Module 8

Rate Design Overview for

Small Water Systems

Workbook

Financial/Managerial Series
This course includes content developed by the Pennsylvania
Department of Environmental Protection in cooperation with the
following grantees:
RCAP Solutions, Inc.
Penn State Harrisburg Environmental Training Center
 Training Module 8
Rate Design Overview for Small Water Systems

Objectives:

The purpose of this training module is to:

Define the main types of rate setting methodologies.

Explain the advantages and disadvantages of each

methodology.

 View an example of each type of rate setting methodology.

 Describe what is needed to build support for increased user

fees.

 Explain that a sufficient rate is the key to a sound financial base

as it can help ensure that revenues exceed costs.

Table of Contents

Introduction p. 2
Rate Structures and Examples p. 2
Building Support for Rate Increases p. 13
Summary p. 19
Resources and References p. 21

1
Introduction

#1

During this training module, we’ll be describing:

The different types of rate structures, their advantages and

disadvantages, and how they are set;
An example of each type of rate structure; and
Why proper rate setting is important and how to build support
for increases.

We’ll provide a basic overview of these in this training module.

Rate Structures and Examples

#2

To do this, let’s start with the definition of a rate structure.

A rate structure is the mathematical method a water system utilizes to

generate revenue by allocating costs among users.

There are many ways a small water system can set up the rate
structure. Two of the main examples are a flat rate and a base rate
plus usage charge.

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 #3

The flat rate structure is generally utilized when the users do not have
meters installed. Every user pays the same regardless of
consumption.

#4

The advantages of a flat rate structure are:

Reduced costs since there are no meters to read and in many

cases there are no bills to generate (many systems use an
annual coupon book) and accounting procedures and systems
can be simplified.

Steady revenue stream over time.

#5

The disadvantages of a flat rate structure are:

Revenue does not increase to cover increased costs from

increased consumption such as in summer months.

Lower consuming users forced to subsidize higher consuming

users, since all users pay the same regardless of consumption.

Problems associated with assignment of multiple unit

businesses and industry.

No incentive to conserve water which can result in increased

costs and source water depletion.

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 Does not indicate tightness of system (leaking) since there are
no meters in the homes.

#6

Let’s work through a short example. Please refer to the example in

your workbook. Take a couple of minutes and see if you can
determine the minimum rate the system should charge its users.

Exercise #1
The Smallville Water Company is a system that wants to utilize a flat
rate structure since water meters have not been installed. Determine
the minimum rate the system should charge its users based on the
information provided below.

Number of users: 500

Projected annual O&M cost: $35,000

Projected annual Admin cost: $15,000
Projected annual Salary cost: $45,000
Projected annual Debt cost: $55,000

Projected annual Total cost: $150,000

Minimum monthly rate: $25.00

Use the space below to complete the exercise.

4
 Rate Setting Tips:

Don’t just use last year’s costs. When determining the rate be
sure to use your cost projections for the upcoming year and
include a reserve for unanticipated expenses.
When projecting costs for the upcoming year, some of the
previous year’s costs plus an inflation factor can be used. This
data can come from the audit report. However, be certain to
include any new expenses you anticipate such as a new truck,
storage tank painting, replacing filter sand, a new computer,
pump replacement, etc., that you may not have had last year.
Rate setting is an ongoing process which is most effective if it is
done annually.

#7

Now that we’ve discussed the flat rate, let’s cover the next type.

The base rate plus usage charge structure, commonly known as the
metered rate, includes two components:

The base rate allows systems to charge all users the same
amount to cover fixed costs such as debt repayment and
administrative costs.

The usage charge allows the system to charge users based on

their water consumption to cover its variable costs, or the costs
that vary along with water consumption such as O&M and
utilities.

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 #8

The advantages of a base rate plus usage charge (metered rate)

structure are:

Revenue fluctuates with water consumption and costs at the

plant.

Users share equally in the fixed costs and pay for the water
they use.

Encourages conservation and protects against depletion of the

water source.

Meter data can be used to assist in leak detection.

In communities providing sewage conveyance and/or

treatment, assists in determining billing for that service.

#9

The disadvantages of a base rate plus usage charge (metered rate)

structure are:

Unsteady revenue stream throughout the year.

Increased administrative costs through bill generation and

mailing along with costs associated with meter reading.

Meter ownership and maintenance costs.

