HomeMy WebLinkAbout2000-04-25 City Council (5)BUDGET
’00-’01 City of Palo Alto
City Manager’s Report
TO:HONORABLE CITY COUNCIL
ATTENTION:FINANCE COMMITTEE
FROM:
DATE:
CITY MANAGER
APRIL 25, 2000
DEPARTMENT:ADMINISTRATIVE
CMR: 223:00
SUBJECT:TRANSMITTAL OF UTILITIES FUNDS TRANSFER STUDY
AND STAFF RECOMMENDATION FOR IMPLEMENTATION
OF ALTERNATIVE METHODOLOGY
RECOMMENDATION
Staff recommends the Finance Committee:
°
Approve a proposed transfer methodology for the Electric and Gas Fund that bases the
transfer on a percent of Adjusted Sales Revenue (ASR) and a steady butincreasing
transfer from the Water Fund. This change in methodology would result in an increase
in the transfers from the three funds to the General Fund of $61,000 in 2000-01.
Include in the new transfer methodology an early warning signal in case of a loss faced
by one of the utility funds and a mechanism for sharing yearly surpluses or losses in each
of the three funds by comparing the Adopted Budget funding or use of the Rate
Stabilization Reserve to year end results.
Recommend a change in the methodology for calculating the rent and maintenance for
traffic signals. The new method would include the cost of capital work. The cha~ges to
the General Fund from the Electric Fund would be increased by $32,500 each year over
a four-year period.
Support a more frequent review of the equity transfers from the Electric, Gas and Water
Funds to the General Fund in light of the new competitive environment facing the
Electric and Gas Funds and an exploration of methods to protect the Electric and Gas
utilities from outside competitive forces.
CMR:223:00 Page 1 of 3
DESCRIPTION OF STAFF PROPOSAL
In 1997-98, in light of the challenges faced by the Electric and Gas Utilities and with
concerns over the financial health of the Water Fund, the City Manager recommended the
General Fund equity transfers from the Electric, Gas, and Water Funds be frozen at 1996-97
levels. In recognition of these two issues, and with the endorsement of the City Council and
Utilities Advisory Commission, staff undertook a study to examine the methodology used to
calculate the transfer amount from the Water, Gas, and Electric Funds to the General Fund.
The current methodology was adopted in 1983 following a Price Waterhouse study of
appropriate policy guidelines for utility ratemaking and equity transfers. In December 1998,
staff hired a consultant, R.W.’Beck, to review the City’s existing transfer policies, to
identify transfers and ratemaking policy options, and to recommend a transfer policy or
policies.
Working with staff and the Utilities Advisory Commission, R.W.Beck conducted fact
finding, evaluated current policies, examined policy options, evaluated fiscal impacts, and
formulated findings and conclusions. Based on the expert opinion provided by R.W. Beck
and after extensive discussion, staff has developed a recommendation for the transfers that
builds upon the analysis provided in the R.W. Beck report but does not mirror the consultant
recommendations. The staff recommendation for the transfers from the Electric, Gas and
Water Funds results in: a stable but growing transfer to the General Fund; implementation
flexibility for the Electric and Gas supply and distribution businesses; and, a Water Fund
transfer that increases at a more moderate rate than that proposed by the R. W. Beck study.
In addition, the recommended transfer methodology includes a mechanism for early warning
signals in the event that the performance of one of the funds deviates, either positively or
negatively from projected performance.
UTILITIES ADVISORY COMMISSION REVIEW AND RECOMMENDATIONS
The Utilities Advisory Commission (UAC) supported the staff recommendations for.the
equity transfers from the Electric and Gas Fund. The UAC agreed that the transfer policy
should be reviewed on a more frequent basis, in line with the two-year budget process. The
UAC also reserved the option to agendize the transfer methodology and level on a yearly
basis for UAC review. The UAC had considerable discussion about the proposed transfer
methodology for the Water Fund and recommended that it be valid for two years and after
that time would be subject to a comprehensive review.
ATTACHMENTS
Attachment 1"Memo to UAC Transmitting Utility Funds Transfer Study
CMR:223:00 Page 2 of 3
PREPARED BY:Gigi Harrington, Deputy Director, Administrative Services
Randy Baldschun, Assistant Director, Utilities
DEPARTMENT HEAD:
CARL Y]~TS -
Adminigtrative Services
~irector, Utilities
CITY MANAGER APPROVAL:
Elk~ILY ~SON
Assistant City Manager
CMR:223:00 Page 3 of 3
ATTACHMENT A
TO:
FROM:
DATE:
SUBJECT:
MEMORANDUM
UTILITIES ADVISORY [~ ~ION
.JUNE FLEMING, CI~\\
MARCH15, 2OOO ~
TRANSMITTAL OF UTILITIES FUNDS TRANSFER STUDY AND
STAFF RECOMMENDATION FOR IMPLEMENTATION OF
ALTERNATIVE METHODOLOGY
RECOMMENDATION
Staff recommends the Utilities Advisory Commission:
Review and comment on the staffproposed utility transfer methodology that incorporates
the concept of percent of Adjusted Sales Revenue (ASR) for the Electric and Gas Funds
and a steady but increasing.transfer from the Water Fund. This change in methodology
would result in an increase in the transfers from the three funds to the General Fund of
$61,000 in 2000-01. The recommendation presented by staff is not consistent with the
recommendations contained in the R.W. Beck Utility Funds Transfer Study.
°Include in the new transfer methodology an early warning signal in case of a loss faced
by one of the utility funds and include a mechanism for sharing yearly surpluses or losses
in each of the three funds by comparing the adopted funding or use of the i:ate
stabilization reserve to year end results.
Recommend a change in the methodology for calculating the rent and maintenance for
traffic signals. The new method would include the cost of capital work. The charges to
the General Fund from the Electric Fund would be increased by $32,500 each year over
a four year period.
Support a more frequent review ofthe equity transfers from the Electric, Gas and Water
Funds to the General FUnd in light of the new competitive environment facing the
Electric and Gas Funds and to explore methods to protect the Electric and Gas utilities
from outside competitive forces.
BACKGROUND
The City of Palo Alto provides a full range of municipal utilities, which include water,
electricity, natural gas, refuse, wastewater collection, and storm drainage. As a result of the
initial investment made by the City and its citizens, Palo Alto’s residents and associated
businesses have enjoyed favorable rates and utility services provided by the City’s municipal
utilities.
The services provided by the Water, Gas, and Electric Funds provide a return on investment
to the General Fund in the form of a Utility Fund transfer, as established in the City’s charter.
The 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)
(b)
(c)
(d)
(e)
For the payment of the operating and maintenance expenses of such utility,
including the necessary contribution to retirement of its employees.
For the payment of interest on the bonded debt incurred for the construction
or acquisition of such utility.
For the payment of the principal of said debt, as it may become due.
For capital expenditures of such utility.
For the annual payment into a reserve fund 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.
The remainder shall be paid into the general fund by quarterly allotments."
While the Charter allows for all surplus revenues to be transferred into the General Fund, the
Council has established a more conservative approach in the current transfer methodology.
The current methodology for calculating the transfers to the General Fund is the Utility
Enterprise Method, which is based upon a rate of return on asset base methodology
(discussed later in this report). This methodology was adopted in 1983 following a study by
Price Waterhouse of appropriate policy guidelines for utility ratemaking and cash transfers.
Since that time there have been significant changes in the financial, economic, and political
environment that have had and will continue to have a major affect on the City’s General
Fund revenues and on Utility ratepayers. Some of the significant changes that have occurred
since the current methodology was established include:
¯The adoption of Proposition 218, and its potential impact on the ability of the Water
Utility to increase revenues.
¯Deregulation of electric and natural gas utilities in California, which increases the need
for the utilities to be competitive.
The Utility Infrastructure Improvement Program, begun in fiscal year 1990-91, which
funded an increased level of capital improvements to restore utility plant and equipment.
Since the current utility transfer methodology is based on the level of utility plant and
equipment, this program triggered an increase in the level of transfers to the General
Fund. The freezing of the Utilities transfers in 1997-98 was largely due to the impact of
this increased level of capital improvements on the transfer levels and utility rates.
¯Recommendations in a 1996 Utility Organizational Review that called for a review of the
transfer methodology, particularly in the Water Fund.
In 1997-98, the City Council froze transfers from the Utility Funds to the General Fund at
1996-97 levels where they remain fixed today totaling $11,835 million annually. It should
be noted that the decision made in 1997-98 to freeze the transfers at 1996-97 levels has
resulted in savings to the utilities funds of $2.241 million in 1999-00 alone, and $4.8 million
over the years that the transfer amount has been frozen. These savings to the Electric, Gas,
and Water Funds represent foregone revenues for the General Fund.
In 1998, the Finance Committee and the Utilities Advisory Commission (UAC) reviewed a
.proposed scope of services for the selection of a consultant to evaluate methodologies for
Utility Fund transfers to the City’s General Fund. Following this review, a Request for
Proposals was issued, and R. W. Beck was chosen to conduct the Equity Transfer Study.
DISCUSSION
The scope of the Equity Transfer Study was to review existing City policies regarding
transfers from the utilities funds to the General Fund; to identify General Fund transfer and
ratemaking policy options; and to make recommendations based on the study findings.
There are a number of objectives that the City considers important in the development of a
utilities transfer methodology. These include:
¯The transfer should provide stable and predi6table utility transfer levels to the City’s
General Fund each year;
¯The resulting transfer level should appropriately balance ratepayer and taxpayer interests;
¯The transfer should result in a just and reasonable earnings level in accordance with legal
rate making standards and be within the range of transfers made by comparable
municipal utilities;
¯The transfer methodology should be acceptable to rating agencies;
¯The resulting transfer level should not unduly cause utility rate levels to be non-
competitive;
¯The methodology should provide some flexibility to accommodate significant changes
in the utility’s overall fiscal health;
¯The methodology should not be difficult to implement or calculate;
¯Different methodologies may be appropriate for different utility businesses; and
If a utility is experiencing an unusual financial hardship, such as a prolonged drought, the
Council shall have the flexibility to deviate from the adopted methodology and approve
a modified transfer level.
Staff has reviewed the consultant report, and after significant discussion has prepared
alternative recommendations for the equity transfers from the Electric, Gas, and Water
Funds. These alternatives build on the background and expert guidance contained in the
R.W. Beck report but present the City with enhanced flexibility given the current competitive
environment.
R.W. Beck Transfer Policy Recommendations
Based on their analysis, R.W. Beck concluded that the current methodology for transfers, the
Utility Enterprise Method, is viable if it undergoes certain modifications (specifically,
adjustments to recognize the risk associated with the electric and gas supply business). The
R.W. Beck recommendations follow.
The current Utility Enterprise Method should be continued, with modifications, to
calculate the General Funds transfer obligation from the Water Fund and from both the
supply and distribution components of the Electric and Gas Funds.
2.Both the Gas and Electric Fund supply and distribution businesses should support a return
of equity based upon their share of the asset base.
The Utility Enterprise Method should be modified to recognize Palo Alto’s utility
systems’ equity capitalization and the City’s tax-exempt status. Modifications include
the following:
4
Revise the rate base calculation to eliminate the deduction of interest on debt; to
eliminate the inclusion of budgeted capital improvement projects, and allocate the net
book value and working capital to the distribution and supply business units, as
appropriate.
¯Replace the current rate of return calculation with a tax-adjusted rate of return on
equity.
