For utility managers, it can be challenging to do the right thing even in good times, but in bad times, it?s nearly impossible. The outcry from public officials, rate payers and other stakeholders about rate increases, capital spending and non-essential operational costs are particularly loud when times are tough. It is hard not to be keenly aware that the prevailing public opinion is to delay capital improvement projects until times get better and managers are naturally tempted to comply with the demands of the crowd. Delaying needed improvements is generally a bad idea, but right now it is a REALLY bad idea due to the financial climate, which has little to do with day-to-day utility management.
The ?sky is falling? approach to management is popular right now, but it bears remembering that following the prevailing opinion is often not prudent, as those who invested in leveraged real estate in the early 2000s can attest. In reality, delaying needed capital projects exposes utilities to additional risk from failing or underperforming infrastructure, increased operations and maintenance costs, and most likely significantly higher borrowing costs in the future.
Everywhere you look in our industry, good projects are being shelved, and typically it is due to political rather than practical considerations. Most of these projects are very much in the financial interests of ratepayers and the delay will end up costing them far more in the long-run. The rush to curtail capital spending is both short-sighted and ill-timed. It is short-sighted because many of the delayed projects are directly tied to reductions in operating and maintenance costs, or improvements to levels of service. It is bad timing because borrowing money is cheap right now ? incredibly cheap.
The true cost of borrowing money right now is lower than it has been in over a generation. The Federal Reserve?s current prediction for inflation over the next 12 months is 3.9 percent and that over the past 20 years, inflation has averaged around 3 percent annually. Realize that when money is borrowed at a rate lower than inflation, the borrower is (in effect) being paid to use the lender?s money for the period of the loan.
There are a series of factors that have driven municipal bond interest rates so low: actions by the Federal Reserve, trouble with euro-zone economies and municipalities not issuing historical levels of debt. None of these factors impact day-to-day utility management, but their combined effect on the bond market presents an exceptional borrowing opportunity. Utilities that proceed with borrowing at current rates are likely to have a near-zero or negative real cost of borrowing over the life of their loans.
Similar market conditions haven?t occurred since at least the 1940s and, while no one can predict the future, it is extremely likely that rates will eventually return to historical levels. Since reversion to historical levels makes projects substantially more expensive on a real dollar cost basis, prudent management practices necessitate that utilities proceed with needed projects. This is especially true for projects that offer operational cost savings or that are required by regulators to address health, safety and environmental requirements.
Regardless of near-term market direction, there are several points worth noting to best understand current market conditions. Municipal bond interest rates have historically trended about 1 – 1.5 percent higher than the actual rate of inflation. Current conditions have rates about 1.5 percent below expected inflation. Reversion to historical levels will add 10 to 15 percent to the true cost of any project completed in normal financing conditions. In the event that inflation increases above current expectations, this cost increase will be magnified.
So, how should utility managers advance their projects given the challenging political conditions?
Identify projects that will offer the biggest reductions to operational and maintenance costs, and show the expected savings to stakeholders.
Explain the risks associated with deferring projects (sewer back-ups, compliance violations, environmental damage, safety issues, etc.), and quantify these risks when possible.
Evaluate and present projects to stakeholders with an assessment of ?pay-back period.?
Be prepared to advocate for the project and show why it is financially, a smart time to proceed.
Acknowledging the current political challenges of doing the right thing, current bond rates make construction on long-term capital projects more cost effective than at any time in the recent past. Being an effective utility manager means advocating against delaying needed capital improvements. ?
Remembering how we all ?almost bought? Apple stock in 2003, everybody likes to point out exceptional opportunities in hindsight, but good managers recognize and take advantage of them as they arise.
Managers who defend needed projects will be doing the right thing by their utility and its customers. The evidence bears this out!
Toby Fedder, P.E., is an associate with Woodard & Curran. He has over 18 years of experience in environmental consulting and financial management. In addition to providing project management for potable water system projects, he leads Woodard & Curran?s enterprise fund/utility management consulting and rate setting services. Fedder also sits on the NEWWA Financial Management Committee.?
