The Financial Reserves Policy for the electric system has four reserves:

• General Operating Reserve;

• Debt Reduction and Capital Funding Reserve;

• Fleet Replacement Reserve; and

• General Plant Reserve.

Recommended Reserves

Given the above comments about utility policy, BWP�s approach is to recommend a range of reserve levels designed to mitigate the aggregate risk profile that BWP might wish to consider. We have provided a minimum reserve level and a recommended level of reserves for each of the reserves discussed above. The recommended ranges for each reserve and existing funding sources include:

• General Operating Reserve

• The General Operating Reserve (GOR) helps withstand unexpected expenses (whether due to unexpected price hikes or emergency repairs) and revenue losses. The table below describes these risks in greater detail and presents �less conservative�, �moderate� and �more conservative� reserve levels to cover these risks.

The reserve levels have been determined by  looking at individual categories and making an assessment as to the likelihood of the risk occurring, recognizing that  all of these risks are unlikely to occur simultaneously.

The $41.0 million recommended GOR includes:

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• $4.5 million for General Consumption Exposure

• $9.0 million for Replacement Power Exposure

• $7.0 million for Purchased Power Exposure

• $20.5 million for 60 days of working capital

The recommended GOR is designed to cover power supply risks as well as revenue-related risks. We have increased reserve levels for Replacement Power Exposure and included moderate reserve levels for a single category of Retail Revenue risk, General Consumption and Sales Decrease. The rationale behind this approach is that the revenue categories can be viewed as addressing a similar underlying risk: the potential need to cover fixed costs over a smaller customer base, and can be addressed with the one reserve. This reserve level also assumes that risks associated with wholesale trading are sufficiently covered by the Risk Management Policy.  A summary of the Recommended GOR level is provided in the following table.

Debt Reduction and Capital Funding Reserve

BWP also created a Debt Reduction and Capital Funding Reserve to help fund capital projects or prepay debt.  By using non-recurring revenues  for system capital projects, or for accelerated undergrounding of power lines,  BWP can reduce or even avoid additional debt for its capital projects. Alternatively, BWP could instead chose to prepay its existing debt, and lower its on-going debt service costs.

BWP�s projected five-year Capital Plan is projected at $21.4 million in FY 2003-04 before stabilizing at approximately $13.5 million annually between FY 2004-05 to FY 2007-08. The total expected capital program is expected to be $75.5 million.

The recommended $15.1 million level reflects 20% of BWP�s projected $75.5 million Capital Plan over the next five years. We have not included a component for debt defeasance since the projected cost of any defeasance program will depend substantially upon market conditions and BWP�s outstanding debt structure at the time of the defeasance.

Fleet Replacement Reserve

The Fleet Replacement Reserve sets aside funds yearly to cover future vehicle replacements for the electric fund, as outlined in BWP�s  Master Fleet Plan (MFP).

The current MFP identifies annual vehicle replacement needs over a ten-year period from FY 2001-02 through FY 2010-11.  The MFP covers the water and electric divisions and includes the identification of shared vehicles. The Fleet Replacement Reserve (FRR) is intentionally designed to accommodate different changes in status or priority of replacement without impacting customers.  The new vehicle standardization policy has been implemented by BWP and is reflected in BWP�s MFP.

In order to set reserve targets, we have viewed the MFP in the context of the vehicles that are attributable in whole or part to the electric division and then reviewed the total replacement costs projected over a five-year period from FY 2003-04 through FY 2007-08. The size of the recommended $4.5 million reserve is tied to the approximate total requirements over a five-year period for vehicles for both the electric and shared vehicles in the MFP.

 Over time, BWP may wish to consider having a FRR that is fully funded and capable of meeting 100% of replacement requirements over a projected horizon of five years.  However, this level of funding is likely not immediately achievable from a rate and policy perspective, and as result, the minimum reserve levels for the FRR are set lower and the recommended reserve level is intended to grow over time.  The FRR recommendation is:

• $4.5 million Recommended FRR � the recommended level is designed to provide greater flexibility and to fund a greater percentage of the longer term future liability tied to changing circumstances as it relates to fleet acquisition, specifically, and the electric enterprise, generally.

General Plant Reserve

BWP has created a reserve  for the renewal and replacement of its existing plant infrastructure.  This reserve would be termed a General Plant Reserve and would be in addition to the other reserve funds outlined in this report. While both the General Plant Reserve and the Debt Reduction and Capital Funding Reserve will help fund future capital expenses, the General Plant Reserve is intended to cover the renewal and replacement of more routine infrastructure, including facilities.  The General Plant Reserve is not intended to cover the funding of major new facilities, such as the Magnolia Power Project, necessary to meet future load requirements.  It is intended that large future capital projects that are integral components of BWP�s resource planning will be funded through a capital plan (i.e. long-term debt), of which the Debt Reduction and Capital Funding Reserve may be a component of the funding strategy.

BWP has significant assets that are depreciated annually.  It is currently estimated that the electric division has assets with a total current cost in excess of $190 million.  To date, there is approximately $131 million of total accumulated depreciation against these assets, and total annual depreciation for FY 2003-04 is projected to be $6.9 million.

