Pay Them in Water

Paying obligations in water (or sewer service, or natural gas or whatever it is that you sell) ? that?s just the old barter system, right? Yes. But it is so much more. It will save or make your utility a lot of money, if done right.

When should you pay in water?

When the city or system gets sued and loses. Or, settlement is made out of court because that will cost less in attorney?s fees, other costs and ?hassle factor.?

When purchasing an expensive product or service locally, like trucks, cars, backhoes and fuel. What do you buy locally that costs a lot of money from vendors that are large purchasers of your services?

To pay a developer to build oversized lines and a pump station that will serve their development?s needs plus the needs of future development in that area. Thus, the system will be able to sell that capacity at a profit while saving future developers money.

When the system over-charged a customer or otherwise owes a big refund or payment.
When the XYZ Corporation wants to set up shop in the system?s service area and employ lots of local people if the company can just get free or cheap utility service.

Why not just stick with the tried and true, ?Just write them a check? strategy? When the payout is small, that?s exactly what you should do. But when the payout is big, giving free or cheap water can save the system money or make a profit. How can you pull this off?

Consider the example in Table 1. This is a simplified presentation of an actual lawsuit situation, with details changed to protect the litigants. A water customer of Wagon Trail City, let?s call him ?Mr. Gold Digger,? sued the city for overcharging him. Mr. Digger had a solid case so the city settled out of court. Through shrewd negotiation Mr. Digger got the city to pay him $50,000. Through shrewd negotiation, the city got Mr. Digger to take that payment in the form of free water, charged at his regular unit rate. Table 1 shows how the average and marginal costs of production are calculated. The difference between the two types of costs determines the system?s cost savings rate from paying in water.

The table shows the amount of each operating cost item as well as the part of each cost that is considered fixed. Fixed costs are rarely related to the marginal cost of production. Therefore, these costs should be paid by customers in the minimum charge and not be considered in the marginal cost calculation.

After deducting the fixed costs (and disregarding a few others), variable costs remain. These go into the calculation of the average and marginal costs to produce. Only part of the variable costs can reasonably be considered marginal costs.

As you can see in the table, in the column with the heading ?Marginal Cost to Produce Percentage,? the item called ?Water Purchased? is considered to be a 100 percent marginal cost. That is because when the city pays its wholesale water supplier, it will have to pay just as much for water the city will give away as it will for water it will sell. If, however, the city produced its own water, some of the production costs may not be marginal costs.

?Chemicals? and ?Electric for Pumping Water? costs are also directly linked to the volume produced. However, the item called ?Plant Maintenance-Supplies? is estimated as a 10 percent marginal cost item. That means that to produce the give-away water the city will incur a small unit cost for this item.

Notice the item called, ?Maintenance Salaries, Benefits, etc.? This is the cost of operations staff; a large variable cost for the city. But none of this cost is considered to be a marginal cost in this case. That is because the marginal volume to be produced and given away is small enough that the operations staff will not have to do any extra work to produce the extra volume.

It should be clear that different systems have different types and levels of marginal costs. Even the same
system?s marginal costs change with time and production level so it is a moving target.

Back to the calculations: the marginal cost per 1,000 gallons is calculated by totaling the amounts in the right-most column of the table and then dividing that by the total billable units of volume used for the year. The marginal cost for Wagon Trail City is $1.39 per 1,000 gallons as compared to an average cost to produce of $8.01. In other words, the marginal cost is only 17 percent as much as the average cost. This cost difference is a big cost savings or even a profit opportunity for the city.

The last step is to calculate the out-of-pocket cost to the city, and to its ratepayers, for giving Mr. Digger $50,000 worth of water for free. That is shown in Table 2.

If the settlement was paid out in cash and all users? rates had to go up for one year to cover that cost, the unit charge would have to go up by $2.10 per 1,000 gallons. That would make lots of customers mad.
However, by paying the settlement in free water at a marginal cost rate of $1.39 per 1,000 gallons, user rates would only have to rise by $0.36 per 1,000 gallons. By paying with water the system will save $41,330 of the $50,000 settlement. That?s a huge savings!

Unless Mr. Digger is a large water user, he cannot use 6,240,000 gallons of water in one year. Therefore, this payout will probably stretch out over several years. If, for example, it took five years to use this volume, the unit charge hit would go down to about $0.07 per 1,000 gallons. Even if Mr. Digger could use 6 million gallons of water in one year, the city still may want to stretch out the free water settlement for five years just to reduce the price increase to the system?s users or the hit to the system?s reserves if rates are not increased.

