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7105 Addendum No. 2 Purchasing Department 901-B Texas St. Denton, TX 76209 (940) 349-7100 www.dentonpurchasing.com ADDENDUM #2 RFP #7105 RFQ WATER/WASTEWATER UTILITIES COST OF SERVICE AND RATE DESIGN STUDY Issue Date: July 2, 2019 Response due Date and Time (Central Time): Tuesday, July 30, 2019, 11:00 A.M. C.S.T RFP # 7105 ADDENDUM #2 The following are changes to the specification sheet: Q1: Will the maintenance contract be for “on-call” services or will awarded Contractor be updating the model annually? A1: The City prefers a “cafeteria” plan with several options. For example, Option 1 might involve a review of staff updates to model using data for the upcoming FY, Option 2 could be assisting staff in updating aspects of the model to accept new data for the upcoming FY, Option 3 could be a complete model update, etc. Staff intends to negotiate the final scope and costs for this particular component of the project with the highest ranking respondent. Q2: Scope of Services, Section 2B, mentions documents “Utilities Financial Strategies and Water Conservation and Drought Contingency Plan” and states the respondent shall review this information to ensure that the proposed rate design is supportive of these goals. Where is that file located? A2: Utilities Financial Strategies and Water Conservation and Drought Contingency Plan document attached herein. NO OTHER CHANGES AT THIS TIME. Please acknowledge addendum of the main solicitation document when submitting a proposal. 1 UTILITIES FINANCIAL STRATEGIES FY 2016-2017 PURPOSE The goal of this document is to establish the financial strategies for the Denton Municipal Electric Fund (DME), Water Fund, Wastewater Fund (collectively referred to in this document as “Utilities” or “Funds”) and the Solid Waste & Recycling Fund (also referenced as “Funds”). As a provider of municipal electric, water, wastewater, and solid waste services, the City of Denton must keep pace with demands, effectively manage escalating capital and operational costs, meet all infrastructure needs, and have the resiliency to recover quickly from unanticipated impacts. This Financial Strategies document addresses these goals by describing the challenges faced by Utilities and establishing strategies to manage these challenges while maintaining financial stability and resiliency. Establishing, routinely evaluating, and implementing financial strategies will help Denton to continue to provide the excellent level of reliable service expected by our customers. The strategies included in this document should be used as guidelines for policy and management decisions. Since issues and challenges change through time, the strategies should be reviewed periodically and modified as appropriate. In general, strategies should address objectives that support and strengthen the financial health of each Fund. Strategies in this document are based in part on Government Finance Officers Association (GFOA) best practices, various utility industry financial policies and practices, and objectives specific to each Fund. CURRENT CHALLENGES Black and Veatch recently released a report entitled “2015 Strategic Directions: U.S. Water Industry Report”. This report surveyed both Water and Wastewater Utilities in the United States with the intention of determining major challenges that Utilities are currently facing or anticipate facing in the near future. The report also compared Utility responses to questions asked in the 2012 Strategic Directions survey to responses to similar questions in 2015. The most important financial challenges reported by industry respondents in order of importance were: aging infrastructure, managing operational costs, managing capital costs, aging workforce, and increasing regulations. It is interesting to note that aging infrastructure, managing capital costs, and increasing regulations were also in the top five responses in 2012. However, the degree of importance attributed to managing capital costs and increasing regulations decreased from 2012 to 2015. Aging infrastructure and an aging workforce increased from 2012 to 2015, with 2 concerns about aging workforce representing the largest increase in importance over the three year time period between surveys. Denton is facing challenges similar to those faced by many utilities in the United States. Aging infrastructure and growth related infrastructure needs are concerns that require sustained, long term commitments to fully address. Increasingly stringent regulations and regulatory responsibilities, cost escalations, and the erosion of buying power due to inflation are also major challenges. Less obvious issues such as an aging workforce, succession planning, trends towards decreasing per capita consumption, changing trends in waste generation and disposal, improving technologies, and continued progress of optimization efforts also influence financial strategies and overall management. Reliability of electricity generation and distribution, and the associated regulatory compliance and infrastructure needs, continue to be major issues. The rapid growth of the City also presents challenges, and will have a large influence on future operating and capital budgets. Recent economic downturns have resulted in more stringent financial “due diligence” standards. As a result, rating agencies and institutional investors are requiring increasingly detailed information about operating and financial conditions, and are now beginning to request and evaluate more detailed reports on regulatory management, local economic conditions, and sustainability efforts as a part of municipal rating analyses. Rating agencies are also giving more scrutiny to reserve levels, capital demands versus debt service, and similar