4.Utility fixed, asset depreciation practices should be reviewed to ensure that service lives
of similar assets are consistent among the utility systems. ’
o A new Energy Supply Transfer Methodology should be developed. This methodology
would allocate profits from the electric and gas supply business units to the Energy
Supply Rate Stabilization Reserves (RSRs) and to the General Fund.
6.Streetlighting and traffic.signal service should be considered public services and should
be excluded from the Utility Enterprise method of calculating General Fund transfers.
7.The traffic signal tariff should recover all of its costs of service, including energy,
operations and maintenance, administration, and capital outlay.
The City should continue to manage the telecommunications function from the Electric
Utility until such time as it determines its future role in telecommunications. If
telecommunications options are pursued, the City should consider establishing a stand-
alone enterprise and reimburse the Electric Utility for its cost to start this function.
Given the rate of change in the electric utility industry, the City should consider
evaluation of its transfer polic.y on a more frequent basis. If competitive factors place
more pressure on electric rates, Pal0 Alto’s relatively high transfers could make the
Electric Fund less competitive.
Staff recommends implementing the consultant’s recommendations 7, 8 and 9, but would
recommend phasing the change in the charges for traffic signals to include the capital
component and all direct charges over a four year period. The increase in charges for this
service is estimated to be $130,000 in 2000-01. Therefore, to implement the increase over
four years, each year the General Fund would pay an increase of $32,500 and in the forth
year the actual direct costs for maintenance and capital work would be paid by the General
Fund.
The consultant’s recommendations for the Equity Transfer would result in a transfer from
the Electric, Gas, and Water Funds to the General Fund totaling $11.739 million (for 1999-
00). This compares to the $11.835 million currently in the budget, representing a slight.
decrease. However, had the transfer not been frozen at 1996-97 levels, the current transfer
amount would total $14.049 million, or $2.310 million more than the consultant
recommendation. It should be noted that the information used by R.W. Beck is somewhat
outdated.
Alternative Transfer Policy
Utilitytransfers to the City involve a transfer policy as well as a transfer methodology. The
recommendation for the transfer methodology advocated in the consultant’s report must be
considered in light of the overall objectives of the City with regards to the transfers from the
Electric, Gas and Water Funds to the General Fund. Staff consequently felt it was
appropriate to explore transfer methodologies that provided alternatives to the consultant’s
recommendation contained in the RW Beck report. Of particular concern is the impact the
consultant’s recommendation places on the distribution business in the Electric and Gas
funds. The transfer methodology proposed by the consultant is heavily weighted towards the
distribution business while the supply business bears almost no burden. Staff believes it is
important for there to be flexibility between the supply and distribution units and that any
methodology that is adopted should provide feedback to the General Fund if there are
performance issues within one of the funds on a yearly basis. Therefore, while the R.W.
Beck report provides research and background information, staff believes it is best to build
on this information to develop transfer policies that work best for the City of Palo Alto.
Surveys of municipal utilities conducted by the American Public Power Association (APPA)
and others indicate that transfer policies and methodologies vary widely. A superior transfer
policy or methodology is not universally established. In fact, in determining the
reasonableness of utility rates, the Supreme Court in FPC v. Hope National Gas (1944)
declined to advocate any one method as proper, stating "it is the result reached, not the
method employed, which is controlling’".
In justifying a city’s transfer policy, the APPA survey indicates that there are three common
alternatives: (1) a contribution in-lieu of taxes or; (2) a return on investment to the city; or
(3) a city charter stipulation. Under an in-lieu of tax policy, the transfer amount is generally
based on what a privately owned utility would pay the city if granted a franchise to operate
in town. This policy recognizes that, by virtue of owning a utility enterprise, the city
foregoes some tax and franchise revenues that it would otherwise receive from a private
utility. Under this policy rationale, one method to arrive at the transfer to the General Fund
applies local property tax rates to the value of utility property. Hypothetical franchise
revenues may also be included. One of the disadvantages of this approach is that estimating
the assessed value of utility plant and estimating franchise fees is not a straightforward
process. For this reason, it is less commonly used.
A return on investment (rate base or equity) methodology recognizes that the city and its
taxpayers are ultimately at risk for the financial consequences of operating a utility system.
The Utilities Enterprise Methodology (UEM) currently used by the Palo Alto Utilities, such
as a return on investment methodology. Based on this risk exposure and the investment in
the utility’s infrastructure, the city is entitled to a return on the investment. Typically this
involves maintaining detailed accounting records of the utility plant in order to calculate the
investment in the system. Another justification of this approach is that the city could sell the
system and earn a return on the cash received based on the market value of the system. A
return on investment approach is sound in theory and mimics to some degree how private
utilities calculate a return to their investors.
Surveys indicate that the most common methods to determine the transfer to the General
Fund are a percent of gross revenue, a percent of adjusted sales revenue, and a percentage
of fixed assets (rate base). According to Standard and Poors, "inf’mite variations of the basic
transfer methodologies are possible". An advantage of these methods is that, with the
exception of return on rate base, they are relatively straightforward to calculate. A
disadvantage of these methods is that as expenses or fixed assets rise, such as has occurred
with the City’s accelerated infrastructure program, revenues must correspondingly rise. In
this instance, ratepayers pay for the infrastructure p.rogram plus pay for the increase in the
transfer amount associated with the revenue increase.
With methods which are based on sales revenue, there is a risk under deregulation that
transfers could be reduced to the extent customers choose alternative suppliers or elect to
generate electricity on site. On the other hand, with any method there are risks, involved if
the methodology produces transfer levels outside the normal range as measured by other
municipal utilities. There is the risk that relatively high utility transfers to the General Fund
can trigger taxpayer groups to push legislation to regulate transfer levels. In 1995, Assembly
Bill 318 (Katz) was introduced to restrain California municipal utilities’ transfers to city
budgets. The bill was ultimately defeated but it did receive considerable support in some
subcommittees. Had it passed, Palo Alto would have had to take dramatic actions to balance
the General Fund budget due to substantially lower utilities transfer.
"The City’s recently completed long-term General Fund financial plan projects that, in
general, expenditures will rise near the rate of inflation, which is estimated at three percent
annually. Given this assumption, it is prudent to approve a utilities transfer methodology
which will result in transfer levels that keep pace with the City’s spending pattern. Balancing
this objective is the need to recognize that the utilities must remain competitively priced and
financially healthy in order to continue to provide transfers to the General Fund and benefit
Palo Alto ratepayers through low rates.
In evaluating the various transfer methodologies available, staff believes that adoption of a
single methodology applicable to Water, Gas, and Electric utilities will fall short in
addressing the unique requirements of each business entity.
The Electric Utility is poised to meet competition as deregulation and market forces continue
to evolve. Both the supply business and the distribution business will face increasing
pressure to successfully manage costs and earn a profit. Because of the current Western Area
Power.Administration (Western) contract, Palo Alto supply costs are approximately 40
percent below market prices. This price advantage will erode significantly in 2005 under the
anticipated terms of the new Western power supply contract. With regard to the electric
distribution business, it is recognized that a considerable level of spending will be necessary
to ensure that reliability on the Palo Alto electric distribution system is maintained. This
needs to occur despite the fact that Palo Alto’s distribution rates for its largest, most
profitable industrial customers exceed PG&E distribution rates by approximately 70 percent.
Furthermore, the distribution business and supply business may experience a reduction in
the customer base if distributed electric generation units gain a technological and price
advantage within the next several years. Under such circumstances, customers would by-
pass or partially by-pass the Palo Alto distribution system, thereby reducing their
contribution to the Electric Utility’s fixed costs.
Natural gas is deregulated and currently Palo Alto’s largest commercial and industrial
customers have an option, yet to be exercised, to buy gas from other suppliers or marketers.
The Palo Alto Gas Utility buys and sells the commodity at close to market prices and
therefore may not always be able to offer a price advantage to customers. This scenario is
expected to continue. Therefore the supply business cannot absorb the financial obligation
to provide an annual transfer to the General Fund without pushing the commodity price
above market and thereby providing an incentive for customers to buy from competitors.
This in itself is not a problem. However, if the customer buys gas and electricity in a package
deal from a competitor, then the Palo Alto Electric Utility is adversely impacted.
With regard to the Water Utility, Palo Alto’s water rates are higher than rates charged in
surrounding areas. More importantly, Palo Alto is facing major water rate increases in the
future to cover its accelerated infrastructure program in combination with major San
Francisco Public Utilities Commission (SFPUC) wholesale water cost increases. Because
of these circumstances, a formula tied to sales revenue or fixed assets will result in very high
transfer levels and that will compound the impact of rising water rates due to SFPUC.
Staff Recommended Utilities Transfer Policy
Given the current and prospective circumstances
following transfer policy for each fund:
described above,staff proposes the
Water Fund:
The current transfer level is $2,044,000. Staff recommends that this amount represent the
initial base level from which subsequent annual transfers will be calculated. Annually, this
base would be escalated at a rate of three percent, which is stable and growing. This
methodology is based upon the following principles:
¯An exclusion of revenues or fixed assets in the calculation to avoid raising
transfer levels due to an accelerated infrastructure program or rising SFPUC
costs.
¯A recognition of the need to provide transfers to the City which keep pace with
the rate of inflation.
Electric Fund:
Staff recommends a transfer policy for the Electric Fund composed of:
(1)
(2)
A formula based on a percentage of Adjusted Sales Revenue (ASR) as the
underlying basis to calculate the transfer. For purposes of this calculation, ASR .
is defmed as metered sales revenue less the Capital Improvement Program (CIP)
expenditures. The formula’s percentage is fixed at 14.5 percent armually and is
based onthe current transfer level, which represents 14.5 percent of the projected
ASR over three years. Simply, the formula applies 14.5 percent to the ASR
budgeted to determine the transfer level for the fiscal year.
To incorporate a performance-based concept, the Utility net income or net deficit
at year-end will be shared between the Rate Stabilization Reserve (RSR) and a
newly created General Fund Transfer Stabilization Reserve (GTSR). The
proportionate sharing is 75 percent Utility RSR and 25 percent GTSR. The GTSR
will have a maximum cap established at 30 percent of the yearly equity transfers
to the General Fund. The GTSR would share in excess utility net income until
it has reached its maximum cap of 30 percent of the yearly equity transfers. The
GTSR would share in funding utility deficits unless the Utility RSR is above its
maximum guideline. Excess net income is represented by any additional funds
at year-end that are above the adopted budget funding level of the Utility Supply
RSR and Distribution RSR. On the other hand, a Utility deficit is represented by
the amount of funds at year-end which are below the adjusted budget’s funding
level of the Supply and Distribution RSR’s.
(3)The transfer level from the Electric Fund as calculated in (1) above will be met
by either the distribution business revenue/reserve, supply business
revenue/reserve, or a combination thereof, as determined by the City Manager,
after taking into account competitive factors faced by the two business units.
(4)The proposed commodity pricing policy identifies the various cost components
that are considered in arriving at the commodity price. One of the components
identified is the transfer to the General Fund. At the time rate schedules are
approved by Council, this component will be updated to reflect the amount
calculated and budgeted.
The methodology is based upon the following principles:
¯ Exclusion of Capital Improvement Program (CIP) expenditures in the net revenue
calculation to avoid raising transfer levels due to the accelerated infrastructure
program.
A proportionate sharing of income or deficit between the Electric Fund and the
General Fund. based upon the year-end performance of the Electric Fund to send
early warnings in the event of loss of customers or issues related to
competitiveness.
