memorandum
memorandum
Environment & Resources Division




Date
February 23, 2015

To
Erik Helm

From
Jerry Stedge, Jacky Haskell, Abt Associates

Subject
Approach to Calculating Cost of Capital (EP-W-11-003, WA 4-96, Task 4)

Estimates of the cost of capital for water utilities are used in SafeWater CBX to conduct impact analyses. This memo describes our approach to calculating the weighted average cost of capital that water utilities pay when making capital improvements, using data from the 2006 Community Water System Survey (CWSS).

Overview of 2006 CWSS Data
The CWSS collects operating and financial information from a representative sample of community water systems selected from the federal version of the Safe Drinking Water Information System (SDWIS/Fed). One section of the survey asks questions about funding sources for capital improvements. The following categories of funding sources were defined in the survey:
   * Current revenue;
   * Equity or other funds from private investors;
   * Department of Homeland Security (DHS) grant;
   * Other government grants;
   * Drinking Water State Revolving Fund (DWSRF), including loans and Principal Repayment Forgiveness;
   * Other borrowing from public sector sources;
   * Borrowing from private sectors sources; and
   * Other.
Question 27C of the questionnaire asked systems how they funded "major capital improvements, repairs, and expansions" during the past five years, including the percentage of capital expenses funded from different sources, the associated interest rate paid, and the average loan period. Responses to this question are summarized in Table 106 of the 2006 CWSS report (U.S. EPA, 2009).

The dataset also provides information on the characteristics of the water systems, including their state, system ownership type (private or public), population served (actual numbers and categories of population size), and survey sampling weights. Other survey information (i.e., strata) is not provided.

Approach
We used the CWSS data to calculate the overall weighted average interest rate (across all funding sources and loan periods) for each size/ownership category, weighted by the percentage of funding from each source and using sampling weights. We also calculated the weighted average interest rates for five loan timeframes (<5 years, 5-15 years, 15-30 years, >=30 years, and unknown), across the categories of public and private borrowing. We used the following size categories (in terms of population served): 25-100; 101-500; 501-1,000; 1,000-3,300; 3,300-10,000; 10,000-50,000; 50,000-100,000; 100,000-500,000; and >500,000.

Assumptions
The CWSS collected data on interest rates only for public and private borrowing. Therefore, we made assumptions for the other funding sources. We assume that there is no cost of capital for grants (DHS or other government grants) and for Principal Repayment Forgiveness under DWSRF. For capital improvements financed by equity or other funds from private investors, we use an average interest rate of 9%. We found several examples of the allowable cost of equity for public utility commissions (see Table 1). Based on these sources, a common rate of return is approximately 9%.

Table 1: Data on the Allowable Rate of Return on Equity for Public Utilities
                                     State
                                   Rate (%)
                                  Description
                                    Source
                                   Multiple
                                     9.40
Average rate earned by 76 domestic U.S. utility electric and electric/gas operating companies during the years 2008-2011
Institute for Energy Economics & Financial Analysis, 2013
                                      CA
                                     10.2
Rate set in 2009 for 5 large multi-district Class A water utilities in California
San Jose Water Company, 2011
                                      CA
                                     9.10
Approved rate for Great Oaks Water Company (GOWC) in 2013
GOWC, 2014
                                      CT
                                     9.63
Allowed rate for Aquarion Water Company of Connecticut
State of Connecticut Public Utilities Regulatory Authority, 2013
                                      FL
                                     9.26
Approved rate for Aqua Utilities Florida, Inc. in 2012
Florida Public Service Commission, 2012
                                      ID
                                      12
Rate for Spirit Lake East Water Company
Idaho Public Utilities Commission, 2013
                                      PA
                                   8.11-9.55
Current market indicated rate as calculated by the Bureau of Technical Utility Services
Pennsylvania Public Utility Commission, 2015
                                      WI
                                      5-8
Typical rate for Wisconsin water utilities
Public Service Commission of Wisconsin, 2010

