Last June, as a heat wave swept through the San Francisco Bay Area, the City Council of a troubled East Bay town gathered around long conference tables and debated how to cut the fat from what was already looking to be a very lean budget. Despite the rising mercury, it was chilly inside , and as the hour approached midnight, some folks donned jackets.
The Hercules Municipal Utility, which kept the air conditioning cranking at City Hall that night, was the subject of a heated discussion. For the better part of the decade, Hercules had subsidized the utility, hoping that one day it would become a profit machine that would help fatten the city’s general fund.
But over the course of a decade, HMU bled money.
Today, the utility has become a drain on the city’s treasury, and its residential customers pay more than other Hercules residents served by competitors. And Hercules is hardly in a position to subsidize HMU – it's that’s forced it to lay off a third of its employees, including cops.
“HMU, admittedly, is a huge problem,” Municipal Services Director John Stier told a weary council at that June meeting. “We’re a little kid playing in a big pen.”
That sentiment had become painfully obvious the day before the meeting, when a left 15 homes without power for more than 24 hours.
“We need to look at why Hercules is in the power business, especially since the thing is running in the red and is projected to keep going that way for years," an HMU customer, Susan Keeffe, following the outage. "Why is my electric rate 17 percent higher than PG&E?”
HMU rates are higher because the utility’s growth has essentially been balanced on the backs of residential ratepayers and taxpayers. Over the past decade, Hercules has spent more than $16 million building a utility that today consists of little more than nine miles of underground cable, switching boxes and a vacant piece of land that was supposed to have been home to a substation.
It is an enterprise awash in IOUs. In the process of serving 840 customers, the utility has saddled Hercules with more than $13 million in . And since 2003, Hercules' redevelopment agency has loaned the utility almost an equal amount of money — this in a town of only 24,000 residents that has a general fund budget of just $14 million.
HMU is just one of a clutch of publicly funded projects in Hercules that have failed to come to fruition even though the city has paid large sums to many companies involved in trying to launch each and every one. Patch is examining several of these endeavors as a way of understanding how it came to be that Hercules, a town that had every reason to embrace and benefit from prosperity, instead finds itself flirting with financial disaster.
“Hercules is obviously financially in tough straits and could well become a classic case of all the wheels on the wagon spinning off,” says Dr. Robert L. Bland, chairman of the University of North Texas Department of Public Administration and an authority on local government budgeting and financial management.
In addition to recent layoffs, Hercules has slashed basic services and such as the Farmers' Market and the annual tree-lighting ceremony. Its redevelopment agency is $18 million in the hole, and Standard & Poor’s has downgraded two of Hercules' bond issues to junk or near-junk status.
“We have them on credit watch negative,” says Sussan Corson, a rating analyst at S&P. Many California cities are in similar positions in today’s economy, and ultimately the ratings will move up or down “depending on what management does to remedy the problem,” Corson notes. “We are waiting to determine what actions they’re going to take.”
On a basic level, the HMU debacle is plain to see — after years of planning and spending, Hercules still doesn't have a self-supporting utility. But on a more complex, less visible and arguably more troubling level, HMU also represents how tangled municipal finances have become in an era when borrowing money was easy and city elders apparently found it easy to flout basic rules governing public budgeting.
In California, all local budgets pivot around a "general fund" budget that is supposed to be inviolate. It pays for such basic services as cops, street repair and parks, and isn't meant to be used for anything more speculative. For special projects or riskier ventures, California towns have redevelopment funds and enterprise funds. Money from the general fund is not supposed to be mingled with or used to support anything that falls into the purview of those latter funds, according to state regulations.
In practice, however, many California towns, including Hercules, have done just that. And in Hercules' case, analysts say, the HMU project featured an unusually frequent and hard-to-follow blurring of lines between the use of general fund monies and other development funds – all involving local businesspeople and southern California financiers to whom Hercules paid relatively handsome fees in the service of what appears to be a lost cause.
Hercules hatched HMU in 2000 during an energy crisis in California in which some big suppliers, like Enron, were accused of manipulating the market. In the wake of those troubles, Hercules began asking itself a very simple question: Why buy expensive electricity from the big power companies when it could supply its own and, presumably, pocket the profits?
And “buying” power was getting more costly by the day. In the summer of 2000, consumers saw electricity prices spike to as much as 800 percent of what they had been the summer before, and rolling blackouts were the order of the day.
Hercules, once home to the nation’s largest dynamite plant, was looking to redefine itself, and HMU held out the promise of independence and profit. Pacific Refinery, the city’s largest employer, had shut down five years before, and its massive hillside storage tanks were being replaced by new homes with manicured lawns and million-dollar views of San Pablo Bay.
Developers transformed acreage written off as an industrial wasteland into Victoria by the Bay, an upscale neighborhood of some 800 homes. And every one of those houses was hooked up to Pacific Gas & Electric Co., northern California’s leading power supplier. If that new subdivision marked the dawn of a boom era for Hercules, as many believed, then why not capitalize on a growing market for electricity with a locally owned and operated utility whose revenues flowed to city coffers?
“The projections were very rosy,” said Hector Rubio, an architect who serves on a local finance committee. “They looked at the best-case possibilities and never considered any alternative to that.”
Rubio is also an HMU customer and recalls that a few years ago he went 10 months without receiving a bill from the fledgling utility. “We were going almost a year without getting a bill, and it was unreal not knowing what to expect,” he says. “Mismanagement has turned what could have been an opportunity into a fiasco.