More complex accounting and recordkeeping software.

6
 #10

How does one ensure that this type of rate structure will generate
sufficient revenues?

You need to take the flat rate methodology a couple of steps further.
We learned in the earlier example that you need to determine your
projected costs for the upcoming year. Now you have to split those
costs into fixed and variable costs.

#11

Projected fixed costs include debt repayment, office expenses and

postage, administrative salaries, meter reading, and other expenses
that do not change relative to a user’s water consumption.

An example is the cost of bill generation. Regardless of the amount

of water used by a customer, it will cost the system the same to read
the meter, print the bill, mail the bill, and process payment.

#12

Projected variable costs include utilities, chemicals, and other

expenses that change relative to a user’s water consumption.

An example is electricity. The electrical costs will vary along with

changes in the volume of water treated and pumped.

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 #13

Rate Setting Tips:

Note that it’s not the number of gallons treated, but the number
of gallons billed. Why? Because you need to recover your
costs based on the water that is consumed (i.e. billed) by users.
A percentage of the water that is treated is lost through leaks
and for other reasons.
One benefit of this methodology is that it forces you to examine
the system’s billed gallonage relative to its treated gallonage.
This could clue you in to some major leaks in the system if the
numbers are very different.

If you have a new system and are trying to determine a rate, your
engineer has very likely produced some projections of total water
consumption for the system, along with projections of costs. You can
use these but be certain that you include a reserve to ensure
sufficient revenue in case the projections are off or incomplete.

#14

Rate Setting Tips:

Even the most complicated rate structure will be inadequate if

system costs exceed revenues.
KISS principle: Keep It Simple, Student.

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So what do you do with all these numbers? Well, let’s run through an
example to see how you might derive a rate from what we have so
far. Since there are some more complicated calculations in this
example, let’s run through it together.

Exercise #2
Here we have a breakdown of the number of users and the projected
fixed costs.

Number of users: 500

Fixed costs:
Projected annual Admin cost: $ 5,000
Projected annual Debt cost: $55,000
Projected annual Admin Salary cost: $15,000
Projected annual Engineering cost: $ 3,000
Projected annual Audit/Legal cost: $ 4,000
Projected annual Insurance cost: $ 3,000

Total Projected Fixed Costs $85,000

#15

Here we have a breakdown of the projected variable costs and the

prior year billed gallons in 1000 gallon units.

Variable costs:
Projected annual Utilities cost: $15,000
Projected annual Chemicals cost: $ 5,000
Projected annual Testing cost: $ 5,000
Projected annual Maintenance cost: $10,000
Projected annual Plant Salary cost: $30,000

Total Projected Variable Costs $65,000

Prior Year Billed Gallons (000s): 35,000

9
 #16

Now what? We need to make a few adjustments.

The numbers assume that all the users will pay their bill every time.
We know better than that so we need to include a modifier to
compensate for delinquencies. You can use your existing
delinquency rate if it is known, otherwise you can use a projection of
anywhere from 5-10% as a modifier. However, this doesn’t mean a
delinquency rate in this range is acceptable. You should always
strive for as low a delinquency rate as possible. This range is
provided as a guide when no other data is available.

We also need a modifier to cover any projections that may be off.

You may want to use a contingency rate of 3-8% for this.

#17

So here’s what we have so far:

Number of users: 500

Total Projected Fixed Costs $85,000
Total Projected Variable Costs $65,000
Prior Year Billed Gallons (000s): 35,000
Delinquency rate: 5% (0.95 payment rate)
Contingency rate: 5% (1.05 contingency)

#18

Now let’s calculate the base rate (customer charge for having
service):

10
 ($85,000 fixed cost) * (1.05 contingency) = $_______
(12 months) * (500 users) * (0.95 payment rate) per month

#19
Instructor Note: Display Slide #19.

Now let’s calculate the usage charge (per 1000 gallon charge):

($65,000 variable cost) * (1.05 contingency) = $_______

(35,000 thousand gallon units) * (0.95 payment rate) per 1000 gal

#20

So let’s take a look at the final rate structure:

$15.66 per month base for each user

$ 2.05 per 1000 gallons of water consumption

Exercise 3
Take a few minutes to determine the rate a user would pay if they
consumed 4000 gallons per month.

A user that consumes 4000 gallons per month will have a bill of
$______ + (___ * $______) = $________.