measures that gauge the resiliency of utilities and local governments. The issue of resiliency is particularly important, and was chosen as a key focus topic for the 2015 Black and Veatch study. Because these issues are constantly evolving, the Financial Strategies document should be regularly reviewed and revised to ensure strategies are effectively addressing challenges. OBJECTIVES One of the primary objectives of the Financial Strategies document is to summarize approaches needed to maintain financial stability and resiliency. Financial stability is, by definition, the proper balance between revenues and expenditures. Revenues must be sufficient to meet the operational requirements and bond covenants. While reserve funds may be available to help meet financial obligations on either a planned or emergency basis, stable and adequate rate revenues remain the cornerstone of both short and long term financial stability and resiliency. It is important to distinguish between the goals of financial stability and resiliency. Although a balanced budget represents a system that is financially stable, if the system is not resilient an unanticipated external shock could unbalance the system and potentially lead to collapse. Local utilities face significant external challenges, including both short and long term economic fluctuations, cost escalations, unfavorable weather patterns, natural disasters, unanticipated capital expenditures, and policy changes from federal, state, and local levels of government. 3 The Financial Objectives outlined below are designed to address both financial stability and improve resiliency. Financial Objectives  Each Fund should operate as a self-supporting business operation (enterprise fund) through balanced revenues and expenditures.  Rates are generally based on cost of service and other financial and pricing objectives, are reviewed annually by staff, and are supplemented by external consultant studies at approximate five year intervals.  To the greatest extent possible, rates should be incrementally adjusted to achieve revenues targets over multi-year periods in order to minimize the need to have large annual rate increases / rate spikes.  Financial policies will ensure to the greatest extent possible that inter-rate class subsidies are minimized or eliminated.  Rates should be competitive and competitiveness should be routinely assessed as part of the budget process.  Each Fund will maintain prudent reserve levels, with targets specific to the objectives of the Fund, to ensure Funds are both balanced and resilient.  Water and Wastewater should each maintain a development plan line reserve to not exceed $1 million each to facilitate local economic growth in accordance with the City Council infrastructure financing policy Resolution R91-008.  Water and Wastewater should maintain a separate impact fee reserve fund and use this fund to offset debt service payments on impact fee eligible capital projects. Each utility should strive to maintain the impact fee reserve level at not less than $1 million.  Solid Waste & Recycling should continue funding the Landfill Closure & Post-closure Fund to meet Texas Commission of Environmental Quality financial assurance requirements.  Solid Waste and Recycling should continue to strategically use the Vehicle Replacement Fund to increase cash funding of collection trucks and reduce the Funds use of debt financing. P RESERVE FUNDS Reserves serve multiple functions. For example, reserves can be used to address variability and timing of expenditures and receipts, and to accommodate occasional disruptions in activities, costs, or revenues. The use of reserves can help limit exposure to revenue shortfalls, meet long term capital obligations, and help reduce the potential for defaults. Reserve funds are established to provide financial stability and are a key component of resiliency. Typically, reserve fund target levels are expressed as a percentage of annual operating 4 expenses, or as a given number of days of operating expenses. Targets in this document are provided as the number of days of operating expenses that could be sustained with the given reserve amount. Reserve fund targets are generally based on average expenses, analyses of cash flows, volatility of revenues and expenditures, estimates of total fixed asset costs, replacement costs for critical system assets, and industry best practices. Targets are expressed as ranges that are appropriate for the unique operating characteristics of each Fund. Factors that affect the target reserve levels include revenue stability, expense volatility, infrastructure age, debt levels, unforeseen expenditures, and management plans for reserve use. Reserve funding amounts are derived from the appropriable fund balance calculations made at the end of each fiscal year, and do not include funds that are restricted, designated, or otherwise committed for specific purposes. Since reserves are established to stabilize and strengthen Fund finances, reserves should not normally be used for recurring expenses. Reserves should be thought of as containing at least two components: a working capital reserve target as well as an operating reserve target. While these components can overlap, it is important to understand the purpose and designated uses of each component. The working capital component of each reserve funds (or “WC”) provides a minimum unrestricted fund balance to provide the liquidity needed to allow regular management of payables and payment cycles. This includes both anticipated issues such as billing and receipt cycles and payroll, as well as small scale unanticipated changes. WC helps meet the fixed cost of doing business when short term cash deficiencies occur due to the timing of revenues and expenditures. As