ENVIRONMENTAL FINANCIAL ADVISORY  BOARD
     Chair, Vacant

      Members

      Terry Agriss

   A. James Barnes

     Julie Belaga

     John Boland

    George Butcher

    Donald Correll

    Michael Curley

    Rachel Denting

    Pete Domenici

    Kelly Downard

    Mary Francoeur

    Vincent Girardy

    Steve Grossman

  Jennifer Hernandez

    Steve Nahfood

    Langdon Marsh

    John McCarthy

      Cherie Rice

      Helen Saht

    Andrew Sawyers

      Jim Smith

      Greg Swartz

     Son/a Toledo

      Jim Tozzi

      Billy Turner

     Justin Wilson

      John Wise

     Stan neiburg
Lesiguated Federal Official
                                February 22, 2006
Honorable Stephen L. Johnson
Administrator
U.S. Environmental Protection Agency
1200 Pennsylvania Avenue NW.
Washington, DC 20460

Dear Administrator Johnson:

       The Environmental Financial Advisory Board (EFAB) is pleased to submit the
enclosed report, "Affordability Rate Design for Households," for the Agency's
consideration and use.  This report provides an option that addresses the "how to pay"
challenge of providing sustainable water and wastewater services.

       Despite substantial environmental achievements, there are still many unmet water
and wastewater needs in U.S. cities and towns. These include capital improvements
needed to comply with regulations and to replace aging infrastructure. They also include
the investments needed to extend water and sewer service to new customers, or to upgrade
existing water infrastructure.  Local governments, water and sewer utilities, states,
individual households, and EPA are all affected by these challenges and all have a stake in
finding equitable solutions.

       EPA, itself, has identified four pillars of sustainable infrastructure to help address
many of these environmental challenges facing the nation.  One of these pillars focuses on
better utility management and another on full cost pricing.  The strength of these pillars
may depend on the effectiveness and assurances that water and sewer rates are affordable
as significant new investments are planned to address environmental needs throughout the
country.

       This report highlights that household-level affordability problems often result in
increased costs and decreased revenues for water and wastewater utilities, impacting all
customers, rich and poor alike.  Excessive numbers of disconnections for non-payment
create major inconvenience for households and may contribute to public health problems.
Perhaps most important, however, is the fact that significant numbers of household-level
affordability problems create a political climate where it is impossible for utilities to
achieve or maintain full-cost rates.  This, in turn, leads to deferrals of maintenance,
upgrading, and replacement, as well as a lower standard of operation. Much of the
deterioration of sewerage systems in older cities can be traced directly to decades of
inadequate rate levels, sometimes associated with multiple failed attempts to increase rate
levels.
                            Providing Advice on "How To Pay" for Environmental Protection

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       EFAB concludes that in many cases, water and wastewater affordability is primarily
a household problem, not a community-level problem, and in these cases can be mitigated
through careful design of utility policies regarding subsidy, rates, collections, and financial
assistance. We encourage EPA to consider disseminating this finding to states and utilities
since it encourages an effective method of dealing with affordability that is important
precisely because it may assist in removing existing political and economic barriers to
achieving full cost recovery, while minimizing negative effects on fiscal accountability. In
the short term, this finding may be especially helpful to EPA and States during compliance
and project negotiations with municipalities and counties to mitigate the financial impact on
their users.

        In a broad sense, we believe that the household-level affordability concerns have
long been, and continue to be, of considerable importance to EPA and its programs.  In this
regard, we suggest that you consider developing an affordability handbook that can assist
utilities in structuring an effective affordability program.  The handbook should include a
special focus on household affordability through proper diagnosis, sound rate design, the
development of an effective subsidy program combined with an appropriate collections
policy. Such a handbook will be especially helpful as government and utilities attempt to
address the growing infrastructure concerns amid resource cutbacks that ultimately impact
poor households.