This amount should be sufficient to cover the system’s costs of

providing water to that particular user.

11
 #21

Some of you may have all residences as customers, but others may
have businesses or industry within their water system. What then?
In many cases, the businesses are sufficiently small that they can be
treated as residences. In some cases they aren’t and need to be
billed differently.

#22

That pretty well covers our two main types of rate structures. What
other types of rates are out there?

A common one is a variant of the rate structure we just discussed.

This variant includes a certain amount of water in the base rate. For
example, the base rate includes up to 2000 gallons a month and
users are charged for consumption over that level.

Other variants on this structure include those that have a declining

per 1000 gallon charge as usage increases (to encourage higher use,
typically to attract and retain industry) and those that have an
increasing per 1000 gallon charge as usage increases (to encourage
conservation in general or in drought conditions). These are known
as decreasing block and increasing block, respectively.

Especially if you have a small water system, it might be best to avoid

these variants unless you have good justification for using one.
Remember the KISS principle!

12
 #23

There are still other rates out there that are based on income levels,
seasonal residences, and other elements but these are best avoided
if possible.

Rate Setting Tips:

Other things to avoid include discounts and free water.

Examples include free water for churches and fire halls.
This practice may be prohibited by funding agencies.

Building Support for Rate Increases

#24

So now we a have a rate structure in place, but at some point in the

future the rate will have to be increased. Why is this? Well, let’s take
a look at the graphic on the slide.

13
 User Revenue Loss
Debt

$$$$$ Reserve
Debt Increasing Costs

Amortized Debt

Time

This graphic illustrates how an unchanged rate cannot keep pace

with increasing costs indefinitely. Here are all the parts of the
graphic:

The left, vertical side (y-axis) of the graphic shows increasing

dollars from bottom to top.

The bottom, horizontal side (x-axis) of the graphic shows

increasing time from left to right.

The green line represents the revenue, which does not change
over time, obtained from users without any rate increases.

The gray block at the bottom of the graphic represents the

expense from amortized debt which does not change over time.

The pink triangle directly above the amortized debt shows the
increasing costs of the water system over time.

The black triangle on the left side illustrates the profit the
system makes over time.

The red triangle at the top represents the loss the system will
incur over time.

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 The blue star in the center represents the point in time when
the system goes from making money to losing money.

The yellow arrow in the upper right hand corner represents the
amount the rate will have to be raised once system losses have
consumed its initial reserves.

Let’s recap, what does it all tell us?

When the system starts, its rate will be generating sufficient revenue
to cover its expenses as well as some excess revenue that can be
kept in reserve. As time goes on, the expenses of the system
increase due to inflation and other factors and the system’s profit
begins to dwindle until the system is only breaking even (at the blue
star). If the rate is not increased at this point, the system will begin to
lose money every day it operates. Once the system reaches the
point in time when its losses have consumed all of its initial reserves,
it will become insolvent if the rate is not increased. The costs are
considerably higher now than they were at the start and users will
experience “sticker shock” as the rate will have to be increased
significantly to avoid bankruptcy.

#25

You will eventually have to increase the user rate. You should review
the rate annually to ensure that you are recovering your costs and
that you won’t have to shock your users with a significant increase.
How do you go about building public support and acceptance for such
an increase? That’s the topic of our next section and there are a
number of things you can do.

#26

The three most important things you can do are:

15
Educate!

Educate!!

Educate!!!

Public education is the key to building user support for rate increases.

#27

Before we discuss this further, let’s investigate what you should do

before you start the public education process.

If the system is running over budget, there are two ways to solve this:

Reduce expenses

Increase revenues

Before you can justify a rate increase, you need to ensure that costs
are at a minimum.

#28

Here are some questions you may want to ask yourself before you
decide that a rate increase is necessary:

Are there physical improvements that can be made at the

plant?

Are there operational inefficiencies that can be eliminated at the

plant?

16
 Are there any major leaks and if so, have they been repaired?

Are water conservation practices in place?

Is the plant or office staffed properly?

Is the delinquency rate high and are those users being pursued
aggressively?

Can existing debt be refinanced?

Can the number of customers be increased?

#29

OK, you’ve made certain that costs are at a minimum. What now?