a general guideline, the WC target level for each Fund is established as 30 days of average total expenses (8%). The undesignated balance of each Fund will first be used to fund the WC reserves to the target level. Once the target WC reserve level is achieved, excess funds shall be applied to the operating reserve. The operating reserve (“OR”) component provides a means of managing expense and demand volatility, ensure that funding is available for emergencies such as equipment or infrastructure failure, and serve to improve overall resiliency. Funds are vulnerable to both short term and seasonal changes in demand and expenses due to weather patterns, regulatory compliance issues, unanticipated price increases for purchasing operational commodities, economic growth, fuel price spikes, market prices for recyclable commodities sold, and other similar budgetary impacts. Appropriate reserve levels can accommodate these changes without negatively impacting rates. Operating Reserves also serve as a buffer in case of large capital needs due to unanticipated infrastructure failures or catastrophe. Operating Reserves therefore help minimize the need for large rate increases from year-to-year and decrease the likelihood of requiring unanticipated actions such as mid-year rate adjustments. In addition, the various Funds may maintain specific 5 additional reserve components in order to maintain financial stability, resiliency, and the requirements of Federal and State Law. In general, Funds with more stable revenue collection can consider lower OR targets. However, Funds with greater volatility should establish higher targets to provide some protection against large scale fluctuations in revenues and expenditures. Funds should review and adjust reserve targets over time, and as necessary, to protect against potential losses and to maintain overall stability. The reserve should be reviewed and recalibrated through the normal annual budget and rate-setting process. Since expenses typically increase over time, the actual dollar amount of the reserve will increase proportionally with increases in expenditures. Working Capital and Operating Reserve targets for each Fund, expressed as a percent of expenses, are: Electric* Water Wastewater Solid Waste & Recycling Working Capital 8% 8% 8% 8% Operating Reserves 8-12% 25-42% 20-31% 6-10% Total 16-20% 33-50% 28-39% 14-18% Operating Days (60-75 days) (120-180 days) (100-140 days) (52-66 days) *does not include Texas Municipal Power Agency (TMPA) Debt payments It should be noted that the Drainage Division maintains a specific Drainage Reserve fund of one million dollars that is separate from the Wastewater Reserve fund. The Drainage Reserve fund is reserved for emergency responses and repairs during and after catastrophic weather events. It is also important to note that Denton Municipal Electric (DME) has enacted a strategy for addressing the debt obligation to the Texas Municipal Power Agency (TMPA). The specifics of this debt reduction strategy are unique to DME and are beyond the scope of this Financial Strategies document. However, the TMPA debt strategy is important to discuss within the context of the reserves because funds accumulated and applied towards the debt are a component of the reserves for DME. As a result, the total DME reserve amount will at times exceed the reserve targets outlined in the table above. The reserve funds in excess of the target range will be applied to the TMPA debt, and the overall TMPA debt strategy and status will be reviewed and discussed with the Public Utilities Board as a part of the annual budget process. Operating Reserve Liquidation If operating reserves exceed the target range, they may be brought back to the target range through a sequential decision making process that will be at least partially contingent on the amount of surplus remaining. While the decision making process is going to be somewhat unique to a given budget year, there are common issues to consider. In general, actions for 6 operating reserves that exceed the target level should only be considered if the reserve is projected to continue above the target level for the next two to three years. If this is the case, the excess funds could be considered for optional uses. Optional uses include, but are not limited to:  Additional debt management through debt reduction payments  Transfer excess funding to specific Fund project(s) (typically one -time capital outlay).  The funding of capital assets using cash funding versus debt service.  Retain reserves as a potential long term rate stability strategy. This option increases reserves, which would allow reserves to be available in future years to either delay or reduce rate increases or for capital and debt management. In general, this approach is a way to plan for revenue smoothing for anticipated future costs, where funds will be used to mitigate the size of a rate increase in a given (future) year.  