Let?s consider a different situation where you can use the same strategy to make a profit. The XYZ Corporation will move to town if it can buy water at a steep discount. If XYZ?s hotshot negotiator talked the city into a $2.00 per 1,000 gallons unit charge the company would save $6.01 per 1,000 gallons on a retail cost basis. The negotiator would probably get a big bonus from XYZ and the company would consider it a big coup to move to your town. If the timeframe of the deal was short enough and the company?s flow was low enough, the city would still make a profit of $0.61 per 1,000 gallons on a marginal cost basis ($2.00/1,000 rate minus $1.39/1,000 marginal cost). And, the other ratepayers would not be hurt because the costs of providing service to XYZ would all be covered by the $2.00 unit charge the company would pay. Everyone wins!

Finally, let?s consider a ?small time? money saving opportunity that can give you other benefits, too. Your system has a contract with a local convenience store to purchase fuel, oil and other minor vehicle supplies. This store also has a carwash that you have told staff to use only if their vehicle gets especially dirty. You want to hold down costs. Because of the carwash this store is a fairly large water and sewer user. This situation presents an excellent savings opportunity for your system by giving water and sewer service in exchange for things you purchase from the store.

Now, you may not get the store to accept payment in water service at the regular retail price. After all, the store probably gives you a discount on your purchases, too. But even at a discounted water price, by paying in water you still should be able to save one-half to three-quarters compared to paying in cash. That means if a carwash is $6.00 in cash, it will be, say, $2.00 in water.

You only get a few chances to give the public a good impression about how well you are maintaining ?their? equipment. While some think that a muddy service truck means that the crew is hard at work, many others see it as a sign of poor maintenance. More frequent carwashes at $2.00 are a cheap investment toward making a good impression. And when is it especially important that you have already filled the impression bank with good impressions? When you ask the ratepayers to approve new debt for expensive capital improvements and when you ask for higher rates. A few of these small investments might produce some really big returns, and clean vehicles, too.

Now that you have seen how easy it is to make or save money by giving away free or cheap water, you are probably thinking, ?OK, what?s the ?catch???

Actually, there are several ?catches? and some could haunt you if you are not careful:

Any time you are presented with the opportunity to pay out a substantial settlement or debt with free water, or sell at a discount, there are legal implications. You need a good water law attorney to advise you. Legal fees add to the marginal costs of doing the deal so at some fee level, there just is not enough money to be made or saved.

The financial calculations will be more complex than were illustrated here so you need a good rate analyst. If you are not a rate analyst, get one. An analyst?s fees have the same effect as legal fees.

Giving away free or cheap water is a slippery slope. Do it once without clear and hard policy limits on the practice and lots of others will line up for an even better deal. Should you go one step further and sell water below the marginal cost to produce? Doing so might be warranted (economic development, increase taxable property) but the payback better be substantial, measurable and sure.

If your system purchases water and the cost of that water is relatively high, the marginal cost will be relatively high, too. That will markedly reduce your savings potential when giving free or cheap water. The same is true for all other costs that are directly linked to production.

If your system has plenty of capacity to produce and distribute free water you can safely do so at a cost basis above the marginal cost to produce. However, if during the time you will give away water you will have to build extra capacity, the math will change completely. Span this event and you could end up losing serious money if the marginal costs jump up more than the price you settled upon.

If a settlement that includes free water will go on for several years, inflation will happen. Inflated costs will eat into the initial savings or profit margin. If cost increases are great enough and the free water deal stretches out long enough, it would actually be cheaper to pay the settlement in cash on the front end unless you have a cost basis adjustment factor built into the deal. Therefore, your cost calculations need to look forward, not backward.

If you are facing a lawsuit you will incur legal and other costs as a result, regardless of how the issue is resolved. Those costs will be a blend of fixed, variable and marginal costs. Therefore, you will need to add these costs into your cost mix to calculate the average and marginal costs before arriving at a settlement amount. Otherwise, you could end up giving away more than you intend.

Paying in water can be complex and risky. But it is well worth looking into because it can make or save tens of thousands of dollars for small systems and hundreds of thousands for large ones. It is also likely that your other customers would prefer you pay someone off with free water rather than write them a big check.

Within the next five years, maybe next month, your city or system will probably face a Mr. Digger or XYZ Corporation situation. If the dollar amount is small, just ?pay the man? and be done with it. But if the amount is large enough and the conditions are right you could pay with water, give the other party what they want and pass big savings or even a profit onto your ratepayers. Wouldn?t that be a nice change of pace?

Carl Brown is President of Carl Brown Consulting, LLC, specializing in water, sewer and storm water system rate analysis and asset management as well as training nationwide; and GettingGreatRates.com, home of many rate setting tools. Contact: (573) 619-3411; carl@carlbrownconsulting.com

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