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HomeMy WebLinkAbout2023-03-07; City Council; ; Adopting a Utilities Reserve PolicyCA Review CKM Meeting Date: To: From: Staff Contact: Subject: Districts: March 7, 2023 Mayor/President and City Council/Board Members Scott Chadwick, City Manager/Executive Manager Vicki Quiram, Utilities Director vicki.quiram@carlsbadca.gov, 442-339-2722 Shoshana Aguilar, Senior Management Analyst shoshana.aguilar@carlsbadca.gov, 760-814-0241 Adopting a Utilities Reserve Policy All Recommended Actions 1.Adopt a City Council resolution adopting a Utilities Reserve Policy for the wastewater enterprise fund 2.Adopt a Carlsbad Municipal Water District Board of Directors resolution adopting a Utilities Reserve Policy for potable water and recycled water enterprise funds Executive Summary Staff have developed a Utilities Reserve Policy for the city’s wastewater funds and the Carlsbad Municipal Water District’s potable water and recycled water funds. Establishing these guidelines will ensure the stability of these essential funds and provide guidance to staff in managing each utility’s finances. The potable water, recycled water and wastewater funds currently follow the policy for reserves that the City Council has adopted for the General Fund, which targets a year-end fund balance of no less than 40% of operating costs. However, this is not an official policy for the separate potable water, recycled water or wastewater enterprise funds. These three enterprise funds1 rely solely on revenues generated by ratepayers provided wastewater services by the city and potable and recycled water by the Carlsbad Municipal Water District. These are essential functions, so continuity of service and financial viability must always be maintained. One component of meeting that obligation is the establishment of a robust reserve policy that will apply to each of these funds. Under City Council Policy No. 1, the resolution adopting the proposed City Council policy requires four affirmative votes from the City Council members. The resolution approving the application of the proposed policy for CMWD utilities requires three affirmative votes of the CMWD Board members. 1 An enterprise fund is a separate financial reporting mechanism for which revenues and expenditures are segregated into a fund with financial statements separate from other governmental activities.March 7, 2023 Item #11 Page 1 of 39 JOINT CIT Y CO U NCIL ,AND CARLSBAD MU NIC I PA IL WATER DISTRICT Staff Report Explanation & Analysis Background Staff made a presentation to the City Council and the CMWD Board on the status of wastewater and water funds in September 2021. As part of that presentation, staff reported on plans to create reserve policies for stronger long-term management of the city Utilities Department and CMWD’s enterprise funds. Carollo Engineers, the city and the district’s utilities rates consultant, was engaged to assist with development of the policy. Properly designed utility reserve policies send a positive signal to ratepayers, investors, and regulatory and credit rating agencies that the city and the CMWD are committed to maintaining long-lasting fiscal strength. Strong and transparent financial policies, including maintaining prudent reserves for emergencies, rate stability, working capital and capital improvement program projects, are consistent with best practices in the utility industry and are important to the city and CMWD. Such policies help to: •Maintain the short-term and long-term financial health of each system’s utility •Maintain stable rates for customers and help ensure manageable rate increases •Fund unanticipated cost contingencies •Ensure funds exist for system improvements •Ensure cash exists for the timely payment of bills •Act as a significant positive credit factor in bond and other credit ratings Reserve policies typically consist of multiple components based on five financial metrics: •Operating/working capital •Debt service •Capital construction (five-year average) •Emergency capital •Rate stabilization fund The sum of the component reserves should meet the overall reserve goal, typically between 180 and 365 days of operating costs. The appropriate target for days of cash on hand is unique to any utility, and should reflect its specific finances, physical system and risks. Based on Standard and Poor’s 2021 Sector Summary for Municipal Water and Wastewater Utilities, agencies with ratings of BBB+ and above held an average cash on hand at a minimum of approximately 200 days. As a point of comparison, the city’s current practice of maintaining 40% of operating costs is equivalent to 146 days of operating costs. The proposed policy recommends minimum and target levels for the unrestricted, undesignated reserves and discusses their use and replenishment. The reserve study details the long-term financial outlook through fiscal year 2034-35, as shown in Exhibit 3. For wastewater, a lower percentage of the capital construction five-year average was used so that the reserve targets for wastewater are not over-inflated. This helps to keep the overall reserve target in alignment with the policy goals as well as to avoid undue pressure on wastewater rates. Because a greater share of wastewater revenue is generated through fixed charges, it is less sensitive to changes in demand and therefore the percentage for wastewater rate stabilization is lower than for potable water and recycled water. March 7, 2023 Item #11 Page 2 of 39 Potable and recycled water As shown in the potable water and recycled water graphs below, models show reserves will be above the targeted maximum through FY 2026-27 for potable water and through FY 2030-31 for recycled water. If the proposed policy is adopted, the following tables show that through those years, we will be spending down reserves to offset the percent of rate increases in future years. After the initial use of existing reserve funds that exceed what is required by the policy, and depending on inflation and the cost increases of water from the wholesaler, rates would be set to assure that the total reserves would remain within the 180 days to 365 days range for the overall reserve goal. The information presented for potable and recycled water below includes projected rate increases in future years between 2% and 6%. Following each new cost of service study, which is performed approximately every three years, staff will recommend rate increases for the next two or three years that reflect the updated projected cost to provide services to CMWD customers and keep the reserve within the targeted limits of the reserve policy. The next cost of service study update is expected to be completed in fall 2023. March 7, 2023 Item #11 Page 3 of 39 Potable water -Days of cash on hand 1000 ,# 900 800 700 600 500 400 300 re-~ 'l, o,'\ o,"> ,,, ... r:,'> ", ", ", '\: 200 100 0 ,.v-,,, ~ {> '\,'o 'V A~ ,fl ,,,() "'"' -:-:"''\, ~,,,,,, ~""' !? :v"I,, r:,'11 ~ r:,"1 :1,'o' ~ r:,{r f3,cr ~,,, r:,'\, ,f> 'l,r:, '\,<;) r:,'1-,f> 4, r:,'? r:,"i ,f> 4-'t ,,_ ..... 4-'t ,,_ ..... 4-'t ,,_ ..... 4-'t ,,_ ..... 4-'t ~'\: ~ ~'\: ~'\: ~ <,_ <,_ " " " -Modeled days cash Target days cash goal -Minimum days cash goal Wastewater As staff reported to the City Council in 2021, the city’s wastewater enterprise fund was expected to see reserves drop below the minimum level desired due to the large amount of critically needed wastewater infrastructure improvements. On Jan. 11, 2022, the City Council approved rate increases of approximately 20% for each of three years in order to prevent a low- fund balance from occurring in fiscal years 2021-22, 2022-23 and 2023-24. The wastewater graph below assumes proposed rate increases in future years between 1% and 4%. However, with each new cost of service study, which is performed approximately every three years, staff will recommend rate increases that reflect the projected cost to provide services to wastewater customers and keep the reserve within the targeted limits. The City Council will then have an opportunity to adjust rates to prevent reserves from dropping lower than the minimum target. The next proposed cost of service study is expected in fall 2023. Increases proposed will cover fiscal years 2024-25 and 2025-26, and the recommendation may be to increase rates over the 1% to 4% assumption shown in the graph in order to more quickly reach the minimum reserve in this fund. If the projections do not change and rate increases are kept between 1% and 4%, reserves may continue to decrease before beginning to rebound in FY 2028-29. March 7, 2023 Item #11 Page 4 of 39 Recycled water - Days of cash on hand 1200 !o°' {J 1000 # 800 600 400 200 0 -;'V' :>, ~ {> 1' '.V ~.:-'b {) ~~ ?,.., -:,.;">'\, :yf' '!i~ :,,"> w"" r:,-e> ~ (){i (\,"5 r:1,'li r:,<Y r:,.Y r:,'\. '\,() ,-.,<::> ,-.,<::> "'"' ~ ,-.,<::> ,fi r:,"> r::,"> s; ,;:,-"-,;:,-"' ,;:,-"' ,;:,-"-,;:,-"-,;:,-"' -1."