.6% 1.561 0.038 2.4% 52.591 58.151 0.896 0.934 1.010 1.7%1.6% 5.102 5.560 0.038 0.038 o.7% For the last three fiscal years, the Gas EPR reserve balance has been under the 5% of Net Book Value limit established in the Municipal Code and, therefore, is in compliance with that mandate. However, the annual increase in reserve funding has been far short of the minimum of 5% of the annual increase in Net Book Value. The most expensive pieces of equipment in the gas distribution system that, if lost, would need to be replaced as soon as possible to avoid service interruption are the facilities at the Gas Receiving Station Number 2 (at Alma Street and Colorado Avenue). Replacement of these facilities is estimated to cost about $750,000, an amount that is more than covered by the current balance of this reserve even though recent annual funding has been less than the recommended 5% of the increase in Net Book Value 4. Wastewater Collection Emergency Plant Replacement Reserve Details about the Wastewater Collection EPR for the last several fiscal years are shown in the table below: UAC December 6, 2006: Changes to Reserve Guidelines Page 5 of 14 Wastewater Collection EPR Reserve (millions of dollars) Net Book Value of Fixed Assets as of end of FY Balance as of end of FY Balance as a fraction of Net Book Value Annual Increase in Net Book Value Annual Reserve Funding Annual Reserve Funding as a fraction of Annual Increase in Net BoOk Value FY 03-04 47.596 FY 04-05 50.958 FY 06-07 budget FY 05-06 pre-audit 52.683 0.629 1.2% 1.725 0.034 2.0% 0.555 0.595 0.666 1.2%1.2% 2.171 3.362 0.040 0.037 1.2% For the last three fiscal years, the Wastewater Collection EPR reserve balance has been under the 5% of Net Book Value limit established in the Municipal Code and, therefore, is in compliance with that ¯ mandate. However, the annual increase in reserve funding has been short of the minimum of 5% of the annual increase in Net Book Value. The primary facilities for wastewater collection are the collection pipelines. There are almost no above-ground facilities in this System. The most expensive pieces of equipment in the wastewater collection system that, if lost, would need to be replaced as soon as possible to avoid service interruption are the largest diameter portions of the wastewater collection system. Atotal blockage or washing away of the last section of the system, a section of 42 inch diameter pipe, through which most of the City’s wastewater flows on its way to the Water Quality ControlPlant would cost over $5 million to replace. This amount is much greater than 5% of the Net Book Value, the maximum amount for the reserve fund. It is more likely that smaller sections of pipe would need repair or replacement in an emergency. The potential damage could be about $1 million. Funding this amount would require that the balance in this reserve needs to increased. Some of the funding needed for increasing this emergency reserve balance may come from C~ funding ret~med to the WWC fund at the end of FY 06-07. Recommendation -for Emergency Plant Replacement Reserves As shown in the detail above, for the last three fiscal years, the EPR reserve balances have been under the 5% of Net Book Value limit established in the City Charter and the annual increase in reserve funding has not met the minimum of 5% of the annual increase in Net Book Value. The City Charter requirement pre-dates the establishment of other reserves, such as the Rate Stabilization Reserves, that contain funds that could be used to pay for emergencies if needed. In addition, each fund has the capacity to borrow funds for such needs. In recent years, Utilities management has not felt that funding the EPRs at the guideline level of 5% of the annual increase inNet Book Value has been necessary. Staff recommends that a minimum reserve guideline be established equal to the greater of: 1) the liability insurance deductible amount (currently $1 million); or 2) the amount needed to cover the most expensive item of equipment which, if lost, would cause interruption in the normal activity of that utility. If the loss were found to be due to negligence, any amount over $1 million would be covered by liability insurance. Exposure under the City’s property loss insurance due to coverage limits and deductibles is likely to be lower than the liability insurance deductible. UAC December 6, 2006: Changes to Reserve Guidelines Page 6 of 14 For the Electric, Gas, and Water EPRs, the current balances are sufficient to meet this minimum guideline so that additional funding is not necessary. For the Wastewater Collection EPR, additional funding is necessary to increase the balance to the minimum level. In the upcoming budget