Water and Sewer Rate Studies: A Financial Planning Guide for Utilities
Executive Overview
Water and sewer rate setting is among the most visible and contentious decisions in municipal governance. Rate increases trigger community backlash, generate media coverage, and test the political courage of elected officials. Yet rates set too low create financial crises: inadequate revenues for system maintenance, deferred capital improvements, and eventual service disruptions.
A professional rate study—conducted by a qualified rate consultant or in-house finance team—provides the objective foundation for rate decisions. It quantifies the full cost of service, projects revenue needs over a multi-year period, and justifies rate increases to customers, auditors, and rating agencies.
This guide walks through the complete rate study process: cost-of-service methodologies, revenue requirement analysis, rate structure design (tiered, seasonal, capacity charges), debt service coverage ratios, affordability analysis, and the GASB enterprise fund accounting framework that underlies utility financial reporting.
By the end, utility managers and finance directors will understand how to build a defensible rate model, communicate rate increases to the public, and maintain financial sustainability for essential water and wastewater infrastructure.
The Purpose of a Rate Study: Why It Matters
Primary Objectives
Cost Recovery: Ensure rates cover the full cost of providing water and wastewater services, including operations, maintenance, debt service, and capital replacement
Financial Stability: Generate sufficient revenues to maintain bond covenants (debt service coverage ratios) and retain adequate reserves for emergencies
Capital Planning: Fund infrastructure replacement and system improvements necessary to maintain water quality, reliability, and regulatory compliance
Equity: Design rate structures that allocate costs fairly across customer classes (residential, commercial, industrial) based on usage and impact
Regulatory Compliance: Meet EPA, state drinking water, and clean water act requirements for system reliability and water quality investments
Transparency: Provide elected officials and customers with clear, defensible justification for rate changes
Legal Framework
Water utilities operate under distinct legal authority from general government funds:
- State Water Law: States grant utilities the power to charge rates sufficient to pay for operations and capital improvements
- Bond Covenants: Revenue bonds issued by the utility typically require minimum debt service coverage ratios (usually 1.20x to 1.50x, depending on bond rating)
- EPA and State Requirements: Clean Water Act and Safe Drinking Water Act require utilities to invest in compliance infrastructure; rates must reflect these costs
- Consumer Protection: Some states (California, Illinois, others) have affordability protections; rates cannot exceed a specified percentage of household income for low-income customers
Frequency of Rate Studies
Best practice suggests:
- Large utilities (>100,000 customers): Comprehensive rate study every 3 years
- Medium utilities (20,000–100,000 customers): Every 5 years
- Small utilities (<20,000 customers): Every 5–7 years
Annual rate studies are conducted in interim years to adjust for inflation, actual operating costs, and changes in cost of service.
Cost-of-Service Analysis: Two Primary Methodologies
Methodology 1: Total Cost of Service Approach
This approach sums all costs incurred to provide service, then allocates those costs across customer classes and usage tiers.
Step 1: Identify All Costs
| Cost Category | Description | Example |
|---|---|---|
| Operations & Maintenance (O&M) | Salaries, chemicals, electricity, meter reading | $2,450,000 |
| Administrative & General (A&G) | Finance, HR, management, customer service | $680,000 |
| Depreciation | Non-cash allocation for asset replacement | $1,200,000 |
| Debt Service (P&I) | Principal and interest on revenue bonds | $2,100,000 |
| Taxes & Permits | License fees, regulatory assessments | $95,000 |
| Total Annual Costs | $6,525,000 |
Step 2: Allocate Costs to Functions
Costs are grouped by function (production/treatment, transmission, distribution) to match them with customer classes. A residential customer mainly uses distribution costs, while a large industrial user bears treatment and production costs.
| Function | Allocation Basis | Residential % | Commercial % | Industrial % |
|---|---|---|---|---|
| Treatment | Volume | 45% | 35% | 20% |
| Transmission | Peak capacity | 40% | 45% | 15% |
| Distribution | Number of connections | 55% | 30% | 15% |
Step 3: Determine Water Consumption Baseline
Separate fixed costs (e.g., meter reading, billing, capital replacement) from variable costs (e.g., chemicals, electricity, which scale with usage).