-,;:,-"-,;:,-,;:,-,,_-1. ,;:,-,,_-1. ,;:,-« -Modeled days cash Target days cash goal -Minimum days cash goal Procedures detailed in policy The policy also includes procedures for the use and replenishment of reserves, reporting and oversight. The following paragraphs summarize procedures in the proposed policy: • To the extent that unrestricted, undesignated reserves are above the minimum and below the target, the utility would seek the City Council or the CMWD Board’s approval to utilize those available funds to pay for capital projects, pay down unfunded liabilities, such as pension obligations, decrease outstanding debt or fund other strategic objectives. No other action would be required if reserves are between the minimum and maximum levels unless directed by the City Council or the CMWD Board. • Reserve levels below the minimum would leave the city or CMWD exposed to significant operational risks. Should a utility draw down reserves below the minimum level, it will implement plans to return reserves to the minimum level within a set timeframe. Such plans will be provided to the City Council or the CMWD Board for approval within 12 months of occurrence. As addressed above, the City Council will have an opportunity during the next rate study to decrease the anticipated exposure by adjusting rates. • Reserve levels will be monitored during the fiscal year and reported in annual financial reports and/or presentations. Reserve minimum and target levels will be analyzed annually, and an over/under reserve determination shall be made in conjunction with year-end financial results. These results will be reported to the City Council and the CMWD Board as part of the year-end financial report presentation. Should unrestricted designated or undesignated reserve levels need adjustment due to new risk factors or due to changes in the industry, these will be brought to the City Council and the CMWD Board as part of the year-end report. March 7, 2023 Item #11 Page 5 of 39 Wastewater-Days of cash on hand ,l' ,l' 365 days --------------:\(;j "' ,, .... "' ~, I ·~··· ----*-I ""' -■ ■ ,,,,,, -r-l ,.,{' f,11> :\ :\~ il Pi,§> <;i,,, .... ~P c-.""" ~"" ~,,,., "'"' ~"' ~'V ~"' ~'V ~"' ~'V ~,. o"l o"' o"' o"' '1,(;j ~ ... ~ ... ~ ... ~ ... ~ ... ~ ... ~ ... .._-v .._-v .._-v .._-v ~ ... ~ ~ ~ ~ -Modeled days cash Tar11et days cash 110al -Minimum days cash iQal Fiscal Analysis There is no immediate fiscal impact from approving this policy. The Water, Sewer and Recycled Water Reserve Study dated January 2023, which is provided as Exhibit 3, projects what the reserve will be based on actual expenditures through FY 2021-22 and the FY 2022-23 budget. The potable water, recycled water and wastewater financial models will be updated to account for the policy targets, if they are adopted. A combination of the reserve requirements and the anticipated revenue based on approved rates will be used to inform operational and capital budgeting for FY 2023-24 and FY 2024-25. Staff will present the City Council with possible new rates to support the policy in our report on the next rate study. Options Staff provide the following options for consideration by the City Council and the CMWD Board: 1. Adopt resolutions establishing the proposed Utilities Reserve Policy for potable water, recycled water and wastewater enterprise funds Pros: • Ensures the fiscal stability of the potable water, recycled water and wastewater funds and guides staff in the management of each utility’s finances • Maintains stable rates for customers and helps ensure manageable rate increases • Ensures funds exist for system improvements • Ensures cash exists for timely payment of bills • Acts as a significant positive credit factor in bond and other credit ratings Cons: • None identified 2. Do not adopt resolutions establishing the Utilities Reserve Policy for potable water, recycled water and wastewater enterprise funds Pros: • The City Council and the CMWD Board could request staff return with different reserve levels than those proposed Cons: • Delays adoption of a Utilities Reserve Policy, which could result in additional consultant expenses Staff recommend Option 1 for the City Council’s and the CMWD Board’s approval. Next Steps Once adopted, the policy will be implemented by staff. It will be used to inform future updates to the cost-of-service studies. Environmental Evaluation This action does not require environmental review because it does not constitute a project within the meaning of the California Environmental Quality Act under California Public Resources Code Section 21065 in that it has no potential to cause either a direct physical change or a reasonably foreseeable indirect physical change in the environment. March 7, 2023 Item #11 Page 6 of 39 Exhibits 1. City Council resolution 2. Carlsbad Municipal Water District Board of Directors resolution 3. Water, Sewer and Recycled Water Reserve Study dated January 2023 March 7, 2023 Item #11 Page 7 of 39 RESOLUTION NO. 2023-0 7 4 A RESOLUTION OF THE CITY COUNCIL OF THE CITY OF CARLSBAD, CALIFORNIA, ADOPTING A UTILITIES RESERVE POLICY FOR THE WASTEWATER ENTERPRISE FUND WHEREAS, the City Council of the City of Carlsbad, California believes financial policies are central to a strategic, long-term approach to financial management; and WHEREAS, the City Council desires to establish a Utilities Reserve Policy for the wastewater enterprise fund to further support the city's other financial management policies; and WHEREAS, the Policy, as it applies to potable water and recycled water enterprise funds, was approved by the Board of Directors of the Carlsbad Municipal Water District of the City of Carlsbad on March 7, 2023 by Resolution No. 1700; and WHEREAS, the Utilities Reserve Policy will inform the future cost-of-service studies, rate setting, and budgetary decisions for the wastewater enterprise fund. NOW, THEREFORE, BE IT RESOLVED by the City Council of the City of Carlsbad, California, as follows: 1.That the above recitations are true and correct. 2.That the City Council adopts the Utilities Reserve Policy provided in Attachment A. PASSED, APPROVED AND ADOPTED at a Joint Meeting of the City Council of the City of Carlsbad and the Board of Directors of the Carlsbad Municipal Water District of the City of Carlsbad on the 7th day of March, 2023, by the following vote, to wit: AYES: NAYS: ABSTAIN: ABSENT: Blackburn, Bhat-Patel, Acosta, Burkholder, Luna. None. None. None. KEITH BLACKBURN, Mayor � SHERRY FREISINGER, City Clerk (SEAL) Exhibit 1 March 7, 2023 Item #11 Page 8 of 39 Policy No. Date Issued Resolution No. Subject: Utilities Reserve Policy Purpose The Utilities Reserve Policy is designed to establish guidelines to ensure the fiscal stability of the potable water, recycled water and wastewater funds and provide guidance to staff in the management of each utility’s finances.1 Background Properly designed utility reserve policies send a positive signal to ratepayers, investors and regulatory and credit rating agencies that the city and the Carlsbad Municipal Water District, or CMWD, are committed to maintaining long-lasting fiscal strength. Strong and transparent financial policies, including maintaining prudent reserves for emergencies, rate stability, working capital and capital improvement program, or CIP, projects, are consistent with best practices in the utility industry and are important to the city and the CMWD as it helps to: •Maintain the short-term and long-term financial health of each system’s utility •Maintain stable rates for customers and help ensure manageable rate increases •Fund unanticipated cost contingencies •Ensure funds exist for system improvements •Ensure cash exists for the timely payment of bills •Act as a significant positive credit factor in bond and other credit ratings Reserve policies typically consist of multiple components set based on operational, capital and financial metrics. The sum of the component reserves should meet the overall reserve goal, typically between 180 and 365 days of operating costs. The appropriate target for days of cash on hand is unique to any utility and should reflect its specific finances, physical system and risks. Based on the Standard and Poor’s 2021 Sector Summary for Municipal Water and Wastewater Utilities, agencies with ratings of BBB+ and above held average cash on hand at a minimum of approximately 200 days. Statement of policy SECTION 1: MINIMUM AND TARGET RESERVES Each utility should have sufficient unrestricted, undesignated reserves to maintain or improve its credit ratings, ensure that operating and maintenance costs will be paid in a timely manner, pay debt service obligations, and invest in needed capital improvements and equipment 1 The policy, as it applies to potable water and recycled water funds, was approved by the Board of Directors of Carlsbad Municipal Water District of the City of Carlsbad on [date] by Resolution No. [number]. Attachment A March 7, 2023 Item #11 Page 9 of 39 City Council POLICY STATEMENT Utilities Reserve Policy Jan. 24, 2023 Page 2 replacement on a timely basis. In addition, each system utility should maintain sufficient reserves to minimize rate increases due to market volatility, weather impacts on demands, emergencies (such as natural disasters), and regulatory changes. The table below summarizes the desired reserve levels for each category Table 1 Minimum and Target Reserves SECTION 2: OPERATING (WORKING CAPITAL) The operating or working capital reserve component provides a source of funds to manage normal monthly changes in revenues or expenses. It ensures sufficient resources to pay budgeted operating and maintenance expenses, including power supply costs, recognizing the timing differences between payment of expenditures and receipt of revenues. Minimum and target levels for the operating reserve component are set based on operating costs, specifically a number of days’ worth of operating and maintenance expenses as described below. Minimum Level Potable Water and Recycled Water: Equal to 90 days of operating and maintenance expenses based on the most recent adopted budget. Wastewater: Equal to 90 days of operating and maintenance expenses based on the most recent adopted budget. Target Level Potable Water and Recycled