¯Flexibility within the Electric Fund supply and distribution units to generate the
transfer payment.
Gas Fund:
Staff recommends the same underlying principles and proPOsed transfer methodology for the
Gas Fund as in the Electric Fund. The 14.5 percent calculation of ASR in the Electric Fund
would be 15 percent in the Gas Fund.
The proposed methodology results in combined water, gas, and electric transfers to the
General Fund that are expected to escalate annually. To the extent the rate of escalation for
the sum transfers is below a three percent annual escalation, the City Manager may elect to
draw down the GTSR; and in years in which the combined transfer is greater than three
percent, the City Manger may elect to place the amount in excess of three percent into the
GTSR. ~
The chart below indicates the cumulative percentage increase over the period 1999-00
through 2008-09 for five different transfer methodologies. These five methods are compared
on a fund by fund basis. They are: the consultant’s modified UEM proposal; a three percent
annual escalation formula; a percent of revenue method; the current Utility Enterprise
Methodology; and the staff recommendation. The staff recommendation utilizes the
Adjusted Sales Revenue method for the Electric and Gas Funds and the three percent annual
escalation formula for the Water Fund. It is important to note that the consultant’s
recommendation would result in higher percentages than indicated because the numbers do
not include additional transfer amounts based on the proposed Energy Supply Transfer
10
Methodology. Also, staff has calculated transfer levels based on the R.W. Beck Method
using more recent financial projections than was contained in the final R.W. Beck report.
The chart indicates that the cumulative percentage increase over ten years varies between 30
percent and 62 percent depending on the methodology. Comparing these increases the last
ten years, the application of the current methodology (UEM) in combination with a transfer
level freeze since 1997-98 has resulted in a 22 percent increase in the transfer level from the
Electric Fund.
COMPARISON OF TRANSFER METHODS
PROJECTED PERCENTAGE INCREASE IN TRANSFER LEVELS BETWEEN 1999-
2000 AND 2008-09
TRANSFER METHOD
1.CONSULTANT PROPOSAL
2.3 % ANNUAL ESCALATION
3.% OF REVENUE
4.CURRENT UEM
5.STAFF RECOMMENDATION
WATER
FUND
94%
30
108
123
30
GAS
FUND
85%
30
47
96
32
ELECTRIC
FUND
32%
30
21
33
33
COMBINED
W-G-E
FUNDS
54%
30
41
62
32
The impact of the proposed transfer methodology from each of the three funds to the General
Fund is shown on Attachment B.
In total, implementing the staff recommendations would result in an increase in the transfer
from the Electric, Gas, and Water Funds to the General Fund in 2000-01 of $61,000. This is
the combination of holding the transfers from electric and gas constant because the percent
of net revenue formula will decrease the transfers slightly in 2000-01, and beginning to grow
the water transfer by three percent per year. The proposed change in the methodology for
rent and maintenance of street lights and traffic signals and recommendation to phase in the
increased charges over four years would result in increased revenue to the Electric Fund and
expenses in the General Fund of $32,500 in 2000-01.
REVIEWED BY: Susan Case, Senior Assistant City Attorney
CC: City Council
11
UTILITY FUNDS TRANSFER
STUDY
CITY OF PALO ALTO
MARCH 2000
CITY OF PALO ALTO
UTILITY FUNDS TRANSFER STUDY
TABLE OF CONTENTS
LETTER OF TRANSMITTAL
TABLE OF CONTENTS
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY .................................1
INTRODUCTION .............................................................................................1
UTILITY BUSINESS ENVIRONMENT ................................................................1
Current Issues ...............................................................................................2
RECOMMENDATIONS AND CONCLUSIONS .................................................2
STUDY PROCESS .............................................................................................4
UTILITY ENTERPRISE METHOD .......................................................................4
Price Waterhouse Report Revisited ...............................................................4
Rate Methodology ........................................................................................5
Fixed Assets ..................................................................................................5
Depreciation .................................................................................................6
Rate Base ......................................................................................................6
Rate of Return ...............................................................................................7
FORMULATE POLICY OPTIONS ......................................................................9
Energy Supply Transfer Method .....................................................................9
Other General Fund Transfer Options .........................................................10
Rent ............................................................................................................10
Telecommunications ...................................................................................11
Water Rate Competition .............................................................................12
INTER-DEPARTMENTAL SERVICES .................................................................12
Utilities Department Services ......................................................................12
"RATEPAYER" OR "TAXPAYER" .......................................................................13
FISCAL IMPACTS ............................................................................................14
Utility Enterprise Method ............................................................................14
Energy Supply Transfer Method ...................................................................19
Conclusions ................................................................................................23
APPENDIX A SURVEY OF MUNICIPAL UTILITIES
APPENDIX B RATING AGENCY PERSPECTIVE
O :~Jlvl~001420\15-TO C.DO C 03/09/2000
CITY OF PALO ALTO
TABLE 1
TABLE 2
TABLE 3
TABLE 4
UTILITY FUNDS TRANSFER STUDY
LIST OF TABLES
PALO ALTO ELECTRIC UTILITY ASSETS ............................................6
ESTIMATED RETURN ON EQUITY ...................................................8
ESTIMATED CAPITALIZATION RATIOS JUNE 30, 1997 ....................8
COMPARISON OF METHODOLOGIES TO CALCULATE
GENERAL FUND TRANSFERS FY 1999-2000 .................................23
EXHIBIT 1
EXHIBIT 1
EXHIBIT 1
EXHIBIT 2
LIST OF EXHIBITS
GENERAL FUND TRANSFER METHODOLOGIES UTILITY
ENTERPRISE METHOD- ELECTRIC ...............................................16
GENERAL FUND TRANSFER METHODOLOGIES (CONT.)
UTILITY ENTERPRISE METHOD - WATER .....................................17
GENERAL FUND TRANSFER METHODOLOGIES (CONT.)
UTILITY ENTERPRISE METHOD - GAS ..........................................18
GENERAL FUND TRANSFER METHODOLOGIES ENERGY
SUPPLY TRANSFER METHOD ........................................................21
This report has been prepared for the use of the client for the specific purposes identified in the
report. The conclusions, observations and recommendations contained herein attributed to
R. W. Beck constitute the opinions of R. W. Beck. To the extent that statements, information
and opinions provided by the client or others have been used in the preparation of this report,
R. W. Beck has relied upon the same to be accurate, and for which no assurances are intended
and no representations or warranties are made. R.W. Beck makes no certification and gives no
assurances except as explicitly set forth in this report.
Copyright 2000, R. W. Beck
All rights reserved.
O:~Jlvlk001420\IS-TOC.DOC 0310912000 R.W. Beck ii
UTILITY FUNDS TRANSFER
STUDY
CITY OF PALO ALTO
MARCH 2000
C TY OF PALO ALTO
UTILITY FUNDS TRANSFER STUDY
INTRODUCTION
The City of Palo Alto operates .six utility enterprises: Water, Electricity, Natural
Gas, Refuse Collection, Wastewater, and Storm Drainage. The City considers the
Refuse, Storm Drain, and Wastewater Utilities to be general governmental
functions, and as such, it does not transfer Net Revenues from these utilities to
the General Fund. However, the Water, Electricity, and Gas Utilities are con-
sidered to be public enterprises, and do transfer Net Revenues to the General
Fund in accordance with Article VII, Section 2, of the City Charter. Historically,
transfer and ratemaking policies and other guidelines have been established by
the City Council to protect and to serve the interests of both the Ratepayers and
Taxpayers in Palo Alto. The current methodology for transfers to the General
Fund is the Utility Enterprise Method, which is based on a Rate of Return on
asset base methodology. This methodology was adopted following a study of
appropriate policy guidelines for utility ratemaking and cash transfers by Price
Waterhouse in December 1982.
Since the 1982 Price Waterhouse report, there have been significant changes in
the financial and economic environment that continue to have a majorimpact on
the City’s Utility operations, General Fund transfers, and Utility Ratepayers. In
1997-98, due to pending changes in the Utility industry, the Council froze the
amount of transfers from the Enterprise Utility funds to the General Fund at the
1996-97 levels. This practice was continued through the 1999-00 budget.
The principal objective of this study is to review existing City policies regarding
the General Fund transfer, ratemaking methodology, and interfund charges for
services among City departments; to identify General Fund transfer and rate-
making policy options; and to make recommendations based on our findings and
conclusions.
UTILITY BUSINESS ENVIRONMENT
In December 1995, after a multi-year investigation, the California Public Utilities
Commission (CPUC) decided that electric utilities under its jurisdiction should
permit their customers to purchase the supplies of electricity from any qualified
provider. To limit market domination, the jurisdictional utilities were to sell at
least half of their fossil-fired electric generating stations to unrelated purchasers
and to purchase their own electricity requirements from an open market power
exchange - the California Power Exchange (PX). In addition, the jurisdictional
O :~lvlk001420\l 5-00238.DO C 03/09/2000
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
utilities would transfer operational control of their transmission grids to a new
non-profit system operator - the California Independent System Operator (ISO).
In September 1996, the California legislature passed and the Governor signed
legislation (AB 1890) to confirm the CPUC decisions and to extend to the publicly-
owned electric utilities state-sanctioned recovery of costs for above-market price
power plants.
Since the cost of power generated by the jurisdictional utility power plants was
significantly greater than recent power market prices, the CPUC froze retail rates
and established a four-year transition period during which time the jurisdictional
utilities would accelerate the write-down of the costs of their above-market price
power plants to market price. This CPUC action was designed to allow utilities to
recoup costly investments in energy production and to promote competition.
The City has also moved ahead to offer Direct Access to its electric utility
customers. To prepare for the competition from third-party suppliers and to offer
competitive energy services to its current customers, the City Council has
approved the division of both the electric and gas utilities into two business units:
energy supply and energy delivery. The energy supply business units will have
to compete for customers based on market prices and service benefits, while the
energy distribution units will continue to operate as "natural" monopolies.
CURRENT ISSUES
In light of reorganization of California’s electric utility industry and pending
reorganization of California’s gas utility industry, the City and its Enterprise
Utilities face a number of issues:
¯Is the current Utility Enterprise Method viable?
¯Are current General Fund transfer policies adequate?
¯Are there other approaches to sharing Enterprise Utility returns with the
General Fund?
¯Should the City’s telecommunications system become an Enterprise Utility?
¯Do any current Enterprise Utilities provide non-profit public services?
RECOMMENDATIONS AND CONCLUSIONS
This report recommends continuing use of the Utility Enterprise Method (UEM) ’
with several modifications and recommends the adoption of a new Energy
Supply Transfer Method for use by the electric and gas supply business units.
Based on our analysis, the following recommendations are presented below:
O:~JlvI~001420\15-00238.DOC 03/09/2000 R.W. Beck 2
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
o
o
The current UEM should continue to be used to calculate the General Fund
transfers from the water utility and from both business units of the electric
and gas utilities. Modifications to the current UEM are recommended
below.
Although electric and gas enterprises are dMded into the distribution and
supply business units, all business units should support return on equity
based upon their share of the working capital allowance.
The UEM should be modified to recognize Palo Alto’s utility systems equity
capitalization and the City’s tax-exempt status. Proposed modifications
include:
Revise the rate base calculation to eliminate the inclusion of budgeted
Capital Improvement Projects (CIPs) and to allocate the working capital
to the distribution and supply business units.