process, the question of how quickly to move the fund to the minimum guideline level will be discussed. Note that the City Charter does state that the annual payment into the reserve should not exceed ten percent of the expenditure for capital outlay for the year, exclusive of bond fund expenditures. This may be found to be the limiting factor for how quickly the reserve can be brought up to the minimum guideline level. Rate Stabilization Reserve (RSR) Council established RSRs in May 1993 [CMR:263:93] for the Water, Electric, Gas and Wastewater Collection Funds to ensure funds are available to cover short-term situations when expenditures exceed revenues; to provide a depository of excess funds when expenditures are less than revenues; and to plan for certain known future occurrences that are of a one-time nature, or to ramp up if the expense is of an ongoing nature. The key points of the Council policy are: Reserves should be used to finance extraordinary one-time contingencies and to cover increased operating costs in the short-run, while allo, wing rates to gradually increase over a reasonable period. Reserves should not be used to solve long-term financial problems or to cover potential major catastrophic disasters. RSR level guidelines should be set to allow reserves to float up or down. The decision to hold more money or less money than the guidelines should be based on an assessment of the uncertainties and financial risk facing the utilities. The adequacy and prudence of the guidelines will be reviewed internally each year, and if appropriate, revised guidelines will be recommended. In May 1998 [CMR:194:98], Council split the Gas and Electric Fund RSRs into Supply and Distribution RSRs when the retail rates in those funds were unbundled into supply and distribution components of the rate. The current RSR guidelines were developed from an evaluation of risks, or costcontingencies, to which the relevant funds are exposed. The funds that would be necessary to cover a variety of risks were then compared to the fund’s supply cost (for the Electric and Gas Supply RSRs) or sales revenue (for all other RSRs). The minimum guidelines were then established as a percentage of the supply cost or sales revenue. The risk evaluation was not necessarily communicated to the public on an annual basis. Staff recommends that such an evaluation and explanation of risks be communicated to the UAC and Council each year as part of the budget and rate development process to determine the target reserve balance for the budget. UAC December 6, 2006: Changes to Reserve Guidelines Page 7 of 14 The desirable amount of money that is held in reserves depends upon the desired balance between having higher reserve balances and longer periods between rate changes and lower reserve balances and shorter periods between rate changes. One approach is to establish the lowest prudent reserve level, which could be equal to the amount of money that would be needed to cover cost contingencies that may arise and could be covered in the time necessary for Council to approve a rate change. The minimum time necessary for staffto take a request for a rate change to the Council is about 3 months. Therefore, this method would result in a reserve level.equal to the amount a cost contingency could increase costs ina 3-month period. Such an approach would require close monitoring of costs and the quick deployment of staff to begin the process for requesting a rate adjustment. This approach is administrativelyburdensome and does not conform to the Utilities Strategic Key Strategy #2: "Manage supply portfolio risk as per Council policy to provide stable gas and electric rates, to preserve a supply cost advantage, and to manage business processes cost effectively." Another approach is to have larger reserves capable of cushioning or smoothing rate adjustments over multiple years so that any unanticipated costs would be passed on more slowly to the customers. This approach may have the advantage of security and the ability to cover a large variety of simultaneous contingencies without changing rates. However, rates could become out of line with market costs and neighboring utilities’ rates at times. For the most part, customers seem to appreciate fewer rate changes and have not petitioned for a change regarding the amount of money held in reserves by the City. In addition, ratings agencies have shown a strong preference for having more, rather than less, money in reserves to maintain the City’s excellent credit rating. A description of the proposed new guideline for each RSR follows. 