       Should EPA need assistance with future affordability issues, EFAB remains ready to
support the agency as needed.  We suggest that EPA should study this issue further, and that
it should also work with states to assess how information on effective affordability strategies
can be disseminated through State Revolving Fund programs.  We also encourage EPA to
continue its work with other groups and/or agencies to develop more detailed proposals for
addressing the significant complexities of affordability policies in a utility environment.

       We hope  that you will find the report and our suggestions constructive and useful.
The Board is prepared to discuss its findings and recommendations, and to take any follow-
up actions that are consistent with its charter.  If you or your staff have questions regarding
the report, or would like to arrange a meeting, please let us know. We greatly appreciate the
continuing opportunity to serve the Agency.
                                           Sincerely,
                                           A. Stanley Meiburg
                                           EFAB Executive Director
Enclosure
cc:   Ben Grumbles, Assistant Administrator for Water
      Lyons Gray, Chief Financial Officer

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                        Environmental
              Financial Advisory  Board
EFAB
Vacant
Chair

A. Stanley Meiburg
Executive Director
Members

Hon. Pete Domenici
Terry Agriss
A. James Barnes
Julie Belaga
John Boland
George Butcher
Donald Correll
Michael Curley
Rachel Deming
Kelly Downard
Mary Francoeur
Hon. Vincent Girardy
Steve Grossman
Jennifer Hernandez
Stephen Mahfood
Langdon Marsh
John McCarthy
Cherie Rice
Helen Sahi
Andrew Sawyers
Greg Swartz
James Smith
Sonia Toledo
Jim Tozzi
Billy Turner
Justin Wilson
John Wise
Affordable Rate Design for Households
This report has not been reviewed for approval by the U.S. Environmental
 Protection Agency; and hence, the views and opinions expressed in the
   report do not necessarily represent those of the Agency or any other
             agencies in the Federal Government.
                  February 2006

               Printed on Recycled Paper

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                            EFAB Affordability Report
                      Affordable Rate Design for Households

Background and Introduction

       The United States Environmental Protection Agency (EPA), state governments and the
water utility industry all have a strong interest in assuring that water and  sewer rates  are
affordable as significant new investments are planned to address environmental needs throughout
the country.  Utility managers have a number of reasons to be concerned about affordability. Not
the least of these is the connection between affordability problems and a general reluctance to
increase rates.  In some cases, this prevents utilities from raising revenue needed to replace
infrastructure and upgrade  their systems.  For environmental officials at the  local, state and
federal levels, the inability of low-income households to pay higher rates is a barrier to achieving
their environmental objectives.  For local officials and the people they represent, the dilemma is
how to responsibly manage their water infrastructure needs while reducing the financial burden
for their lower-income households.

       More recent discussions of water utility asset management have proposed the use of a
triple bottom  line:  financial,  environmental,  and  social.    Financial  and  environmental
performance both depend on the ability  to recover the full cost  of the services provided, while
social performance requires that utilities set rates that are affordable  for their citizens.   If
affordability is  defined as a community  problem,  conflict between full cost pricing and
affordability is frequently inevitable.   But when  affordability  is properly conceived  of as a
household-level problem, conflict among these objectives is no longer necessary.

       This paper discusses an approach to dealing with household-level affordability problems
through careful design of utility policies regarding subsidy, collections, and financial assistance.
But it should be stressed that these  policies are in no way substitutes for established financial
management  practices, such  as full  cost recovery.  Effective programs  for dealing with
affordability are  important  precisely  because they remove  existing political and  economic
barriers to  achieving full  cost recovery,  while  minimizing negative effects  on fiscal
accountability.

Discussion

       Despite substantial achievements, there are still many unmet water and wastewater needs
in U.S. cities and towns. These include capital improvements needed to comply with regulations
and to replace aging infrastructure.  They also include the investments needed to extend water
and  sewer service  to  new customers,  or to upgrade existing water  infrastructure.  Local
governments, water and sewer  utilities,  states, individual households, and the  US EPA are all
affected by these challenges and all have a stake in finding equitable solutions.