Revise the Composite Rate of Return to reflect each utility’s
capitalization and the City’s tax-exempt status.
Revise General Funds Transfer formula to eliminate the deduction of
interest on outstanding debt.
These modifications can be made within the scope of the current policy.
Review utility fixed asset depreciation practices to ensure that service lives
of similar assets are consistent among the utility systems.
The electric and gas supply business units should be Structured to share
some of their returns with the City General Fund. It is proposed that a new
Energy Supply Transfer Method be adopted.
Under the new Energy Supply Transfer Method, profits (revenues less
expense and deposits to reserves) from the energy supply business units
would be shared equally between the utility enterprise fund and to the
General Fund until the Rate Stabilization Fund Balances reach their
maximum level.
Streetlighting and traffic signal services should be considered public services
and should be excluded from the UEM methodology in calculating General
Fund transfers.
The traffic signal tariff should recover all costs of service: energy, operations
and maintenance, administration, and annual capital outlays.
The City should continue to manage the telecommunications function
through the Electric Utility until the future role of telecommunications is
determined. If telecommunications options are pursued, the City should
consider establishing a stand-alone enterprise fund and reimburse the
Electric Utility for its start-up costs.
O:~Jlv~001420\15-00238.DOC 03/09/2000 R.W. Beck 3
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
10.Given the rate of change in the electric utility industry, the City should
evaluate its transfer policy on a more frequent basis. If competitive factors
place more pressure on electric rates, Palo Alto’s relatively high transfers
could make the electric utility less competitive.
STU DY PROCESS
This study included the following steps:
¯Fact Finding
¯Evaluation of Current Policies
¯Examination of Policy Options
¯Evaluation of Fiscal Impacts
¯Formulation of Findings and Presentation of Conclusions
During the fact-finding phase, key staff members, City officials, and the Utilities
Advisory Commission where interviewed. In addition, other California muni-
cipally-owned utilities and Wall Street rating agencies familiar with Palo Alto’s
financial condition and outstanding debt were interviewed.
Evaluation of current policies focussed on implementation of the UEM for deter-
mining the General Fund transfers, while examination of options focussed on
survey results and the ideas of City officials.
UTILITY ENTERPRISE METHOD
During the fact-finding phase, the Price Waterhouse report, industry literature on
ratemaking, and all aspects of the current transfer methodology were reviewed.
PRICE WATERHOUSE REPORT REVISITED
In December 1982, Price Waterhouse submitted its report entitled "Study to
Develop Appropriate Policy Guidelines for Utility Ratemaking and Cash
Transfers." The Price Waterhouse report stated:
"We recommend that the City Council consider directing the Utilities
Department to prepare recommended rates for the electric, gas, and water
utilities based on revenue requirements determined by the utility
enterprise method. In addition, we recommend the City Council consider
a "range of reasonableness" in determining what is an appropriate net
income and resulting cash transfer for each utility. Finally, we recommend
that the City Council adopt a process of formally considering a ftfll range
of operational and financial data and forecasts whenever exercising its
authority to set rates."
The City Council adopted this recommendation and directed City staff to imple-
ment it.
O:~JIVIX,001420~15-00238.DOC 03/09/2000 R.W. Beck 4
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
The report describes the "range of reasonableness" in determining net income.
The bottom of the range of a reasonable Rate of Return would be a return
calculated using the original cost depreciated times a rate equal to the then-
current interest rate on Treasury Bonds (a long-term, risk-free investment). The
upper end of the range would be a return based on the current "fair value" of the
system (determined by either indexing or appraisal) times a rate equal to that
authorized by the CPUC for similar utilities.
RATE METHODOLOGY
In general, the purpose of the Utility Enterprise Method is to enable the utility to
establish its annual revenue requirements to provide for recovery of its annual
cost of service. The annual cost of service includes costs for purchased power,
fuel, labor and its benefits, consumable materials and supplies, tangible property
of a non-durable nature, charges for depreciation of the utility fixed assets, and
an annual Rate of Return on the utility’s assets used in the enterprise.
For California investor-owned utilities, the CPUC authorizes a composite Rate of
Return on a rate base. The rate base is composed of the net book value of the
utility’s fixed assets, or its Original Cost Less Depreciation (OCLD), plus a
working capital allowance. The composite Rate of Return is a melded value of
the interest rate of outstanding debt, the dividend rate on preferred stock, and a
rate of return on stockholder equity all weighed proportionately by the dollar
amount of these three elements of capitalization. The CPUC also separately
authorizes a rate of return on stockholder equity sufficient to attract new capital
and pay dividends.
In Palo Alto’s case, as with all publicly-financed enterprises, the City owns the
equity capital invested in its utility enterprises. As an owner, the City expects to
receive a return on its investment, and that return is the annual General Fund
transfer. Currently, the annual transfer to the City’s General Fund is calculated as
the product of the Composite Rate of Return authorized by the CPUC for
neighboring electric, gas and water utilities and the rate base of the respective
City-owned utilities less interest on outstanding debt.
FIXED ASSETS
In the late 1980s, the Utilities Division engaged a consultant to establish the net
book value of the water, electric, and gas system fixed assets. Working from an
inventory of utility fixed assets, the consultant estimated the fixed assets original
costs adjusted by the Handy-Whitman Utility Construction Cost Index. Since the
consultant’s study, the City recorded the installation, retirement, and salvage of
fixed assets using the City’s Fixed Asset Accounting Policy. The instructions for
Fixed Asset Accounting define fixed assets as land, buildings, electric system, gas
system, water system, machinery and equipment, and office furniture and
equipment. We believe the Fixed Asset methodology and resulting figures are
reliable.
O:~MX00~420\~S-00~38.DOC 03/0912000 R.W. Beck 5
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
In the past, the City has partnered with other cities to jointly build electric
generation and transmission assets. These include the NCPA Hydroelectric
Project No. 1 (commonly known as the Calaveras Project) and the Transmission
Agency of Northern California’s (TANC) share of the California-Oregon
Transmission Project (COTP). As of June 30, 1998, the electric utility assets,
together with the City’s share of JPA assets, are estimated as follows:
TABLE 1
PALO ALTO ELECTRIC UTILITY ASSETS
Assets
Utilities Dept., Electric Division
NCPA projects, except geothermal
TANC transmission
Net Book Value
($Millions)
June 30, 1998
$82.6
75.6
18.0
$176.2
DEPRECIATION
As a part of the City’s Fixed Asset Accounting procedure, charges for depreciation
are recorded monthly. Quarterly, depreciation is charged on the original costs
and accumulated in a separate asset account. Furthermore, as old plant is
removed, the cost of removal is charged and the salvage value of the retired plant
is credited to accumulated depreciation. The City uses straight-line depreciation
based upon estimated service lives for each asset. For each of the fixed asset
categories, we compared the City’s estimated service lives with those tabulated
from industry surveys, and we compared the estimated service lives for similar
fixed assets between the City’s utility systems (e.g., SCADA systems, UG con-
duits, water mains, and gas pipes of the same materials). In a number of cases,
we found significantly different service lives for what appears to be similar fixed
assets located in the separate utility systems.
Another area of concern is the difference between the 100-year depreciable life of
water mains and the 75-year renewal and replacement cycle for the same
facilities. If water mains are being replaced on a 75-year cycle, then the depreci-
able life should be the same.
Recommendation: The City of Palo Alto should review its utility fixed asset
depreciation practices to ensure that service lives of similar assets are consistent
among the utility systems.
RATE BASE
The original costs of utility fixed assets less depreciation (OCLD) are usually
called "Net Book" value or the OCLD value for a utility’s plant-in-service. For
each utility, OCLD is the foundation of its rate base. For purposes of calculating
the General Fund transfer, the City’s rate base is defined as each utility’s OCLD
OAJM~001420\15-00238.DOC 03/09/2000 R.W. Beck 6
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
fixed asset at the close of the last fiscal year plus one half of the difference
between estimated expenditures for CIPs in the current budget year
(Construction Work in Progress) and concurrent Contributions in Aid of
Construction plus the ut~lity’s inventory of materials and supplies and a working
capital allowance. The working capital allowance equals 1/t2 of the annual
energy supply costs plus 1/8 of all other budgeted annual expenses.
The definition used by the City to estimate its rate base is not consistent with the
CPUC’s definition, as the CPUC excludes Construction Work in Progress when
calcul.ating the Investor-Owned Utility (IOU) rate base. Moreover, when the City
projects its CIP costs, there is no mechanism to reconcile budgeted costs with
recorded or actual costs for the project.
Recommendation: Since there currently is a freeze on the amount of General
Funds transfer, a revision of the rate base calculation to exclude projected or
budgeted CIP costs and include recorded values of plant after it is placed in
service is recommended.
RATE OF RETURN
Another key element of the UEM is the Rate of Return used in calculating the
General Funds transfer. Annually, the CPUC reviews its authorized Rate of
Return for utilities under its jurisdiction. The authorized Rate of Return is a
composite value composed of a Rate of Retrain on retained earnings (equity) and
the interest rate on outstanding debt weighed together in proportion to their
respective level of debt and equity capitalization. The interest rate on
outstanding debt is already known, while the rate of return on retained earnings
(equity) is market-driven. The CPUC also examines its authorized return on
equity.
While the CPUC fully considers investment risk factors before authorizing a
Return on Equity, the use of the CPUC-authorized Return on Equity also raises
questions. The CPUC-authorized Return on Equity should be adjusted to
recognize the City’s tax-exempt status.
The public investment markets, stocks and bonds, reflect the yields required by
investors subject to federal and state income tax. Municipalities are exempt from
the payment of such taxes and public policy frowns on municipalities profiting
from their tax exemptions. Consequently, the acceptable market return on the
utilities’ retained earnings should be adjusted for the City’s tax-exempt status.
Recommendation: To adjust for the City’s tax-exempt status, the CPUC-
authorized Return on Equity should be reduced by the marginal income tax rates
saved by investors in the City’s securities-approximately 30%. The effects of the
calculation are shown below:
O:~IVI~001420\15-00238.DOC 03/09/2000 R.W. Beck 7
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
TABLE 2
ESTIMATED RETURN ON EQUITY
CPUC-authorized
Assumed marginal income tax rate
Palo Alto tax-adjusted Return on Equity
PG&E Electric
11.20%
30.O0%
7.84%
PG&E Gas
11.20%
30.00%
7.84%
CWSC Water
10.35%
30.00%
7.25%
The City’s current annual General Fund transfer is the product of the most recent
CPUC-authorized Composite Rate of Return and the estimated City utility rate
base. A separate calculation is performed for each of the City’s three utility
systems: electric, gas, and water.
A review of the current formula raises several issues. The Composite Rate of
Return .currently used by Palo Alto reflects the CPUC jurisdictional utility’s ratio
of debt and equity capitalization; not Palo Alto:s utility capitalization ratios. If
Palo Alto continues using a composite rate, the composite rate should reflect Palo
Alto’s cost of debt weighted together with a tax-adjusted Return on Equity on its
own rate base. The City utility capitalization ratios are compared with nearby
IOU ratios, as shown below:
TABLE 3
ESTIMATED CAPITALIZATION RATIOS
JUNE 30, 1997
City Utilities City
Electric, Gas,Electric Utility PG&E CWSC
Fraction & Water + JPA Electric & Gas Water
Debt 0%54%56%46%
Equity 100%46%44%54%
Use of the current UEM raises a third issue: whether to’ include the City’s share
of JPA assets and capitalization in the calculation of the General Fund transfer
formula. If the JPA assets and capitalization are used to estimate the transfer
amount, then interest expense on the City’s share of outstanding JPA debt should
be deducted from the composite return. In other words, the remainder would be
the same as the directly computed rate of re~urn on equity times the retained
earnings times the equity capitalization fraction. This issue only applies.to the
electric utility.