The objective would be to fund sufficient reserves so that unforeseen circumstances, specifically as it might relate to general plant assets, could be addressed through the General Plant Reserve.  Funds in the General Plant Reserve would be used specifically for the rehabilitation, renewal and replacement of general plant assets.

In determining the appropriate reserve levels for the General Plant Reserve, the Financial Reserves Policy would recommend focusing on depreciation of the general plant assets.

Assuming that depreciation is a reasonable benchmark for developing appropriate funding levels, there remains some question as to whether the target levels should be tied to accumulated depreciation or to annual depreciation.  In the former case, the advantage would be that BWP would be looking back to pick up the replacement cost of assets that have already aged, and the disadvantage is that this would likely necessitate larger reserve targets.  In the latter case, the advantage would be that the reserve requirement would be lower, but the disadvantage is that the reserve would essentially be picking up rehabilitation for assets moving from this point forward.  The recommended General Plant Reserves is:

• $1.2 million Recommended General Plant Reserve � this level of reserve is intended to provide a more conservative approach to funding renewal and replacement.  It does not include any costs for power supply or distribution assets.

Funding Strategies

The purpose of this section is to develop a more comprehensive funding plan for the recommended reserves above. Funding sources include:

• Use of existing reserves and cash balances of $32.7 million. BWP has accumulated certain reserves to date and these reserves should be considered in the funding of the minimum and recommended reserve levels. As of FY 2002-03, BWP estimates that it will have the following funds available to fund reserves:

• Future budgeted net revenues. For purposes of this report, budgeted net revenue is defined as net income. 

• Additional net wholesale revenues and/or other non-recurring sources of funds.

Application of Sources of Funds

In setting the recommended reserve levels as well as overall funding strategies, it is also worth developing a policy in regard to the future application of funds. The objective would be to create a methodology to establish how the reserve levels would be funded in the future. There are currently three sources of funding: (i) existing reserves, (ii) future budgeted net revenues; and (iii) additional net wholesale revenues and/or non-recurring sources of funds. The Financial Reserves Policy recommends a priority of funding for the reserve from existing and future sources. In all cases, all sources of funds, including future additional net wholesale revenues, would be applied as follows:

1.      To meet the recommended level of reserves in the GOR;

2.      To meet the recommended level of reserves in the Debt Reduction and Capital Funding Reserve;

3.      To meet the minimum level of reserves in the FRR and General Plant Reserve; and

4.      To meet the recommended level of reserves in the FRR and General Plant Reserve.

Based on this priority and once each recommended level has been achieved, future sources of funds would be applied to the Debt Reduction and Capital Funding Reserve.

Additional Recommendations

In addition to the recommended reserve levels, we would also recommend the following:

• Establish a replenishment plan for any withdrawals of one to three years, maximum.   

• Consider interim strategies of access to funds such as assuring access to the City investment pool for a certain amount; a line of credit commitment; or uncommitted capacity in a commercial paper program. Any of these options might also be considered as an interim solution if BWP draws down a significant amount of the funds and has not yet replenished it. Additionally, such strategies might be considered as options for covering the next level of exposure, i.e., higher exposure levels on a permanent basis, by providing access to funds, but not requiring a cash build-up. 

• Plan to revisit and re-evaluate the funding levels at least every two years. Since reserve targets are based on certain assumptions and estimated risks for BWP, the Financial Reserves Policy should be reevaluated more often if there is a material change in BWP�s risk exposures. 

• Recognize that any reserve funding strategies are not a permanent means of addressing any long-term financial impact.  Those can only be addressed through the overall financial plan. 

Water Fund

BWP has also evaluated potential areas of exposure and developed appropriate reserves to ensure the long-term fiscal stability of the water fund.

In developing financial reserves for the water fund, we would note that the water fund has characteristics that mitigate volatility and are important in setting appropriate reserve levels. These characteristics include BWP�s strong service area combined with a citywide customer base which for the most part are residential customers. The service area is also mature and the water system does not have risks associated with rapid growth, such as increased cost pressure generated from long-term large capital water supply requirements. BWP�s supply is generated both locally through existing water rights and from MWD through existing contractual relationships.

Notwithstanding this stability, unforeseen events can occur which would impact BWP�s revenues or expenses. It is appropriate to consider consequences should local production be impacted due to equipment failure or force majeure events, if a make-up purchase is required due to an outage, if operating costs are higher than anticipated, or if regulatory changes are imposed impacting water quality and treatment requirements. In each case, BWP maintains some flexibility to address events through the existing Water Cost Adjustment Charge (WCAC) mechanism. The Financial Reserves Policy is not intended to replace the WCAC. We have included the WCAC as part of the Financial Reserves Policy. The WCAC remains an important management tool that should be considered in the context of setting appropriate reserves. The Financial Reserves Policy is not intended to address significant structural changes, such as those resulting from regulatory changes affecting treatment requirements. These types of changes are likely to take a long lead time to implement and to necessitate a more permanent response, such as restructuring rates, as opposed to simply using reserves.

