Right-sizing Reserve Funds

Jeff Hughes is the Director of the Environmental Finance Center.

“How much should our utility maintain in reserves?”  This is one of the most common questions I get from utility managers during my finance courses. It is also one of the most difficult questions to answer.  Just calculating how much a utility has in reserve and what it can be used for can be challenging given the diversity of labels and descriptions given to reserves.

 

Reserves can be held in working capital reserves, operating reserves, debt service reserves, rate stabilization funds, contingency reserves, capital reserve funds… and more. Some reserves are created to be spent while other reserves are designed not to be spent.  Reserves can be: restricted or unrestricted; designated or non-designated; capital or operating, protected or not protected; cash or cash-like.

While some aspects of reserve nomenclature is dictated by Generally Accepted Accounting Principles (GAAP), most is not and the terms vary from state to state and from utility to utility.

Most importantly, there are multiple reasons for establishing and maintaining reserves and each utility will have it’s own objectives for reserves based on their financial condition, operating environment and governing board preferences. Common reasons for having reserves include:

Reducing debt: Utilities wishing to reduce future debt because of their existing outstanding debt or because of a philosophical aversion to debt (or paying interest) may see accumulating reserves as a way of avoiding or reducing future debt.

Reducing cost of debt: Reserves can be held to provide additional peace of mind to lenders that debt will be paid back (often called restricted debt service reserves). Lenders that feel more secure tend to offer debt at lower cost. At one time, the vast majority of revenue-backed debt required the establishment of debt service reserves equal or greater than one year’s payment.

Mitigate the disruption of sudden unplanned expenditures:  Utility managers tend to be extremely risk averse, particularly when it comes to threats to their ability to provide service. As a result, utilities will often call reserves “contingency reserves” as a type of insurance policy for dealing with the costs of coping with sudden equipment breakdowns caused by natural disasters or wear & tear.  The target for these reserves may be set based on the value of equipment; the annual operating expenses and the risk of costs.

Mitigate the disruption of a rapid decline in revenues: Utilities with higher risk of revenue vulnerability due to the potential loss of customers or the rapid reduction in service purchases establish reserves (also sometimes called contingency reserves) to cover sudden un-forecasted revenue shortfalls.  The term “rainy day fund” has been given new meaning for utilities that have grown accustomed to revenue from residential irrigation and are at risk of experiencing significant declines in revenue during a particularly naturally wet and rainy irrigation season.  These reserves may also be labeled “rate stabilization reserves” in the sense that they protect against rates to adapt to sudden unexpected usage reductions.

Stabilize rate increases: Some “rate stabilization reserves” however are much more about planned revenue smoothing than contingency planning. Utilities with robust finance plans and rate models sometimes look towards the future and identify when rate increases are needed to meet costs. In some cases, the future can look quite bumpy with large projects going on line at the same time a large temporary whole purchaser may be planning to reduce usage. In an effort to smooth out the road ahead, many utilities are turning towards “rate stabilization reserves” to mitigate the size of a rate increase in a given year.

The total amount in reserves also can depend on whether a utility “lumps” or “splits” their funds. The choice to lump or split could be all about strategy or it could be a result of regulatory requirements:

Lumpers: These utilities prefer to have all their reserves in one place and have limited restrictions on how their reserves are used. Lumpers may be able to reduce their total reserve funds by using the same pool to cover multiple threats (lumping does not help as much if reserves are designed to be spent in the future).

Splitters: These utilities like to identify different uses for funds, split them up, and then set targets for specific types of funds. Splitting helps with transparency and may lead to small pots of money that attract less attention from cash strapped local governments.

The targets for reserves can be found in diverse places ranging from self established and/or approved financial performance targets to loan documents to state law requirements.

The question about how far a utility can go in maintaining reserves may be a function of board preferences or of governing financial regulations. Some industries such as banks are required by their regulators to maintain reserves.  The legality of maintaining reserves really is a question about the legality of generating the funds that went into the reserves in the first place. Generating reserve funds requires having revenue that exceeds operating expenditures.  This can be a regulatory challenge for some utilities that are aggressively regulated by utility commissions. Rates are a function of rate cases and accounting formulas and may not be able to support a reserve policy. Utilities that are not regulated by Public Service Commissions have much more freedom in setting rates that generate revenue. For example, a local government policy can set rates to generate x percent of excess revenue for a reserve fund.

Researching reserve funds can be as challenging as establishing a reserve fund. Rating agencies and other researchers routinely set metrics for monitoring reserves, but the different nomenclature and accounting procedures can make peer group analysis challenging in this area. In future blog posts, we will share the research related to what utilities are doing, but that does not really address what utilities should be doing. How often do utilities use funds in their reserve? What is the cost of maintaining unused reserves?