Solid Waste Ratemaking: The Whys and How

Cost of service studies are an essential tool in managing a solid waste agency in these uncertain times. They provide opportunities for introduction of smart technologies, cost optimization, improved customer service and long-term financial planning.

Doing more with less has become a mantra within public-sector agencies. As a result, managers and other decision makers face issues such as operating budgets being cut annually, fleet purchases being deferred past normal replacement cycles, and salaries not reflecting the value of employees when compared to their counterparts in similar industries.  There are a myriad of reasons why solid waste agencies encounter fiscal pressures, some of which are beyond the control of agency managers. Oftentimes, however, there are remedies to ease fiscal pressures if the issues are well understood. First and foremost, a study of rate structures should be undertaken. This paper will provide guidance on the basis and benefits of conducting such studies and our tried and tested methodologies for effective solid waste ratemaking.

Why Do a Solid Waste Rate Study?

In our experience of conducting cost of service or rate studies for solid waste agencies across the U.S. over the last 20+ years, there are a variety of reasons why a decision to conduct a study has been taken, including:

  • Declining or negative fund balances
  • Difficulty gaining political support for rate increases
  • Fuel, equipment and insurance costs are skyrocketing
  • Problems with customer service
  • Education of political leaders
  • Frequent calls for full or part privatization
  • Consolidation with neighbors
  • Improve efficiency of recycling programs
  • Desire to enter new markets or services

Steps in Conducting a Solid Waste Rate Study

There are 10 primary steps used in conducting solid waste rate studies for clients. These are more fully described in the paragraphs below.

Step 1: Identify and Establish the Objectives

Customer rates must be in alignment with the mission of the agency. Rates are an important price signal by which public agencies communicate to customers the value of services they deliver. So, at the onset of performing a rate study, the agency should identify and prioritize its ratemaking objectives. In setting customer rates, agencies typically endeavor to achieve some or all the following ratemaking objectives:

  • Generate adequate revenues to meet the jurisdiction’s financial obligations
  • Comply with legal, regulatory and debt covenant requirements
  • Achieve fairness and rate equity among customers and among customer classes
  • Design rates that are simple and easy for ratepayers to understand
  • Set rates that are competitive in relation to other jurisdictions and/or private operators
  • Keep rates stable over time

By identifying and prioritizing these objectives at the outset of the ratemaking process, managers can better inform political decision makers as to what they are seeking to accomplish and improve understanding of the trade-offs inherent in their rate structures. Once the cost structure has been analyzed and the initial results are developed, it is often helpful to revisit (and perhaps even reprioritize) these ratemaking objectives prior to making final decisions about designing new rates.

Step 2: Develop a Project Road Map

Experience has taught us that developing a project road map is essential to the success of a rate study project. This includes laying out all facets of the rate design process, how they interact together, and how the rate process interfaces with the agency’s annual budget and capital improvement plan process.

For rate analysis, a Pro Forma Model is typically developed at this point in the rate analysis to help collect all the required data and to prepare a long-term cash flow analysis. This usually includes the following critical information:

  • Staffing and organizational charts
  • Wages and benefit rates
  • Rate schedules
  • Bond debt
  • Fund account summaries (totals and comparisons)
  • Past and current operating budgets
  • Fleet replacement plan
  • Waste deliveries and customer records
  • Capital improvement plan
  • Administrative costs

Individual spreadsheets are linked to develop an overall model to conduct the rate analysis.  The general configuration of a Pro Forma Model is crafted to help answer many “what if” questions, such as:

  • An analysis of operational expenditures (personnel, contract and purchased services, materials and supplies, transfers)
  • Analysis of capital outlays (equipment replacement and capital projects)
  • Revenue sufficiency analysis (annual revenue projections and rate plan to provide sufficient revenues)
  • Funds analysis (reserve requirements, transfers to reserves, administrative costs, beginning and ending fund balances)

Used in this way, scenario analysis is a process of examining and evaluating possible events that could take place in the future by considering various feasible results or outcomes. In rate modeling, this process is typically used to estimate changes in the solid waste business cash flow.

When performing this analysis, we typically generate different future states of the agency, the industry and the economy. These future states will form discrete scenarios that include assumptions such as customer metrics, operating costs, inflation, interest rate and other such drivers. Our rate models typically start with three basic scenarios:

Base case scenario—This is the expected scenario based on management assumptions

Worst case (pessimistic) scenario—Considers the most serious or severe outcome that may happen in a given situation

Best case (optimistic) scenario—This is the ideal projected scenario

The pessimistic and optimistic scenarios serve to bound expectations around the base case.