This report concludes that the UEM is still appropriate for the calculation of the
General Funds transfer for all three utility systems. Since most of the rate base
resides in the distribution business units, the burden of the General Fund transfer
will be placed on the new electric and gas distribution rates. The situation will be
the same for the CPUC jurisdictional utilities when they divest themselves of the
energy supply assets; in other words, most of the rate base of the CPUC
jurisdictional utilities will also be concentrated in their distribution business units.
O:~JIv~01420~15-009.38.DOC 03/09/2000 R.W. Beck 8
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
The UEM also can be applied to the ~ew energy supply business units. A major
portion of working capital is allocated to energy supply. With the separation of
the utilities into business units, 1/12 of the energy supply working capital
becomes the rate base for the energy supply units. The "FISCA/ iMPACTS"
section of this report discusses and illustrates how the modified UEM would
work.
FORMULATE POLICY OPTIONS
In response to the restructuring of California’s energy industries, the City Utilities
Department has reorganized the electric and gas utilities into respective energy
supply and energy delivery units. The energy delivery units would continue to
operate as a natural monopoly under City Council regulation, while the energy
supply units would operate in the open marketplace driven by price competition.
ENERGY SUPPLY TRANSFER METHOD
With the formation of the energy supply business units in the electric and gas
utilities, a different approach to sharing the enterprise returns seems appropriate.
Deregulation and the granting of open access to electric and gas customers has
turned the old paradigm of recovery of operating costs and a "reasonable" Rate of
Return upside down. Now, market-priced revenues less out-of-pocket operating
expenses results in a loss or a profit. To earn a profit, energy supply business
units must control costs, such as energy commodity, ancillary service, delivery to
the distribution business unit, administrative overhead, and manage their prices.
Currently, there are three major electricity commodity markets: the California
PX, the California-Oregon Border, and the Palo Verde, Arizona, switchyard.
Commodity market price reflects supply and demand whose volatility is driven
by such external factors as catastrophe, weather, equipment failure, and
unforeseen bad. The energy supply business units have created their respective
supply rate stabili~.ation accounts to mitigate commodity price volatility. Success
of the supply business will be based on year-end returns.
Under the proposed formula, operating returns from the supply business unit
would first be used to restore, when necessary and possible, the Calaveras
Reserve and the energy supply business unit RSR to their Target Levels.
Afterwards, any remaining operating profit would be shared equally between the
utility enterprise and the General Fund until the RSR balances exceed their
respective maximum levels when the excess would be transferred to the General
Fund pursuant to the City Charter. To smooth the volatility of profits, the City’s
share of the annual profits could be transferred to the General Fund over a three-
year period. The "FISCAL iMPACTS" section of this report discusses and
illustrates how the Energy Supply Transfer Method Would work.
O:~JIVI~001420\lS-00238.DOC 03/09/2000 R.W. Beck 9
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
OTHER GENERAL FUND TRANSFER OPTIONS
As we found from surveying other California municipal utilities (see Appendix A,
Survey of Municipal Utilities), many of the municipal utilities use a percent of
gross revenue formula to calculate their General Fund tra.nsfer. Although
popular, revenue-based General Fund transfer formulas are sensitive to changes
in revenues, particularly if customers opt for Direct Access causing utility
revenues to decline. Although Direct Access proponents argue that Energy
Service Providers (ESPs) could offset the reduction in General Fund transfers
through an ESP business license fee; to our knowledge no one has tried it.
Many of these utilities justify their payments to their respective General Funds as
in-lieu taxes. The in-lieu payments generally take two forms: in-lieu franchise
fee or in-lieu property tax or both. Franchise fees were the earliest form of
regulation. Franchises were and are granted to utility operators so that their
facilities could be placed on the public right-of-way. In California, absent any
local franchise pre-existing the state law, the annual franchise fee is the greater of
1% of the gross revenues from sales in the jurisdiction, or 2% of the value of the
utility property located in the public way of the jurisdiction.
Since the passage of Proposition 13, property taxes are limited to 1% of the
assessed value of real property and its improvements. IOU property is assessed
by the California State Board of Equalization, and the valuations are allocated by
them to local government, while all other property owners are assessed locally by
the county. Under the UEM of ratemaking, franchise fees and property taxes are
recoverable expenses.
It is important to note that Palo Alto’s General Fund Transfers, when expressed as
a percent of revenues, are among the highest in the state (see Appendix A, Survey
of Munidipal Utilities). Given Palo Alto’s rather conservative financial planning
and generous reserves, this practice does not yet place the utility enterprises at a
competitive disadvantage. However, the Transfer Policy should be periodically
reviewed to assess these competitive forces.
Recommendation: Given the rate of change in the electric utility industry, the
City should considerevaluation of its Transfer Policy on a more frequent basis.
RENT
The City of Palo Alto, unlike many other cities, holds its real property as an asset
of the General Fund. This unusual arrangement requires that rent be paid by
enterprise utilities to occupy these properties. On its face, the arrangement
results in the General Fund receiving rents at market value, but it has had the
effec~ of placing a burden on the utilities revenue requirement due to increasing
rents caused by the escalation of real estate values in Palo Alto.
O:~lVI~001420\15-00238.DOC 03/09/2000 R.W. Beck 10
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
Due to the large amount of property occupied by the Water Utility, increasing
rents are a contributing factor to higher water rates. A long-term solution may be
for the respective utility enterprises to consider buying out their rental agree-
ments and owning the property themselves.
TELECOMMUNICATIONS
At present, the City-owned telecommunications system is funded and operated
by the electric utility system. Recently, there have been discussions exploring the
possibility of creating a separate Telecommunications Enterprise within the City.
City staff requested clarification as to whether the telecommunications function
should be operated as a non-profit public service or as a profit center. The
answer to this question depends upon the path that the City chooses to take in
terms of its telecommunications system development. Recently, other cities have
embarked on joint venture operations with telecommunications or cable
television companies. If the City elects to either construct or otherwise contract
for the development of a telecommunications system, it will likely be for the same
reasons that it entered into the provision of electric and gas services to its
residents - to provide higher quality public service at a lower cost to its residents.
At the present time, it makes sense to retain this function within the Electric
Utility. If a telecommunications build-out option is pursued, it would make sense
to create a stand-alone enterprise function and reimburse the Electric Utility for
funding the telecommunications start-up cost. For this reason, the Electric Utility
should maintain good records of funds expended on telecommunications.
Similar to the electric and gas operations, the City should reasonably expect some
return for use of City streets and rights-of-way.
The recommended UEM calculation employed for the Water, Electric and Gas
Utilities could be used for the Telecommunications enterprise. One advantage of
employing this method is that it is familiar to City staff managing this function.
The General Fund Transfer Policy presents a unique opportunity for the City to
employ a different methodology for calculating a telecommunications transfer.
Since the City’s telecommunications infrastructure is in its infancy and the City
plans for future telecommunications system use is uncertain, much more risk is
associated with this enterprise. At this time, a Transfer Policy similar to the
proposed energy supply transfer is suggested. One of the interviewed rating
agencies expressed some concern over implementation of this type of an equity
transfer policy (see rating agency perspective under Appendix B, Rating Agency
Perspective). Before instituting such an option, these concerns should be
addressed.
There are other Transfer options the City could employ in the growth stage of
.Telecommunications development. Payments to the General Fund could be
based upon a percentage of profits generated by the enterprise. As the
Telecommunications enterprise matures and experiences a more stable revenue
stream it would always be possible to change to a more traditional formula.
O:~JM~001420\15-00238.DOC 03/09/2000 R.W. Beck 11
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
Another method for consideration, particularly if the City opts to partner with a
private party, is a guaranteed minimum payment to the City by the private party.
The telecommunications payment that is employed in Anaheim, California, has a
minimum guarantee of $1 million per year, or 5% of gross revenues, whichever is
lower, from its private universal telecommunications service provider. The
Anaheim Agreement also provides for a distribution of profits when they are
realized. Negotiations with private parties leave considerable latitude in
developing payment formulas.
WATER RATE COMPETITION
The Utilities Department staff is concerned that the Water System rates are
becoming non-competitive and cite studies comparing Palo Alto water rates with
those of surrounding cities - particularly the Los Altos area. R. W. Beck reviewed
the staff analysis and agrees that Palo Alto water rates are unfavorable when
compared to Los Altos. We believe, however, that the Los Alto rates are not the
best yardstick. The. water utilities presently being used for the Palo Alto rate
comparison have one significant difference from Palo Alto: none of them buy
their entire water supply from the San Francisco Water Department, the most
costly water supply on the Peninsula. A better yardstick woui~ be to compare
Palo Alto water rates with those of the California Water Service Company Mid-
Peninsula Service Area. The Mid-Peninsula Service Area includes Menlo Park
and San Mateo. The key similarity is that the California Water Service Company
purchases its entire supply, like Palo Alto, from the San Francisco Water
Department. If, after comparing rates using the Mid-Peninsula Service Area ’as
the yardstick, the staff finds that Palo Alto water rates are still uncompetitive, the
Water System should then examine its operations to identify areas for cost
reduction.
I NTER-DEPARTMENTAL SERVICES
City administrative or overhead service costs are allocated to all City
departments, which include the utilities. These costs include the General Fund
services, the internal fund services, and utility enterprise services. General Fund
services are allocated using a ’Delphi’ approach. The internal service funds
provide essential services such as vehicle replacement and maintenance,
computer equipment replacement, printing and mailing, and general benefits
and insurance. Each of these funds operate on a cost-reimbursement basis.
UTILITIES DEPARTMENT SERVICES
The Utilities Department provides streetlighting and traffic signal utility services
to the City. Streetlighting was the very first commercial electric service to be
offered to the public. Usually, local government purchased streetlighting from a
private vendor, or furnished it themselves. Over the years, electric utilities,
O:kJIv~001420~lS-00238.DOC 03/09/2000 R.W. Beck 12
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
regardless of ownership, have supplied three categories of streetlight service:
lighting energy only, lighting energy and fixture maintenance, or fully bundled
service: lighting energy, fixture maintenance and fixture ownership.
The City of PaloAlto purchases streetlighting service from the Utilities
Department under an approved tariff: Rate Schedule E-14, Streetlights. An issue
is whether to continue to treat streetlighting, as a commercial venture and require
streetlighting service to support a portion of the General Funds transfer, or treat it
as a cost reimbursable public service and eliminate the streetlight physical assets
from the transfer calculation. The City has already eliminated that obligation for
its refuse collection system. The basic purpose of streetlighting is to promote
safety and convenience on the streets at night through adequate visibility, and to
promote civic progress. Statistics show that good streetlighting installations bring
about material reductions in traffic accidents, act as a deterrent to crime, and
promote more business in commercial areas.
The Utilities Department provides traffic signal service under Rate Schedule E-16,
Unmetered Electric Service. We understand that the current rates for traffic
signal service do not recover the full cost of service, particularly annual capital
outlays.
Traffic Signal Rate Schedule E-16 should include all of the elements of cost:
energy, operations and maintenance, administration, and capital improvements.