- Fixed Costs (per customer): $35/month (minimum charge)
- Variable Costs (per gallon): $0.00325/gallon (marginal cost of production)
Step 4: Calculate Rates
For a typical residential customer (average 8,000 gallons/month):
- Fixed charge: $35.00
- Variable charge: 8,000 × $0.00325 = $26.00
- Monthly bill: $61.00
Rates are then tiered (higher rates for usage above a baseline) to encourage conservation and reflect higher marginal costs at peak times.
Methodology 2: Revenue Requirements Approach
This approach works backward from required revenues to establish rates.
Step 1: Identify Revenue Requirements
| Item | Amount |
|---|---|
| Operating expenses (O&M, A&G) | $3,130,000 |
| Debt service (P&I) | $2,100,000 |
| Reserve fund contribution | $300,000 |
| Capital improvement plan (pay-as-you-go) | $750,000 |
| Total Required Revenues | $6,280,000 |
Step 2: Estimate Billable Consumption
If the utility has 15,000 metered connections, each consuming an average of 8,000 gallons/month:
- Total annual consumption: 15,000 × 8,000 gallons × 12 months = 1.44 billion gallons
- Fixed revenue from meter charges: 15,000 connections × $35/month × 12 = $6.3 million
- This exceeds our revenue requirement! So we reduce the meter charge and add a usage component.
Step 3: Solve for Required Unit Rate
If fixed charges cover only partial recovery ($5 million), then:
- Revenue needed from usage charges: $6,280,000 - $5,000,000 = $1,280,000
- Required unit rate: $1,280,000 / 1.44 billion gallons = $0.00278/gallon
Step 4: Build Tiered Rate Structure
- Tier 1 (0–6,000 gal/month): $0.00250/gallon (within-district conservation rate)
- Tier 2 (6,001–12,000 gal/month): $0.00325/gallon (standard rate)
- Tier 3 (12,001+ gal/month): $0.00425/gallon (excess consumption rate; encourages conservation)
Example Residential Bill (10,000 gallon month):
- Fixed charge: $35.00
- Tier 1 (6,000 gal × $0.00250): $15.00
- Tier 2 (4,000 gal × $0.00325): $13.00
- Total: $63.00/month
Comparison: Cost-of-Service vs. Revenue Requirements
| Dimension | Cost-of-Service | Revenue Requirements |
|---|---|---|
| Approach | Allocates actual costs by function | Works backward from required revenue |
| Complexity | More detailed; requires function allocation | Simpler; policy-driven |
| Flexibility | Less room to adjust; costs drive rates | More flexible; can model different scenarios |
| Communication | Easy to explain to customers ("here's what we spend") | May be harder to justify rate structure |
| Use Case | Mature utilities with stable operations | Growing utilities; major rate changes |
Best Practice: Use both methodologies and compare results. If they diverge significantly, the utility likely has inefficiencies or pricing inequities to address.
Rate Structure Design: Fixed, Tiered, and Seasonal Components
Fixed Charges (Connection/Service Fees)
Fixed charges recover costs that don't vary with usage: meter maintenance, reading, billing, customer service, and a portion of fixed infrastructure costs.
Typical Range: $20–$60/month per connection (varies by utility size and service area)
Advantages:
- Predictable revenue (less sensitive to drought or conservation)
- Reflects true cost to serve customers
- Fair to all customers (not volume-based)
Disadvantages:
- Low-income customers dislike flat fees (regressive)
- May discourage conservation (high-use customers say "we're already paying, so use more")
Volume-Based (Usage) Charges
Structured in tiers to encourage conservation and reflect higher marginal cost at peak demand.