Water: Equal to 120 days of operating and maintenance expenses based on the most recent adopted budget. Wastewater: Equal to 120 days of operating and maintenance expenses based on the most recent adopted budget. March 7, 2023 Item #11 Page 10 of 39 PROPOSED MINIMUM AND TARGET RESERVES Reserve metric Operating (working capital) Days of operating costs Debt service Percent of annual debt service Potable water and recycled water M inimum 90 100% Target 120 100% Wastewater Minimum 90 100% Target 120 100% Capital construction 5-year average Percent of 5-year rolling average of annual spending on capital improvement projects 50% 100% 25% 50% Emergency capital Percent of system replacement value 0.5% 1% 0.5% 1% Rate stabilization fund Percent of rate revenues 10% 20% 5% 10% Utilities Reserve Policy Jan. 24, 2023 Page 3 Events or Conditions Prompting Use of the Operating Component The operating reserve component may be routinely used to cover temporary cash flow deficiencies caused by timing differences between receipt of revenues and incurring expense obligations and unexpected increases in operating expenses or decreases in revenues. SECTION 3: DEBT SERVICE The debt service reserve component ensures ability to make debt service payments in an extreme event that may impact the ability to provide services, thus impacting revenues at a time critical infrastructure repairs are needed to restore systems. The debt service reserve is intended to prevent an event in which the city and/or the CMWD would be unable to pay its debt service obligations during such emergencies, or extreme market disruptions. The minimum and target levels for the debt service reserve are set based on a percentage of the amount of debt service to be paid in a given fiscal year. Due to the strong negative implications of missed debt service payments, both the minimum and target levels are equal to 100% of the maximum annual debt service in the current fiscal year. Minimum Level Potable Water and Recycled Water: 100% of the maximum annual debt service payment in the current fiscal year. Wastewater: 100% of the maximum annual debt service payment in the current fiscal year. Target Level Potable Water and Recycled Water: 100% of the maximum annual debt service payment in the current fiscal year. Wastewater: 100% of the maximum annual debt service payment in the current fiscal year. Events or Conditions Prompting Use of the Debt Service Component The debt service reserve may be utilized in the event that one of the utilities is otherwise unable to pay its debt service obligations. It is not anticipated that the city and/or the CMWD would ever utilize these reserves absent a significant disaster or extreme market disruption. SECTION 4: CAPITAL CONSTRUCTION The capital construction reserve component provides funds to ensure continuity of construction over fiscal years as well as a source of funds to complete in-progress projects in the event that their intended funding source becomes unavailable during the course of construction. The capital construction reserve is set as a percentage of the forward-looking five- year rolling average Utilities Department and CMWD CIP budget. The capital construction minimum and target levels for wastewater are inclusive of the city’s Encina Wastewater Authority (EWA) costs as EWA does not plan to hold reserves internally. EWA provides wastewater treatment for the City of Carlsbad and operates the Carlsbad Water Recycling Facility. Due to the proportionally higher CIP costs for the wastewater fund (as compared to the potable water and recycled water funds), a lower percentage minimum and target values are used for wastewater. This helps to keep the overall reserve target in alignment with the Policy goals as well as to avoid undue pressure on wastewater rates. March 7, 2023 Item #11 Page 11 of 39 Utilities Reserve Policy Jan. 24, 2023 Page 4 Minimum Level Potable Water and Recycled Water: 50% of the projected five-year rolling average annual CMWD CIP expenditures for the potable water utility or recycled water utility. Wastewater: 25% of the projected five-year rolling average annual Utilities Department CIP expenditures for the wastewater utility. Target Level Potable Water and Recycled Water: 100% of the projected five-year rolling average annual CMWD CIP expenditures for the potable water utility or recycled water utility. Wastewater: 50% of the projected five-year rolling average annual Utilities Department CIP expenditures for the wastewater utility. Events or Conditions Prompting Use of the Capital Construction Component The capital construction reserve component may be used to fund capital expenditures during the year as funding resources are acquired (e.g., bond proceeds, capital contributions, revenues, etc.) or to fund projects in the event that their intended funding source is no longer available. SECTION 5: EMERGENCY CAPITAL The emergency capital reserve component provides funds to ensure ability to repair the system after an emergency or natural disaster such as a flood or an earthquake. It is set based on a percentage of the estimated replacement value of each utility’s system. The replacement values used for this analysis are determined by adjusting the original cost of each utility’s assets (from the city and the CMWD’s fixed asset records) to current fiscal year dollars using the regional Engineering News-Record Construction Cost Index. While an annual evaluation of the system replacement value is not necessary for setting the minimum and target reserve levels, the replacement value should be adjusted annually (between evaluations) to account for cost inflation. Minimum Level Potable Water and Recycled Water: Equivalent to 0.5% of the replacement value of depreciable capital assets for the potable and recycled water systems. Based on the 2019 Asset Management Plan, the replacement value of the potable water system is currently estimated at $1.5 billion, yielding a minimum reserve balance of $7.5 million, and the replacement value of the recycled water system is currently estimated at $346 million, yielding a minimum reserve balance of $1.7 million. Wastewater: Equivalent to 0.5% of the replacement value of depreciable capital assets for the wastewater system. Based on the 2019 Asset Management Plan, the replacement value of the wastewater system is currently estimated at $780 million, yielding a minimum reserve balance of $3.9 million. March 7, 2023 Item #11 Page 12 of 39 Utilities Reserve Policy Jan. 24, 2023 Page 5 Target Level Potable Water and Recycled Water: Equivalent to 1% of the replacement value of depreciable capital assets for the potable and recycled water systems. Based on the 2019 Asset Management Plan, the replacement value of the potable water system is currently estimated at $1.5 billion, yielding a minimum reserve balance of $15.0 million, and the replacement value of the recycled water system is currently estimated at $346 million, yielding a target reserve balance of $3.5 million. Wastewater: Equivalent to 1% of the replacement value of depreciable capital assets for the wastewater system. Based on the 2019 Asset Management Plan, the replacement value of the wastewater system is currently estimated at $780 million, yielding a target reserve balance of $7.8 million. Events or Conditions Prompting Use of the Emergency Capital Component The emergency capital reserve component may be used in an emergency event requiring the need to fund necessary capital expenditures (e.g., natural disaster causing significant damage to the distribution or collections system). SECTION 6: RATE STABILIZATION The rate stabilization reserve component provides a source of funds to smooth rates or avoid rate increases in the event of short- or mid-term disruptions to revenues such as drought- related demand reductions. The minimum and target levels are set based on a percentage of expected user rate revenues. The selected percentages reflect the revenue risk associated with potential decreases in water demands. The potential demand decreases assumed for each reserve level are informed by an analysis of customer usage data and the CMWD drought response plan. Minimum Level The percentage assumptions for the minimum levels are set to provide sufficient reserve funds to cover a demand reduction of approximately 15%, which is the average of the conservation targets for drought response levels 1 and 2 as described in the Drought Response Plan. Because a greater share of wastewater revenue is generated through fixed charges, they are less sensitive to changes in demands; therefore, the percentage for wastewater is lower than for potable water and recycled water. March 7, 2023 Item #11 Page 13 of 39 Utilities Reserve Policy Jan. 24, 2023 Page 6 Potable Water and Recycled Water: Equal to 10% of budgeted rate revenues in each fiscal year. Wastewater: Equal to 5% of budgeted rate revenues in each fiscal year. Target Level The percentage assumptions for the minimum levels are set to provide sufficient reserve funds to cover a demand reduction of approximately 30%, which is the average of the conservation targets for drought response levels 2 and 3 as described in the Drought Response Plan. That reduction would reflect usage roughly equivalent to the average usage in the three lowest demand months of the year. Because a greater share of wastewater revenues is generated through fixed charges, they are less sensitive to changes in demands; therefore, the percentage for wastewater is lower than for potable water and recycled water. Potable Water and Recycled Water: Equal to 20% of