The tariff should be designed to recover all appropriate costs. Traffic signal
service should be treated as a public service function for the same purposes
stated for streetlighting.
Recommendation: The Utilities Department should continue to provide
streetlighting and traffic signal services under approved tariffs based on cost-of-
service principles. Cost-of-service principles are inclusive of all costs: operating
expenses and capital improvements. It is recommended that the obligation to
support General Fund transfers be eliminated.
"RATEPAYER" OR "TAXPAYER"
The Chairman of the Utilities Advisory Commission (UAC) has observed, in
recent years, that expansion of the City-owned utilities have been funded by
"Ratepayers" exclusively from current revenues. The Chairman has raised the
question as to whether Palo Alto "Ratepayers" are the de facto investors and,
therefore, are the "Taxpayers" entitled to receive a share of the utility profits
derived from assets paid for by the Ratepayers?
The use of the terms "Ratepayer" and "Taxpayer" can be ambiguous.
Traditionally, a "Ratepayer" is considered a customer of the utility who does not
have an interest in the ownership of the enterprise, whether publicly-owned or
investor-owned. "Taxpayer" is a proxy’term for "Owner" of a publicly-owned
utility, while "stockholder" is the ownership term for an IOU.
O:~M~0014~0X15-00238.DOC 03/09/2000 R.W. Beck 13
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
Although in recent years, capital expansion may have resulted from current
revenues, the "Ratepayer" does not have an ownership interest. The respective
roles of "Ratepayers" and "Taxpayers" remain unchanged. Therefore, the
Taxpayer is entitled to receive a share of the utility profits based on value. If either
the "Taxpayers" or "Ratepayers" perceive inequities in their relationships, how-
ever, they then need to petition the regulator for relief.
FISCAL IMPACTS
We have prepared several exhibits that illustrate our findings and conclusions.
Exhibit I entitled "General Fund Transfer Methodologies: Utility Enterprise
Method" illustrates and compares the current and recommended Rate of Return
Methodology. Exhibit2 entitled "General Fund Transfer Methodologies:
Energy Supply Transfer Method" illustrates a proposed Energy Supply Transfer
Me~ thodology for the electricity and gas supply business units.
UTILITY ENTERPRISE METHOD
Exhibit I compares the Utility Enterprise Method under its current formulation
with the recommended modified UEM for each of the utility systems: Electric,
Water, and Gas. Under the "Currenf’ column, the rate base equals Net Book
Value at Beginning of Year, plus 1/12 of the energy supply costs, plus 1/8 of all
other operating expenses, plus material and supply inventory, plus one half of
the difference between the budgeted CIP less Contributions in. Aid of
Construction (CIAC).
Next to the "Current" column is the "Recommended" Columns. The components
of the rate base are allocated to the distribution and supply business units for the
electric and gas utilities. The rate base line entries under the "Current" column
are allocated to their ~espective distribution and supply business units under the
"Recommended" columns. The budgeted working capital is allocated pursuan.t
to the long-range financial forecast, while Net Book Value of the utility assets and
materials and supplies are directly assigned to the distribution business units and
the purchased energy supply costs are assigned to the energy supply business
unit. In all cases, budgeted CIPs and CIAC have been eliminated, thereby
reducing the rate base.
For the electric utility, an additional column entitled "Recom’d + JP~’ has been
inserted next to "Recommended" columns. This column is an extension of the
recommended UEM illustrating the impacts of JPA assets on the General Fund
Transfer. Like "Recommended" methodology, the "Recom’d + JP~’ relies on the
City + JPA capitalization ratios and the recommended tax-adjusted Return on
Equity.
O:~JIvI~001420k15-00238.DOC 03/09/2A300 R.W. Beck 14
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
Under the "Current" column, the General Fund transfer is estimated by multi-
plying the rate base by the CPUC-authofized Composite Rate of Return (9.45%)
less any interest payments on outstanding long-term debt (none). Under the
"Recommended" columns, the General Fund transfer is estimated by multiplying
the ratebase by the City of Palo Alto Utilities’ (CPALo equity capitalization
fraction and by the CPAU’s Equity Rate of Return. The calculated General Fund
transfer is less than the amount under the old methodology calculation and
either more or less, depending on the utility, than the currently frozen transfer
amounts.
O:~IvI~001420\lS-00238.DOC 03/09/2000 R.W. Beck 15
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
EXHIBIT 1
GENERAL FUND TRANSFI.:R METHODOLOGIES
UTILITY ENTERPRISE METHOD - ELECTRIC
Fiscal Year: 1999-2000
Terms
plus Net Book Value, BOY- 000
plus Net Book Value of JPA Assets, BOY- 000
plus (Budgeted Energy Supply/12)
plus (Operating Expenses/8)
plus Materials and Supplies
plus (Budgeted CIP- CIAC)/2
equals Ratebase
plus
minus
equals
Notes
1
2
3
4
5
6
CuKent
$ 82,576
$1,924
$3,376
$ 270
$ 5,198
$ 93,343
Recommended
Distribution Supply Total
Estimated Ratebase - $000
$ 82,576 $ $ 82,576
$ 1,924 $ 1,924
1,658 $ 1,718 $ 3,376
270 $$270
notapplicable
84,504 $ 3,642 $ 88,146
Recom’d
+JPA
$ 82,576
$ 90,70O
$ 1,924
$ 3,376
$ 270
na
$ 178,846
Composite Rate of Return 7
Interest Rate on Debt
IOU Equity Rate of Return 8
Income Tax Rate 9
CPAU Equity Rate of Return 10
CPAU Equity Capitalization Fraction
(Ratebase times Rate of Return)11
~lnterest on Debt 12
General Fund Transfer 13Current Budgeted Amount 14
9.45%
0.00%
na
na
11.20%
30.0%
na 7.84%
na 100.00%
$
$
$
$
8,821
7,316
na
na
11.2%
30.0%
7.84%
49.29%
not applicable
not applicable
11.20%
30.0%
7.84%
100.00%
Calculated General Fund Transfer - $000
8,821 $ 6,625 $ 286 $6,911 $6,911
not applicable na
$ 6,625 $ 286 $ 6,911 $ 6,911
Notes;
1
2
3
4
5
6
7
8
9
10
11
12
13
City of Palo Alto Utilities Long Range Financial Forecasts, May 13,1999, given to R.W.Beck
Electric DistributionElectdc Distribution and Supply
3Aug99 letter from L.Hirmina to D.Park
pl, line 32
pl, lines (54+58-32-41-42.48)
3Aug99 letter from L.Hlrmina to D.Park
pl, lines (41+42+48-20-21)
CPUC authorized composite ROR
not applicable
not applicable
not applicable
Ratebase X IOU Composite ROR
none
note 11 minus note 12
only,
(ditto)
not applicable
pl, lines (45+49-32-,~
(ditto)
eliminated
not applicable
CPUC authorized eq
marginal income tax
CPAU tax-adjusted
Ratebase X CPAU
eliminated
equals note 11
Electdc Supply only/
none
pl, line 27
pl, lines (42-27)
eliminated
not applicable
CPUC authorized equity ROR
marginal income tax rate
CPAU tax-adjusted ROR
Ratebase X CPAU ROR
~,liminated
equals note 11
Does not exclude streetlighting or traffic signal assets from rate base, as
has been recommended.
O:~JIv~001420klS-00238.DOC 03/09/2000 R.W. Beck 16
CITY OFPALO ALTO UTILITY FUNDS TRANSFER STUDY
EXHIBIT 1
GENERAL FUND TRANSFER METHODOLOGIES (CONT.)
UTILITY ENTERPRISE METHOD - WATER
Fiscal Year: 1999-2000
Terms
plus Net Book Value, BOY- 000
plus
plus
plus
equals
plus
minus
equals
Notes:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Notes
1
2
(Budgeted Commodity Supply/12)3
(Operating Expenses / 8)4
Materials and Supplies 5
(Budgeted ClP - ClAC)/2 6
Ratebase
IOU Composite Rate of Return 7 ¯
Interest Rate on Debt
IOU Equity Rate of Return 8
Income Tax Rate 9
CPAU Equity Rate of Return 10
CPAU Equity Capitalization Fraction
(Ratebase times Rate of Return)11
Interest on Debt 12
General Fund Transfer 13
Current Budgeted Amount 14
$
$
$
$
$
$
$
$
$
Current Recommended
Distribution Suppl,/Total
Estimated Ratebase - $000
29,073 $ 29,073 $-$ 29,073
44O
601
1,625
31,739
9.86%
0.00%
na
rla
na
na
$$440 $ 440
$ 601 $- $ 601
$$- $
notapplicable
$ 29,674 $ 440 $ 30,114
not applicable
not applicable
10.35%
30.0%
7.25%
10.35%
30.0%
7.25%
100.00% 100.00%
Calculated GeneralFund Transfer-S000
3,129 $ 2,150 $ 32 $ 2,182
notapplicable
3,129 $ 2,150 $ 32 $ 2,182
2,044
ICity of Palo Alto Utilities Long Range Financial Forecasts, May 1999, given to R.W.Beck
~Water Utility
19Feb99 Memo from Divinski to Harrington
pl, line 23
pl, line (25+34+42+48-31-32)
no data available
pl, line (31+32-11)
CPUC authorized composite ROR
CPUC authorized equity ROR
marginal income tax rate
CPAU tax-adju.sted ROR
none
note 1’~ minus note 12
Current Budgeted Amount
O:kJlvl~01420’dS-00238.DOC 03/09/2000 ’ R. W. Beck 17
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
EXHIBIT 1
GENERAL FUND TRANSFER METHODOLOGIES (CONT.)
UTILITY ENTERPRISE METHOD - GAS
Fiscal Year: 1999-2000
Terms
plus Net Book Value, BOY - 000
plus (Budgeted Energy Supply/12)
plus (Operating Expenses/8)
plus Materials and Supplies
plus (Budgeted ClP- ClAC)/2
equals Ratebase
plus
minus
equals
Notes
1
2
3
4
5
6
IOU Composite Rate of Return 7
Interest Rate on Debt
IOU Equity Rate of Return 8
Income Tax Rate 9
CPAU Equity Rate of Return 10
CPAU Equity Capitalization Fraction
(Ratebase times Rate of Return)11
Interest on Debt 12
General Fund Transfer 13
Current Budgeted Amount 14
$
$
$
$
$
$
$
$
$
Current Recommended
Distribution Suppl~,Total
Estimated Ratebase - $000
32,275 $ 32,275 $$ 32,275
876
602
1,568
35,321
$ $ 876 $ 876
$ 462 $ 140 $ 602
$ - $ - $
not applicable
$ 32,737 $ 1,016 $33,753
9.45%not applicable
0.00%not applicable
na 11.20%11.20%
na 30.0%30.0%
na 7.84%7.84%
na 100.00%100.00%
Calculated General Fund Transfer - $000
3,338 $ 2,567 $ 80 $ 2,646
not applicable
3,338 $ 2,567 $ 80 $ 2,646
2,475
Notes:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
City of Palo Alto Long Term Financial Forecasts, May 1999,
Gas Distribution and Supply
19Feb99 Memo from Divinski to Harrington
pl, line 25
pl, lines (28+35+42+48-25-32-33)
no data available
pl, line (32+33)
CPUC authorized composite ROR
not applicable
not applicable
not applicable
Ratebase X IOU composite ROR
none
Note 11 minus Note 12 ~
~1, line 45
given to R.W.Beck
Gas Distribution only
(ditto)
not applicable
pl, lines (23+32+39+46-27-29)
eliminated
not applicable
CPUC authorized equity ROR
marginal income tax rate
CPAU tax- adjusted ROR
Ratebase X CPAU ROR
eliminated
Equals Note 11
O:~1~001420\15-00238.DOC 03/09/2000 R.W. Beck 18
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
ENERGY SUPPLY TRANSFER METHOD
Exhibit 2 illustrates the application of the recommended Energy Supply Transfer
Method to the electric and gas supply business units for the next six fiscal years.