Common Tier Structures:
Uniform (Single-Rate) Structure:
- All consumption charged at $X per thousand gallons
- Simple but doesn't incentivize conservation
- Now rare; most utilities have moved to tiered pricing
Two-Tier (Inclining Block) Structure:
- Tier 1: 0–500 CCF (Ccf = centum cubic feet = 100 cubic feet ≈ 748 gallons) @ $2.50/CCF
- Tier 2: 500+ CCF @ $4.00/CCF
- Encourages conservation; higher rates for high-use customers
Three-Tier Structure:
- Tier 1 (Baseline): 0–350 CCF @ $2.50/CCF (essential use)
- Tier 2 (Above baseline): 351–600 CCF @ $3.50/CCF (discretionary use)
- Tier 3 (Excess): 600+ CCF @ $5.00/CCF (luxury/waste)
Example: Tiered Bill Calculation
A residential customer uses 450 CCF per month:
- Tier 1: 350 CCF × $2.50 = $875
- Tier 2: 100 CCF × $3.50 = $350
- Total volume charge: $1,225
- Plus fixed charge: $40
- Total bill: $1,265 per month
Seasonal Rates
Some utilities implement higher rates during peak-demand seasons (summer in most climates) to recover peak infrastructure costs and encourage conservation during drought.
Implementation:
- May/September = standard rate
- June/August = peak-season rate (10–25% premium)
Example:
- Off-season (Nov–April): $2.50/CCF
- Summer (June–August): $3.00/CCF (20% premium)
This incentivizes shifting discretionary use (lawn irrigation) to off-peak times.
Capacity / Impact Fees
New development and large customers often pay capacity charges to reflect their impact on system infrastructure. These are typically one-time charges.
Typical Charges:
- Residential connection: $3,000–$8,000
- Commercial/industrial: $5,000–$20,000+ (based on water demand)
Purpose:
- Recover cost of infrastructure expansion (pipes, treatment capacity, storage)
- Ensures existing customers don't subsidize growth
Calculation Example: A new 10,000 square-foot office building requires 50 GPM (gallons per minute) peak demand. The utility's capital cost per GPM is $50,000 (pipes, treatment plant expansion, etc.).
- Capacity charge = 50 GPM × $50,000/GPM = $2,500,000
This seems high; it's typically spread across multiple buildings or phased.
Debt Service Coverage Ratio: The Key Financial Metric
Definition and Calculation
The Debt Service Coverage Ratio (DSCR) is the primary metric that bond rating agencies, creditors, and regulators use to assess utility financial health.
DSCR = Net Operating Revenues / Annual Debt Service (P&I)
Example:
- Net Operating Revenues (after expenses): $2,850,000
- Annual Debt Service (principal + interest): $2,100,000
- DSCR = 2,850,000 / 2,100,000 = 1.36x
This means the utility generates $1.36 in revenue for every $1.00 of debt service owed.
Minimum Thresholds
Bond rating agencies and lenders typically require:
- Investment-grade utilities: DSCR ≥ 1.50x
- Standard utilities: DSCR ≥ 1.25x
- Distressed utilities: DSCR ≥ 1.10x
A DSCR below 1.0x means the utility cannot cover debt service from operations and would need to draw reserves or request bail-out funding.
DSCR Impact on Rate Setting
If a utility has inadequate DSCR, rates must increase. Here's how:
Scenario: Water Utility with Weak DSCR
Current situation:
- Operating revenues: $4,200,000
- Operating expenses: $3,150,000
- Net operating revenue: $1,050,000
- Annual debt service: $1,500,000
- Current DSCR: 0.70x (inadequate!)
To achieve 1.25x DSCR:
- Required net revenue = Debt Service × Target DSCR
- Required net revenue = $1,500,000 × 1.25 = $1,875,000
- Revenue gap = $1,875,000 - $1,050,000 = $825,000
To close the gap with rate increases:
- Current average residential bill: $75/month
- Monthly revenue increase needed: $825,000 / 12 / 15,000 customers = $4.58/customer
- Required rate increase: $4.58 / $75 = 6.1%
This illustrates why utilities cite debt service coverage when justifying rate increases to the public.
Affordability Analysis: EPA 2.5% Threshold
The Affordability Problem
Rate increases can create hardship for low-income households. The EPA's "affordability criterion" suggests that a water bill should not exceed 2.5% of median household income (MHI).