budgeted rate revenues in each fiscal year. Wastewater: Equal to 10% of budgeted rate revenues in each fiscal year. Events or Conditions Prompting Use of the Reserve The rate stabilization reserve component may be used to cover unexpected changes in operating revenues and changes in operating costs to reduce year-over-year volatility in needed rate increases. Procedure SECTION 1: USE AND REPLENISHMENT OF RESERVES The city or the CMWD’s potable water, recycled water and wastewater utilities will treat the minimum reserve levels as practical reserve floors and allow reserves to increase or decrease as necessary within the minimum and target levels prescribed above. To the extent that unrestricted, undesignated reserves are above the minimum level and below the target level, the utility has the flexibility to utilize those available funds to pay for capital projects (reducing the need for future debt), pay down unfunded liabilities such as pension obligations, decrease outstanding debt or fund other strategic objectives. No other action would be required if reserves are between the minimum and target levels unless directed by the City Council or the CMWD Board. If reserve funds exceed the target level, the utility would seek the City Council or the CMWD Board’s approval to use the excess to finance capital improvements on a pay-as- you-go basis, pay down existing debt, offset other long-term liabilities such as pension obligations, reduce rates or for other strategic purposes. Reserve levels below the minimum targeted reserves would leave the city and/or the CMWD exposed to significant operational risks. Should a utility draw down reserves below the minimum levels, it will implement plans to return reserves to their minimum levels within a set timeframe. Such plans will be provided to the City Council and/or the CMWD Board for approval within 12 months of occurrence. March 7, 2023 Item #11 Page 14 of 39 Utilities Reserve Policy Jan. 24, 2023 Page 7 SECTION 2: REPORTING AND OVERSIGHT Reserve levels will be monitored during the fiscal year and reported in annual financial reports and/or presentations. Reserve minimum and target levels will be analyzed annually, and an over/under reserve determination shall be made in conjunction with year-end financial results. These results will be reported to the City Council and the CMWD Board as part of the year-end financial report presentation. Should unrestricted designated or undesignated reserve levels need adjustment due to new risk factors or due to changes in the industry, these will be brought to the City Council and the CMWD Board as part of the year-end report. The Policy will be reviewed annually and updated (at a minimum once every three years) if there are material changes in the risk exposures or new conditions that require changes in reserve levels. March 7, 2023 Item #11 Page 15 of 39 RESOLUTION NO. 1700 A RESOLUTION OF THE BOARD OF DIRECTORS OF THE CARLSBAD MUNICIPAL WATER DISTRICT OF THE CITY OF CARLSBAD, CALIFORNIA, ADOPTING A UTILITIES RESERVE POLICY FOR POTABLE WATER AND RECYCLED WATER ENTERPRISE FUNDS WHEREAS, the Carlsbad Municipal Water District, or CMWD, Board believes financial policies are central to a strategic, long-term approach to financial management; and WHEREAS, the CMWD Board desires to establish a Utilities Reserve Policy for potable water and recycled water enterprise funds to further support the District's other financial management policies; and WHEREAS, the Policy, as it applies to the wastewater enterprise fund, was approved by the City Council of the City of Carlsbad on March 7, 2033 by Resolution No. 2023-076; and WHEREAS, the Utilities Reserve Policy will inform the future cost-of-service studies, rate setting and budgetary decisions for the potable water and recycled water enterprise funds. NOW, THEREFORE, BE IT RESOLVED by the Board of Directors of the Carlsbad Municipal Water District of the City of Carlsbad, California, as follows: 1.That the above recitations are true and correct. 2.That the CMWD Board adopts the Utilities Reserve Policy provided in Attachment A. PASSED, APPROVED AND ADOPTED at a Joint Meeting of the Carlsbad Municipal Water District Board of Directors of the City of Carlsbad and the City Council of the City of Carlsbad on the 7th day of March, 2023, by the following vote, to wit: AYES: NAYS: ABSTAIN: ABSENT: Blackburn, Bhat-Patel, Acosta, Burkholder, Luna. None. None. None. KEITH BLACKBURN, President � / __... :;;-HERRY FREISINGER, Secretary1( "(SEAL) Exhibit 2 March 7, 2023 Item #11 Page 16 of 39 Policy No. Date Issued Resolution No. Subject: Utilities Reserve Policy Purpose The Utilities Reserve Policy is designed to establish guidelines to ensure the fiscal stability of the potable water, recycled water and wastewater funds and provide guidance to staff in the management of each utility’s finances.1 Background Properly designed utility reserve policies send a positive signal to ratepayers, investors and regulatory and credit rating agencies that the city and the Carlsbad Municipal Water District, or CMWD, are committed to maintaining long-lasting fiscal strength. Strong and transparent financial policies, including maintaining prudent reserves for emergencies, rate stability, working capital and capital improvement program, or CIP, projects, are consistent with best practices in the utility industry and are important to the city and the CMWD as it helps to: •Maintain the short-term and long-term financial health of each system’s utility •Maintain stable rates for customers and help ensure manageable rate increases •Fund unanticipated cost contingencies •Ensure funds exist for system improvements •Ensure cash exists for the timely payment of bills •Act as a significant positive credit factor in bond and other credit ratings Reserve policies typically consist of multiple components set based on operational, capital and financial metrics. The sum of the component reserves should meet the overall reserve goal, typically between 180 and 365 days of operating costs. The appropriate target for days of cash on hand is unique to any utility and should reflect its specific finances, physical system and risks. Based on the Standard and Poor’s 2021 Sector Summary for Municipal Water and Wastewater Utilities, agencies with ratings of BBB+ and above held average cash on hand at a minimum of approximately 200 days. Statement of policy SECTION 1: MINIMUM AND TARGET RESERVES Each utility should have sufficient unrestricted, undesignated reserves to maintain or improve its credit ratings, ensure that operating and maintenance costs will be paid in a timely manner, pay debt service obligations, and invest in needed capital improvements and equipment 1 The policy, as it applies to potable water and recycled water funds, was approved by the Board of Directors of Carlsbad Municipal Water District of the City of Carlsbad on [date] by Resolution No. [number]. Attachment A March 7, 2023 Item #11 Page 17 of 39 City Council POLICY STATEMENT Utilities Reserve Policy Jan. 24, 2023 Page 2 replacement on a timely basis. In addition, each system utility should maintain sufficient reserves to minimize rate increases due to market volatility, weather impacts on demands, emergencies (such as natural disasters), and regulatory changes. The table below summarizes the desired reserve levels for each category Table 1 Minimum and Target Reserves SECTION 2: OPERATING (WORKING CAPITAL) The operating or working capital reserve component provides a source of funds to manage normal monthly changes in revenues or expenses. It ensures sufficient resources to pay budgeted operating and maintenance expenses, including power supply costs, recognizing the timing differences between payment of expenditures and receipt of revenues. Minimum and target levels for the operating reserve component are set based on operating costs, specifically a number of days’ worth of operating and maintenance expenses as described below. Minimum Level Potable Water and Recycled Water: Equal to 90 days of operating and maintenance expenses based on the most recent adopted budget. Wastewater: Equal to 90 days of operating and maintenance expenses based on the most recent adopted budget. Target Level Potable Water and Recycled Water: Equal to 120 days of operating and maintenance expenses based on the most recent adopted budget. Wastewater: Equal to 120 days of operating and maintenance expenses based on the most recent adopted budget. March 7, 2023 Item #11 Page 18 of 39 PROPOSED MINIMUM AND TARGET RESERVES Reserve metric Operating (working capital) Days of operating costs Debt service Percent of annual debt service Potable water and recycled water M inimum 90 100% Target 120 100% Wastewater Minimum 90 100% Target 120 100% Capital construction 5-year average Percent of 5-year rolling average of annual spending on capital improvement projects 50% 100% 25% 50% Emergency capital Percent of system replacement value 0.5% 1% 0.5% 1% Rate stabilization fund Percent of rate revenues 10% 20% 5% 10% Utilities Reserve Policy Jan. 24, 2023 Page 3 Events or Conditions Prompting Use of the Operating Component The operating reserve component may be routinely used to cover temporary cash flow deficiencies caused by timing differences between receipt of revenues and incurring expense obligations and unexpected increases in operating expenses or decreases in revenues. SECTION 3: DEBT SERVICE The debt service reserve component ensures ability to make debt service payments in an extreme event that may impact the ability to provide services, thus impacting