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Regulation 101Regulation 101
A Primer for the
Edmonton City Council
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Today’s Topics
• Understand regulatory accounting– Principles– Terminology and reports– How the SU develops rates, increases
• Understand the choices to be made– Questions to ask– Alternatives to consider– Impacts
• High level questions– Goals and process of regulation– Utility fiscal policy
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What We Will Analyze
• Concentrate on the Sanitary Utility– Larger, older utility– Can discuss Land Drainage Utility if desired
• Initial focus on budget for 2006– Basis for approving current rates– Note that process involves longer-term view – See how different assumptions affect the results
• Review budget vs. actual 2005 results– Understand the financial reports– Think about the implications
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The Financial Fundamentals
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Basic Accounting Statements
• Operating statement (or “income statement”)– Revenues and expenses for an accounting period– Usually for a calendar year
• Balance sheet– Assets equal liabilities + equity– Stated as of a date, usually end of the year
• Cash position– Change over the year (like operating statement)– Includes financing (+) and investment (-)
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Operating Statement - 2005
Budget
Revenues $93.8
Expenses
Operations 46.0
Depreciation 10.7
Franchise fee 7.1
Interest 9.7
Subtotal 73.5
Net income $20.3
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Revenues
2005
Rates
Rate charges* $85.1
Other charges* (e.g., overstrength)
3.5
Outside revenue 5.2
Total $93.8* Subject to Franchise Fee
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Operation & Maintenance Expenses
• Labour
• Supplies
• Chemicals
• Power
• Insurance
• Central management fees
• Billing expense
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Depreciation Expense
• Applies to expenditures on assets– Items that will be used over several years
– Written off (expensed) over their useful life
• Electronic and lab equipment: 5 years
• Office equipment & furniture: 6.67 years
• Buildings, wastewater treatment plant: 44 years
• Mains, pump stations: 75 years
• Land: Not depreciated
• Annual amount called “depreciation”/”amortization”
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Calculating Depreciation Expense
Year Investment / life 1954 1955 1956 1957 ... 2006 2007
1954 $1 500 000
1954
1955
1955
1956
1956
…
2005
2005
2006
2006
2007
2007
Total
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Calculating Depreciation Expense
Year Investment / life 1954 1955 1956 1957 ... 2006 2007
1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000
1954
1955
1955
1956
1956
…
2005
2005
2006
2006
2007
2007
Total
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Why Depreciation is a “Non-Cash Expense”
Year Investment / life 1954 1955 1956 1957 ... 2006 2007
1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000
1954
1955
1955
1956
1956
…
2005
2005
2006
2006
2007
2007
Total
An expense is recorded in each of these years—
but there is no cash outlay
The cash was spent in this
year
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Calculating Depreciation Expense
Year Investment / life 1954 1955 1956 1957 ... 2006 2007
1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000
1954 $120 000 / 10 12 000 12 000 12 000 12 000 -- --
1955
1955
1956
1956
…
2005
2005
2006
2006
2007
2007
Total $32 000
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Calculating Depreciation Expense
Year Investment / life 1954 1955 1956 1957 ... 2006 2007
1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000
1954 $120 000 / 10 12 000 12 000 12 000 12 000 -- --
1955 $600 000 / 75 8 000 8 000 8 000 8 000 8 000
1955 $40 000 / 8 5 000 5 000 5 000 -- --
1956
1956
…
2005
2005
2006
2006
2007
2007
Total $32 000 $45 000
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Calculating Depreciation Expense
Year Investment / life 1954 1955 1956 1957 ... 2006 2007
1954 $1 500 000 / 75 $20 000 $20 000 $20 000 $20 000 ... $20 000 $20 000
1954 $120 000 / 10 12 000 12 000 12 000 12 000 ... -- --
1955 $600 000 / 75 8 000 8 000 8 000 ... 8 000 8 000
1955 $40 000 / 8 5 000 5 000 5 000 ... -- --
1956 $3 825 000 / 75 51 000 51 000 … 51 000 51 000
1956 $160 000 / 10 16 000 16 000 … -- --
…
2005 $6 000 000 /75 80 000 80 000
2005 $240 000 / 8 30 000 30 000
2006 $15 000 000 / 75 200 000 200 000
2006 $1 380 000 / 10 13 800 13 800
2007 $12 000 000 / 75 160 000
2007 $830 000 / 20 41 500
Total $32 000 $45 000 $68 250 $94 560 $9 256 023 $9 386 228
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Balance Sheet
• Assets = Liabilities + Equity • Assets are “things owned”
– Facilities, equipment (net of depreciation write-off)– Cash– Receivables (cash not yet received)
• Liabilities are “things owed”– Debt (to debt holders)– Payables (bills not yet paid)
