Strategies for operating your co-op or utility in a high-interest rate and high inflation environment
- Jul 13, 2022 11:42 am GMT
High interest rates, high inflation - how do we operate our electric co-op or utility?
We are now in the midst of an economic period we have not seen since the 1970s and early 1980s. Interest rates are moving higher for the foreseeable future, inflation is at a level not seen in 40 years, and economic growth is slowing. This was called "stagflation" in the '70s and '80s.
The point of this article is to discuss how this economic environment impacts management issues at power and utilities organizations. We'll touch on the large areas for consideration. There are not always straightforward answers in these areas, but many points for consideration.
Please add additional points and ideas in the comments section.
Key Points on operating in a high interest rate and high inflation environment
The current environment of higher interest rates and high inflation may be new to many co-op and utility managers.
This environment has happened before and hopefully is part of your organization’s enterprise risk management mitigation plans.
There are proven strategies to follow to navigate these waters including taking care of employees, accelerating projects where it makes sense, manage vendor increases, and manage customer rates.
Accounting standards can provide an assist in deferring costs as you ride out the current environment, for later recovery in customer rates .
What comes first? Take care of your employees!
What? Doesn't the customer come first? In this age of skilled and experienced labor shortages, employees in every industry are in high demand. The power and utilities industry depends on experienced team members to deliver customer service.
A relevant quote from Richard Branson, who founded a travel empire, had these thoughts on employees that pays homage to the need for dedicated, content, and driven team members:
"Clients do not come first. Employees come first. If you take care of your employees, they will take care of the clients."
There is nothing like the current stagflation period to sap the energy and enthusiasm of management and line workers. The thought of working just as hard but seeing your income fall behind can be demotivating. I remember the time in the last stagflation period (yes, I was there 😂) when not getting at least a 10% raise was deflating to your ego. Inflation was running at about 10% in that period.
In the municipal utility and electric co-op environment, it can be politically challenging to increase pay rates at the current inflation rate. It most likely is impossible to do so. But, in the name of employee retention, efforts could be made to pay bonuses to cover the pay/inflation gap or to help with employee retention.
The financial implications of this can be handled in several ways:
1. Bonus amounts can be included in the current year budget and customer rates.
2. Bonus amounts can be deferred using accounting standards ASC 980 or GASB 62 for recovery in future rate changes.
3. Bonus amounts can be paid from cash reserves and included in the current year's financial results and NOT added to customer rates.
Option 3 can be an option where the co-op or municipal utility uses its community leadership to hold down rate increases.
Accelerate capital projects where it makes sense
Notwithstanding the options under taking care of employees, co-ops and utilities still need to take care of business and reliable service delivery to customers. Even though interest rates are moving up, debt is still cheap by historical standards. Before that changes, management should keep the projects moving and accelerate projects if at all possible. Accelerating projects will accelerate debt taken out for those projects.
The objective should be to keep debt service as low as possible and keep a close watch on capitalization (the ratio of debt to total assets). The average public power capitalization was 50% debt in a recent survey. For a distribution utility, moving to a higher capitalization can lead to a squeezing of options and impact on rates. But entities such as joint action electric agencies can take on debt loads of 80% or more since the repayment of debt for a joint action electric agency is the revenue stream of its members who have pledged to pay back the debt.
Manage vendor price increases
Keep in close contact with vendors for their plans for increases in costs both in maintenance items and construction items (such as poles, conductors, meters, etc.) Stock up if:
1. A need is there for upcoming projects AND
2. The cost of internal capital is less than the anticipated price increases
Do not have unnecessary inventory, as inventory cannot be included in customer rates until you build infrastructure with it, but if keeping cash costs less than an anticipated price increase (i.e. Cost of capital < Expected price increase), consideration should be made to stocking up on needed inventory.
Manage customer rate options
Since the last bout of high inflation, electric rate increases have been slow and steady. According to the Bureau of Labor Statistics, increases in electricity costs for consumers increased by approximately 1.3% over the last ten years, relatively close to the rate of inflation.
That has changed with recent increases in commodity costs in natural gas, coal, and oil. Overall, electricity prices on average across the United States have increased 12% from 2021 - mid-2022. The Energy Information Administration (EIA) forecasts that the price per megawatt (mW) for electricity in the summer of 2022 will be triple that of the summer of 2021 in the northeast, nearly double in the Midwest and Texas, and increase 40% to 90% in other power markets in the US. Island utilities, such as a Caribbean or Micronesia utility, generate power mainly with oil. The price of a barrel of oil has doubled since the start of 2021. These increases are generally passed through to customers through a price adjustment mechanism built into electric rates.
What options are there to mitigate increases in customer rates? The commodities must be purchased to generate the electricity that customers are using. If a co-op or utility wishes to reduce or smooth cost increases, there are several options available using accounting tools to mitigate the financial statement impact.
1. Defer a portion of power cost increases on the balance sheet, using accounting standards GASB 62 or ASC 980. Once commodity costs have stabilized, the spike in power costs can be blended into the annual budget and become part of an overall rate adjustment.
2. Suspend power cost adjustment clauses and defer the costs for future recovery, as discussed in #1 above.
3. Defer other significant expenses, such as tree trimming programs, using ASC 980 or GASB 62. Apply the same principle as in #1 to bring these deferred costs back into the budget.
4. More renewable power? Maybe, if you count nuclear and hydropower as renewable resources (it is, in my opinion). Renewable wind and solar power do not support peak loads, and battery technology is not yet on a large enough scale to store and release excess daytime generation at night. This is not yet a complete solution, but it is moving in the right direction.
5. Tap into rate stabilization reserves. If you have rate stabilization reserves, they are there for a rainy day. It’s raining. Use some of those reserves to mitigate rate increases or the impact on the financial statements for foregoing rate increases for now.
There are no easy answers in the area of rates. Deferring expenses is a short-term fix, as the deferred costs must be either recovered in the future or written off if the deferrals will not become part of the co-op or utility rates.
Trim co-op or utility costs?
Cost reductions are difficult to make in a co-op or utility. The average cost structure of a power distribution organization is approximately 80% power related, 10% labor, and 10% "other".
Power costs are variable and follow customer power needs. Labor is a fixed cost, as operations workers perform either capital or maintenance projects and must be part of the workforce to do both. So, the way to cut labor costs is to trim headcount, which is counter-intuitive in today's labor shortage of power and utilities workers.
That leaves us with approximately 10% of the overall utility budget to review for reduction. Significant costs in that 10% are maintenance (non-labor), employee pensions and benefits, finance, Human Resources, information technology, and other support services. These areas should be reviewed for cost control, but significant savings are not usually practical.
Is there any hope in this discussion?
This article turned a bit gloomy, which is not my intent. But the topic is rather gloomy and the outlook for a turnaround is cloudy. Your takeaway can be to review each area discussed in this article for potential mitigation methods. We'll ride out this economic period; the cycles always come through. These times teach us to manage and plan smarter, consider economic changes in your enterprise risk management process, and develop mitigation plans for events such as this.
About Russ Hissom - Article Author
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, improving business processes, and implementing strategy. Russ is passionate about the Power and Utilities Industry 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, broadband providers, and water, wastewater, and gas utilities as a past partner in a national public accounting and consulting firm's power and utilities practice. Russ was named one of the 2021 Top Voices in the Energy Central Community by EnergyBiz Network.
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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