Rate of return for municipal enterprise funds: the case of Rock Hill, SC.

Grigsby, William W. ; Parker, Darrell

MUNICIPAL SERVICES AND ENTERPRISE FUNDS

Local Governments often undertake the delivery of utility services through the operation of publicly owned utilities within the framework of an enterprise fund. Among the most common type of enterprise is the municipally owned electric company. Other common utilities provided include water and sewer services. The revenues, expenditures, and debt associated with owning and operating these enterprises pose a significant public finance concern for municipalities. The activities of a municipality that are intended to operate in a manner similar to a private business are accounted for in a separate fund known as an "enterprise fund." It is the intent of this separate fund to permit the treatment and operation of publicly owned enterprises to obtain accounting information similar to that available for their private counterparts.

For a municipal utility, surplus revenues can be transferred from the enterprise fund to the general fund to subsidize other operations. The extent to which the municipality is free to generate profits and transfer them to other uses will vary depending on the state regulatory environment. In South Carolina, municipal utility rates are not governed by statewide regulatory rules. Municipalities can set and change rates without regard for the regulatory bodies governing investor owned utilities. Unfortunately, this encourages the practice of adopting transfer policies to be heavily influenced by political concerns, rather than the underlying foundations of economics and governmental accounting.

One alternative that provides discipline for local government is the adoption of a policy determining the level of transfers. If a private utility were operating within the City limits, it would be required to pay franchise fees and taxes. In addition, the utility owners would have earned a rate of return on their investment. Rate of return policies when adopted would typically claim to base rates and generate transfers to achieve a fair rate of return. This case highlights the rate of return and transfer policies adopted in Rock Hill, SC. The diverse pressures facing the city operated electric, water, and sewer systems provide insight into the managerial accounting issues for municipalities.

When a governmental unit engages in activities that sell services to the general public, the unit reports on such activities with a "proprietary fund type," specifically an enterprise fund. As the name suggests, this type of fund or activity is accounted for in the same manner as a privately owned business. Such funds use full accrual accounting and account for all assets, current and long lived, used in the generation of the revenue of the fund. The standard setting body for governmental accounting in the United States is the Governmental Accounting Standards Board (GASB). This board's statement on enterprise fund accounting can be summarized simply: "In order to take advantage of the work done by regulatory agencies and trade associations to develop useful accounting information systems for investor owned enterprises, it is recommended that governmentally owned enterprises use the accounting structures developed for investor-owned enterprises of the same nature." [2, Statement No. 20]

Investor owned utilities are normally regulated by the states in which they operate. The rates for charges for services are approved by the individual state's regulatory agency. The normal process is for the regulatory agency to allow charges that will provide a given rate of return on the utility's investment. The approach to the analysis is to compare the income for a certain period, six months to a year, prior to the rate setting hearing with the costs of the property used and to be used within a reasonable time. Usually adjustment are made to the reported income for interest, or rate of return, on equity; for refunds to consumers as a result of rate hearings; the cost of legislative-advocacy expenses; business gifts and some entertainment expenses; and other expenses that such regulatory agencies determine not to have been prudently incurred or not incurred in the interest of the public. Additionally, the utility investment amount used in the analysis, the rate base, will not include the carrying value of property donated to the utility, and depreciation expenses on such property will not be include in the allowable expenses.

MUNICIPALLY OWNED ELECTRIC COMPANIES IN SOUTH CAROLINA

The process of electricity provision involves generation, transmission, and distribution. The most visible portion of this process is the end stage of electric distribution. However, if a municipality is going to provide electric distribution, they must have a power generation provider. Many municipalities have formed joint power agencies to own or control the generation of electricity. Public power agencies permit collaboration among municipalities to own electrical generation capacity. In South Carolina, Piedmont Municipal Power Agency (PMPA) is the co-owner of Catawba Nuclear Power Plant #2. This provides nuclear power generation for the eight municipal distribution systems. By becoming part owner of a generation facility, these municipalities seek gains from vertical integration. Unfortunately, they also must accept the liabilities of becoming the ultimate risk holders for the nuclear facility.

One of the advantages to the city of operating the municipal electric utility is the potential for cross subsidization between electric customers and the tax base. In South Carolina the rate setting authority for a municipal utility rests with the city council. No further rate setting oversight is required, as is the case in some other states. Consequently, the electric utility is seen as an alternate revenue source to pay for city services. This raises the potential for the city to behave as an unregulated monopoly and to extract the maximum revenues from utility operations.