1.Electric Supply RSR The current guideline for the minimum reserve level is that it be equal to 51.5 percent of the electric supply purchase cost. The maximum level is. equal to twice the minimum level. The minimum guideline was developed from the electric supply recurring and one-time cost contingencies. The recurring cost contingencies include: ¯Western hydrologic production and market price variability, ¯Calaveras hydrologic production and market price variability, o Calaveras plant outage, ¯Market price risk related to the electric supply portfolio’s unhedged load positions, and ~Transmission cost uncertainties. One-time cost contingencies may include: Regulatory and legal cost uncertainties, and ,Supplier default. The cost contingencies identified above will be included in the annual risk assessment. The chart below provides information for the Electric Supply RSR over the past three fiscal years. UAC December 6, 2006: Changes to Reserve Guidelines Page 8 of 14 Electric Supply Rate Stabilization Reserve (millions of dollars) Budget Estimate of Reserve Balance as of the end of FY Budgeted Purchase Cost (Adopted Budget) Budget Estimate of Reserve Balance as a fraction of Budgeted Purchase Cost Maximum Guideline Level (% of purchase cost) Minimum Guideline Level (% of purchase cost) Actual Balance as of end ofFY (pre-audit figure for FY 05-06) FY 03-04 34.423 38.670 89% FY04-05 52.462 36.202 145% FY05-06 23.876 57.013 42% 80%103%103% 40%51.5%51.5% 58.562 44.199 64.542 The proposed new minimum reserve guideline is that it be equal to 50% of the electric supply purchase cost. The proposed maximum guideline would be 100% of the electric supply purchase cost. This guideline is essentially the same as the existing guideline, but adds the requirement to conduct the annual evaluation of risks facing the electric supply business unit to determine target reserves levels as part of the budget and retail rate development process. 2. Electric Distribution RSR The current guideline for the minimum reserve level is that it be equal to 19 percent of the distribution sales revenue. The maximum level was set to twice the ~inimum level. The minimum guideline was developed from the electric distribution cost contingencies, including: o A decline in sales revenue of 10 percent for two years, ¯Rise in ongoing operating expenses for two years, and ,Unusual one-time cost contingencies (e.g. potential seismic upgrades at the Municipal Service Center, effectiveness of efficiency programs, regulatory and legal cost uncertainties or expansion of the CIP). Although the electric distribution business unit faces less uncertainty than the supply business unit, the cost contingengies identified above will be included in the annual risk assessment. The chart below provides information for the Electric Distribution RSR over the past three fiscal years. Electric Distribution Rate Stabilization Reserve (millions of dollars) Budget Estimate of Reserve Balance as of the end of FY Budgeted Sales Revenue (Adopted Budget) Budget Estimate of Reserve Balance as a fraction of Budgeted Sales Revenue Maximum Guideline Level (% of sales revenue) Minimum Guideline Level (% of sales revenue) Actual Balance as of end of FY (pre-audit figure for FY 05-06) FY03-04 8.296 30.119 28% FY04-05 6.876 28.193 24% FY 05,06 8.849 26.994 33% 3O%38%39% 15%19%19% 7.557 13.519 11.324 The proposed new minimum reserve guideline is that it be equal to 20% of the electric distribution sales revenue. The proposed maximum guideline would be 50% of the electric distribution sales revenue. This guideline is almost the same as the existing guideline, but adds the requirement to UAC December 6, 2006: Changes to Reserve Guidelines Page 9 of 14 conduct the annual evaluation of risks facing the electric distribution business unit to determine target reserves levels as part of thebudget and rate development process. 3. Gas Supply RSR The current guideline for the minimum reserve level is that it be equal to 37.5 percent of the gas supply purchase cost. The maximum level was set to twice the minimum level. The minimum guideline was developed from the gas supply cost contingencies, including: ¯An increase in gas pool customer sales volumes of 10 percent, ¯Market price risk for unhedged supplies, and ~Unusual one-time cost contingencies (e.g. regulatory and legal cost uncertainties and supplier default/credit risk). The cost contingencies identified above will be included in the annual risk assessment. The chart below provides information for the Gas Supply RSR over the past three fiscal years. Gas Supply Rate Stabilization Reserve (millions of dollars) Budget Estimate of Reserve Balance as of the end of FY Budgeted Purchase Cost (Adopted Budget) Budget Estimate of Reserve Balance as a fraction of Budgeted Purchase Cost Maximum Guideline Level (% of purchase cost) Minimum Guideline Level (% of purchase cost) Actual Balance as of end ofFY (pre-audit figure for FY 05-06) FY 03-04 7.605 16.673 45% 40% 20% 6.822 FY 04-05 6.556 16.733 39% 75% 37.5% 3.821 FY 05-06 3.200 20.320 16% 75% 37.5% 2.801 The proposed new minimum reserve guideline is that it be equal to 35% of the gas supply purchase cost. The proposed maximum guideline would be 75% of the gas supply purchase cost. This guideline is essentially the same as the existing guideline, but adds the requirement to conduct the annual evaluation of risks facing the gas supply business unit to determine target reserves levels as part of the budget and rate development process. 