We assume that the cost of capital for current revenue is equal to the system's overall cost of capital from all other funding sources. While there is no interest rate associated with using current revenue as a funding source, there are opportunity costs related to the potential alternative uses of those funds, which include purchasing existing equity capital or retiring existing debt. It is likely that current revenue is often used temporarily to finance capital improvements, until the funding needs are high enough that it is appropriate to incur the transaction costs of new debt or equity financing. Therefore, in the long run, we assume that water systems will maintain their current capital structure, with capital improvements being financed consistent with that structure and its average cost of capital, even if such expenditures are initially financed with a different mix of funding sources.

In the CWSS data, there are some cases where current revenue was used to fund 100% of the system's capital improvements. In such cases, there is no system-specific overall cost of capital to use for current revenue. Considering the potential alternative uses of current revenue, purchasing existing equity is the more likely option, because equity typically has a higher cost of capital than debt. Therefore, we use the rate of return on equity as the cost of capital for current revenue when these funds were used for 100% of capital improvements.

Missing Data
For public and private borrowing, there were missing data for interest rates. For example, the interest rates for private sector loans were missing in 47% of cases where the funding percentage for that funding source was positive. We filled in the missing rates using the average interest rates provided in Table 106 ("Average Interest Rates for Capital Funds By Ownership and Lender") of the CWSS report (summarized in Table 2).

For some size/ownership categories, the report indicated that there were no observations available (indicated by "NA" in Table 2). However, there are some water systems in those size/ownership categories with positive funding percentages but missing interest rates. Therefore, we filled in those rates using the average rate for that ownership category.

Table 2: Average Interest Rates Provided in the 2006 CWSS Report

                             System Size Category
Ownership /
Funding Source
                                    <=100
                                    101-500
                                   501-3,300
                                 3,301-10,000
                                 10,001-50,000
                                50,001-100,000
                                100,001-500,000
                                 Over 500,000
                                      All
Public
 
 
 
 
 
 
 
 
 
DWSRF Loans
                                                                              1
                                                                            2.4
                                                                            1.8
                                                                            3.3
                                                                            3.5
                                                                            2.9
                                                                            3.2
                                                                            3.1
                                                                            2.3
Other Public Sector
                                                                            0.5
                                                                            4.4
                                                                            3.8
                                                                            3.1
                                                                            3.9
                                                                            4.3
                                                                            3.3
                                                                              4
                                                                            3.5
Private Sector
                                                                              5
                                                                            4.2
                                                                            4.7
                                                                            4.9
                                                                            4.5
                                                                            4.4
                                                                            4.3
                                                                            4.6
                                                                            4.6
Other
                                                                             NA
                                                                             NA
                                                                              0
                                                                            4.5
                                                                            4.8
                                                                            4.9
                                                                            1.4
                                                                              1
                                                                            3.9
Private
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
DWSRF Loans
                                                                             NA
                                                                             NA
                                                                            1.5
                                                                              6
                                                                            6.4
                                                                            0.8
                                                                            6.2
                                                                             NA
                                                                            5.6
Other Public Sector
                                                                            3.1
                                                                            4.5
                                                                            5.5
                                                                            4.6
                                                                            5.3
                                                                            4.8
                                                                            4.6
                                                                             NA
                                                                            4.4
Private Sector
                                                                             NA
                                                                            7.7
                                                                            6.7
                                                                              6
                                                                            4.3
                                                                            7.5
                                                                            5.8
                                                                            6.2
                                                                            6.5
Other
                                                                              6
                                                                             10
                                                                             NA
                                                                             NA
                                                                             NA
                                                                              0
                                                                              0
                                                                             NA
                                                                            5.9
Source: 2006 CWSS Report, Volume II, Table 106 (U.S. EPA, 2009).
DWSRF = Drinking Water State Revolving Fund
NA = not available

Weighted Average Interest Rates
The average interest rates across all funding sources are summarized in Table 3. In most size categories, the interest rates for private systems are higher than those for public systems. The average interest rates range from 3.8% to 8.6%. The average interest rates by loan period (for funding sources involving loans) are presented in Table 4. These rates could not be calculated for some combinations of size/ownership category and loan periods, because there were no observations available (indicated by "NA" in the table).