revenues at a time critical infrastructure repairs are needed to restore systems. The debt service reserve is intended to prevent an event in which the city and/or the CMWD would be unable to pay its debt service obligations during such emergencies, or extreme market disruptions. The minimum and target levels for the debt service reserve are set based on a percentage of the amount of debt service to be paid in a given fiscal year. Due to the strong negative implications of missed debt service payments, both the minimum and target levels are equal to 100% of the maximum annual debt service in the current fiscal year. Minimum Level Potable Water and Recycled Water: 100% of the maximum annual debt service payment in the current fiscal year. Wastewater: 100% of the maximum annual debt service payment in the current fiscal year. Target Level Potable Water and Recycled Water: 100% of the maximum annual debt service payment in the current fiscal year. Wastewater: 100% of the maximum annual debt service payment in the current fiscal year. Events or Conditions Prompting Use of the Debt Service Component The debt service reserve may be utilized in the event that one of the utilities is otherwise unable to pay its debt service obligations. It is not anticipated that the city and/or the CMWD would ever utilize these reserves absent a significant disaster or extreme market disruption. SECTION 4: CAPITAL CONSTRUCTION The capital construction reserve component provides funds to ensure continuity of construction over fiscal years as well as a source of funds to complete in-progress projects in the event that their intended funding source becomes unavailable during the course of construction. The capital construction reserve is set as a percentage of the forward-looking five- year rolling average Utilities Department and CMWD CIP budget. The capital construction minimum and target levels for wastewater are inclusive of the city’s Encina Wastewater Authority (EWA) costs as EWA does not plan to hold reserves internally. EWA provides wastewater treatment for the City of Carlsbad and operates the Carlsbad Water Recycling Facility. Due to the proportionally higher CIP costs for the wastewater fund (as compared to the potable water and recycled water funds), a lower percentage minimum and target values are used for wastewater. This helps to keep the overall reserve target in alignment with the Policy goals as well as to avoid undue pressure on wastewater rates. March 7, 2023 Item #11 Page 19 of 39 Utilities Reserve Policy Jan. 24, 2023 Page 4 Minimum Level Potable Water and Recycled Water: 50% of the projected five-year rolling average annual CMWD CIP expenditures for the potable water utility or recycled water utility. Wastewater: 25% of the projected five-year rolling average annual Utilities Department CIP expenditures for the wastewater utility. Target Level Potable Water and Recycled Water: 100% of the projected five-year rolling average annual CMWD CIP expenditures for the potable water utility or recycled water utility. Wastewater: 50% of the projected five-year rolling average annual Utilities Department CIP expenditures for the wastewater utility. Events or Conditions Prompting Use of the Capital Construction Component The capital construction reserve component may be used to fund capital expenditures during the year as funding resources are acquired (e.g., bond proceeds, capital contributions, revenues, etc.) or to fund projects in the event that their intended funding source is no longer available. SECTION 5: EMERGENCY CAPITAL The emergency capital reserve component provides funds to ensure ability to repair the system after an emergency or natural disaster such as a flood or an earthquake. It is set based on a percentage of the estimated replacement value of each utility’s system. The replacement values used for this analysis are determined by adjusting the original cost of each utility’s assets (from the city and the CMWD’s fixed asset records) to current fiscal year dollars using the regional Engineering News-Record Construction Cost Index. While an annual evaluation of the system replacement value is not necessary for setting the minimum and target reserve levels, the replacement value should be adjusted annually (between evaluations) to account for cost inflation. Minimum Level Potable Water and Recycled Water: Equivalent to 0.5% of the replacement value of depreciable capital assets for the potable and recycled water systems. Based on the 2019 Asset Management Plan, the replacement value of the potable water system is currently estimated at $1.5 billion, yielding a minimum reserve balance of $7.5 million, and the replacement value of the recycled water system is currently estimated at $346 million, yielding a minimum reserve balance of $1.7 million. Wastewater: Equivalent to 0.5% of the replacement value of depreciable capital assets for the wastewater system. Based on the 2019 Asset Management Plan, the replacement value of the wastewater system is currently estimated at $780 million, yielding a minimum reserve balance of $3.9 million. March 7, 2023 Item #11 Page 20 of 39 Utilities Reserve Policy Jan. 24, 2023 Page 5 Target Level Potable Water and Recycled Water: Equivalent to 1% of the replacement value of depreciable capital assets for the potable and recycled water systems. Based on the 2019 Asset Management Plan, the replacement value of the potable water system is currently estimated at $1.5 billion, yielding a minimum reserve balance of $15.0 million, and the replacement value of the recycled water system is currently estimated at $346 million, yielding a target reserve balance of $3.5 million. Wastewater: Equivalent to 1% of the replacement value of depreciable capital assets for the wastewater system. Based on the 2019 Asset Management Plan, the replacement value of the wastewater system is currently estimated at $780 million, yielding a target reserve balance of $7.8 million. Events or Conditions Prompting Use of the Emergency Capital Component The emergency capital reserve component may be used in an emergency event requiring the need to fund necessary capital expenditures (e.g., natural disaster causing significant damage to the distribution or collections system). SECTION 6: RATE STABILIZATION The rate stabilization reserve component provides a source of funds to smooth rates or avoid rate increases in the event of short- or mid-term disruptions to revenues such as drought- related demand reductions. The minimum and target levels are set based on a percentage of expected user rate revenues. The selected percentages reflect the revenue risk associated with potential decreases in water demands. The potential demand decreases assumed for each reserve level are informed by an analysis of customer usage data and the CMWD drought response plan. Minimum Level The percentage assumptions for the minimum levels are set to provide sufficient reserve funds to cover a demand reduction of approximately 15%, which is the average of the conservation targets for drought response levels 1 and 2 as described in the Drought Response Plan. Because a greater share of wastewater revenue is generated through fixed charges, they are less sensitive to changes in demands; therefore, the percentage for wastewater is lower than for potable water and recycled water. March 7, 2023 Item #11 Page 21 of 39 Utilities Reserve Policy Jan. 24, 2023 Page 6 Potable Water and Recycled Water: Equal to 10% of budgeted rate revenues in each fiscal year. Wastewater: Equal to 5% of budgeted rate revenues in each fiscal year. Target Level The percentage assumptions for the minimum levels are set to provide sufficient reserve funds to cover a demand reduction of approximately 30%, which is the average of the conservation targets for drought response levels 2 and 3 as described in the Drought Response Plan. That reduction would reflect usage roughly equivalent to the average usage in the three lowest demand months of the year. Because a greater share of wastewater revenues is generated through fixed charges, they are less sensitive to changes in demands; therefore, the percentage for wastewater is lower than for potable water and recycled water. Potable Water and Recycled Water: Equal to 20% of budgeted rate revenues in each fiscal year. Wastewater: Equal to 10% of budgeted rate revenues in each fiscal year. Events or Conditions Prompting Use of the Reserve The rate stabilization reserve component may be used to cover unexpected changes in operating revenues and changes in operating costs to reduce year-over-year volatility in needed rate increases. Procedure SECTION 1: USE AND REPLENISHMENT OF RESERVES The city or the CMWD’s potable water, recycled water and wastewater utilities will treat the minimum reserve levels as practical reserve floors and allow reserves to increase or decrease as necessary within the minimum and target levels prescribed above. To the extent that unrestricted, undesignated reserves are above the minimum level and below the target level, the utility has the flexibility to utilize those available funds to pay for capital projects (reducing the need for future debt), pay down unfunded liabilities such as pension obligations, decrease outstanding debt or fund other strategic objectives. No other action would be required if reserves are between the minimum and target levels unless directed by the City Council or the CMWD Board. If reserve funds exceed the target level, the utility would seek the City Council or the CMWD Board’s approval to use the excess to finance capital improvements on a