The presentation format is similar to typical retail goods businesses. Total
Revenue equals Supply Sales plus Wholesale Revenue. Gross Profit equals Total
Revenue less Cost of Supply. Net Revenue equals Gross Profit minus the sum of
Administrative and General Expenses and the General Fund transfer amount
computed by the modified UEM.
In principle, Net Revenues and reserve fund Interest Earnings are first used to
restore the Calaveras and Supply RSR accounts to their Target Levels after
meeting their current respective financial obligations. Although the Utilities
Department budget includes Interest Earnings on both the Calaveras and the
respective Rate Stabilization Reserves in the current revenues, we recommend
that the Interest Earnings be credited to the respective reserve accounts, so as to
avoid cross-subsidization of current operating costs and reserve fund obligations.
After the respective Reserve Account balances are restored to their Target Levels,
Exhibit2 assumes an equal split in Available Earnings between the utility
enterprise and the General Fund until the Rate Stabili~.ation Reserve balances
equal their Maximum Target when the entire excess is transferred to the General
Fund pursuant to the City Charter.
The electric supply business unit projection shows positive N6t Revenues in five
of the next six fiscal years. Exhibit 2 illustrates the use of the Net Revenues
together with their Interest Earnings to restore the Calaveras Reserve Account to
its Target Level and then to restore the Supply RSR Account to its Target Level.
During the first two fiscal years, the electric supply business unit Net Revenues
exceed those necessary to restore the Calaveras Reserve to its Target Level and
the Electric Supply RSR Balances to its maximum levels; the remaining funds are
transferred to the General Fund. In fiscal year three, there is an operating loss
that draws down the Supply RSR Account and the Calaveras Debt Service would
be paid out of the Calaveras Reserve Account.
During the last three fiscal years, the electric supply business unit Net Revenues
are used to restore the Calaveras Reserve to its Target Level. The Rate
StabiliT.ation Reserve interest earnings are shared with the General Fund, since
RSR balances are greater than Target ~ind Electric Supply Reserves to Target
Levels, resulting in no Available Earnings.
In Exhibit 2, the gas supply business unit shows operating losses during the first
three fiscal years; consequently, Gas Supply RSR Account Balances are being
drawn down to cover the operating deficits. The draw down of the Gas Supply
RSR Account is not troublesome inasmuch as the current reserve balance is
estimated by staff to be 2.9 times greater than the Target Level. However, under
the Energy Supply Transfer Method, any RSR balances greater than the
Maximum Level would be transferred to the General Fund. During the last three
O.’~IvI~01420\15-00238.DOC 03/09/2000 R.W. Beck 19
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
fiscal years, the Gas Supply business unit shows Net Revenue after payment of
expenses. The Net Revenue, together with RSR Interest Earnings, are used to
restore the Gas Supply RSR Account Balance to Target Level.
Based on Exhibit 2, energy supply business profits are volatile. In order to
provide, continuity of annual transfers, any returns transferred to the General
Fund would be paid out over the next three fiscal years.
O:~JIvI~001420\lS-00238.DOC 03/09/2000 R.W. Beck 20
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
EXHIBIT 2
GENERAL FUND TRANSFER METHODOLOGIES
ENERGY SUPPLY TRANSFER METHOD
Term
plus Supply Sales- 000
.plus Wholesale Revenue- 000
equals Total Revenue - 000
less Cost of Supply
equals Gross Profit
~ less G&AExpense
less General Fund transfer
equals Net Revenues
Calaveras Reserve Account
Target Level
plus Account Balance BOY
plus Interest Earnings
minus Debt Service
equals
plus Deposit to Target Level
equals Account Balance EOY
Remaining Net Revenues
Notes FY99-00
1
2 $27,813
3 $ 3,347
$31,160
4 $ 23,091
$ 8,069
5 $ 4,543
6 $ 286
$ 3,240
7 $ 67,858
8 $70,917
9 $ 4,255
10 $ 9,200
$ 65,972
11 $ 1,886
$ 67,858
$ 1,354
Supply Rate Stabilization Reserve Account
plus
plus
equals
Target Level
Maximum Level
Account Balance BOY
Interest Earnings
Remaining Net Revenues
minus General Fund Share
Account Balance EOY
General Fund Share of Earnings
Payout - 1st yr.
-2nd yr.
-3rd yr.
Total -
12 $10,391
$13,855
$12,189
13 $ 1,113
$ 1,354
$14,656
$ 802
$13,855
Electric IFY00-01 FY01-02 FY02-03 FY03-04 FY04-05
$26,959 $27,798 $30,134 $30,202 $32,565
$ 3,454 $ 2,419 $ 1,731 $ 1,708 $ 862
$30,413 $30,217 $31,865 $31,910 $33,427
$21,742 $26,660 $26,187 $26,773 $27,180
$ 8,671 $ 3,557 $ 5,678 $ 5,137 $ 6,247
$ 4,827 $ 4,024 $ 4,052 $ 4,090 $ 4,389
$ 286 $ 286 $ 286 $ 286 $ 286
$ 3,558 $ (753)$ 1,340 $ 761 $ 1,572
$64,615 $65,290 $67,779 $70,540 $72,919
$67,858 $54,615 $61,823 $62,855 $63,570
$ 4,071 $ 3,877 $ 3,917 $ 4,067 $ 4,232
$ 9,074 $ 6,669 $ 4,225 $ 4,114 $ 4,202
$62,855 $61,823 $61,515 $62,808 $63,600
$ 1,760 $ $ 1,340 $ 761 $ 1,572
$64,615 $61,823 $62,855 $63,570 $65,172
$ 1,798 $ (753) $ - $ $ -
$ 9,784 $11,997 $11,784 $12,048 $12,231
$13,045 $15,996 $15,712 $16,064 $16,308
$13;855 $13,045 $12,890 $13,063 $13,206
$ 1,297 $ 1,491 $ 1,451 $ 1,301 $ 546
$ 1,798 $ (753) $ $ $
$16,950 $13,784 $14,341 $14,364 $13,752
$ 3,905 $ 893 $ 1,279 $ 1,158 $ 760
$13,045 $12,890 $13,063 $13,206 $12,991
$802 $ 3,905 $ 893 $ 1,279 $ 1,158 $760
$-$ 267 $ 1,302 $ 298 $ 426 $386
$ 267 $ 1,302 $ 298 $ 426
$ 267 $ 1,302 $ 298
$-$ 267 $ 1,569 $ 1,867 $ 2,026 $ 1,110
Notes:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Palo Alto Utilities Long Term Forecasts - May 13,1999
Electric Supply Line 16,
Electric Supply Line 18
Eleciric Supply Line 27
Electric Supply Lines (42-27-29)
General Fund Transfer from Ratebase Formula
Electric Supply p2, line 28
Electric Supply p2, line 18
Electric Supply Line 48
Electric Supply Line 29
Deposit to bring to Target Level
45% of Supply Sales
60% of Supply Sales
Electric Supply Line (17-48)
O:~IIvI~001420\15-00238.DOC 03/09/2000 R.W. Beck 21
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
EXHIBIT 2
GENERAL FUND TRANSFER METHODOLOGIES (CONT.)
ENERGY SUPPLY TRANSFER METHOD
Term
plus Supply Sales- 000
plus Wholesale Revenue- 000
equals Total Revenue - 000
less Cost of Supply
equals Gross Profit
less G &A Expense
less General Fund transfer
equals Net Revenues
Notes
1
2
3
4
5
6
Gas
FY99-00 F¥00-01 FY01-02 FY02-03
$9,038 $9,079 $11,456 $13,148
$-$$$-
$ 9,038 $ 9,079 $11,456 $13,148
$ 10,510 $10,520 $10,813 $11,077
$ (1,472)$ (1,441)$ 643 $ 2,071
$ 1,123 $ 1,143 $ 1,164 $ 1,185
$8o $ 8o $ 80 $ 80
$ (2,675)$ (2,664)$ (601)$ 806
FY03-04 FY04-05
$13,161 $ 13,174
$$
$13,161 $ 13,174
$11,385 $11,608
$ 1,776 $ 1,566
$ 1,207 $ 1,225
$8o $ 80
$ 489 $ 261
Calaveras Reserve Account
Target Level 7
plus Account Balance BOY 8
plus Interest Earnings 9
minus Debt Service 10
equals
plus Deposit to Target Level 11
equals Account Balance EO¥
Remaining Net Revenues
Supply Rate Stabilization Reserve Account
Target Level
Maximum Level
Account Balance BOY
Interest Earnings
Remaining Net Revenues
General Fund Share
Account Balance EOY
plus
plus
equals
minus
General Fund Share of Earnings
Payout - 1st yr.
-2rid yr.
-3rd yr.
Total -
12 $ 2,711 $ 2,724 $ 3,437 $ 3,944 $ 3,948 $ 3,952
$ 3,615 $ 3,632 $ 4,582 $ 5,259 $ 5,264 $ 5,270
$ 7,871 $ 3,615 $ 1,238 $ 785 $ 1,717 $ 2,393
13 $ 417 $ 286 $ 148 $ 126 $ 186 $ 232
$ (2,675) $ (2,664) $ (601) $ 806 $ 480 $ 261
$ 5,613 $ 1,238 $785 $ 1,717 $ 2,393 $ 2,886
$ 1,998 $ - $$ - $$ .
$ 3,615 $ 1,238 $785 $ 1,717 $ 2,393 $ 2,886
$ 1,998 $- $- $$$
$$ 666 $- $$$
$ 666 $$$
$ 666 $$
$$ 666 $ 666 $ 666 $$
Notes:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Palo Alto Utilities Long Term Forecasts - May 13,1999
Gas Supply Line 9
Gas Supply Line 11
Gas Supl~ly Line 23
Gas Supply Line (36+42-23)
General Fund Transfer from Ratebase Formula
30% of Supply Sales
40% of Supply Sales
Gas Supply Line 12
O :kJIVF,001420\15-00238.DO C 03/09/2.000 R. W. Beck 22
CITY OF PALO ALTO UTILITY FUNDS TRANSFER STUDY
CONCLUSIONS
The City,s current UEM for calculating General Fund transfers has been evalu-
ated and modifications have been recommended so that the methodology reflects
souhd transfer practices in the new business environment. A new Energy Supply
Transfer Method is recommended for use by the electric and gas supply business
units. A comparison of the two recommended methods, currently budgeted
transfer amounts, and the amounts using the old formulas is presented in the
table below:
TABLE 4
COMPARISON OF METHODOLOGIES
TO CALCULATE GENERAL FUND TRANSFERS
FY 1999-2000
U~lity
System
Utility Enterprise Method - $000 Energy
Supply
Transfer
Recommended
Formula
$6,911
$2,182
6.8%
$2,646
6.9%
$11,739
-0.8%
Old Current
Formula Budget
$8 821 $7,316
20.6%-
$3,129 $2,044
53.1%-
$3,338 $2,475
34.9%-
$15,288 $11,835
29.2%-
Electric $802
Water N/A
Gas $1,198
Combined $2,800
Chanse
The current budgeted General Fund transfers have been established on an ad hoe
basis; the recommended UEM can provide a smooth transition to a method that
more nearly reflects the Utility’s financial structure. Furthermore, introduction of
the Energy Supply Transfer Method will present the General Fund with the
opportunity to share in any market profits of the energy supply business units.