Table 3: Weighted Average Interest Rates (%) across All Funding Sources
                                 Size Category
                                    Public
                                    Private
<=100
                                                                            3.8
                                                                            7.8
101-500
                                                                            5.5
                                                                            8.2
501-1,000
                                                                            4.0
                                                                            8.6
1,001-3,300
                                                                            4.7
                                                                            7.1
3,301-10,000
                                                                            5.8
                                                                            7.0
10,001-50,000
                                                                            6.1
                                                                            7.0
50,001-100,000
                                                                            4.9
                                                                            6.9
100,001-500,000
                                                                            4.7
                                                                            3.9
Over 500,000
                                                                            3.7
                                                                            7.8

Table 4: Weighted Average Interest Rates (%) by Loan Period [a]

                             System Size Category
Ownership / Loan Period
                                    <=100
                                    101-500
                                   501-1,000
                                  1,001-3,300
                                 3,301-10,000
                                 10,001-50,000
                                50,001-100,000
                                100,001-500,000
                                 Over 500,000
Public
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
<5-year
                                                                             NA
                                                                             NA
                                                                             NA
                                                                            0.0
                                                                            4.6
                                                                            3.0
                                                                             NA
                                                                            0.0
                                                                             NA
5-15 year
                                                                             NA
                                                                             NA
                                                                            5.6
                                                                            5.9
                                                                            4.9
                                                                            4.2
                                                                            4.0
                                                                            3.4
                                                                            4.3
15-30-year
                                                                            0.6
                                                                            2.5
                                                                            2.2
                                                                            2.5
                                                                            4.3
                                                                            4.0
                                                                            3.8
                                                                            3.8
                                                                            3.6
30+ year
                                                                            1.0
                                                                            4.2
                                                                            5.4
                                                                            3.7
                                                                            3.2
                                                                            4.6
                                                                            4.8
                                                                            4.5
                                                                            4.6
Unknown
                                                                             NA
                                                                            3.7
                                                                            1.1
                                                                            1.8
                                                                            4.2
                                                                            4.4
                                                                            4.5
                                                                            3.3
                                                                            3.2
Private
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
<5-year
                                                                            6.1
                                                                             NA
                                                                             NA
                                                                            6.0
                                                                             NA
                                                                            6.3
                                                                             NA
                                                                             NA
                                                                             NA
5-15 year
                                                                             NA
                                                                            9.2
                                                                            7.8
                                                                             NA
                                                                            6.0
                                                                             NA
                                                                             NA
                                                                             NA
                                                                             NA
15-30-year
                                                                            3.0
                                                                            7.8
                                                                            5.5
                                                                             NA
                                                                            4.9
                                                                            4.4
                                                                            5.7
                                                                            6.1
                                                                             NA
30+ year
                                                                             NA
                                                                            4.5
                                                                             NA
                                                                            4.8
                                                                            4.6
                                                                             NA
                                                                            1.3
                                                                            5.4
                                                                             NA
Unknown
                                                                            6.1
                                                                            9.9
                                                                            5.9
                                                                            5.9
                                                                            7.7
                                                                            5.6
                                                                             NA
                                                                            3.2
                                                                            6.2
Source: 2006 CWSS data.
NA = not available
   a. The average interest rates for loan timeframes were calculated across the following funding sources only: DWSRF loans, public borrowing, private borrowing, and "other" funding.