pay-as- you-go basis, pay down existing debt, offset other long-term liabilities such as pension obligations, reduce rates or for other strategic purposes. Reserve levels below the minimum targeted reserves would leave the city and/or the CMWD exposed to significant operational risks. Should a utility draw down reserves below the minimum levels, it will implement plans to return reserves to their minimum levels within a set timeframe. Such plans will be provided to the City Council and/or the CMWD Board for approval within 12 months of occurrence. March 7, 2023 Item #11 Page 22 of 39 Utilities Reserve Policy Jan. 24, 2023 Page 7 SECTION 2: REPORTING AND OVERSIGHT Reserve levels will be monitored during the fiscal year and reported in annual financial reports and/or presentations. Reserve minimum and target levels will be analyzed annually, and an over/under reserve determination shall be made in conjunction with year-end financial results. These results will be reported to the City Council and the CMWD Board as part of the year-end financial report presentation. Should unrestricted designated or undesignated reserve levels need adjustment due to new risk factors or due to changes in the industry, these will be brought to the City Council and the CMWD Board as part of the year-end report. The Policy will be reviewed annually and updated (at a minimum once every three years) if there are material changes in the risk exposures or new conditions that require changes in reserve levels. March 7, 2023 Item #11 Page 23 of 39 and Carlsbad Municipal Water District Water, Sewer, and Recycled Water Reserve Study DRAFT RESERVE POLICY FINAL | January 2023 Exhibit 3 March 7, 2023 Item #11 Page 24 of 39 {city of Carlsbad WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | i Contents Section 1 – Introduction 1 1.1 Utility Reserve Policy Considerations 1 Section 2 – Proposed Unrestricted, Undesignated Reserves 3 2.1 Summary Reserve Policy Recommendations 3 2.2 Operating (Working Capital) 3 2.3 Debt Service 4 2.4 Capital Construction 5 2.5 Emergency Capital 5 2.6 Rate Stabilization 6 Section 3 – Potential Reserve Procedures 8 3.1 Procedures for the Use and Replenishment of Reserves 8 3.2 Procedures for Reporting and Oversight 9 Section 4 – Projected Reserve Performance 10 Section 5 – Conclusion 14 Tables Table 1 Minimum and Target Reserves 3 Table 2 Projected Rate Revenue Increases 10 Figures Figure 1 Minimum and Target Levels for Total Reserves Projection – Potable Water 10 Figure 2 Minimum and Target Levels for Total Reserves Projection – Recycled Water 11 Figure 3 Minimum and Target Levels for Total Reserves Projection – Sewer 12 March 7, 2023 Item #11 Page 25 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 1 Section 1 INTRODUCTION The City of Carlsbad (City) and the Carlsbad Municipal Water District (CMWD) provide potable water and recycled water service to approximately 28,900 connections and sewer service to approximately 26,600 accounts. Potable and recycled water services are managed by the CMWD while sewer services are provided through the City’s Utilities Department. All services fall under the purview of the Public Works Branch of the City and ultimately the Carlsbad City Council and/or the CMWD Board of Directors. The City Council suggests financial management policies for City funds including the utility funds. Currently, the potable water, recycled water, and sewer funds follow the policy that the City Council has adopted for the General Fund, which targets a year-end funds balance of no less than 40% of operating costs. However, this is not an official policy for the separate potable water, recycled water, or sewer funds. As essential functions, continuity of service and financial viability must always be maintained for the City and the CMWD’s utilities. One component of meeting this requirement is the establishment of a robust reserve policy. The Utility Cash Reserve Policy (Policy) described in this memorandum is designed to establish guidelines to ensure the fiscal stability of the potable, recycled water, and sewer funds and provide guidance to staff in the management of each utility’s finances. 1.1 Utility Reserve Policy Considerations Properly designed utility reserve policies send a positive signal to ratepayers, investors, and regulatory and credit rating agencies that the City and the CMWD are committed to maintaining long-lasting fiscal strength. Strong and transparent financial policies, including maintaining prudent reserves for emergencies, rate stability, working capital and capital improvements, are consistent with best practices in the utility industry and are important to the City and the CMWD as it helps to: • Maintain the short-term and long-term financial health of each system’s utility. • Maintain stable rates for customers and help ensure manageable rate increases. • Fund unanticipated cost contingencies. • Ensure funds exist for system improvements. • Ensure cash exists for the timely payment of bills. • Act as a significant positive credit factor in bond and other credit ratings. Reserve policies typically consist of multiple components set based on operational, capital, and financial metrics. The sum of the component reserves should meet the overall reserve goal, typically between 180 and 365 days of operating costs. The appropriate target for days of cash on hand is unique to any utility and should reflect its specific finances, physical system, and risks. Based on the Standard and Poor’s 2021 Sector Summary for Municipal Water and Wastewater Utilities, agencies with ratings of BBB+ and above held average cash on hand at a minimum of approximately 200 days. As a point of comparison, the City’s current practice of maintaining 40% of operating costs is equivalent to 146 days of operating costs. March 7, 2023 Item #11 Page 26 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 2 Utilities may implement multiple types of reserves, including restricted reserves, unrestricted designated reserves, and unrestricted undesignated reserves. Unrestricted, undesignated reserves may be used for any lawful purpose and have not been designated for specific capital and operating purpose because rate-funded reserves are not restricted for specific uses other than the normal restrictions on rate revenues. In contrast, for example, reserves funded with connection fees would be restricted for appropriate uses. This Policy recommends minimum and target levels for the unrestricted, undesignated reserves, discusses their use and replenishment, and details a long-term financial outlook from Fiscal Year Ending (FYE) 2022 through FYE 2035. March 7, 2023 Item #11 Page 27 of 39 March 7, 2023 Item #11 Page 28 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY I CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT Section 2 PROPOSED UNRESTRICTED, UNDESIGNATED RESERVES The proposed unrestricted, undesignated reserve policy outlines the minimum and target levels of the appropriate types of unrestricted, undesignated reserve components. Under the proposed reserve policy, each utility would have sufficient unrestricted, undesignated reserves to maintain or improve its credit ratings, ensure that operating and maintenance costs will be paid in a timely manner, pay debt service obligations, and invest in needed capital improvements and equipment replacement on a timely basis. In addition, each system utility would maintain sufficient reserves to minimize rate increases due to market volatility, weather impacts on demands, emergencies (such as natural disasters), and regulatory changes. 2.1 Summary Reserve Policy Recommendations Table 1 Minimum and Target Reserves I Operating I I Capital I I Rate (Working Debt Service Construction Emer~ency Stabilization . Capital Capital) 5-Yr Avg Fund Days of Percent of Percent of 5-Percent of Reserve Metric Operating Annual Debt Year Rolling System Percent of Rate Costs Service Average Replacement Revenues Annual CIP Value Potable Water and Recycled Water Minimum 90 Days 100% 50% 0.5% 10% Target 120 Days 100% 100% 1% 20% Sewer Minimum 90 Days 100% 25% 0.5% 5% Target 120 Days 100% 50% 1% 10% 2.2 Operating {Working Capital} The operating or working capital reserve component provides a source of funds to manage normal monthly changes in revenues or expenses. It ensures sufficient resources to pay budgeted operating and maintenance expenses, including power supply costs, recognizing the timing differences between payment of expenditures and receipt of revenues. Minimum and target levels for the operating reserve component are set based on operating costs, specifically a number of days' worth of operating and maintenance expenses as described below. FINAL I JANUARY 2023 I 3 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 4 Minimum Level Water and Recycled Water: Equal to 90 days of operating and maintenance expenses based on the most recent adopted budget. Sewer: Equal to 90 days of operating and maintenance expenses based on the most recent adopted budget. Target Level Water and Recycled Water: Equal to 120 days of operating and maintenance expenses based on the most recent adopted budget. Sewer: Equal to 120 days of operating and maintenance expenses based on the most recent adopted budget. Events or Conditions Prompting Use of the Operating Component The operating reserve component may be routinely used to cover temporary cash flow deficiencies caused by timing differences between receipt of revenues and incurring expense obligations and unexpected increases in operating expenses or decreases in revenues. 