Example:
- Median household income in jurisdiction: $60,000/year
- 2.5% threshold: $60,000 × 0.025 = $1,500/year ($125/month)
- If current water+sewer bill is $100/month, a 30% rate increase pushes to $130/month, exceeding affordability
Calculating Affordability Impact
In a rate study, utilities project the impact of proposed rates on household income ratios:
| Income Level | Household | Current Bill | % of Income | Proposed Bill | % of Income | Burden Increase |
|---|---|---|---|---|---|---|
| $25,000 (low) | A | $78 | 3.7% | $85 | 4.1% | +0.4% |
| $60,000 (median) | B | $78 | 1.6% | $85 | 1.7% | +0.1% |
| $120,000 (high) | C | $78 | 0.8% | $85 | 0.8% | 0.0% |
This analysis shows that low-income households bear disproportionate burden. Many states and EPA guidance recommend:
- Assistance programs: Low-income rate discount (e.g., 15–20% discount for customers <200% federal poverty level)
- Hardship waivers: Allow nonpayment of late fees for documented hardship
- Payment plans: Spread large bills over multiple months
- Grant funding: Use WIFIA or state funding to reduce cost of required capital improvements, thus reducing rate pressure
LIHEAP and Other Assistance
The Low Income Home Energy Assistance Program (LIHEAP) provides federal grants for utilities to offer assistance to low-income households. Utilities should explore whether they qualify for LIHEAP funding to subsidize water costs for eligible customers.
GASB Enterprise Fund Accounting for Utilities
Water and sewer utilities are typically accounted for as enterprise funds under GASB guidance, separate from general government.
Enterprise Fund Characteristics
| Feature | General Government | Enterprise Fund (Utility) |
|---|---|---|
| Accounting Basis | Modified accrual | Full accrual (like private business) |
| Revenue Recognition | When due | When earned |
| Expense Recognition | When paid | When incurred (accrual) |
| Capital Assets | Listed in note; not depreciated | Capitalized and depreciated |
| Depreciation Expense | Not recorded in fund | Recorded as operating expense |
| User Fees | Revenue | Revenue (operating) |
| Bonds | Special revenue bonds | Revenue bonds (enterprise debt) |
| Reserves | Fund balance / reserves | Restricted and unrestricted net position |
Enterprise Fund Financial Statements
Utilities report three primary statements:
1. Statement of Revenues, Expenses, and Changes in Net Position
| Operating Revenues | |
| Water sales | $3,200,000 |
| Sewer usage charges | $2,400,000 |
| Connection fees | $150,000 |
| Other | $50,000 |
| Total Operating Revenues | $5,800,000 |
| Operating Expenses | |
| Salaries and benefits | $1,600,000 |
| Chemicals and supplies | $450,000 |
| Utilities (electricity) | $280,000 |
| Maintenance | $380,000 |
| Depreciation | $1,200,000 |
| Other | $190,000 |
| Total Operating Expenses | $4,100,000 |
| Operating Income | $1,700,000 |
| Non-Operating Items | |
| Interest income | $12,000 |
| Interest expense (bonds) | ($850,000) |
| Gain on asset sale | $50,000 |
| Total Non-Operating | ($788,000) |
| Net Income Before Transfers | $912,000 |
| Capital contributions (grants) | $300,000 |
| Transfers out to General Fund | ($150,000) |
| Change in Net Position | $1,062,000 |
| Beginning Net Position | $18,500,000 |
| Ending Net Position | $19,562,000 |
Key observations:
- Depreciation is expensed (unlike general fund accounting)
- Interest expense is significant
- Net position grows by the amount of retained earnings and capital contributions
2. Balance Sheet / Statement of Net Position
| Assets | |
| Cash and investments | $2,100,000 |
| Accounts receivable | $380,000 |
| Inventory | $95,000 |
| Capital assets (gross) | $45,000,000 |
| Less: Accumulated depreciation | ($12,500,000) |
| Capital assets (net) | $32,500,000 |
| Total Assets | $35,075,000 |
| Liabilities | |
| Accounts payable | $210,000 |
| Accrued expenses | $140,000 |
| Current portion of revenue bonds | $850,000 |
| Revenue bonds (long-term) | $14,650,000 |
| Total Liabilities | $15,850,000 |
| Net Position | |
| Restricted—debt service reserve | $850,000 |
| Restricted—capital improvements | $1,200,000 |
