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Electric Cooperative Financial Strategies - Cash Reserves and Capital Credits

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Owner, Utility Accounting Education Specialists - utilityeducation.com

Russ is the owner of Utility Accounting Education Specialists a firm that provides power utilities consulting services and online/on-demand courses on accounting, finance, FERC best-practices,...

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Managing your electric co-ops' capital credit policy is a key part of financial strategy

Electric cooperative financial strategies include operating cash flows, cash reserves, debt, and customer investments, which are called capital credits. A key financing component for an electric cooperative operations and projects are customer (aka owner) "capital credits". What are capital credits, and how can your cooperative establish a capital credit policy that maintains proper cash balances and cash flows while eventually refunding credits or paying to your owners.

Article Takeaways

1. Capital credits are investments by electric co-op customers in the cooperative's equity.

2. Establishing cash reserves is the first step in any policy development for capital credit retirements.

3. Long-term co-op financial planning incorporates cash reserve, equity, capital improvements, rate changes, and debt issues for a holistic and comprehensive approach.

 

What are capital credits, and how do they impact electric co-op finances?

Electric cooperatives had their roots in the New Deal policies of the 1930s. When the Rural Electrification Administration (REA) began, funds were loaned to applicants to construct electric facilities in rural areas. The program rapidly grew the electrification of rural America.

The financing of electric cooperatives was and is a mixture of loans from the REA, electric rates, and capital credits. Capital credits (patronage capital) are the amounts invested in the co-op by customers through their electric rate payments.

The mechanics of capital credits are based on how much the member paid the cooperative for electricity for the most recent year. After determining that the cash flow needs of the co-op have been met and that the co-op has adequate cash reserves to serve customers, the margin on sales that a co-op has each year is allocated to a member's capital credit account. A capital credit is like a share of stock. It follows the owner wherever they go. In this case, the stock may provide dividends. :)

Electric co-ops return capital credits to customers using this process:

The balance in each co-op member's account is calculated annually. Payments are made by year by year of the accumulated member capital credit. Capital credits can be returned to member's through future reductions in rates or as direct payments.

Best practices in cash reserve balances - How do we calculate optimal cash flow needs?

While this article discusses the capital credit process, if your organization is a public power or investor-owned utility, then this section on best practices in calculating cash reserve balances also applies to your utility.

The simple formula for calculating reserve needs is:

The wild card in this equation is the cash reserves amount. What is an optimal balance, but not too much to suggest that electric rates are set at a level that is too high? We'll dive into the mechanics of calculating the amount of cash to retain in the business with a detailed example shortly.

Cash reserves serve to build organization equity, which minimizes debt requirements. Other goals for cash reserves include providing funds for capital projects and mitigating rate increases.

Cash reserves and the bond rating agencies

An electric cooperative's main debt funding source is the REA. But a good resource to determine unrestricted cash reserve needs can be based on metrics published by bond rating agencies. For example, Moody's Investor Service (Moody's) uses the following levels to determine the weighted impact of unrestricted cash reserves on a bond rating:

Unrestricted cash on hand is calculated as:

Unrestricted cash and investments + lines of credit x 365 days divided by annual operating and maintenance expenses

What is the right amount of cash reserves to have available?

But realistically, cash reserves are more than just unrestricted cash and investments. At a minimum, there should be enough cash reserves to pay for one operating cycle's expenses for openers. For example, if your co-op purchases power from a G&T Co-op or produces power, there will be a lag between purchasing this month's power and payments from customers at the end of next month. Next, capital project needs must be funded for a defined period. Depreciation expense in customer rates is designed to pay for routine fixed-assets replacement. If not all of the amounts recovered in customer rates through depreciation are used in a year, the unused portion should be set aside as reserves. Amounts should also be reserved for capital additions that are slated to be constructed and paid for with internal reserves.

An example of a cash reserves calculation is based on this scenario for Customer Service Cooperative:

1. Co-op operating expenses for the year are $40 million plus $20 million for purchased power

2. Depreciation expense is $5 million

3. Routine capital improvements in the current year are $5 million

4. Debt service for the year is $4 million

5. Additional capital projects to be funded with reserves in the current year are $2 million

What are the minimal and optimal cash reserves for Customer Service Cooperative? The minimal amount is calculated using 30-days of unrestricted cash on hand. The optimal amount is based on 150 days of cash on hand, which is Moody's minimum for an "Aa" rated bond.

 

Each organization will be different in its approach to cash reserves. The reserve philosophy is based on the risk tolerance of management and the Board and the decades of embedded history of the organization.

Allocating margins to each capital credit account

A simple and consistent approach to allocating margins to each capital credit account is with the following formula:

Margin/Total Sales = Allocation Factor

Allocation Factor x Individual Member Payments (Sales) = Share of Capital Credits

The share of the capital credit is credited to the member's account. The capital credits are tracked by year of the credit.

Returning, aka "retiring" capital credits to members

Capital credits are returned to both members and former members. A common method of returning member capital credits is first to pay out the oldest balances. This is also called a FIFO (first in, first-out) method. FIFO is the method, but it should (and is) for many co-ops part of a longer-term financial strategy that incorporates electric rates, capital improvements, and debt issues.

As an example policy, the Basin Electric Cooperative, a $2 billion electric cooperative, returned $64 million to members in 2021 through a combination of rate refunds and retirement of capital credits. This philosophy uses a combination of rewarding current ratepayers for their system contributions while paying a dividend to legacy capital credit holders for their past investments in the co-op. This is a twist on the FIFO method. But the key is Board policy of a consistent approach. The Boards of co-ops are made up of members, so this approach was definitely agreeable to the co-ops' membership.

The electric financing model

The electric co-op financing model uses the proven combination of equity and debt. Cash reserves and capital credits are a way to manage the equity portion of the equation. The key is to incorporate reserve, capital credit planning, electric rates, capital additions, and debt issues into the long-ranging planning and forecasting of the co-op. A written policy with Board approval is key to a smooth and beneficial process.


About Russ Hissom - Article Author

Russ is the owner of Utility Accounting Education Specialists. Russ is passionate about the Electric and Telecom Industries and his goal is to share industry best-practices to help better your business and enhance your career knowledge. He has over 35 years serving electric investor-owned and public power utilities, electric cooperatives, and telecom providers as a past partner in a national public accounting and consulting firm's energy practice. Russ was named one of the 2021 Top Voices in the Energy Central Community by EnergyBiz Network.

Find out more about about Utility Accounting Education Specialists here or you can reach Russ at russ.hissom@utilityeducation.com




 

The material in this article is for informational purposes only and should not be taken as legal or accounting advice provided by UAES. You should seek formal advice on this topic from your accounting advisor.

 

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