2.3 Debt Service The debt service reserve component ensures ability to make debt service payments in an extreme event that may impact the ability to provide services, thus impacting revenues at a time critical infrastructure repairs are needed to restore systems. The debt service reserve is intended to prevent an event in which the City and/or the CMWD would be unable to pay its debt service obligations during such emergencies, or extreme market disruptions. The minimum and target levels for the debt service reserve are set based on a percentage of the amount of debt service to be paid in a given fiscal year. Due to the strong negative implications of missed debt service payments, both the minimum and target levels are equal to 100% of the maximum annual debt service in the current fiscal year. Minimum Level Water and Recycled Water: 100% of the maximum annual debt service payment in the current fiscal year. Sewer: 100% of the maximum annual debt service payment in the current fiscal year. Target Level Water and Recycled Water: 100% of the maximum annual debt service payment in the current fiscal year. Sewer: 100% of the maximum annual debt service payment in the current fiscal year. Events or Conditions Prompting Use of the Debt Service Component The debt service reserve may be utilized in the event that one of the utilities is otherwise unable to pay its debt service obligations. It is not anticipated that the City and/or the CMWD would ever utilize these reserves absent a significant disaster or extreme market disruption. March 7, 2023 Item #11 Page 29 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 5 2.4 Capital Construction The capital construction reserve component provides funds to ensure continuity of construction over fiscal years as well as a source of funds to complete in-progress projects in the event that their intended funding source becomes unavailable during the course of construction. The capital construction reserve is set as a percentage of the forward-looking five-year rolling average Utilities Department and CMWD capital improvement program (CIP) budget. The capital construction minimum and target levels for sewer are inclusive of the City’s Encina Wastewater Authority (EWA) costs as EWA does not plan to hold reserves internally. EWA provides wastewater treatment for the City of Carlsbad and operates the Carlsbad Water Recycling Facility. Due to the proportionally higher CIP costs for the sewer fund (as compared to the potable water and recycled water funds), a lower percentage minimum and target values are used for sewer. This helps to keep the overall reserve target in alignment with the Policy goals as well as to avoid undue pressure on sewer rates. Minimum Level Water and Recycled Water: 50% of the projected five-year rolling average annual CMWD CIP expenditures for the potable water utility or recycled water utility. Sewer: 25% of the projected five-year rolling average annual Utilities Department CIP expenditures for the sewer utility. Target Level Water and Recycled Water: 100% of the projected five-year rolling average annual CMWD CIP expenditures for the potable water utility or recycled water utility. Sewer: 50% of the projected five-year rolling average annual Utilities Department CIP expenditures for the sewer utility. Events or Conditions Prompting Use of the Capital Construction Component The capital construction reserve component may be used to fund capital expenditures during the year as funding resources are acquired (e.g., bond proceeds, capital contributions, revenues, etc.) or to fund projects in the event that their intended funding source is no longer available. 2.5 Emergency Capital The emergency capital reserve component provides funds to ensure ability to repair the system after an emergency or natural disaster such as a flood or an earthquake. It is set based on a percentage of the estimated replacement value of each utility’s system. The replacement values used for this analysis were determined by adjusting the original cost of each utility’s assets (from the City and the CMWD’s fixed asset records) to current (FY 2022) dollars using the regional Engineering News-Record Construction Cost Index. While an annual evaluation of the system replacement value is not necessary for setting the minimum and target reserve levels, the replacement value should be adjusted annually (between evaluations) to account for cost inflation. The analysis completed for this memorandum applies a 3.5% annual escalation factor to the replacement value to match the construction cost inflation factor utilized in the City and the CMWD’s most recent rate studies. March 7, 2023 Item #11 Page 30 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 6 Minimum Level Water and Recycled Water: Equivalent to 0.5% of the replacement value of depreciable capital assets for the potable and recycled water systems. Based on the 2019 Asset Management Plan, the replacement value of the potable water system is currently estimated at $1.5 billion, yielding a minimum reserve balance of $7.5 million; and the replacement value of the recycled water system is currently estimated at $346 million, yielding a minimum reserve balance of $1.7 million. Sewer: Equivalent to 0.5 percent of the replacement value of depreciable capital assets for the sewer system. Based on the 2019 Asset Management Plan, the replacement value of the sewer system is currently estimated at $780 million, yielding a minimum reserve balance of $3.9 million. Target Level Water and Recycled Water: Equivalent to 1% of the replacement value of depreciable capital assets for the potable and recycled water systems. Based on the 2019 Asset Management Plan, the replacement value of the potable water system is currently estimated at $1.5 billion, yielding a minimum reserve balance of $15.0 million; and the replacement value of the recycled water system is currently estimated at $346 million, yielding a minimum reserve balance of $3.5 million. Sewer: Equivalent to 1% of the replacement value of depreciable capital assets for the sewer system. Based on the 2019 Asset Management Plan, the replacement value of the sewer system is currently estimated at $780 million, yielding a minimum reserve balance of $7.8 million. Events or Conditions Prompting Use of the Emergency Capital Component The emergency capital reserve component may be used in an emergency event requiring the need to fund necessary capital expenditures (e.g., natural disaster causing significant damage to the distribution or collections system). 2.6 Rate Stabilization The rate stabilization reserve component provides a source of funds to smooth rates or avoid rate increases in the event of short- or mid-term disruptions to revenues such as drought-related demand reductions. The minimum and target levels are set based on a percentage of expected user rate revenues. The selected percentages reflect the revenue risk associated with potential decreases in water demands. The potential demand decreases assumed for each reserve level are informed by an analysis of customer usage data and the CMWD drought response plan. Minimum Level The percentage assumptions for the minimum levels are set to provide sufficient reserve funds to cover a demand reduction of approximately 15%, which is the average of the conservation targets for drought response levels 1 and 2 as described in the drought response plan. Because a greater share of sewer revenue is generated through fixed charges, they are less sensitive to changes in demands and therefore the percentage for sewer is lower than for potable water and recycled water. March 7, 2023 Item #11 Page 31 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 7 Water and Recycled Water: Equal to 10% of budgeted rate revenues in each fiscal year. Sewer: Equal to 5% of budgeted rate revenues in each fiscal year. Target Level The percentage assumptions for the minimum levels are set to provide sufficient reserve funds to cover a demand reduction of approximately 30%, which is the average of the conservation targets for drought response levels 2 and 3 as described in the drought response plan. That reduction would reflect usage roughly equivalent to the average usage in the three lowest demand months of the year. Because a greater share of sewer revenues is generated through fixed charges, they are less sensitive to changes in demands and therefore the percentage for sewer is lower than for potable water and recycled water. Water and Recycled Water: Equal to 20% of budgeted rate revenues in each fiscal year. Sewer: Equal to 10% of budgeted rate revenues in each fiscal year. Events or Conditions Prompting Use of the Reserve The rate stabilization reserve component may be used to cover unexpected changes in operating revenues and changes in operating costs to reduce year-over-year volatility in needed rate increases. March 7, 2023 Item #11 Page 32 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 8 Section 3 POTENTIAL RESERVE PROCEDURES Along with component minimums and targets, most reserve policies for public utilities include procedures related to the use and replenishment of reserves, reporting and oversight, and updates to reserve metrics, minimums, or targets. 