General Operating Reserve

Water utilities are subject to certain risks, which can vary from small temporary disruptions of service to substantial events, which could result in significant adverse financial consequences to customers. Our approach is to identify and address larger, broader areas of risk that are not likely to be addressed by either insurance or other BWP policies.  

The water fund has a well-established customer base, supply governed by local production and existing contractual relationships with the Metropolitan Water District of Southern California (MWD) and little, if any, exposure to volatile industry conditions. The Financial Reserves Policy is further intended to provide greater timing flexibility to address unforeseen circumstances that may necessitate longer or more permanent solutions, including drought conditions which could otherwise impact BWP�s revenue or cost structure. The WCAC also provides BWP with flexibility in meeting changing circumstances due to unforeseen events. Notwithstanding this flexibility, it is appropriate to maintain a prudent level of reserves to protect against the risk profile facing the water enterprise and is consistent with BWP�s objectives of maintaining low and stable rates. We considered the following categories of exposure for the water enterprise in developing a prudent level of reserves:

• General Consumption/Sales Decrease � this exposure addresses the year-to-year variations in revenues especially given a certain amount of fixed costs within the system.

• Availability of Local Water Supply � this exposure is intended to address the potential cost exposure if BWP cannot meet its local production requirements due to a decrease or temporary interruption of local supply, including but not limited to events related to equipment failure or water contamination. 

• Operational Exposures � this exposure reflects the financial impact of events and circumstances that can affect a water system�s operating budget, including increased variable costs such as chemicals;, additional maintenance costs of unplanned failures and other unexpected increases in the operating budget.

Summary of Exposure Estimates

The table below provides a matrix of the various risk areas for the water fund discussed in the Financial Reserves Policy, with a range of funding responses to each of them, from less conservative levels to more conservative reserve levels.

We would note that some of these categories may be viewed as overlapping, or, alternatively, as another way to estimate a similar exposure.  Further, it is not a requirement to consider only one category of approaches, for example, the one resulting in minimum or more conservative reserves. We have chosen from different reserve levels by category to optimize the aggregate requirement to match BWP�s aggregate risk profile for the water fund.

Recommended General Operating Reserve

BWP�s approach is to recommend a range for the General Operating Reserve (GOR). The recommended reserve level provides a higher degree of comfort and flexibility to withstand more unexpected events but may take longer to accumulate, depending on the water fund�s financial performance over the next several years.

A summary of recommended reserve levels is provided in the following table.

Capital Reserve

BWP has considered funding an additional reserve to cover capital funding and replacement. The rationale for the Capital Reserve would be to provide flexibility to implement capital projects on an emergency basis or when opportunities arise that can reduce BWP�s capital requirements and costs moving forward. The Capital Reserve would be in addition to the General Operating Reserve for the water fund recommended as part of the Financial Reserves Policy.  Additionally, while we have not set aside a separate fleet replacement reserve for the water fund given the size of the requirement, we have included a component for fleet replacement in the Capital Reserve requirement.

Capital Plan

BWP�s projected five-year Capital Plan is expected to range from $3.9 million[1] in FY 2003-04 to $3.0 million in FY 2007-08. The total expected capital program is expected to be $17.1 million.

Recommended Capital Reserve

In setting reserve levels for the Capital Reserve, we have taken into account that the objective is to provided additional flexibility to take advantage of potential opportunities to accelerate capital programs. The recommendation is:

• $3.6 million Recommended Capital Reserve � the recommended level reflects 20% of BWP�s projected $17.9 million Capital Plan over the next five years. This includes $17.1 million for the existing Capital Plan plus $759,000 of projected fleet replacement costs over the next five years.

Recommended Reserves

Given the above comments about utility policy and opportunity, the Financial Reserves Policy recommends a range of reserve levels designed to mitigate BWP�s aggregate water risk profile. We have provided a minimum reserve level and a recommended reserve level for each of the reserves discussed above. The recommended ranges for each reserve and existing funding sources include:

Funding Strategies

The purpose this section is to develop a more comprehensive funding plan for the recommended reserves above. Funding sources include:

• Existing reserves of $7.3 million. As of FY 2002-03, BWP estimates that it will have the following funds available to fund reserves:

• Future budgeted net revenues. 

• Other non-recurring sources of funds.

BWP will revisit the established reserve levels at least every two years.  Since reserve targets are based on certain assumptions and estimated risks for BWP, the Financial Reserves Policy will be reevaluated more often if there is a material change in the risk exposures to BWP. The Financial Reserves Policy is intended to provide guidelines that can impact budget and other policy decision-making. The Financial Reserves Policy is intended to serve as a tool in promoting fiscal stability. The Financial Reserves Policy is not intended to include significant regulatory changes that may affect the cost of operating the water system.

FISCAL IMPACT

The goal of BWP�s Financial Reserves Policy is to establish prudent reserve levels.  These reserve levels should serve to minimize, or at least mitigate, the impact to customers of significant operating and business risks, while ensuring competitive and stable electric rates and the continued ramping in of water rates to pay for replenishment of depleting stored groundwater credits.

RECOMMENDATION

Staff recommends that the City Council adopt BWP�s Financial Reserves Policy for recommended reserve levels and funding strategies as discussed in the staff report.

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