       EPA has identified four pillars of sustainable infrastructure to help  address  these
challenges.  One of these pillars focuses on better utility management and another on full cost
pricing.  Nevertheless, the  strength of  these pillars may depend  on the  effectiveness of the
response to the affordability challenge.   Should programs, such as SRF and USDA, etc., that
deliver the benefit of grant and loan subsidies to households in some communities, continue to be
the primary means of keeping water and sewer services affordable? How can full cost pricing be

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implemented while addressing the basic needs of the lowest income households?  The answers
to these and related questions are critical to meeting the environmental challenges of the coming
years.

       In an effort to assess and better understand these issues, EFAB sponsored a workshop in
August 2004.  Panelists representing the utility industry, state financial assistance agencies and
consumer advocacy  organizations presented their insights into affordability  challenges and
provided examples of solutions that have been tried, and their effectiveness.

       Water and wastewater service affordability has been studied and researched widely over
the last few years.  Several studies have shown that sewer and water rates are outpacing inflation.
Mandated treatment upgrades, replacement of deteriorated infrastructure, and a general move in
the direction of full cost pricing all contribute to this result. Regardless of the reason, this and
related trends have  elicited cries of increased regressive  effect,  particularly  on low-income
consumers. Communities across the nation are increasingly wary of rising sewer and water rates,
often resulting from consent decrees with federal and state governments, old infrastructure, and
growth and economic expansion. These issues are growing in importance and will not disappear
anytime soon.

       In every community in the U.S., some households inevitably have difficulty in paying
water and wastewater bills.  The relative number may be large  or small,  but there are always
some that find public utility service unaffordable.  This is true whether  the community as a
whole  is wealthy or poor, whether the average cost of water and wastewater service  is high or
low, and whether the utility's collections policy is strict or lax. Of course, this phenomenon is not
unique to the provision of water. The same households that have trouble paying for water service
are likely to have trouble paying for many other basic needs  leading to a variety  of social
assistance programs (food stamps, housing assistance, and energy assistance programs).

       This is not a problem that should be ignored, or left to the uncertain workings of existing
charities and public welfare systems.  In the absence of effective mitigation programs, the
financial and environmental costs of household-level unaffordability can be significant and far-
reaching. A significant amount of work has been pursued in defining affordability and examining
how best to design  effective affordability policies and programs. An important first step in
addressing affordability concerns is the proper design of user rates.

A Closer Look at the Problem

       The failure to set full cost rates is frequently attributed to community affordability limits,
which may  be wrongly characterized in terms of the community's ability to pay. In fact, the
underlying cause is  generally the existence of  relatively  large numbers of households  with
individual affordability problems.  This creates a political climate in which significant increases
in rate level are seen  as unacceptable, due to the harm that would be visited  on the lowest-income
customers.

       Water and wastewater rates that do not recover the full cost of service occur in the U.S.,
and throughout the world.  In the absence of unlimited outside subsidies, utilities  deal with this
situation by deferring maintenance,  deferring facility upgrades  and replacements, eliminating
staff functions, and maintaining low wage levels.  One of the most common manifestations of

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these funding problems in older American cities is a deteriorated sewer system, plagued by leaks
and overflows.

       For both full cost rates and less-than-full-cost rates, there are always some households,
which find it difficult to pay the utility bill.  The most common impacts on the utility include'
bloated accounts receivable  and  a rising number of uncollectible accounts.  Depending on
collections policy, there may be significant numbers of temporarily disconnected accounts.
These problems result in decreased revenue collection, which creates a need for still-higher rate
levels and/or increases the gap between revenue and full cost. On the household side, temporary
disconnection creates major inconvenience and has the potential to promote the spread of various
kinds of viral and diarrhea diseases (due to reduced hand-washing and unsafe disposal of human
waste). Disconnecting and reconnecting customers also takes time and energy away from utility
staff that could be spent on more productive activities.