3.1 Procedures for the Use and Replenishment of Reserves Procedures for the use and replenishment of reserves may lay out how reserve funds can be used if they exceed the minimum or target values, what authorization is needed to use the funds, and what steps must be taken if reserves fall below the minimum or above the target. The specific procedures used vary by agency particularly on the level of involvement of the governing body in reserve decisions and the types of authorizations required to make reserve-related decisions. In developing the specific reserve policy that is presented to the City Council and the CMWD Board of Directors, the City and the CMWD should tailor the procedures to best match how it wishes to manage the finances of the utilities and the reserves. One example of potential procedural language is shown below. Use and Replenishment Example: “The City or the CMWD’s potable water, recycled water, and sewer utilities will treat the minimum reserve levels as practical reserve floors and allow reserves to increase or decrease as necessary within the minimum and target levels prescribed above. To the extent that unrestricted, undesignated reserves are above the minimum and below the target, the utility has the flexibility to utilize those available funds to pay for capital projects (reducing the need for future debt), pay down unfunded liabilities such as pension obligations, decrease outstanding debt, or fund other strategic objectives. No other action would be required if reserves are between the minimum and maximum levels unless directed by the City Council or the CMWD Board of Directors. If reserve funds exceed the target level, the utility would seek City Council or CMWD Board of Directors approval to use the excess to finance capital improvements on a pay-as-you-go basis, pay down existing debt, offset other long-term liabilities such as pension obligations, reduce rates, or for other strategic purposes. Reserve levels below the minimum targeted reserves would leave the City/CMWD exposed to significant operational risks. Should a utility draw down reserves below the minimum targeted level, it will implement plans to return reserves to their minimum targeted levels within a set timeframe. Such plans will be provided to the City Council or the CMWD Board of Directors for approval within 12 months of occurrence.” March 7, 2023 Item #11 Page 33 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 9 3.2 Procedures for Reporting and Oversight Some agencies’ reserve policies have provisions related to monitoring, reporting, and modifying reserves. If the City or the CMWD wishes to include such provisions in its reserve policy, it can tailor them to fit within the financial reporting and management procedures that are already in place to minimize additional administrative effort. One example of potential procedural language is shown below. Reporting and Oversight Example: “Reserve levels will be monitored during the fiscal year and reported in annual financial reports or presentations. Reserve minimum and target levels will be analyzed annually, and an over/under reserve determination shall be made in conjunction with year-end financial results. These results will be reported to the City Council and the CMWD Board of Directors as part of the year-end financial report presentation. Should unrestricted designated or undesignated reserve levels need adjustment due to new risk factors or due to changes in the industry, these will be brought to the City Council and the CMWD Board of Directors as part of the year-end report. The Policy will be reviewed annually and updated (at a minimum once every three years) if there are material changes in the risk exposures or new conditions that require changes in reserve levels.” March 7, 2023 Item #11 Page 34 of 39 March 7, 2023 Item #11 Page 35 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY I CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT Section 4 PROJECTED RESERVE PERFORMANCE The following figures show the projected reserve performance of each utility over the next 10 years. The projections were completed using the rate models developed fo r the 2021 rate study, assuming the long- term rate revenue increases shown in Table 2. Because each system has different capital needs to maintain or expand its infrastructure, the reserve performance as compared to the proposed policy minimum and targets differs across each utility. Table 2 Projected Rate Revenue Increases I FYE I FYE I FYE I FYE I FYE I FYE I FYE I FYE I FYE I FYE I FYE I FYE I FYE I FYE SyStem 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 Potable 2.0% 2.0% 2.0% 2.0% 2.0% 6.0% 6.0% 6.0% 6.0% 6.0% 5.5% 5.5% 5.5% 5.5% Water Recycled 4.0% 4.0% 4.0% 4.0% 4.0% 3.0% 3.0% 3.0% 3.0% 3.0% 5.0% 5.0% 5.0% 5.0% Water Sewer 20.0% 20.0% 20.0% 4.0% 4.0% 3.0% 3.0% 3.0% 3.0% 3.0% 1.0% 1.0% 1.0% 1.0% The following figures present each system's performance projections based on the minimum and target levels for each reserve discussed above. These minimum and target levels are flexible depending on the City or t he CMWD's needs and should be considered a starting point established from other agency averages. The water ut ility would maintain reserve above the minimum through FYE 2029 as shown in Figure 1. The same fig ure indicates that the potable water utility will retain target level reserves until FYE 2026 as it draws down reserves for capital investment in infrastructure, long-term projections show the reserves exceeding the minimum level by FYE 2035. V, C 0 ~ Figure 1 $120 $100 s8o s6o s40 $20 $- Total Potable Water Reserves FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 -Modeled Reserve Balance -Total -Target --Minimum Minimum and Target Levels for Total Reserves Projection -Potable Water FINAL I JANUARY 2023 I 10 March 7, 2023 Item #11 Page 36 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY I CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT After the initial spend-down for cash funding of capital, the pot able water utility's t otal reserves would remain within the 180 days to 365 days of cash on hand range for t he overall reserve goal as shown below in Figure 2. 1000 Days 900 Days 800 Days 700 Days 600 Days 500 Days 400 Days 300 Days 200 Days 100 Days Days Potable Water -Days Cash on Hand FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 -Modeled Days Cash Target Days Cash Goal --Minimum Days Cash Goal Figure 2 Projected Reserves as Days of Cash on Hand -Potable Water The recycled wat er ut ility would maintain t he reserves above the target level through FYE 2028 and above the minimum level through FYE 2035 as shown in Figure 3. The increase in reserves for FYE 2023 results from expected St ate Revolving Fund loan draws to reimburse for projects t hat were previously cash funded as well as grant receipts for capital projects. V, C 0 ·-~ Figure 3 $25 $20 us $10 ss $- -- - I FYE FYE 2022 2023 Total Recycled Water Reserves FYE FYE 2024 2025 FYE 2026 -------------------· HIUI FYE FYE FYE FYE FYE FYE FYE FYE FYE 2027 2028 2029 2030 2031 2032 2033 2034 2035 -Modeled Reserve Balance -Total -Target --Minimum Minimum and Target Levels for Total Reserves Projection -Recycled Water FINAL l JANUARY 2023 l 11 March 7, 2023 Item #11 Page 37 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY I CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT After the initial spend-down for cash funding of capital, the recycled water utility's total reserves would remain within the 180 days to 365 days of cash on hand range for t he overall reserve goal, as shown in Figure 4. 1200 Days 1000 Days 800 Days 600 Days 400 Days 200 Days Days ,,,~" Recycled Water -Days Cash on Hand !o°><:) ,,_o :A" <J"' ~ ~ FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 -Modeled Days Cash Target Days Cash Goal --Minimum Days Cash Goal Figure 4 Projected Reserves as Days of Cash on Hand -Recycled Water Due t o the large amount of anticipated investments in the sewer infrastruct ure using cash-funded capital, the City is project ed to draw sewer reserves below the minimum level starting in FYE 2023, as shown in Figure 5. Reserves would continue to decrease through FYE 2026 before beginning to rebound. Long-term projections show reserves exceeding the minimum by FYE 2033. Total Sewer Reserves V, s30 C 0 $25 ~ $20 sis $10 ss $- -----, ----------I ■ ---.111 FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 -Modeled Reserve Balance --Target --Minimum Figure 5 Minimum and Target Levels for Total Reserves Projection -Sewer FINAL I JANUARY 2023 I 12 March 7, 2023 Item #11 Page 38 of 39 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY I CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT Expressed as days of cash on hand, sewer reserves would be drawn down to a minimum of 33 days in FYE 2026 before rebounding over the next several years. Total days of cash on hand would meet the overall policy goal of 180 days starting in FYE 2029. Projected sewer reserves as days of O&M are shown in Figure 6. 700 Days 600 Days 500 Days 400 Days 300 Days 200 Days 100 Days Days Sewer -Days Cash on Hand FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 -DaysCash Target Days Cash Goal --Minimum Days Cash Goal Figure 6 Projected Reserves as Days of Cash on Hand -Sewer FINAL I JANUARY 2023 I 13 WATER, SEWER, AND RECYCLED WATER RESERVE STUDY | CITY OF CARLSBAD & CARLSBAD MUNICIPAL WATER DISTRICT FINAL| JANUARY 2023 | 14 Section 5 CONCLUSION This Policy provides direction to the water, recycled water, and sewer utilities’ management and staff for decisions and recommendations related to the financial profiles of each utility. In its most abbreviated form, this Policy sets targets for reserve balances based on the risk profiles of the potable water, recycled water, and sewer utilities and establishes tolerable maximums. This Policy also provides recommended actions when reserves deviate from the target levels. March 7, 2023 Item #11 Page 39 of 39