4.Gas Distribution RSR The current guideline for the minimum reserve level is that it be equal to 20 percent of the distribution sales revenue. The maximum level was set to twice the minimum level. The minimum guideline was developed from the gas distribution cost contingencies, including: A decline in sales revenue of 10 percent for two years, ~Rise in ongoing operating expenses for two years, and Unusual one-time cost contingencies (e.g. potential seismic upgrades at the Municipal Service Center, effectiveness of efficiencyprograms, regulatory and legal cost uncertainties or expansion of the CI:P). As with the electric fund, the gas distribution fund faces much less risk than the gas supply fund. The cost contingencies identified above will be included in the annual risk assessment. The chart below provides information for the Gas Distribution RSR over the past three fiscal years. UAC December 6, 2006: Changes to Reserve Guidelines Page 10 of 14 Gas Distribution Rate Stabilization Reserve (millions of dollars) Budget Estimate of Reserve Balance as of the end of FY Budgeted Sales Revenue (Adopted Budget) Budget Estimate of Reserve Balance as a fraction of Budgeted Sales Revenue Maximum Guideline Level (% of sales revenue) Minimum Guideline Level (% of sales revenue) Actual Balance as of end of FY (pre-audit figure for FY 05-06) FY 03-04 6.421 11.238 57% FY 04-05 3.862 10.591 36% FY 05-06 4.691 14.761 32% 40%40%40% 20%20%20% 6.703 4.023 3.868 The proposed new minimum reserve guideline is that it be equal to 20% of the gas distribution sales revenue. The proposed maximum guideline would be 50% of the gas distribution sales revenue. This guideline is almost identical to the existing guideline, but adds the requirement to conduct the annual evaluation o frisks facing the gas distribution business unit to determine target reserves levels as part of the budget and rate development process. 5.Water RSR The current guideline for the minimum reserve level is that it be equal to the sum of: 1) 15 percent of sales revenue for that year; plus 2) the estimated annual net sales revenue decline due to abnormal weather. The reserve’s guideline for the maximum level is twice the minimum level.. The Water Fund is subject to changes in sales revenue caused by wet or cold weather, cost and effectiveness of water efficiency programs, expansion of the Capital Improvement Program for the distribution system, and cost impacts related to San Francisco’s upgrade of the Hetch Hetchy regional water supply system. These cost contingencies will be included in the annual risk assessment to determine target reserves levels as part of the budget preparation. The chart below provides information for the Water RSR over the past three fiscal years. Water Rate Stabilization Reserve (millions of dollars) Budget Estimate of Reserve Balance as of the end of FY Budgeted Sales Revenue (Adopted Budget) Budget Estimate of Reserve Balance as a fraction of Budgeted Sales Revenue Actual Balance as of end ofFY (pre-audit figure for FY 05-06) FY 03-04 6.885 21.073 33% 6.178 FY 04.05 FY 05-06 6.728 8.433 23.265 23.381 29%36% 5.217 4.143 The proposed new minimum reserve guideline is that it be equal to 20% of the water sales revenue. The proposed maximum guideline would be 50% of the water sales revenue. It is expected that the cost contingencies for the water fund will lie within that range. The additional new component is the requirement to conduct the annual evaluation of risks facing the water fund to determine target reserves levels as part of the budget and rate development process. UAC December 6, 2006: Changes to Reserve Guidelines Page 1 1 of 14 6.Wastewater Collection RSR The current guideline for the minimum reserve level is that it be equal to the sum of: 1) 15 percent of sales revenue for that year; plus 2) the estimated annual net sales revenue decline due to abnormal weather. The reserve’s guideline for the maximum level is twice the minimum level. As with the Water Fund, the Wastewater