Discussion
The weighted average interest rates in Table 3 do not follow clear trends by size category. It is likely that this result is due to small sample sizes and assumptions that do not vary by system size category. For example, the average interest rate of 3.8% for the smallest public systems (serving up to 100 people) is very similar to the average interest rate for public systems serving over 500,000 people (3.7%). However, the interest rate for these small systems is based on a sample of 14 systems, seven of which used current revenue as their only funding source. Therefore, for half of the public systems in the <=100 size category, we assumed an average interest rate of 9% (for equity), which is not based on system size.

Similarly, the average interest rates for the smallest (population served <=100) and largest (population served >500,000) size categories for private systems were both 7.8%. There is only one water system in the larger category. In the smaller category, 34 out of 53 systems used current revenue only; again, we assumed an average rate of 9% for all of these systems.

References
Florida Public Service Commission. 2012. "Aqua Utilities Florida, Inc. Rate Increase Request." Fact Sheet: Docket No. 100330-WS. Available at http://www.psc.state.fl.us/about/decisions/Aqua_Fact_Sheet.pdf (accessed February 11, 2015)
Great Oaks Water Company. 2014. "Application of Great Oaks Water Company (U-162-W) for an Order authorizing it to issue long-term debt in the amount of $4,000,000." Application to the California Public Utilities Commission, January 28, 2014. Available at http://www.greatoakswater.com/ApplicationForAuthorizationToIssueLong-TermDebt.pdf (accessed February 11, 2015)
Idaho Public Utilities Commission. 2013. "New rates effective Nov. 1 for Spirit Lake East Water customers." Case No. SPL-W-13-01, Order No. 32904. October 17, 2013. Available at http://www.puc.idaho.gov/press/131016_SpiritLakeEastfinal.pdf (accessed February 11, 2015)
Institute for Energy Economics & Financial Analysis. 2013. "Public Utility Regulation Without the Public: The Alabama Public Service Commission and Alabama Power." Prepared for Arise Citizens' Policy Project. March 1, 2013. Available at http://www.arisecitizens.org/index.php/component/docman/doc_view/948-arise-report-public-utility-regulation-without-the-public-3-1-13?Itemid=44 (accessed February 11, 2015)
PA Public Utility Commission. 2015. "Bureau of Technical Utility Services Report on the Quarterly Earnings of Jurisdictional Utilities for the Period Ended September 30, 2014." Quarterly Report, 2014 Quarter 2. Public Meeting held January 29, 2015. Docket Number: M-2014-2460381. Available at http://www.puc.state.pa.us/filing_resources/quarterly_earnings_sum_rpt.aspx (accessed February 11, 2015)
Public Service Commission of Wisconsin. 2010. "Introduction to Water Rates." June 2010. Available at https://www.cityoflacrosse.org/DocumentCenter/Home/View/3860 (accessed February 11, 2015)
San Jose Water Company. 2011. "Application of San Jose Water Company (U-168-W) for an Authorized Cost of Capital for Utility Operations for 2012-2014." Application to the California Public Utilities Commission, May 2, 2011. Available at http://www.sjwater.com/files/documents/A1105002_20110502.pdf (accessed February 11, 2015)
State of Connecticut Public Utilities Regulatory Authority. 2013. "PURA Renders Decision on Aquarion Water Rate Request." September 24, 2013. Available at http://www.ct.gov/pura/cwp/view.asp?Q=532350&A=4144 (accessed February 11, 2015)
U.S. EPA. 2009. "2006 Community Water System Survey, Volume II." Office of Water. EPA 815-R-09-002, May 2009. Available at http://water.epa.gov/infrastructure/drinkingwater/pws/cwssvr.cfm (accessed February 12, 2015)
U.S. EPA. 2010. "Drinking Water State Revolving Fund: 2009 Annual Report." Office of Water. EPA 816-R-10-021, November 2010. Available at http://water.epa.gov/grants_funding/dwsrf/upload/dwsrf-annualreport2009nov2010.pdf (accessed December 9, 2014)