| Unrestricted | $2,175,000 |
| Total Net Position | $4,225,000 |
| Total Liabilities + Net Position | $20,075,000 |
3. Statement of Cash Flows
| Operating Activities | |
| Cash from customers | $5,750,000 |
| Cash for operating expenses | ($3,800,000) |
| Net cash from operations | $1,950,000 |
| Capital Activities | |
| Capital asset purchases | ($1,200,000) |
| Net cash from capital | ($1,200,000) |
| Financing Activities | |
| Proceeds from bond issuance | $2,000,000 |
| Repayment of bonds | ($850,000) |
| Net cash from financing | $1,150,000 |
| Net Change in Cash | $1,900,000 |
| Cash—beginning | $200,000 |
| Cash—ending | $2,100,000 |
Key Enterprise Fund Metrics
Auditors and rating agencies focus on:
- Current Ratio = Current Assets / Current Liabilities (target > 1.5x)
- Debt Service Coverage Ratio = Net Operating Revenues / Debt Service (target > 1.25x)
- Reserve Fund Coverage = Reserves / Annual Operating Expenses (target 90–180 days)
- Debt per Capita = Total Debt / Population served (benchmarked against peers)
- Operating Expense Ratio = Operating Expenses / Operating Revenues (lower is more efficient; target 70–85%)
Step-by-Step Rate Study Process
Phase 1: Data Gathering (Weeks 1–4)
- Compile prior 3 years of audited financial statements
- Collect operating expense detail (utilities, labor, supplies)
- Obtain capital improvement plan for next 10 years
- Review outstanding debt agreements and bond covenants
- Gather customer billing data (consumption by class, number of connections)
- Inventory equipment and useful lives (for depreciation analysis)
- Obtain external benchmarking data (AWWA, state surveys)
Phase 2: Financial Analysis (Weeks 5–8)
- Normalize operating expenses (remove one-time items, adjust for inflation)
- Project O&M expenses 5–10 years forward
- Calculate required debt service for existing and planned debt
- Determine reserve fund targets
- Identify capital improvement plan funding gaps
- Calculate total revenue requirement (O&M + DS + Reserves + CIP)
Phase 3: Cost Allocation (Weeks 9–12)
- Allocate costs by function (treatment, transmission, distribution)
- Allocate costs by customer class (residential, commercial, industrial)
- Analyze fixed vs. variable cost split
- Review usage patterns (consumption by class, seasonal variation)
Phase 4: Rate Design (Weeks 13–16)
- Model multiple rate structures (uniform, tiered, seasonal)
- Test affordability impact under each scenario
- Model competitive impact (compare to regional utilities)
- Model conservation impact (price elasticity)
- Prepare 5-year financial projection under each rate scenario
Phase 5: Public Engagement (Weeks 17–20)
- Present preliminary findings to utility board
- Host public hearing(s) on proposed rate changes
- Publish rate study summary for public comment (30-day period typical)
- Address public feedback and adjust if needed
Phase 6: Implementation (Weeks 21–24)
- Board approves final rate schedule
- Utility updates billing system with new rates
- Customer notification (30–60 days before effective date)
- Implement assistance programs (if applicable)
Sample Rate Study: Small Water Utility
Scenario: City of Riverside (population 35,000)
Current Financial Situation:
- 10,000 water connections
- Water sales revenue: $3,200,000/year
- Operating expenses: $2,400,000/year
- Depreciation: $900,000/year
- Annual debt service: $1,100,000
Current Average Bill (Residential, 8 CCF/month):
- Fixed charge: $35/month
- Usage: 8 CCF × $2.00/CCF = $16
- Total: $51/month = $612/year
Revenue Requirement Analysis:
| Category | Amount |
|---|---|
| Current O&M expenses | $2,400,000 |
| Inflation adjustment (3%) | +$72,000 |
| Projected O&M | $2,472,000 |
| Debt service | $1,100,000 |
| Reserve contribution (3% of revenue) | $180,000 |
| Capital improvement plan | $250,000 |
| Total Revenue Needed | $4,002,000 |
| Current revenue | $3,200,000 |
| Revenue Gap | $802,000 |
Rate Increase Required: $802,000 / $3,200,000 = 25% increase
Proposed Rate Structure:
| Component | Current | Proposed | Change |
|---|---|---|---|
| Fixed charge | $35 | $38 | +8.6% |
| Tier 1 (0–5 CCF) | $2.00 | $2.30 | +15% |
