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Water Rate Cost-of-Service Study Section 3. Revenue Requirements HF&H Consultants, LLC | July 8, 2025 | Page 19 of 53 Reserves are essential for rate stabilization and unforeseen expenses. They are drawn from when the Water Enterprise Fund faces higher-than-average costs and replenished during lower-cost years. Separate reserves support both operating and capital needs, each with its own minimum and optimal target levels. Rates must be structured to maintain these target balances. Current Policy The City’s reserve policy requires that the target reserve balance is made up of an operating reserve component and a capital reserve component. The operating reserve component is equal to 25% of annual operations and maintenance (O&M) expenses. The capital reserve component includes $2 million to provide funding for pay-as-you-go construction projects. The operating component of the reserves provides working capital for month-to-month O&M expenses. With sufficient working capital, the City can operate without cash flow constraints. This current reserve policy tracks with HF&H’s recommendation of a minimum operating reserve that is equal to at least 1.5 times the billing frequency (or three months in the City’s case). The City’s reserves should never drop below this minimum balance. The capital improvement component of the reserves provides cash funding for the City’s capital improvement program. The fund balance needs to be sufficient to pay contractors and purchase materials without delays caused by cash flow limitations. Given the City’s plans to fund an average of $13.1 million in capital projects per year with rate revenues, this component is necessary. City Proposed Policy The City is proposing to revise the existing policy to escalate the portion of the capital reserve component according to the year-over-year change in the Construction Cost Index for the San Francisco Bay Area, as provided by Engineering News Record.12 This escalation of the reserve target ensures the City’s monetary goal keeps pace with increases to construction costs each year. REVENUE INCREASES Rates are set to generate enough revenue to cover projected annual expenses and maintain adequate reserves. While it is preferable to keep annual rate increases steady over the multi- year rate plan, the total revenue collected remains within the overall cost of service. In other words, although the rates are smoothed to avoid large year-to-year changes, they are still based on the total revenue needed over the rate period and do not exceed it. As shown in Figure 3-5 and Figure 3-6, the annual increases in revenue requirements are uneven from year to year, while the rate increases are designed to be more consistent. This difference causes the fund balance to fluctuate from year to year, ensuring that revenues and expenses remain balanced over the three year period. Revenue increases were derived to cover the City’s Enterprise costs and to maintain adequate reserves. Figure 3-6 summarizes the projected revenue from current rates, annual revenue requirements, annual variances, and the rate increases proposed to help address the City’s 12 The Water Enterprise Fund has a formal policy of maintaining two million in reserves. The proposed reserve policy will be recommended for adoption via resolution to Council. ATTY/RESO.0109/CC RESO WATER RATES - EXHIBIT A REV: 11-05-25 MI