Use for rate reduction by reducing current proposed rates, if it is projected that the rate reduction can be sustained for a specific period of time. SYSTEM CAPITAL AND REINVESTMENT POLICIES The funding of capital assets should be based on the type of asset, cost, and expected life. Generally, major new infrastructure, funded via debt, should be financed with a payment schedule equal to or less than the expected asset life. Existing infrastructure strategies are more complex since existing assets lose value each year of service as the assets moves through use cycles towards eventual replacement. This decrease in value is generally reported as an annual depreciation expense, which is based on the original cost of the asset over its anticipated useful life. While this expense reflects the consumption of the existing asset and the original investment, the replacement of the asset is likely to cost more when considering adjustments for inflation and the current construction market. Thus, it is likely that the annual replacement liability may be substantially greater than annual depreciation expense. The issue of true replacement costs becomes particularly important when considering debt funding versus rate revenue funding for existing infrastructure replacement. Debt funding existing asset replacement can have long term negative financial consequences due to the compounding issues of true replacement costs and debt interest. To ensure that utilities systems are sustainable over time, the replacement of existing assets should be financed from current revenues to the greatest extent possible. As a future goal, the target level of current revenue infrastructure replacement funding should be generally based on annual depreciation expenses, adjusted for major assets replaced at long intervals and that are too expensive to fund with current revenues. However, analyses should also include the current versus original asset cost to account for the effects of inflation and other cost escalation factors. The current revenue funded capital target for infrastructure replacement for Water and Wastewater is based on estimates of the average annual replacement costs for major infrastructure components. For the Water Department, the target is 100% of annual transmission and distribution infrastructure replacement costs, and 25% of annual plant replacement costs. Wastewater targets are 100% of 7 the annual interceptor and collector infrastructure replacement costs, and 25% of annual plant replacement costs. Average annual replacement costs should be evaluated, adjusted and implemented on a regular basis, preferably annually and at a minimum of every 3 years. DEBT MANAGEMENT Debt management strategies establish acceptable outstanding debt levels, outline debt repayment, and address total debt coverage targets. Strategies for debt related to vehicles and equipment replacements are also included in this section. Debt management strategies are as follows:  Generally, debt financing should only be considered for projects involving new capacity.  If practical, debt repayment schedules should be based on level annual payments over the payment life.  Bond covenants have been established to define the minimum debt coverage ratio as a means of protecting against non-payment. The Utility systems (Electric/Water/Wastewater) must maintain a debt coverage ratio of 1.25 or greater by covenant, calculated as a ratio of the most recently completed prior fiscal year net revenues divided by the projected debt service costs the first fiscal year after the current fiscal year bond sale. The goal of the Solid Waste Fund is to maintain the same debt coverage ratio of 1.25 or greater. It should be noted that the calculation outlined above is slightly different than the calculation method outlined in the Debt Service Management Policy (Policy No. 430.07).  If needed, operating reserve funds may be used to supplement the net revenues required to achieve the utility system 1.25 debt coverage ratio per Ordinance 2002- 318.  In general, vehicles and associated equipment should be financed with a vehicle replacement fund that is self-sustaining. After vehicles or associated equipment assets are purchased, annual payments should be made into a vehicle replacement fund so that subsequent replacement of vehicles/equipment is financed from that fund. Expensive vehicles and equipment may be financed with short term debt if needed. Specialized equipment with an asset life of approximately 10 or more years may be purchased with bond funds of a term appropriate to the specific item. Less expensive equipment should be financed from current revenue to the maximum extent possible. 8 PRO FORMA AND FORECAST DOCUMENTS Five year pro forma documents should be prepared annually for each Fund. Pro formas should include projections of commodity use/volumes, revenues, expenses, rate changes, and reserve balances. Pro formas serve as a five year financial planning summary document. Pro formas also identify and highlight future financial issues that must be addressed through revenue increases, cost reductions, changes in capital financing options, or rate changes. Each Fund should also prepare an annual forecast document, covering a period not less than 20 years, that projects customer growth, production/treatment volumes, customer billings, billed usage/volumes, and other data that supports the development of budget and capital plans and similar planning documents. CONCLUSIONS The financial strategies outlined in this document are intended to guide policy and management decisions. In doing so, the strategies will help Denton continue to provide reliable service at competitive rates, while accommodating financial variability, population growth, and infrastructure needs. The strategies will also ensure a balanced, sustainable and resilient budget. The financial strategies document will be reviewed each year with the Public Utility Board prior to the beginning of the budget cycle. 