When working with utilities around the world, we often encounter a curious dynamic. Regulators and policymakers, particularly those overseeing publicly-owned utilities, sometimes feel pressure to implement “rate of return” or “building blocks” approaches to setting tariffs. This pressure often stems from regulatory consultants whose experience comes primarily from privately-owned utilities.
Yet even in countries like the United States—often considered the birthplace of rate-of-return regulation—many municipal water and electric utilities successfully use the cash needs approach. This shouldn’t be surprising: the cash needs approach aligns naturally with public sector accounting standards and the budgeting processes of local governments. The relevant distinction isn’t between developed and developing economies, but rather between private and public ownership models and their different accountability structures.
Why Cash Needs Makes Sense for Public Utilities
The cash needs approach is exactly what it sounds like: tariffs are set to recover the utility’s actual cash requirements – primarily operating and maintenance expenses, debt service obligations, and essential capital improvements. This method has several advantages for publicly-owned utilities:
- It aligns with public sector governance: Most public utilities are departments or agencies of municipal or national governments. While some government shareholders seek returns on their equity investments, the primary mandate of these utilities is public service delivery rather than financial returns. The cash needs approach recognizes this fundamental difference in purpose.
- It promotes better planning: The cash needs approach requires utilities to explicitly plan their investments rather than relying on the more abstract mechanism of WACC plus depreciation to recover capital costs. This promotes more disciplined capital planning and creates clear accountability for how public funds are used. When utilities have to justify specific expenditures rather than rely on a general return on assets, the planning process becomes more rigorous and transparent.
- It’s more transparent: Both oversight bodies and customers can more easily understand a method based on actual cash expenditures than one involving complex calculations of regulatory asset values, depreciation, and allowed returns. This transparency is particularly important for public entities managing public funds.
The Investment Challenge
Critics sometimes argue that the cash needs approach doesn’t provide sufficient funding for system expansion. However, this challenge isn’t unique to the cash needs approach – it’s a fundamental issue of public infrastructure financing. Many successful municipal utilities in the United States and elsewhere use the cash needs approach while funding major expansions through municipal bonds, dedicated reserve funds, and other public financing mechanisms.
A Flexible Framework
The cash needs approach can be as sophisticated as it needs to be. For utilities just beginning to establish sound financial management, it might focus primarily on operating costs and essential maintenance. More mature utilities might incorporate complex reserve funds, detailed capital planning, and sophisticated debt management – all while maintaining the basic principle of matching revenues to actual cash requirements.
Some utilities may eventually transition to rate-of-return regulation, particularly if they introduce private sector investment or establish themselves as autonomous commercial entities. But this should be driven by changes in their institutional structure and financing model, not by a misguided notion that rate-of-return regulation is inherently more “advanced.”
Looking Ahead
The choice of regulatory approach should be guided by a utility’s ownership structure, institutional capacity, and financing model – not by preconceptions about what constitutes “best practice.” For publicly-owned utilities, the cash needs approach often provides the most appropriate framework for ensuring financial sustainability while maintaining focus on their public service mandate.
As we’ve noted in our previous post, different approaches to regulation require different supporting systems and capabilities. The cash needs approach, with its alignment to public sector accounting and governance, often provides the most practical path to sound utility management and sustainable service delivery.