How the Problem Can Be Addressed

The following principles can be considered:

1.     Existing rate policy should not make the problem worse. Rates should recover the
full cost of service,  but they should also reflect, through their design, the cost responsibility of
various users and kinds  of use.  This means that individual elements of the rates should be
individually cost-justified, preferably reflecting the incremental cost of the associated service.
Rates that set the volumetric price of water higher than the incremental cost obviously worsen
the affordability problem for some users. Conversely, volumetric prices that are too low promote
uneconomic use of water, increasing costs for all users, including  the poor.  Policies for such
things as recovering capital costs through benefit assessments and one-time charges should also
be examined to verify that they  are cost-justified for all customers. Rates that set the volumetric
price of water equivalent to incremental costs are more beneficial to all users.

2.     Customers who require assistance should be identified,  if possible.  Most utilities
know which customers have had difficulty in paying bills in the past, but that information is not
necessarily helpful in identifying the customers that will require assistance in the future.  If there
is some  way to characterize these customers in a way that allows individual  accounts to be
identified, a subsidy program can be targeted. This means that some objective process must
identify hardship customers. Approaches for  targeting customers could focus on household
income, eligibility for specified public assistance programs, retirement status, age, and other such
criteria.  One way to do this is to  define any customer who has qualified for any type of public
assistance program as  a hardship  customer.  Another approach is  to  allow customers to
individually apply for  assistance.  The latter approach  places an unfamiliar and probably
inappropriate burden on water utilities. It is also less desirable for other reasons, including the
fact that many  very needy  households will  not apply.  The use of social service agencies to
certify hardship customers is much preferable.

       Where targeting is not feasible because hardship customers cannot be reliably identified,
another option  is to design subsidies that benefit all low-use accounts on the assumption that
most needy customers  will  fall within that  group.  This type of untargeted subsidy is  more
costly and less effective, but it is distinctly preferable to ad hoc approaches or to attempts to deal
with the problem through block rate design.

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3.     The source of the subsidy should be identified. There are at least four choices here: (a)
the subsidy can come from general tax revenues, through some established state or local social
program; (b) the subsidy can come from a federal program similar to LIHEAP that directly
provides subsidy to the consumer, who in turn would pay the utility; (c) the subsidy can come
from all utility customers who do not receive a subsidy (non-hardship customers);  or  (d) the
subsidy can  come from all utility customers, whether or not they can  be considered hardship
customers.   Each of these options has  advantages and disadvantages.   The first two options
(subsidy from tax  revenues and  federal programs) may not be possible or feasible in every
community.  Note, however, that the first two options may become more  feasible with significant
state and local government assistance.

       The difference  between the other  two options can be  illustrated  by a  very  simple
       example.  This example  considers only the case where there is no outside subsidy
       available to the utility—the program is funded by increasing some charges, or charges to
       some customers.  The example is constructed for a medium-sized community.   Note,
       however, that the customer and water use assumptions  can  be scaled: dividing each
       number by 100, for example, will produce exactly the same results for a community with
       1,000 customers.

       Assume:      Number of (residential) customers = 100,000
                    Total water sales = 750 MG/month
                    Number of hardship customers = 6,000
                    Water sales to hardship customers = 30 MG/month
                    Average water sales to hardship customers = 5,000 gal/HH/month
                    Average water sales to non-hardship customers = 7,660 gal/HH/month

       For this example, water use is assumed invariant with respect to price.  In addition, for
       convenience, subsidies are conveyed through the fixed charge,  resulting  in a negative
       fixed charge in some cases.  In  practice, such a policy would require a minimum bill
       constraint; the revenue effect of such a constraint has not been included here.  The table
       shows four alternative rate designs:

       A.     Base case.—The original, subsidy-free rate design. Hardship customers receive
       smaller average bills because they are assumed, on average,  to have lower water use.
       However, a bill of $42.50 per month will still create an affordability problem for some
       households.

       B.     Targeted subsidy, financed by non-hardship customers.--This design incorporates
       a subsidy of $20.00 per month for hardship customers  only, financed by increasing the
       variable charge for non-hardship customers.   Note that the increased cost  for non-
       hardship customers is small.

       C.      Targeted subsidy, financed by all customers.-This is the same  as design B, except
       that all customers contribute equally to financing the subsidy.  The result (as compared to
       B) is a slightly lower cost for non-hardship customers and a slightly smaller subsidy for
       hardship customers.