• Equity is the owner’s value– Retained earnings– Contributed capital (including SSSF)
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Financed and Contributed Assets
Actual at 2005-Dec-31 Financed Contributed
Original cost $524.2 $386.7
Accum. depreciation 137.5 52.9
Net book value $386.7 $333.8
• “Financed” assets – Financed by debt and retained earnings
• “Contributed” assets– Assets transferred from the City in 1954– Assets funded by contributions
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Balance Sheet: Assets
As of December 31 (actual) 2004 2005
Investment in facilities
Facilities - financed (net cost) $352.3 $386.7
Facilities - contributed (net cost) 294.5 333.8
Cash and deposits 52.5 44.6
Cash in SSSF 42.5 51.9
Accounts receivable 11.5 18.5
Misc. (inventory, etc.) 1.7 1.9
Total assets $755.0 $837.4
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Balance Sheet: Liabilities + EquityAs of December 31 (actual) 2004 2005
Liabilities
Long-term debt $167.8 $176.1
Accounts payable 11.2 15.7
Miscellaneous 3.2 4.7
Total liabilities 182.2 196.5
Equity
Contributed capital 294.5 333.8
Retained earnings - reinvested 183.2 210.7
Retained earnings - to be invested 52.5 44.6
SSSF balance 42.5 51.9
Total equity
Grand total $755.0 $837.4
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Sanitary Servicing Strategy Fund
• SSSF is a separate fund– Separate board– Funds used only for designated projects
• SSSF plans through 2074• SSSF collects mostly from developers • SU interaction with SSSF
– SU pays $2.6 million to SSSF– SSSF pays SU for some projects
• $1.9 million in 2004• $23.0 million budgeted for 2005• $7.0 million in 2005
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SSSF Funding - 2004
Balance at year-end 2003 $30.2
Funds received from others 10.9
Payment from SU 2.6
Interest earned 0.8
Capital expenditures -1.9
Balance at year-end 2004 $42.5
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SSSF 2004 Revenues
Source: SSSF 2004 Annual Report
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Capital Structure
• Split of capital between debt & equity (2005)
$M %
Debt $176.1 42%
Equity 255.3 58%
Total $403.5 100%
• Typical regulated: 65%/35% to 50%/50%• Wider variation for municipal utilities
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Return on Equity (RoE)
• Definition: Net income ÷ Retained earnings– UFP uses retained earnings at start of year– Usual definition is average retained earnings
• Details of definition– UFP uses earnings after dividend payment– Usual definition is before dividend payment– UFP states RoE before SSSF payment
• Comparison with others– Typical regulated value is 8.5% - 11.5%– Most drainage utilities have no stated target
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Return on Equity Calculations
UFP Method Standard Method
2005 2006 2005 2006
Net income $20.3 $18.9 $20.3 $18.9
Less SSSF (2.6) (2.6)
After SSSF 17.7 16.3
Dividend (5.0) (5.5)
After dividend 12.7 10.8
Retained earnings $235.7 $255.3 $235.7 $255.3
Return on equity 5.4% 4.2% 8.6% 7.4%
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Income vs. Cash
• Operating income “cash income”• Not all cash receipts are income
– Borrowed money is not income
• Not all cash payments are expenses– Repayment of borrowing is not an “expense”– Asset purchases only partly expensed
• Timing differences– Revenue booked before cash received (billed in Dec.,
paid Jan.)– Expenses booked before bills paid– These are end of year differences, usually small
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Cash Statement - 2005
BudgetNet income $20.7
+ Depreciation expense 10.3
- Dividend -5.0
= Cash from operations $26.1
- Paid into SSSF -2.6- Debt repayment -13.8
+ Contributions (incl. SSSF) 31.8
+ New debt 35.2
- Investment in facilities -81.2
Change in cash balance -$4.6
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Financial Statements - Review
• Income statement– Shows the operating profit for the year– Shows the depreciation write-off amount for the year
• Cash statement– Shows investments, financing for the year– Part of financing comes from year’s income
• Balance sheet– Shows the total of all past results at a given date
(Income, investments, financing, accrued depreciation)
– Changes in balance sheet totals reflect above two reports
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Setting Next Year’s Rates
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The Basic Income Equation
Revenues
- Operating expenses
= Net income
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The Basic Regulatory Equations
Operating expenses
+ Target net income
= Revenue requirement
(also called “cost of service”)
Revenue requirement
- Revenue at present rates
= Rate increase
#1
#2
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Revenue Requirement - 2006
Expenses Budget
Operations $48.3
Depreciation 11.2
Franchise fee 7.3
Interest 11.3
Subtotal 78.1
Target net income ??