Collection Fund is subject to changes in sales revenue caused by wet or cold weather and the effectiveness of water efficiency programs. Temporaryramp- up or expansion of the Capital Improvement Program could impact reserve levels. In addition, the Wastewater Collection fund may incur costs due to cleanups required after sewer backups. These cost contingencies will be included in the annual risk assessment to determine target reserves levels as part of the budget preparation. The chart below provides information for the Wastewater RSR over.the past three fiscal years. Wastewater Collection Rate Stabilization Reserve (millions of dollars). Budget Estimate of Reserve Balance as of the end of FY Budgeted Sales Revenue (Adopted Budget) Budget Estimate of Reserve Balance as a fraction of Budgeted Sales Revenue Actual Balance as of end ofFY (pre-audit figure for FY 05-06) FY 03-04 3.276 12.901 25% FY 05-06FY 04-05 3.466 12.252 28% 4.917 5.810 13,660 43% 2.823 4.293 The proposed new minimum reserve guideline is that it be equal to 20% of the wastewater collection sales revenue. The proposed maximum guideline would be 50% of the wastewater collection sales revenue. It is expected that the cost contingencies for the wastewater collection fund will lie within that range. The additional new component of the requirement to conduct the annual evaluation of risks facing the wastewater collection fund to determine target reserves levels as part of the budget and rate development process. Recommendation for the Rate Stabilization Reserves Staff recommends that an evaluation and explanation of risks for each of the RSRs be communicated to the UAC. and Council each year as part of the budget and rate development process to determine the target reserve balance for the budget. Since the retail rate level assessment is undertaken every .year due to the volatile nature of supply commodity costs, this risk evaluation and communication is to be done annually even if the City is in the second year of a two-year budget cycle. The annual risk assessment will include, but may not be limited to, hydropower production and market price variability; plant outage costs; market price risk related to unhedged supply to meet load; transmission cost risks; variations in sales volumes due to customer usage pattern changes due to weather or efficiency programs; regulatory and legal cost uncertainties; the risk of supplier default; and unanticipated changes to capital improvement program costs. This annual assessment will be compared to the established guideline levels to assist in the determination of the Rate Stabilization Reserve level target for each fiscal year. The recommendations for the guidelines for the RSRs are summarized in the table below. UAC December 6, 2006: Changes to Reserve Guidelines Page 12 of 14 Rate Stabilization. Reserves ~ Electric Supply Gas Supply Electric Distribution Gas Distribution Water Wastewater Collection Reserve Balance as of end of FY 05-06 (pre-audit) ¯ $64.542 million $2.801 million $11.324 million $3.868 million $4.143 million $4.293 million i i Proposed New Guidelines when applied to FY 06-07 budget numbers Maximum $55.275 million 100%of purchase cost $20.023 million 75%of purchase cost $14.297 million 50% of sales revenue $7.833 million 50%of sales revenue $11.156 million 50% of sales revenue $6.840 million 50% of sales revenue Minimum $27.637 million 50% of purchase cost $9.344 million 35% of purchase cost $5.719 million 20% of sales revenue $3.133 million 20% of sales revenue $4.462million 20% of sales revenue $2.736 million 20% of sales revenue Note that the recommendation does not change the guideline basis of purchase cost for the electric and gas supply RSRs. Although the risks in these funds don’t directly relate to the purchase cost, past risk evaluations have demonstrated that the risks will fall between the minimum and maximum guideline levels. In addition, the recommendation does not change the guideline basis of sales revenue for the electric and gas distribution, water, and wastewater collection RSRs. RESOURCE IMPACT The impact of the recommended changes to the Emergency Plant Replacement Reserves is that funding of the Electric, Gas, and Water EPRs can cease as they are at least at the minimum guideline levels. Funding of the Wastewater Collection EPR is required to increase it to the minimum guideline level. During the budget process, staff will outline the plans to fund this reserve over the next several fiscal years. There is no resource impact of the recommended changes to the Rate StabiliZation Reserves as a result of the recommended changes to the guideline levels. The annual risk evaluations that will be done may result