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      D.    Non-targeted subsidy, financed by all customers.-This illustrates a non-targeted
      subsidy, where the rate design is altered to favor low-use customers. To the extent that
      hardship customers are low water users, they will benefit from this design.  While this
      may be true on average, it should be noted that some hardship customers are, in fact,
      relatively high water users.

Nonhardship customers -
Fixed charge $/month
Variable charge $/l,000 gal
Cost of subsidy: $/month for
avg. customer
Average bill ($/month)
Hardship customers --
Fixed charge $/month
Variable charge $/ 1,000 gal
Subsidy $/month for avg.
customer
Average bill ($/month)
A

10.00
6.50
0.00
59.79

10.00
6.50
0.00
42.50
B

10.00
6.667
1.277
61.06

-10.00
6.50
20.00
22.50
C

10.00
6.66
1.226
61.01

-10.00
6.66
19.20
23.30
D

-10.00
9.167*
0.426
60.21

-10.00
9.167*
6.667
35.83
       * The particular example used for Alternative D leads to a much higher variable charge.
       The impact of this charge on high-use customers would have to be evaluated.
       This comparison  is only for the purpose  of  illustrating the  impact of targeting  and
       defining the source of any subsidy.  In practice, there are numerous choices in the design
       of a rate schedule as well as additional considerations not discussed here.

       Note that  none of these alternatives subsidize the  volumetric  charge.  This preserves
       incentives for all customers to use  water efficiently. It also avoids a fallacy associated
       with the attempted use of block-type rate designs to deliver subsidies: within each block
       of an increasing block  design, the size of the subsidy increases with water use  (the
       smallest users receive the smallest subsidy in these cases).
4.     There must be an effective collections policy.  No matter how carefully subsidies are
defined, targeted (where possible), and delivered, there will always be some customers who do
not, for various reasons, pay their utility  bill.   The effective operation of a subsidy program
requires that there be consequences for those who do not pay.  Good commercial practice usually
involves an escalating series of warnings, communication with the customer regarding possible
sources of assistance (see #5, below), and ultimate turnoff of the service. When service has been
disconnected for more than a few  days, the utility should notify appropriate public health  and
housing agencies, and should regularly inspect the premises  to determine that service has not
been illegally reconnected.

5.     There must be  a safety  net.   Even when  all of  the preceding  steps  are fully
implemented, some customers will still reach the end  of the collections process unable to settle
their bill.  The utility should determine what kinds of public  assistance, or assistance from
private charities, may be available to such households. This information can be communicated
to the  household during  the collections process (step #4, above).  Some utilities also arrange

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installment payment plans in special circumstances, but this is only suitable for households with
short-term  cash  flow problems.  The  provision of the safety net should not be the utility's
responsibility, but any existing programs should be recognized and integrated into the utility's
plan.

Conclusion

       Household-level  affordability problems often  result in increased  costs and  decreased
revenues for water and wastewater utilities that impact all customers.  Excessive numbers  of
disconnections for non-payment create major inconvenience for households and may contribute
to public health problems. Perhaps most important, however, is the fact that significant numbers
of household-level affordability problems create a political climate where is it impossible for
utilities to achieve or maintain full-cost rates.  This, in turn, leads to deferrals of maintenance,
upgrading, and replacement, as well as a lower standard of operation. Much of the deterioration
of sewerage systems in older cities can be traced directly to decades of inadequate rate levels,
sometimes associated with multiple failed attempts to increase rate levels.

       The  household affordability  problem can  be effectively  mitigated through  proper
diagnosis, sound rate design, the development of an effective subsidy program combined with an
appropriate collections policy, and ultimately supported by public or private charitable assistance
in the  very neediest  cases. When household-level affordability problems  have been explicitly
dealt with, it may be  possible for underfunded utilities to seek the rate levels needed to properly
operate and maintain  their systems.