Step 3: Establishing or Adjusting Future Solid Waste Rates

An important aspect of predicting future revenues and expenditures is to understand the agency’s past operating performance. Therefore, an important step in the ratemaking process is to gather and analyze historical financial and operational information. At a minimum, the financial information needed in the ratemaking process should include:

  • The general ledger trial balance for the most recently completed two fiscal years, which typically includes detailed line item revenues and expenditures for the agency as well as the beginning and ending reserve balance
  • Fiscal year-to-date revenues and expenditures (year-to-date amounts can be annualized to project the operating results for the current year)
  • Debt service schedules
  • Operating and capital budgets

The purpose of gathering financial information is to help the solid waste manager understand historical revenues, expenditures and ending fund balance. The financial and operational information gathered in this step will be used further along in the ratemaking process to project the revenue requirements, allocate costs and, ultimately, design new rates. Additionally, and perhaps more importantly, the process of gathering and analyzing historical information will better equip the solid waste manager to understand the agency’s past operating performance.

Step 4: Address Cost Savings

This oftentimes means analyzing operational changes to see if improvements can result in efficiencies. For example, a solid waste agency operating a collection fleet at less than full capacity may consider the possibility of extending collection routes to include accounts in the neighboring community. In this way, they could pick up a few more customers to take advantage of underused labor and equipment. This could result in a win-win for both communities in the form of a service efficiency and revenue enhancement.

Step 5: Assess Customer Revenue Stream

This step in the ratemaking process uses current customer census information to estimate expected revenue and compare that to the actual revenue recorded in the agency’s accounting system. Each of the agency’s individual solid waste rates is extended by the number of customers that are charged that rate. In the case of roll-off services, the number of loads at each level/type of service is extended by the corresponding rate for that service. The extended amounts for each level/type of service are annualized and summarized to arrive at the total calculated annual revenue at current rates.

There are three main reasons for performing this step. First, this process organizes the customer census information that will be used in designing the new rates and forecasting the number of customers at each level/type of service and expected revenue at the new rates. Secondly, as discussed further below, the recalculated revenue for each customer sector can be compared to its respective revenue requirement for each customer sector. Finally, the recalculated revenue should be compared to the revenue reported in the accounting system. This serves to confirm that the customer census data is accurate. The accuracy of the customer census information is a critical factor in designing new rates and meeting future revenue requirements, which is the agency’s most important ratemaking objective as discussed in the next step.

Step 6: Assess Revenue Requirements

Required revenue is the total amount of money the agency must collect to pay expenditures and provide its targeted levels of service while meeting its financial obligations. This is expressed on a cash basis (rather than on the accrual or modified accrual basis on which many public agencies base their financial reporting) and should include any rate-funded capital expenditures. The revenue requirement for the current year is determined by annualizing the agency’s fiscal year-to-date cash expenditures. For example, if the fiscal year ends on June 30th, year-to-date cash expenditures for the nine months ended March 31 should be divided by nine and multiplied by 12 to annualize the year-to-date amount. Additionally, adjustments should be made for any significant non-recurring expenditures.

Revenue requirements for future years are projected by applying anticipated changes in expenditures to the current revenue requirement. These changes may include such items as inflation, increases in workers’ wages and tipping fee adjustments. They may also include expected costs for special projects and new programs. In addition to projected cash expenditures, any adjustments must be made to account for required increases in fund balance or debt coverage ratios. Once the agency has projected the amount of money it will need to collect in future years, the next step in the ratemaking process is to determine how much of that money should come from each customer sector.

Step 7: Allocate Revenue Requirement Among Customer Classes

In this step, the agency should compare their revenue requirement for each customer sector with the actual revenue generated by that customer sector. This comparison enables the solid waste manager to determine the extent to which the jurisdiction is achieving the goal of rate equity among its customer classes. It also provides a target revenue amount for use in designing new rates. The process of allocating the revenue requirement is simply a matter of seeking to identify the cause-and-effect relationship between various types of cost. The activities and use of resources that cause costs to be incurred are cost drivers and need to be clearly identified.

However, this cause-and-effect relationship is not always obvious for all types of cost. Indirect costs (or common costs) are those types of costs that are shared among different types of operations and are not as readily linked to a service. These are cost items such as building rent, utilities, management salaries, allocations of cost from other city departments and transfers to the general fund. Additionally, the portion of the revenue requirement attributable to increasing the agency’s reserve balance should also be treated as an indirect expense.

The process of allocating the revenue requirement to the various customer sectors is a two-step process. First, direct costs are assigned to each customer sector based on the appropriate cost driver(s) for each type of cost. Second, the remaining indirect costs are assigned to each customer sector based on their proportionate amount of direct costs. For each customer sector, the combination of direct and indirect costs comprises the revenue requirement.

Step 8: Design Customer Rates

The two general approaches to designing solid waste customer rates are the cost-based approach, and the market-based approach. The cost-based approach entails designing rates that most accurately reflect the cost of providing a service. The market-based approach is more focused on how the rate will be perceived by customers. Solid waste rates are usually set using a measure of both approaches.