in a resource impact that would be identified at the time. POLICY IMPLICATIONS The recommended changes to the reserve guidelines require Council approval. ATTACHMENT CMR:358:06 - Recommendation for Finance Committee to Review Certain Utility Emergency Plan Reserve and Rate Stabilization Reserve Policies, Guidelines, or Purposes and Direct Staff to Work With the Utilities Advisory Commission to Develop Recommendations for Changes to the Same PREPARED BY: Jane Ratchye, Senior Resource Planner UAC December 6, 2006: Changes to Reserve Guidelines Page 13 of 14 APPROVED BY: VALE~IE ~NG DIRECTOR OF UTILITIES UAC December 6, 2006: Changes to Reserve Guidelines Page 14 of 14 Draft UAC Meeting Minutes Excerpts December 2006 Attachment 2 Jane Ratchye’s presentation followed the staff report. - In September, the Finance Committee directed staff to work with the UAC on the Utilities Emergency Plant Replacement Reserves (EPRRs) and the Rate Stabilization Reserves (RSRs). The EPRRs were set-up by City Charter with the stipulation that the maximum level of those reserves cannot be more than five percent of the net book value of the fixed assets for that fund. In 1988, Council added directives that: 1) the annual funding to those reserves should be about five percent to the annual increase in the net book value and 2) the balance of those reserves should be able to cover the cost of the most expensive item in that utility that, if taken out of service, would result in a loss in utility service. The City’s insurance policies also cover some disasters. The City’s liability insurance has a one million dollar deductible currently. The City Charter sets the maximum for these reserves. All of these reserves are under that maximum so we are in line with the City Charter. Staff is recommending that these reserves have a minimum level equal to the greater of: 1) the deductible for the city’s liability insurance; or 2) an amount that would cover the cost of the most expensive piece of equipment that would need to be repaired in order to return utility service forthwith. Under staff’s recommendation, the Wastewater Collection Emergency Plant Replacement Reserve would need to be funded to meet that one million dollar minimum. Do you want to pause here and have any questions on the EPRRs? Commissioner Dawes asked about overlap between the EPRRs and the distribution reserves. Ratchye noted that the EPRRs are meant for something where the money is needed right now because something just broke that needs to be replaced. Most of the reserves are significantly below the maximum levels from the City Charter since Utilities does have distribution rate stabilization reserves in all the funds. The RSRs did not exist at the time of the City Charter. Commissioner Melton noted that for the Wastewater Collection EPRR, the most expensive item could cost five million dollars to replace, but the staff report says that the cost would only be one million dollars. Ratchye noted that staff struggled with this because it is hard to imagine that somehow the entire 42-inch section that would cost five million dollars to replace would disappear without being caused by an earthquake, that is covered by FEMA, or there being a liability issue that would be covered by our liability insurance, or something covered by our property insurance. Staff could not come up with something that was reasonable, so we estimated that a reasonable number for repair would be the one million dollars. Ratchye then discussed the six Utilities rates stabilization reserves (RSRs). The RSRs were established in 1993 and they are to finance extraordinary one time contingencies to cover increased operating costs in short run and they are supposed to allow rates to gradually increase over a reasonable period and that is how you have seen them being used over the time you have been on the Commission I am sure. They are not to solve long term financial problems or to cover major catastrophic disasters. The reserves should be allowed to flow up or down with levels generally between the minimum and the maximum guideline based on the assessment of the financial risks of facing the whole Utility. The intent when these reserves were established is to review their adequacy annually. Staff is not recommending major changes in the minimum Page 1 of 3 and maximum guidelines for any of the rate stabilization reserves. The new element is to require an annual risk assessment for each fund as part of the annual budget and retail rate setting process. The risk assessment would be used to develop the target level should be for the RSRs. The ranges for minimum and maximum that we have now should capture the risks that we expect to see. Risks