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Who Pays Big Water's Interest Costs?

Short answer:  The ratepayer definitely is paying

Should the ratepayer be paying?   Not sure, there are some reasons for doubt.

We need some help here - please read on.

Reason #1 For Doubt

There is a 1972 Pennsylvania Supreme Court decision called "York".  We have seen it referenced in a number of filings related to acquisition cases.  The text of the decision can be found here (LINK).  The case addresses issues with the merger of telephone utilities.  Two sections of that opinion are relevant.  The first is page 1, paragraph 6 which states:

York Opinion part 1 5-Dec-2023.jpg

About midway through the opinion there is a footnote that states:

Those two statements appear to be very cut and dried that ratepayers do not pay for interest costs.

Reason #2 For Doubt

Big Water's rate case filings contain Profit and Loss (P&L) type statements with an unusual structure:  Interest is shown as an after tax cost.  A P&L statement for a "traditional" business would show interest cost as a pre-tax expense.  The following table compares the two (the numbers are made up for the illustration):

P&L Statements 25-Nov-2023.jpg

Both formats include the same five cost items:

Operating Expenses

Depreciation

Misc Expenses

Interest

Income Taxes

For the PA Utility Format, interest is the last thing deducted from "Operating Income (after tax)".  That makes it appears that it is an "after tax" or a "below the line" expense. 

Several observations about the two formats:

No matter what order you subtract the same five costs from Operating revenue,  you get the same bottom line net income. 

PA utilities subtract the first three costs to arrive at what they call "Operating Income Before Tax".  It is a subtotal they have created for their type of P&L statement. 

Next, they subtract Income Taxes and arrive at another new subtotal called "Operating Income (after tax)". 

There is an important caveat here:  Income taxes are NOT calculated based on their "Operating Income Before Tax".  Rather, they subtract Interest from "Operating Income Before Tax" and then calculate taxes.  Guess what:

(Operating Income Before Tax) - (Interest) = Pre-Tax Income

Therefore, the tax calculation is the same in either format. 

So, a couple of lines have been moved around and two new subtotals created.  The substance has not changed. 

But, interest now appears to be an after tax cost - or in the language of the York decision "Below the line".  WHY?

Is it related to the "York" opinion????

The Ratepayer Pays Every Dime Of Interest Cost

For most businesses, Net Earnings is what is left over when all the cost items are deducted from revenue.  In the real world, Net Earnings could be either a profit or a loss. 

The world of regulated utilities is different.  In Pennsylvania, the amount of "Operating Income (after tax)" is first calculated and then all the other costs except interest are added to that to determine the amount of revenue the utility is allowed to collect from its customers.  The utility is essentially guaranteed a profit. 

The critical feature here is that the calculated "Operating Income (after tax)" includes the full interest cost of the utility.  The algebra is a bit involved, but is fully developed here (LINK).

The bottom line is:

Average Return #5 26-Nov-2023.jpg

Isn't that "interesting"!  "Operating Income (after tax)" is simply the sum of Interest Cost plus Net Earnings.  Once this number is determined by the above calculation, all the other cost elements get added to it to determine allowable revenue. 

 

The result is that the ratepayer winds up paying the full interest cost of the utility. 

Is It Legal?

That is a question we really wish we had an answer to.  Here are some general observations:

We figured this out as a result of a 2021 sewer rate case.  It is likely that it has been going on a long time.  The "York" decision is over 50 years old.  Is there more legal history to the case?  Probably, but we do not know how to find it.

Going back to the first part of the "York" court decision:

York Opinion part 1 5-Dec-2023.jpg

Clearly, interest costs impact the rates paid by customers.  The "operating income (after tax)" the utility is permitted to collect directly includes the interest costs. 

Is there "wiggle room" because Interest Cost is "below the line"?  That term generally means an after tax cost. Interest is definitely not an after tax cost.  And, the utility companies deduct it from income when calculating taxes. 

"Operating Income (after tax)" is not a commonly used term in business finance.  Could it be an artificial construct to "work around" the "York" decision?  The second part of the "York" decision leads us to believe it is indeed a "work around".  It states (referring to interest cost):  "While such charges must be paid by the company, they are to be paid out of the return allowed the company for the use of its property and capital devoted to the public service."  Could "Operating Income (after tax)" be interpreted to be the "return allowed the company"?  That is very likely what the utility companies and regulators would claim.  The fact that it specifically includes just Net Earnings and Interest Cost looks suspicious to us.  If it is nothing more than a "work around", we think that stinks to high heaven.

If the "York" decision was applied so that interest cost was really "below the line", then the rate setting process would set the ROE and calculate the Net Earnings before interest cost.  Then whatever interest cost was incurred would reduce Net Earnings.  That is definitely not happening today.  As the page on profitability shows (LINK), the Big Water companies seem to earning outsized profits in Pennsylvania.  Interest costs being truly "below the line" would go a long ways to equalize Pennsylvania with other states. 

 

Bottom line:  Is it legal?  We are suspicious, but do not know.   

Can You Help Us?

Interest is a major cost for utility customers.  The "York" decision raises the issue of whether or not it should be a part of rate setting.  Subsequent to the "York" decision there should be some legal history for the "Operating Income" (after tax) "work around".  However, we do not have a clue at how to begin to track that down.  Any help that readers might provide would be very much appreciated. 

Big bucks are involved.  Just the two largest water and sewer utilities in PA (Aqua and American) are collecting $175 million/year for interest costs.  They serve about 1.2 million customers in a state that has over 5 million households.  That makes them small potatoes compared to the electric and gas utilities.  The electric utilities serve everyone. 

If the "Operating Income" (after tax) "work around" does not have a legal basis, there is potentially a multi-billion dollar class action lawsuit that should be brought against the utility companies and PA's regulator. 

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