Revenue requirement ??
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What Determines Target Net Income?• Past investments (current book value)
– Equity investors require a market-based return• Fairness• Need to attract future equity capital
– Debt holders require safety and repayment
• Future investment– Muni, Crown: cannot raise outside equity– Not all investment can be funded by debt– Borrowing restrictions– Not wise to borrow to the hilt
• Cushion and smoothing– Cover unfavourable variances– Keep annual changes smooth and moderate
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Determining Required Earnings
• Utility boards focus on existing investment– Most experience with investor-owned utilities– Fair return determined by market– Future investment can be financed externally– Hard for them to change methods– Current ≈ 10% return on equity
• Other WW utilities have wide range of earnings• City Council approach
– Utility Fiscal Policy– Based on needs of each utility
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Current Utility Fiscal Policy
A. 6% return on opening equity
B. 40% of earnings paid as dividend by 2014
C. Up to 35% of additions financed by earnings
• A + B = 10% return on equity
• C gives different answer than A + B
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Earnings Required By UFP
• 6% return (after 40% dividend) = $28.1 M
• 35% financing from retained earnings = $39.1 M
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Revenue Requirement - 2006
Expenses
Operations $48.3
Depreciation 11.2
Franchise fee 7.3
Interest 11.3
Subtotal 78.1
Target earnings 18.9
Revenue requirement $97.0
Revenue @ present rates 93.8
Increase needed $3.2
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Revenues
Previous Rates
New Rates
%
Change
Rate charges* $85.1 $87.4 2.7%
Other charges* (e.g., overstrength)
3.5 3.5 ―
Outside revenue 5.2 6.1 17.3%
Total $93.8 $97.0 3.4%* Subject to Franchise Fee
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Questions
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What Do PUBs Regulate?
• Operating expenses– Allowed operation and maintenance costs– Depreciation rates
• Investment– Investment on which return is allowed
• Earnings– Capital structure– Return on equity
• Rate structure
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What Does Council (Want to) Regulate?
• Budget• Capital program
– Timing of some programs– Affects future costs
• Interest• Depreciation
• Earnings– Net income– Dividend
• Capital structure• Timing of rate increases (?)• Rate structure (?)
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Setting Rates – The Long Term View
• Review– Have examined revenue requirement for 1 year– Investment and financing decisions affect future
• Looking only at next year can cause problems– Rates not predictable– Large increases in some years– Less financing flexibility
• SU has used 20 year forward look– More sophisticated than most other utilities– Gives SU and Council more flexibility
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Overview of Rate Setting Process
Construction,Capital Needs
Expenses + Net Income = Required Revenue Rate Increases
Target Net Income(Retained earnings)
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Steps in Rate Setting ProcessConstruction
Operating costs
Capital Required
Funded by debt
Funded by earnings
+
Required revenue=
Rate increaseIncrease too big?