assessments have been done in the past, but not necessarily annually and the results have not necessarily been made public. Commissioner Bechtel commented that, from a practical point of view, the maximum is not as important as the minimum because the minimum is the one you really feel, bottom line, you should have that money in reserve. We should not be quibbling about too much maximums. Commissioner Melton observed that the annual risk assessment should lie between the minimum and the maximum levels, but in the past, the reserve levels have gone below the minimums. Girish Balachandran, Assistant Director for Resource Management noted that the risks need to be looked at for the long-term. For example, given our hedging strategy, we tend to end up being lower than minimum for the prompt 12 months. But, for the second and third years the risk exposure is substantially more. The annual risk assessment is the time when we get the dialogue going on rates and that connection happens and so the timing of this is right. We do not have a hard and fast rule as to how much we are going to hedge. It seems that the common sense approach would be to look at the real risk exposure for the rate period in question and calculate rates based on that. Commissioner Melton agreed with this approach, but noted a certain degree of tension and uncomfortableness if that annual risk assessment is below the minimum guideline and we are not setting rates to at least keeps our reserves at the minimum guidelines. Ratchye noted that these are guidelines and not policy. Even if reserves have been lower than the minimum for a single year, you will see the levels in the longer-term view climbing up above the minimum. Commissioner Dawes agreed with Chair Melton. He also is concerned when reserve levels are below the guideline minimums. In addition, the risks on the electric side are highly dependent on hydro availability, which is not known with any certainty at the time of budget development. Balachandran noted thatthis is what’s been done for last several years. For electric, we look at two hydro years for coverage on our reserves in an attempt to accommodate the volatility of that key assumption. On the gas side, the laddering strategy for the first eighteen months has a minimum of 60 percent hedged and a maximum of 100 percent. In the last few years we are hedged at 80 percent or so. That is why the risk exposure that you see has been below the guideline. But we could actually be hedget at 60 percent so the risk exposure could be.much higher. Karl Van Orsdol, Energy Risk Manager, stated that the first time this is done, we will do it with a lot of detail and a lot of explanation as to why we have chosen the risk approaches that we have. As Girish said we need to do two years for hydro, you are using the prompt 12 months for which Page 2 of 3 there is actual data and then using the model for the following twelve months. It is much more conservative approach then doing it for a twelve month period. Commissioner Rosenbaum commented that the section from the City Charter was interesting. The Charter does not seem to contemplate the rate stabilization reserves we now have. Ratchye noted that not everything we do emanates from the Charter. Balachandran noted that there are other reserves established by the Council which are not written into the Charter. Commissioner Dawes stated that he is comfortable with the proposed guidelines. If we come up to real changes in the risk assessment, we may have to adjust the reserves, but not the guidelines. So we really have to adjust the dollars and not worry about tweaking guidelines. Commissioner Dawes move that the UAC recommends the staff recommendation in Table II for revision of guidelines with the exception that when the target reserve is below the minimum guidelines that the assumption used are the most conservative available to the particular utility. After discussion, Commissioner Dawes agreed to change "most conservative available: to "an appropriately conservative set of assumptions." The motion died for a lack of a second. Commissioner Rosenbaum moved staff recommendation. Commissioner Bechtel seconded the motion. Commissioner Bechtel noted that the risk assessment means more than the minimum and maximum guideline levels. In the budget process, we can discuss the risk assessment. Commissioner Dawes indicated that he supports the motion as he has great confidence in staff to envision circumstances in the market. Commissioner Melton was still not comfortable with the Emergency Plant Replacement Reserves since it doesn’t cover the cost of the most expensive item for the Wastewater Collection fund. Motion passes unanimously. Page 3 of 3