Identify the problems that need attention. These can include:

Worn-out equipment that costs too much to maintain and

should be replaced

Portions of the system need to be upgraded

Additional engineering or other professional services are

needed

Regulatory violations

Rising costs due to inflation or other factors

Document everything that justifies the rate increase. Photo and video
documentation or other visual evidence can be particularly compelling
and will be useful in the next step.

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 #30

Once it’s clear that a rate increase is needed, it’s time to start building
support for the increase through the public education process.

The most likely forum for this will be a public meeting. If desired,
supporting materials can be distributed prior to or during the meeting.
Don’t forget that this type of meeting should be announced and
advertised to allow the customers the opportunity to attend.

Discuss the current situation with the water system. Highlight the
problems that have been corrected and discuss those that still need
attention and what they will cost. Everything you present should help
the users to answer the question of why the rate increase is
necessary. Provide as much detail as possible.

#31

Building Support Tip:

Show the users the reasons for the increase; don’t just tell
them.

You can show the group a broken piece of equipment or a section of

old water line.

Show them a video of old equipment in operation or of the well head

or surface intake.

Provide a chart that shows increasing costs over time like the one
shown earlier.

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 #32

You may want to have a “spokesperson” handle this at the meeting

while the local officials, engineer, and plant personnel are there to
provide support and answer specific questions.

#33

If you’re successful, you will have built user support for the rate
increase but you’ll likely have accomplished a few other things well.

These can include:

User appreciation for the importance of reliable water treatment

to public health and safety and the protection of the
environment

Communication of the link between clean water and community

growth

Understanding that clean water is relatively inexpensive relative

to the cost of other services such as cable television

Summary

#34

Before we summarize what has been covered, let’s see how we are
doing so far. You’ll find a short exercise in your workbooks. Take a
few minutes to answer the questions. You can look back through
your workbooks if you need.

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 Rate Setting Exercise

1. What are the two main types of rate structures used by small
water systems?
a. ______________________________________
b. ______________________________________
2. When is a flat rate generally used?
a. ______________________________________
3. The base rate plus usage charge divides expenses into two
categories. What are they?
a. ______________________________________
b. ______________________________________
4. Besides the two expense categories and number of users, what
other information is needed to determine the initial base rate
plus usage charge?
a. ______________________________________
5. What is a major assumption of these two rate structures with
regards to users?
a. ______________________________________
6. Is it a good practice to provide free or discounted water to
certain customers?
a. ______________________________________
7. Is it likely that a water system will have to enact a user rate
increase at some point in the future?
a. ______________________________________
8. What are the two main ways to get a system back on budget?
a. ______________________________________
b. ______________________________________
9. What is the most important way to build user support for a rate
increase?
a. ______________________________________
10. Can visual aids assist with the public education process?
a. ______________________________________

#35

The key points of this training module are:

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 Different systems can have different types of rates structures
based on their needs.

The main rate structures in use by small water systems are:

o Flat rate
o Base rate plus usage charge

Other variations on rate structures exist but should only be

used when justified.

There is a particular methodology associated with each rate

structure.

There are advantages and disadvantages to each rate

structure.

Since expenses almost always increase over time, the rate

must also increase to ensure that revenues exceed costs.

Local officials can use certain techniques to help build local

support for increased user fees.

Resources and References

#36

The following are references and resources you can use when you
have to structure your own rate.

PA Dept. of Environmental Protection, Technical Assistance and

Outreach, (717) 772-4058, Dennis Lee

RCAP Solutions, Inc, (814) 861-6093

Don Schwartz, PA/NJ Program Manager

21
University System of Maryland, Environmental Finance Center
Jean Holloway, Training Manager

EPA – “Building Support for Increased User Fees” document

RCAP – “Small System Guide to Developing & Setting Water Rates”

document

The complete list of training modules includes:

Module 1, Water Supply System Basics Operations
Module 2, Responsibilities of Governing Boards
Module 3, The Safe Drinking Water Act
Module 4, Dealing with Consultants, Technical Assistance
Providers, Regulators, and Funding Agencies
Module 5, The Basics of Accounting and Finance for Small
Water Systems
Module 6, Business Planning for Small Water Systems
Module 7, Budgeting and Capital Improvements Planning
Overview for Small Water Systems
Module 8, Rate Design Overview for Small Water Systems
Module 9, Bidding, Purchasing, and Leasing
Module 10, Project Management Overview for Small Water
Systems

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