Interest cost increases operating expense
Reconsider construction plans or UFP
Contributions, SSSF
-
=
=
-
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Construction Forecast
• Forecast of project additions by year• 20-year forecast• Some investment required by legislation• Council policy determines some timing
– Mature neighbourhood program– Planned rehab vs. emergency rehab
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Construction Financing
• Sources of capital– SSS Fund (Sanitary Utility)– Contributions and grants– Debt (debentures)– Retained earnings (retained cash)
• Debt subject to constraints – Certain assets don’t qualify (design, equipment)– Financial tests
• Current year decisions affect future flexibility
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Construction Expenditure ForecastProject Fund
Source
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Gold Bar WWTP rehab SLD $0.5 $1.1 $4.6 $.2 $.1 $-- $-- $-- $-- $--
RET 1.2 2.2 1.9 1.9 1.9 2.0 2.0 2.1 2.1 2.1
Gold Bar Upgrade SLD 10.5 17.8 8.6 1.4 .2 .2 0 0.4 1.4 7.7
“ “ “ RET 0.8 0.1 -- -- -- -- -- -- -- --
Mature Neighbourhood rehab SLD .9 1.2 5.1 5.7 9.3 7.6 8.0 8.4 6.5 5.5
“ “ “ RET 5.0 7.2 6.0 6.0 3.0 0 0 0 2.3 3.8
Flood Prevention RET 5.2
“ “ Schg 1.7 4.7 .6 2.2 3.5 3.5 3.6 3.7 3.7
WESS Stage 1 SSSF 10.3 6.0 . . .
. . .
. . .
. . .
. . .
. . .
. . .
. . .
. . .
. . .
. . .
. . .
Total $96.4 $89.2 $82.2 $67.4 $57.4 $41.3 $34.7 $44.1 $67.9 $69.5
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Construction Financing Plan
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Total project expenditures $96.4 $89.2 $82.2 $67.4 $57.4 $41.3 $34.7 $44.1 $67.9 $69.5
Funded by contributions/
SSS Fund
33.5 28.0 18.9 20.2 22.5 8.5 2.6 3.3 20.1 19.9
Financed by debt 43.9 42.4 42.9 31.6 20.9 19.5 19.4 27.8 32.0 32.5
Financed by earnings $18.9 $18.7 $19.3 $15.5 $14.0 $13.3 $12.8 $13.0 $15.8 $17.1
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Debt Financing Constraints
• Constraints on borrower– ACFA constraints– Borrower is the City
• Constraints based on type of investment– Only certain projects/costs qualify – Not for design, equipment
• Constraints created by cash needs– Interest– Debt principal repayments
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Debt Constraints
• ACFA constraints on City– Debt principal < 2 times revenue– Debt service (interest + principal payment) < 35% of revenue– Utility can exceed because City borrowing is low
• Difference between debt life and asset life
– Some assets depreciated over 44-75 years
– Associated debt has maximum 25 year term
– Debt being paid off faster than recovery of cost
– Can create cash flow problem
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Variables for Council to Decide
• Return on equity• Dividend to City• % funding from debt vs. retained earnings• Target capital structure • Pattern of rate increases• Cash balances• Let’s look at some scenarios
– #1: Current SU plan– #2: Increase dividend to 50%– #3: Maximize use of debt
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Financial Results – Current Plan
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Revenue $97.7 $106.3 $110.9 $115.7 $120.7 $126.0 $131.4 $137.0 142.8 148.9
Expenses 78.1 84.0 87.8 90.7 93.0 95.0 97.1 99.3 101.1 104.1
_________ _________ _________ _________ _________ _________ _________ _________ _________ _________
Net income 19.6 22.2 23.1 25.0 27.7 30.9 34.3 37.7 41.7 44.7
Dividend payment $5.8 $6.1 $6.2 $6.1 $6.3 $8.5 $9.5 $14.0 $15.6 $16.9
Debt service/revenue 24.8% 25.1% 26.7% 28.6% 29.4% 29.4% 29.4% 30.1% 30.8% 31.0%
Debt/revenue 2.2X 2.3X 2.5X 2.5X 2.4X 2.3X 2.2X 2.1X 2.1X 2.0X
Cash balance $41.3 $34.3 $26.6 $22.6 $21.3 $20.7 $22.0 $20.1 $15.7 $12.1
Cash needed
for construction$18.3 $18.9 $19.5 $13.8 $14.1 $12.9 $12.7 $13.1 $16.9 $17.2
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Financial Results - Dividend @ 50%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Revenue $97.7 $106.3 $110.9 $115.7 $120.7 $126.0 $131.4 $137.0 $142.8 $148.9
Expenses 78.1 84.0 87.8 90.7 93.0 95.0 97.1 99.3 101.1 104.1_________ _________ _________ _________ _________ _________ _________ _________ _________ _________