The availability of alternate revenues from utilities has been a stable source of revenues. Unfortunately for the municipalities, even though they currently operate within a protected geography, they do not operate within a complete vacuum. The Energy Policy Act of 1992 encouraged open transmission of electricity. This creates the potential for retail wheeling. Under retail wheeling customers are permitted to bypass the local utility and purchase power from a cheaper source. The potential is for the same type of competition now present in the long distance business.

Legislation has already been introduced in South Carolina addressing the deregulation of the electric utilities. The proponents of deregulation advocate immediate competition for the investor owned utilities. As the bill is written the municipals would remain protected initially, but each city would have the ability to opt into the competitive market.

This poses a couple of political controversies. First, if lower electric rates will be extended to some constituents, how will legislators explain to voters in these high cost cities why they are not also permitted to reap the advantages of competition? Second, how will each city decide whether to adopt an open market approach?

One danger from a rapid move toward deregulation is that the current fabric of subsidizations will not be thoroughly understood. Consequently, the legislator will act without fully understanding the nature of the market distortions the change will unveil. Subsidization occurs between some municipal general funds and their enterprise funds. Since they do not operate on a rate of return basis, they are vulnerable to financial strains from rapid market changes. Furthermore, there are potential subsidizations between rate classes. Not all rate structures favor the same constituencies. This may result in a subsidy for industrial customers in one city and a subsidy for residential customers in another. Politicians cannot be completely sure which constituencies may gain or lose from the regulatory shift.

The prospect of open competition for retail customers is a serious threat for these utilities. Investor owned utilities have been governed by rate of return regulation and have lower rates than the municipal systems. In addition, they produce power from a variety of sources and are not completely dependent on nuclear energy.

The first stages of competition are already creeping into public awareness in advance of any legislative action. At least one independent marketing company is running ads for retail customers targeted at the member utilities. The company states the intent to use the list of customers that sign up for lower rates to pressure the legislators into rapidly including all retail customers in deregulation. In Greer, South Carolina, court cases are determining the extent to which BMW and their suppliers can skirt the geographic boundaries of PMPA. Even in advance of deregulation, the PMPA cities are under pressure to lower their rates and limit their dependence on utility revenue transfers.

RATE OF RETURN AND COST TO SERVE POLICIES FOR ROCK HILL

The City of Rock Hill adopted a first step toward a municipal rate of return policy in December 1995. The resolution established a guideline for reducing the operating transfers from the utility to a level associated with what is called a rate of return policy. Operating transfers are to reflect a franchise fee at the same rate an investor owned utility would pay, a payment in lieu of property taxes, and a "rate of return" calculated as three percent of gross utility revenues.

Rate setting will continue by the same political process used in the past. The implementation of this policy is to be delayed until general fund transfers fall to match this level. The transfer reduction is scheduled to take place at two percent per year. Unfortunately, the reduction in transfers is not expected to permit a reduction in utility rates. The cost of purchased power is projected to increase at a 2.5% rate as the nuclear facility begins to retire $1.3 billion in long-term debt. The rate of return policy provides some insulation for the city budget, but it does not improve the competitiveness of the local utility.

Requirements:

1. Is "3% of gross revenues" a reasonable calculation of rate of return on investment? Is this the manner in which a state regulatory agency would approach the calculation for the purpose of rate setting?

2. Look at the CAFR for the City of Rock Hill: (http://www.ci.rock-hill.sc.us/) and examine the general-purpose financial statement of the enterprise fund. Can you evaluate the financial statements for the activities of electric, water, and sewer services?

3. What are some of the consequences to the citizens of Rock Hill for the possible cross subsidization between electric customers and the tax base? What are some of the consequences for the commercial electric customers?

4. What personal income tax benefits could accrue to the individual citizens of Rock Hill if the electric rates were comparable with regulated electric utilities and property tax rates were raised to the levels to cover the costs of government?

5. What are the alternatives available to the City of Rock Hill to prepare for the inevitability of competition in delivering electricity to the consumers in Rock Hill? What do you suggest?

REFERENCES

Staff. (1993). Codification of Governmental Accounting and Financial Reporting Standards As of July 30, 1993, Government Accounting Standards Board, Norwalk, Conn.

William W. Grigsby, Winthrop University

Darrell Parker, Winthrop University

Table 1: Retail Rate by Class of Customer

Participant Industrial Residential Commercial

Rock Hill $6.32 $8.51 $7.98
Easley 6.39 7.27 6.39
Newberry 5.57 7.32 6.61
Gaffney 5.88 7.51 7.43
Union 5.27 6.74 6.74
Greer 5.86 6.78 8.11
Clinton 6.21 5.59 8.57
Laurens 7.31 7.97 7.31
SC Average 3.59 7.08 5.86

Source: Moody's Public Finance, 1994