9 ADDENDUM – PERFORMANCE METRICS This section presents performance metrics that may be used for benchmarking Utility performance over time, or that may be used to compare against other utilities. For some Water and Wastewater metrics, the American Water Works Association “AWWA” Benchmarking Survey provides a comprehensive, defensible means of benchmarking for on a regional and national basis. The Fitch Ratings U.S. Water and Sewer Revenue Bond Rating Criteria, September 3, 2015also provides some qualitative metric attributes that may be useful for Water and Wastewater. Similar benchmarking surveys are available for Denton Municipal Electric through the American Public Power Annual Directory and Statistical Report. Additional sources may be identified through future research efforts. When considering these performance metrics, it is important to note that each Utility is unique, and comparisons need to be considered with each utility’s specific characteristics in mind. However, comparisons among utilities are becoming increasingly sophisticated, and measures of utility performance from studies by utility-specific professional organizations and via programs used by financial rating agencies are generally becoming more comparable over time. The metrics included below are designed to assess and track the financial performance of the respective utilities. However, it is important to note that some performance metrics related to personnel and operational issues are also included. While these metrics may not be directly related to financial performance, the issues conveyed by the metrics have the ability impact budgets and therefore may ultimately influence financial performance. For this budget cycle, the concept of Performance Metrics is being proposed and discussed with the PUB, and is therefore currently considered an addendum to the Financial Strategies document. However, if the approach is deemed beneficial, staff proposes to make the Performance Metrics section a permanent part of the Financial Strategies document at some point in the future. The current list of performance metrics should be evaluated on a routine basis, and additional metrics should be added as needed. Performance metrics are intended to be reviewed as a part of the budget presentations provided to the Public Utility Board, particularly with regards to evaluating trends over time. By reviewing performance metrics on a regular basis, tracking trends, and assessing metrics against benchmarks, Denton Utilities will be able to make more informed management decisions. The following table summarizes the proposed performance metrics. 10 Table 1. Performance metrics and benchmark sources. Performance Metric Utilities Benchmark Cash Reserves W,WW,DME, SW  Year over year  AWWA1, Fitch3 (W/WW) Current Ratio SW  Year over year Customer accounts per employee W,WW, DME, SW  Year over year  AWWA1,  APPA2 (DME) Debt Ratio W, WW, DME  Year over year  AWWA1 (W/WW)  APPA2 (DME) Debt Service Coverage Ratio W,WW, SW  Year over year  AWWA1, Fitch3 (W/WW) Employee Turnover W,WW,DME, SW  Year over year  AWWA1 (all) O&M cost per account W,WW, DME, SW  Year over year  AWWA1, (W/WW)  APPA2 (DME O&M cost per mile of pipe (W,WW) or transmission distribution lines (DME) W,WW, DME  Year over year  AWWA1,  APPA2 (DME) Retirement eligibility W,WW,DME, SW  Year over year  AWWA1 (all) Top 10 customers as a % of operating revenue W,WW,DME, SW  Year over year  Fitch3 (W = Water; WW = Wastewater; DME = Denton Municipal Electric; SW = Solid Waste) 1 American Water Works Association “Benchmarking Performance Indicators for Water and Wastewater Utilities Survey and Analyses Report, 2014”. 2 American Public Power Annual Directory and Statistical Report 3 Fitch Ratings U.S. Water and Sewer Revenue Bond Rating Criteria, July 31, 2013. 11 Cash Reserves (days): Calculated as the amount of undesignated cash reserves ÷ total expenditures. This metric measures the Fund’s available liquid resources to meet near term liabilities and the utility’s resiliency to unforeseen hardships or difficult operating conditions. Current ratio: Calculated as current assets ÷ current liabilities. This metric summarizes liquidity and the ability to pay short-term liabilities (debt and payables) with short-term assets (cash, inventory, receivables). Customer accounts per employee: Calculated as the number of active accounts ÷ the total number of Full Time Employees (FTEs). The total number of FTEs does not include Customer Service, Utility Administration, or Drainage. Debt Ratio: Calculated as total liabilities ÷ total assets. This metric quantifies a utility’s level of indebtedness by providing a measure of the extent to which assets are finances through borrowing. Debt Service Coverage Ratio: calculated as the previous fiscal years net operating revenues ÷ upcoming fiscal year debt service obligations (principal and interest) to give the current fiscal year’s Debt Service Coverage Ratio. This metric summarizes the amount of cash flow available to meet interest, principal, and sinking fund payments. Employee Turnover. Calculated as the number of employees leaving the organization during the prior fiscal year ÷ total number of FTEs. The total number of employees excludes Customer Service and Utility Administration, or Drainage. O&M cost per account. Calculated as total operation and maintenance costs ÷ total number of accounts. Higher ratios may indicate inefficiency or may be the result of aging infrastructure. Depreciation is not included in the total operation and maintenance costs. O&M cost per mile of pipe (W,WW) or transmission distribution lines (DME) . Calculated as the total operations and maintenance costs ÷ the total miles of distribution system piping (W), collector piping (WW), or transmission and distribution lines (DME). Higher ratios may indicate inefficiency or may be the result of aging infrastructure. Depreciation is not included in the total operation and maintenance costs. Retirement eligibility. Calculated as the number of employees eligible for retirement in the next 5 years ÷ total number of FTEs. The total number of employees excludes Customer Service, Utility Administration, and Drainage. Top 10 customers as a percent of operating revenue. Calculated as the annual revenue from the top ten customers of each utility ÷ total annual revenue. This metric reflects volatility risks from customer concentration.