Net income 19.6 22.2 23.1 25.0 27.7 30.9 34.3 37.7 41.7 44.7
Dividend payment $8.5 $9.8 $10.3 $11.2 $12.5 $14.2 $15.9 $17.6 $19.5 $21.1
Debt service/revenue % 24.8% 25.1% 26.7% 28.6% 29.4% 29.4% 29.4% 30.1% 30.8% 31.0%
Debt/revenue 2.2X 2.3X 2.5X 2.5X 2.4X 2.3X 2.2X 2.1X 2.1X 2.0X
Cash balance $38.6 $27.9 $16.1 $7.0 ($0.6) ($6.8) ($11.9) ($17.3) ($25.6) ($33.5)
Cash needed
for construction
$18.3 $18.9 $19.5 $13.8 $14.1 $12.9 $12.7 $13.1 $16.9 $17.2
•Dividends 2007-2015 increase from $90.2 M to $132.0M
•But not enough cash for construction by 2008
•Will need larger increases
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Financial Results – Maximum Debt Use2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Revenue $97.7 $106.3 $110.9 $115.7 $120.7 $126.0 $131.4 $137.0 $142.8 $148.9
Expenses 78.1 84.5 89.0 92.5 95.1 97.4 99.6 102.0 103.9 107.1_________ _________ _________ _________ _________ _________ _________ _________ _________ _________
Net income 19.6 21.7 21.9 23.2 25.6 28.5 31.8 35.0 38.9 41.8
Dividend payment $5.8 $5.9 $5.8 $5.7 $5.7 $7.8 $8.8 $13.0 $14.5 $15.7
Debt service/revenue % 24.8% 26% 28.9% 32.1% 33.7% 34.6% 35.5% 36.7% 37.9% 38.6%
Debt/revenue 2.3X 2.5X 2.8X 2.8X 2.8X 2.7X 2.7X 2.6X 2.6X 2.5X
Cash balance $50.0 $54.8 $58.1 $61.3 $65.8 $69.3 $73.0 $72.0 $69.5 $67.9
Cash needed
for construction
$5.9 $6.2 $6.2 $4.1 $3.2 $3.3 $3.2 $4.5 $4.9 $5.0
•Dividends 2007-2015 decrease from $90.2 M to $72.9 M
•Cash balance very high; suggests a possible rate decrease
BUT
•Debt service expense > 35% of revenue
•Debt to revenue ratio stays too high
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Questions
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Reviewing the Results
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Reviewing the Results
• How did the utility perform?– Satisfactory results?– Relative to budget
• Review accounting reports– Operating statement (revenues & expenses)– Cash flow– Balance sheet
• Improve regulatory oversight– Better understanding– More confidence
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Operating Statement - 2005
Budget Actual
Revenue $93.8 $99.8
Expenses
Operations 46.0 46.5
Depreciation 10.7 10.1
Franchise fee 7.1 7.1
Interest 9.7 8.8
Subtotal 73.5 72.5
Net income $20.3 $27.3
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Cash From Operations - 2005
Budget Actual
Net income $20.3 $27.3
+ Depreciation expense +10.7 +10.1
- Debt repayment -17.3 -13.8
- Dividend -5.0 -5.1
- Paid into SSSF -2.6 -2.6________________________ ________________________
Cash from operations $6.1 $15.9
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Questions
61
Looking Ahead
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High Level Issues
• Council’s regulatory process– Goals – Aspects of regulation
• Reviewing the Utility Fiscal Policy
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Goals of Regulation
• Equity and efficiency– Reasonable total costs– Allocation of costs among customers
• Accountability– Utility decisions and proposals– Regulators’ decisions
• Transparency– Information– Process
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Aspects of Regulation
• Structure – who evaluates utility proposals and suggests Council action?
– City Council as a whole?– City Council committee? TPW?– Oversight board?
• Criteria – what are the criteria for decisions?– Financial: main criterion is cost of service– Economic: impact on customers
• Process – what procedures are used?– Information flow– Public participation
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Reviewing the UFP
• What are the goals?– Level of rates– Income to City– Appropriate financing of future investment
• Suggestions– UFP should be specific to needs of SU and LDU– There is no one “best” UFP
• Different for SU, LDU• Results will depend on interest rates, capital needs
– Have Drainage Services evaluate impacts
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Practice in Other Cities
• Most are similar Edmonton in structure
• Some have advisory councils
• Few use long-term planning like SU
• Details in the notebook
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Questions