The cost-based approach starts with calculating the various direct cost components of each level of service by using cost statistics such as direct labor and equipment cost per home, container cost per home and disposal expense per home. Indirect costs are allocated to each type of service proportionately to arrive at the total cost for that service.

The market-based approach is often more of an art than a science and must account for customer behavior and sensitivities. Under the market-based approach, for example, rates can be designed to: 1) encourage customers to recycle, 2) be consistent with the rates in nearby jurisdictions or 3) maintain the structure of the existing rates.

Step 9: Revisit Ratemaking Objectives and Set Final Rates

In this step, solid waste managers should revisit the ratemaking objectives described previously and evaluate whether, and the extent to which, the new rates meet their agency’s objectives. In this way, the solid waste ratemaking process is completed where it began, with a review of the jurisdiction’s ratemaking objectives.

Step 10: Presenting Rate Analysis

Completion of Step 9 provides the agency with a new rate structure to sustain the types of services offered. However, the key to successfully implementing these new rates is spending time with the folks that will have to approve them, all the while educating them on the objectives and the methodology used. This is very much like presenting your case before Judge Judy. You must remember that most politicians are not financial experts nor are they experts of your operations. You and your consultant are the experts. Bear in mind also that the ultimate jury are the ratepayers, and they can be a tough sell. Openness and transparency throughout the rate setting process will go a long way towards convincing people of the need for new rates. As such, Step 10 needs to be conducted in parallel with previous steps and should not only start after Step 9 is completed.

Lessons Learned

Having completed more than 50 solid waste rate studies for local agencies throughout the United States and U.S. territories, there are number of important lessons we have learned that can serve as valuable lessons for our readers. These include:

  • Benchmarking of Rates and Levels of Service—We typically undertake this exercise at the end of the assignment to provide local decision makers with an idea of how their agency matches up with sister communities. It is important to ensure that this benchmarking survey is conducted in a way to provide an “apples to apples” comparison, otherwise the results are meaningless.
  • Reserve or “Rainy Day” Funds—There is no standard financial policy for reserve funds of enterprise systems. However, we have found that “best in class” solid waste systems have established financial policies to reserve an annual minimum of 15 to 25 percent of the operating expenses of the agency. This kind of reserve policy enables the agency to have the financial wherewithal to fund recurring operational expenses such as fleet replacement, weather emergencies or Acts of God. This is a prudent financial policy in our experience.
  • Scenario Analysis—We do most of our rate analysis assignments using Microsoft Excel providing the client with this non-proprietary software after the conclusion of the study. Excel offers a Scenario Modeling Module that allows numerous “what-if” comparisons. This is a wonderful tool. It is important to recognize, however, that, while using the module, dozens or more comparisons can be developed, but it is oftentimes difficult to communicate all these comparisons to political decision makers. Consequently, we have used the rule of simplicity in providing model comparisons to our clients.

An Essential Tool

As indicated previously, cost of service studies are an essential tool in managing a solid waste agency in these uncertain times. With experience in more than 50 such financial studies in recent years, it is our opinion that they provide opportunities for introduction of smart technologies, cost optimization, improved customer service and long-term financial planning. The customized models developed in these studies can help decision makers in analyzing operational outcomes and key performance indicators and comparing the financial results to industry benchmarks.

WIH Resource Group’s Team of experts provide in depth solid waste cost of service studies utilizing proprietary Pro Forma Models that are customized for individual clients.  CLICK HERE to contact the team to learn more about how we can assist you or call 480.241.9994 or email us at admin@wihrg.com

Posted by: WIH Resource Group

ABOUT WIH RESOURCE GROUP, INC. (WRG)

WIH Resource Group is global leader providing of diversified environmental (solid waste management consulting, recycling and M&A consulting), financial, expert witness services, transportation / logistics consulting solutions to its Clients throughout North America and internationally.

WRG provides solutions to complex challenges to its clients in the areas of environmental, alternative fuel fleet conversion studies, customer satisfaction surveys, fleet management matters, equipment and assets valuations, mergers & acquisitions (M&A), landfill gas management, renewable energy, waste & recycling collections, business process improvement, procurement services assistance, waste management operations, recycling processing, transfer stations, operational performance assessments (OPAs), recycling facilities (MRFs) studies, transportation and other feasibility and related financial analysis.

Formed in 2005, WRG’s Team consists of subject matter experts from the waste, recycling, alternative fuels, and transportation industries from both the public and private sectors.  WRG’s Team of experts have over 150 years of combined experience.

CLICK HERE to learn more about the rest of the Team of subject matter experts at WIH Resource Group.

For more information about WIH Resource Group’s diversified client services, and how we can best serve you, visit www.wihrg.com

Contact us today to see how we can best serve you at 480.241.9994 or admin@wihrg.com

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