       This report illustrates the use of a two-part tariff to convey a subsidy to certain customers
within the framework of a full cost  recovery rate policy.  Where hardship customers can  be
identified with reasonable accuracy,  a (targeted) subsidy  can be  directed to them.   Where
hardship customers  cannot be identified, a  non-targeted subsidy can be  provided to low-use
customers.   However, not all  hardship customers  are low-use customers.  Also, in many cities
significant  numbers  of hardship customers  may live in multi-family structures with a single
master meter.  These situations, to the extent that they occur, would reduce the effectiveness of
the kind of subsidy program described here.  It is essential that each community analyze its own
affordability problem and develop a rate policy which meets  its specific needs.

       Historically,  federal water and sewer  funding programs  such as SRF, USDA  Rural
Development, and HUD  Small Cities have played an important role in mitigating community
level  affordability problems.  The role of these programs  in dealing with targeted household
affordability issues has not been addressed in this document and may deserve more attention in
the future.  Also, it should be clear that affordability is enhanced by any change which reduces
the average cost of water utility operations, or which spreads costs over a broader base. To this
end, increased use of regional cooperatives, combined water/wastewater districts, or other forms
of joint operations should be considered where relevant and feasible.   These topics are not
addressed in this document, but may also deserve more attention in  the future.

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              UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
                             WASHINGTON. D.C. 20460
                                   JUN - 9  2006
                                                                           OFFICE OF
Mr. A. Stanley Meiburg                                                      WATER
EFAB Executive Director
61 Forsyth Street, SW
Atlanta, Georgia 30303

Dear Mr. MI
         /
       Thank you for providing the Environmental Protection Agency with the
Environmental Financial Advisory Board's (EFAB) report on "Affordable Rate Design
for Households" dated February 2006. The Administrator, Stephen L. Johnson, has asked
me to respond directly to you about the report's identification of household affordability
as a challenge that municipalities face when addressing utility management and full cost
pricing issues.

   The EFAB report raised some interesting points on the significance of household
affordability in providing adequate funding for water and wastewater operations.  We
support EFAB's conclusion that "in many cases, water and wastewater affordability is
primarily a household problem... [that] can be mitigated through careful design of utility
policies regarding subsidy, rates, collections, and financial assistance."  We also fully
support the report's conclusion that "each community analyze its own affordability
problem and develop a rate policy which meets its specific needs."

   The Office of Water has historically evaluated overall municipal financial resources
or capability, rather than affordability for individual households, in the administration of
our water and wastewater programs.  This approach has left household affordability
determinations to the discretion of local officials who are generally responsible for
ensuring that the funds necessary to provide water and wastewater services are obtained
through user rate structures, local appropriations or special fees.

   EFAB's report identifies local household affordability as an issue which can often be
overcome in the pursuit of full cost pricing. Local officials have a great deal of latitude
when establishing user rates for drinking water and wastewater. Although Congress
required recipients of Federal construction grants to proportionally distribute operational
costs to all users of the wastewater treatment system, Congress did allow an exception for
municipalities to provide special lower rates for low-income residential users. This water
and wastewater rate setting flexibility provides local officials with the ability to address
household affordability issues for various types of rate payers.
                              Internet Address (URL) • http://www.epa gov
     Recycled/Recyclable • Printed with Vegetable Oil Based Inks on 100% Postconsumer, Process Chlorine Free Recycled Paper

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   The affordability principles set forth in the EFAB report can serve as building blocks
for local utilities as they examine policies regarding rate structures, collections, subsidies
and financial assistance.

   Consistent with EFAB's recommendations, we will be making this report available to
our State partners, including the State Revolving Fund programs, and to utilities dealing
with affordability issues. As we develop our FY2007 work plans, we will consider
whether there would be additional value in developing a handbook for utilities, building
off of EFAB's work, to further assist utilities in structuring effective affordability
programs.

   Thank you for EFAB's continuing contribution to EPA's National Water Program.  If
you have any concerns you would like to discuss, please contact me or call James
Hanlon, Director of the Office of Wastewater Management, at 202/564-0748.
                                        Benjamin H. Grumbles
                                        Assistant Administrator

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