O:NIM~001420\15-00238.DOC 03/09/2000 R.W. Beck 23
APPENDIX A
SURVEY OF MUNICIPAL UTILITIES
APPENDIX A
SURVEY OF MUNICIPAL UTILITIES
SURVEY OF CALIFORNIA UTILITIES
Based on the McGraw-Hill 1999 Directory of Electric Utilities, there are 31 pub-
licly-owned electric utilities in California, of which 23 are municipally-owned.
R. W. Beck conducted a survey of 9.1 California municipally-owned electric and
water utilities. The objective of the study was to ascertain the justifications and
policies of other cities regarding general fur{d transfers. Traditionally, investor-
owned electric, water, and gas utilities have paid fees and taxes to local govern-
ments, counties, and cities.
Franchise fees have been levied by local government since the beginning of the
utility industry as a payment for the use of the public way by investor-owned
utilities (IOUs). In California, absent any specific provisions in a City’s Charter,
state law governs the calculation of the payment - generally .1% of revenues
generated within the city limits.
Property taxes have been the other significant payment to local government. The
California State Board of Equalization appraises all utility properties within the
state on a uniform basis and then allocates the assessed valuation to each county.
The county, in turn, allocates a portion of the county-assessed valuation to each
city. Proposition 13 limits the tax rate to 1% of the property’s cash value. In other
words, IOUs generally pay property taxes in an amount equal to 1% of the value
of their property lying within the city.
In California, there are two categories of publicly-owned utilities: municipally-
owned and special districts. Irrigation districts are also authorized to provide
electric, gas, or water utility service. Finally, the California State Constitution
reserves to each municipal corporation the right to provide electric, gas, and
water utility services.
MUNICIPAL UTILITIES
All of the utilities surveyed include an amount for general fund transfers in their
revenue requirements. The method used in determining the amount of general
fund transfers is generally defined in one of the following documents: the City
Charter, City Council Resolution, Rate Ordinance, or Budget Plan approved by
the City Council. Most municipal utilities justify the general fund transfer as a
replacement for property taxes and franchise fees that otherwise would have
been paid to the city if an investor-owned company operated the electric utility.
Other municipal utilities argue that the general fund transfer represents a return
O :~]lv~001420\15-APPA.DO C 03/09/2000
APPENDIX A SURVEY OF MUNICIPAL UTILITIES
for the city’s investment in the utility. In addition to the general fund transfer,
many cities levy a Utility User’s Tax ranging from 5.0% to 7.5% of a customer’s bill.
The results of the survey are presented at the end of this.
ELECTRIC
Nine of the municipal utilities surveyed use a percentage of gross retail revenues
to calculate its general fund transfer for a given fiscal year. However, there are
some minor differences in the way each utility applies this approach. For
example, most utilities apply the percentage on the last fiscal year’s gross retail
revenues, while one utility applies it to the sum of operating expenses, capital
outlays, and debt service. In one city, a portion of the general fund transfer is
redirected to the utility as payment for streetlighting. The percentage used by
the utilities surveyed ranged from 4% to 12%. The percentages in general are
determined on an annual basis and are, in most cases, restricted by a maximum
rate allowable that is defined in the City Charter.
Other than Palo Alto, we have found that three other utilities are currently using
the return on ratebase approach in calculating the amount of transfers to the
general fund. However, one of these utilities includes in the ratebase calculation
plant that has been paid for by developers and uses this approach in combination
with another approach to determine the amount of transfers to the general fund.
First, the utility uses the return on ratebase approach to set the limits on the
amount of general fund transfer. The minimum amount of general fund transfer
in any given year is equal to 5% of ratebase. The maximum amounf of a general
fund transfer in any given year is ~equal to 10% of ratebase. Then another
calculation is done to estimate the difference in revenues the utility could have
earned if the utility charged neighboring utilities’ rates. If 50% of this difference
in revenues does not violate the minimum and maximum amounts calculated
based on a percentage of ratebase, then 50% of the difference in revenues will be
the general fund transfer for the fiscal year. If 50% of the difference in revenues
violates the minimum and maximum amounts allowed, then the general fund
transfer will be equal to the limit that was not met.
In most cases, particularly if the transfer policy is contained in the City Charter,
the general fund transfer policy has not been changed for more than 20 years.
Some utilities have reviewed their transfer policies within the last 10 years; how-
ever, no hhanges were adopted. There were a few utilities that have reviewed
and changed their policy within the last three years. In most cases, the
percentage used in calculating the transfer was reduced. One utility, however,
changed its policy from using the percentage of sales method to the return on
investment method. One major reason electric utilities have reviewed their
general fund transfer policy is the deregulation of electric generation. As
mentioned earlier, most utilities have either reduced the percentage that it uses to
calculate the general fund transfer or have frozen the amount of general fund
O.~M~001420\IS-~PP^.DOC 03/09/2000 R.W. Beck A-2
APPENDIX A SURV~ OF MUNICIPAL UTILITIES
transfer to current levels in order to maintain competitiveness and its survival in
the deregulated market.
Electric deregulation can also cause a reduction of general fund transfers if the
fund transfer is calculated as a percentage of retail revenues. This reduction in
general fund transfers can occur if the retail revenues of an electric utility is
reduced due to the loss of revenues from customers who decide to purchase
electricity from van alternate energy service provider. All utilities using the
percentage of retail revenue method are aware of this threat to the general fund
transfer. Most utilities plan to establish a fee that will be levied on energy service
provider~ serving the utility’s customer. Other utilities plan to either increase the
percentage used, set the general fund transfers at a fixed dollar amount, or, in
some cases, utilities plan to abandon the percentage of retail revenues method
and just freeze the dollar amount of general fund transfers to the current level.
WATER
All municipal utilities surveyed use a percentage of gross retail revenues to
calculate its’general fund transfer for a given fiscal year. However, there are some
minor differences in the way each utility applies this approach. For example,
most utilities apply the percentage on the last fiscal year’s gross retail revenues,
while one utility applied it to the sum of operating expenses, capital outlays, and
debt service. The percentage used by the utilities surveyed ranged from 5% to
17%. The percentages in general are determined on an annual basis and are, in
most cases, restricted by the maximum rate allowable, which is defined in the
City Charter.
O:~JM~001420\IS-APPA.DOC 03/09/2000 R.W. Beck A-3
APPENDIX A SURV~ OF MUNICIPAL UTILITIES
O:~JM~01420\IS-APPA.DOC 03/09/2000 R.W.. Beck A-4
APPENDIX A SURVEY OF MUNICIPAL UTILITIES
Z
O:~JIvlX001420\IS-APPA.DOC 03/09/2000 R.W. Beck A-5
APPENDIX B
RATING AGENCY PERSPECTIVE
APPENDIX B
RATING AGENCY PERSPECTIVE
Both of the major credit rating agencies, Moody’s Investors Service (Moody’s)
and Standard and Poor’s (S&P), were contacted concerning the’ir current perspec-
tive regarding the methodology and amounts of General Fund Transfers from
Enterprise functions. Their positioris on various methods of determining General
Fund Transfers, insight into what concerns they may have regarding transfers,
and their appetite for new and innovative methods of determining General Fund
Transfers were all explored.
METHODOLOGY
The Rating Agencies (Agencies) were asked if they have any preference in terms
of the methodology employed in the determination of General Fund Transfers.
Traditional methods such as In-Lieu Property Tax, In-Lieu Franchise Tax, Asset
based and Percent of Gross Revenue based transfers were explored.
Moody’s responded that they do not favor one methodology over another for
any of the services, however, they indicated that a return on asset methodology
might be preferable for water utilities if there are challenges in court caused by
Proposition 9.18 (Prop. 9.18). They generally are concerned about the potential
impact of Prop. 218 on Water Utility Transfers. It is their belief that well defined
and documented user fee based charges should withstand any legal challenges,
however, they will likely remain concerned about this subject until there actually
is a favorable opinion from the Courts.
S&P did not express a preference to one methodology over another. They shared
the same concern over Prop. 9.18 as it may or may not affect future water utility
transfers.
The current methodology employed by the City should provide reasonable pro-
tection against any Prop. 218 challenges.
LEVEL OF TRANSFERS
The Agencies were asked if there is a dollar or percentage threshold at which
point the level of Transfers begin to cause them concern.
S&P indicated that the level of transfer is not important as long as (1) the utility
can continue to support the level of transfer in a competitive environment, and
(9.) the General Fund is not overly dependent on this source of funding. S&P
stated that the City should "be mindful of General Fund needs while allowing the
electric utility to be nimble."
O :~JM~001420\15-APPB.DOC 03/09/2000
APPENDIX B RATING AGENCY PERSPECTIVE
Moody’s position is similar in that the overall level of transfer is not overwhelm-
ingly important until it becomes a competitiveness issue. At that time, transfers
are evaluated in a different light. Moody’s did indicate that once the transfer
level exceeds 10% of gross revenues they believe it becomes a potential liability.
Their rationale is that the General Fund may be too dependent upon this source
of revenue. -Transfers much in excess of 10% begin to cause them a rating concern
for both the enterprise and General Fund functions.
EMPLOYING DIFFERENT METHODOLOGY BY ENTERPRISE
The Agencies were asked if they employed different criteria for the evaluation of
electric, water, gas, and telecommunications enterprise activities.
Moody’s indicated that it would not present a problem to use differing meth-
odologies based upon utility. Their major concern is that the methodology be’
fairly applied and defensible. As mentioned earlier, they are paying particular
attention to water transfers in light of concerns over interpretation of Prop. 218.
S&P had similar comments with regard to the transfer methodology being fair
and defensible. They also will continue to follow the development of Prop. 218
issues. S&P was much more concerned about the application of "risk n’ reward"
methodology, as described in the following section.
ALTERNATIVE TRANSFER METHODOLOGY
The option of exploring transfers based upon an alternative methodology was
also discussed with the Agencies. More specifically, the possibility of determining
transfers based upon the level of return to the City as opposed to the level of
investment in the system or the gross revenues of the system was evaluated.
Moody’s only concern over such a methodology was whether the General Fund
would become dependent on a volatile source of revenues. Employing such a
strategy for a start-up enterprise such as telecommunications appeared to be less
of a concern in the start up phase. If these revenues prove to be substantial in the
future, and the" General Fund becomes dependent upon them in future years, it is
likely to attract the Agencies’ attention.
S&P expressed concern over the use of a methodology that substantially differs
from the common and accepted practices that are presently employed. They did
not rule Out their use .entirely, however, it is clear that there would need to be
discussions with the City regarding the use of an alternative methodology.
Lastly, the Agencies were asked for any publications or material that they fre-
quently make available to their clients regarding this subject matter. Some of this
material is dated, but they indicated that it continues to accurately represent their
thoughts and positions. This information is included at the end of this appendix.
O:kIlV~01420\IS-APPB.DOC 03/09/2000 R.W.. ,Beck B-2
Attachment B
18,000
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
Utility Transfer Proposal
5 6 7 8 9 10
Time
’-’"’3% Annual Escalation ~Staff Recommends