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Materials from the July 28, 2011 West Bench presentation

Thanks to those of you who could attend the Open House at West Bench School.  Thanks as well to RDOS staff who did so much to pull the event together on a warm summer's evening.

One issue that did come up was the long-term implications of operating costs versus capital costs.  Recall that the UV treatment option has relatively high capital cost but low operating costs whereas the filtration options have low capital costs (due to their eligibility for the second $3.38M grant) but high on-going payments to the City of Penticton. UV proponents pointed out that once the capital cost of the UV plant is paid off, water rates will drop significantly (whereas the rates of the Penticton options will not change that much).  How do we make sense of this argument?

Specifically: What is the value now of lower water rates in the future (i.e., after the 20-year debt has been retired). "Present value" is still the appropriate measure, but now we have to increase the time horizon sufficiently to capture the "mortgage free" years.

 Image

(Click on the image to get a larger version) This graph shows the estimated annual cost per household in "actual" and "real" dollars for the UV system (high capital/low operating) and the Bulk option (low capital/high operating).

Actual dollars is, as its name implies, the actual number of dollars that residents will have to pay each year (we are assuming 3% inflation). Operating costs are sensitive to inflation—indeed, the bids from the City of Penticton include an automatic Consumer Price Index (CPI) adjustment every year.  Capital costs are not sensitive to inflation because the actual number of dollars paid to repay a loan is determined when the loan is negotiated (payments do not increase with inflation).  Since inflation compounds, the actual costs (operating + debt repayment) balloon significantly over the 50 year horizon.

The problem with actual dollars is that they are not meaningful.  Sure, a $7,307/year water bill in 50 years seems outrageous.  But keep in mind that a $2 cup of coffee inflated at the same rate will cost just under $9 in 50 years, so we have to keep in mind that all prices (and hopefully all wages) rise with inflation.

A more meaningful way to think about cash flows in the future is in "real" dollars rather than actual dollars. A real dollar is an amount of value, rather than a unit of currency. Thus, a cup of coffee in 50 years that costs $8.77 in 2061 dollars is only really worth $2 in 2011 dollars (a cup of coffee is a cup of coffee).  The same is true of your water bill.  A bill of $7,307 in 2061 dollars is equivalent to a more reasonable $1,667 in 2011 dollars.  Accordingly, the graph also shows annual per-household water costs in real dollars.  You will notice that real costs go flat after Year 20.  This is because once the capital debt of the system is paid off, the only cost to ratepayers is operational costs.  And like a cup of coffee, the real value of operating and maintaining a particular water system is constant over time (regardless of what inflation does to the actual cost).

 

 

Once we have these curves, we can calculate the present value of the two alternatives over a 50-year horizon.  This longer horizon captures the impact of being debt-free for 30 years (this assumes, of course, that the water system has a 50-year expected life and will not require any significant capital upgrades until after Year 50).

Based on our pre-design estimates (and using 6% interest/3% inflation), we put the 50-year present value (really a cost) of the UV system at -$11.9M.  Compare this to the 20-year present value of -$9.3M: The impact of an additional 30 years of operation is surprisingly small due to the fact that money in the future is worth less than money now (due to interest and inflation). The 50-year present value of the Bulk Water option is -$17M versus -$10.5M for the 20-year horizon.  In other words, The UV option is about $5M cheaper than the Bulk Penticton Water option over a 50 year horizon.

This is significant.  But the next question to ask is the following: What would have to happen in order to make the 50-year cost of Bulk Water roughly equivalent to the 50-year cost of UV?  The wiggle-room for the Bulk Water option is the annual fees paid to the City of Penticton.  As noted by Mayor Dan Ashton, the City of Penticton needs to recover the costs of its massive investments in its water treatment plant.  However, it is important to keep in mind that those massive costs are sunk—the money is already spent.  As such, the City of Penticton faces two possibilities:

  1. If it is successful in winning the West Bench water contract, Penticton will get an up-front buy-in plus an on-going payment from West Bench towards its system
  2. If it is not successful in winning the West Bench water contract, the City will get nothing from the West Bench.

The critical issue is this: The City's total cost of its water utility changes very little in either case.  The marginal cost of treating water is low and the costs of pumping it from the valley floor to the West Bench are borne by West Bench residents in the Bulk Water option.  So the City of Penticton may be willing to look at the more than $500K it wants to charge the West Bench every year to see if it can match the 50-year cost of UV.  Put differently, the City of Penticton can collect something less than $500K per year from West Bench residents or it can collect $0. This is something City of Penticton staff and councillors are going to have to think about.

I put the magic number at about $112K.  That is, the City of Penticton has to reduce its annual operating charge by about 20% in order to be competitive over 50 years with UV.

Note that the average Year 1 cost per household for Bulk Water is about $1,570 versus $2,120 for UV (recall that UV makes it up with lower rates in years 20-50).

 

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