| Tier 2 (5–8 CCF) | $2.00 | $2.50 | +25% |
| Tier 3 (8+ CCF) | $2.00 | $3.10 | +55% |
Impact on Typical Bills:
| Usage | Current | Proposed | Change | % Change |
|---|---|---|---|---|
| 4 CCF/month | $43 | $47 | +$4 | +9% |
| 8 CCF/month | $51 | $64 | +$13 | +26% |
| 12 CCF/month | $59 | $80 | +$21 | +36% |
| 16 CCF/month | $67 | $100 | +$33 | +49% |
Affordability Analysis:
Utility surveys 500 randomly selected customers:
- 15% report inability to pay if water rates increase >15%
- 8% report current bill exceeds 3% of household income
- Proposed rates would push 12% of customers above 3% threshold
Recommendation: Implement low-income assistance program:
- Customers at <150% federal poverty level receive 20% rate discount
- Estimated program cost: $120,000/year
- Fund via general fund grant or philanthropic donation
- Reduces revenue gap to $682,000, still requires 21% increase
Final Rate Schedule (Proposed):
| Charge | Amount |
|---|---|
| Fixed monthly charge | $38 |
| Tier 1 (0–5 CCF/month) | $2.30/CCF |
| Tier 2 (5–8 CCF/month) | $2.50/CCF |
| Tier 3 (8+ CCF/month) | $3.10/CCF |
| New connection fee | $4,000 |
| Effective date | July 1, 2026 |
Communication Strategy: Explaining Rates to the Public
Utility rate increases are unpopular. Effective communication can reduce backlash and build public support:
Key Messages
- System maintenance: "Our pipes are aging. This investment prevents main breaks and service interruptions."
- Safety and compliance: "EPA requires us to upgrade treatment facilities to meet drinking water standards."
- Affordability support: "Customers who cannot afford increases can apply for our assistance program."
- Efficiency: "We've cut operating costs by 5% through efficiency improvements; the rate increase is for necessary infrastructure."
- Comparison to peers: "Riverside's water rates are still 15% below the regional average."
Communication Channels
- Bill inserts: Simple one-page explanation of rate increase and effective date
- Website: FAQs, rate schedule, interactive bill calculator ("What will my bill be?")
- Public meetings: Utility board presentation with Q&A
- Local media: Op-ed from utility director, interviews with local news
- Community forums: Meet with neighborhood associations, senior centers
- Customer service training: Ensure customer service staff can answer common questions
Sample Bill Insert Language
Water Rate Increase Effective July 1, 2026
Your water bill will increase an average of 21%. Here's why:
- Aging pipes: We're replacing 2 miles of 50-year-old mains
- Treatment upgrades: EPA compliance improvements
- Debt service: Bonds for infrastructure from 2020–2024
What is your bill increasing? A customer using 8 units/month will see their bill increase from $51 to $64/month.
Do you need help? The Riverside Water Assistance Program provides discounts for households earning <150% of federal poverty level. Call (555) 123-4567 for an application.
Conclusion
Water and sewer rate studies are technical but essential. They provide the financial and policy foundation for rates that are both affordable and sustainable.
Finance directors and utility managers who invest in a professional rate study—conducted every 3–5 years and updated annually—will:
- Maintain strong bond ratings and lower borrowing costs
- Avoid deferred maintenance crises
- Protect system reliability and water quality
- Make defensible rate decisions supported by data
- Communicate transparently with the public
The framework in this guide—from cost-of-service analysis to affordability assessment to enterprise fund accounting—applies to utilities of all sizes. Adapt the level of complexity to match your utility's capacity; even small systems benefit from a simplified version of this process.
Water is essential infrastructure. Rates that recover full cost of service ensure that the next generation inherits a reliable, sustainable system.
This article was prepared with AI-assisted research by DWU Consulting. It is provided for informational purposes only and does not constitute legal, financial, or investment advice. All data should be independently verified before use in any official capacity.