Hercules began getting behind HMU when a former city manager, Ken Hobbs, invited a Solana Beach firm, Astrum Utility Services, to pitch the idea to the City Council. Hobbs and Astrum dangled a tantalizing idea: local control could translate into better customer service, lower rates and a growing revenue base.
Some on the council were unconvinced.
“I thought then and I said that the utility is not needed,” recalls former City Councilman Andy Paras. “All they are doing is acting like middlemen.”
Paras, now living in a neighboring city, said he voted against the proposal a decade ago because he thought “the people would ultimately shoulder the cost” of what he perceived to be an unnecessary “layer of utility management.”
The council approved a contract with Astrum to pursue the idea, with Paras voting no. The deal would have given Astrum two cents on every dollar the utility billed in perpetuity. But that never happened because the city canceled Astrum’s contract two years later, before a single meter was ever installed.
The company earned only $10,000 from the Hercules venture, but its affiliate investment firm, Kinsell, Newcomb & DeDios, would go on to collect $864,000 in underwriting fees from a series of Hercules bond issues starting in 2007. That same year, former Hercules City Manager Mike Sakamoto resigned from the city to become a senior executive at the investment firm.
With Astrum out of the picture, Hercules turned to Chevron Energy Solutions, a subsidiary of the energy giant, to provide expertise and money. Chevron, which had purchased PG&E’s Energy Service Group the year before, loaned Hercules about $360,000 to get the utility off the ground.
“At that time, many municipalities in California were looking at creating utilities,” says Ken Pimental, spokesman for Chevron Energy Solutions. “We were uniquely positioned to help provide legal advice and guidance, engineering and even construction services to help municipalities connect and interconnect to the PG&E grid.”
By the time HMU officially launched in 2003, the city’s financial statements reveal it had spent close to $500,000 on startup costs, much of that for undefined “administration” expenses, even though the utility had no employees at the time. Those running HMU at the time, including former city manager Sakamoto and several former council members, did not respond to interview requests.
Faced with a mounting debt to Chevron and insufficient city funds to bankroll the utility, Hercules decided to raise cash in the public markets. But with virtually no assets and no operating history, the utility had nothing to convince lenders it could actually repay loans with revenue generated from electricity sales.
Town elders in Hercules solved the problem by making the city itself the borrower through the issuance of lease revenue bonds. In the complex world of municipal finance, “revenue” bonds are typically repaid from the profits of the project being financed.
In this case, however, the utility had no profits. So the city decided to repay the bonds with money from somewhere else. That money would come from leasing the city’s swim center on Refugio Valley Road, not to an outside party, but back to the city.
To pull this off, then-city manager Sakamoto turned to the Hercules Public Financing Authority (PFA), using it as a conduit to raise money and funnel it between the city and bondholders.
The creative financing structure permitted Hercules to borrow money without using General Obligation bonds, which require two-thirds voter approval because they are repaid by taxpayers through property and other taxes.
Instead, the financing authority merely promised to repay what it borrowed using revenues from a specific project, which in this case consisted of a swim complex that had been built with taxpayer money four years earlier. For the purposes of the 2003 bonds, the swim center — with its Olympic and toddler pools and clubhouse-style amenities — was valued at $7.4 million.
On its surface, the 2003 Lease Revenue Bond issue appeared to be a simple way to raise money for a fledgling utility unable to borrow on its own. The financing arm of the city issued bonds secured by lease payments, and backed by Allied Irish Bank with a letter of credit, which guaranteed the debt would be repaid — a promise that cost the city $562,000 in fees and interest payments to the bank over the life of the guarantee.
It was an easy transaction producing quick revenues to secure the bonds. The financing authority leased the city-owned swim center for $1, and the city then leased its own facility back from the PFA for annual “rental” payments of “up to” $1 million. Money received by the PFA in rent from the city was passed along to the bond trustee who actually disbursed principal and interest payments to bondholders.
Although municipal officials characterized the city’s role as nothing more than a “conduit” — a middleman passing money back-and-forth from the utility to the PFA only on paper — the city was in fact the borrower, responsible for paying debt service through its annual rental payments drawn from the General Fund. The financing authority was the conduit, not the city.
Mechanics aside, the end result of the creative borrowing was that it gave Hercules $7 million in borrowed funds to construct the HMU utility. Over the next two years, the utility would spend more than $2 million on consultants — $870,000 to Chevron Energy Solutions and almost $1.3 million to a pair of Pleasant Hill companies owned by Dr. Dean Tibbs, a utility industry veteran who formerly worked at PG&E.
According to city financial records much of what Tibbs’ companies earned was billed as “strategic advances,” vaguely defined “consulting services” or “support to CES (Chevron).”
It remains unclear precisely what role Tibbs’ two firms played in the utility’s formative days. Tibbs told Hercules Patch his contracts were so old he couldn't recall specific details about his work, and he hasn't responded to subsequent requests for a more in-depth interview.
Whatever Tibbs’ role, former utility Manager Glenn Reddick — who came aboard as a consultant just as Tibbs was pulling up stakes — said it was difficult to figure out exactly what was going on.
Tibbs had three people working on the HMU project, Reddick recalled, and they were expected to manage rates, handle regulatory issues and have their electrician install meters and pull wire.
Compared to the paltry revenues generated by the utility in its infancy, the amount of money Hercules spent on administration and consultants was substantial.
In its first full year of operation, the utility collected just $68,000 from electricity sales and service charges while spending about $400,000 on administration and contractors, according to city financial reports. None of that was reflected in the utility’s bottom line, which simply reported HMU ended its first year with net assets of $247,000. The utility had nearly $1.3 million in borrowing supported by sales of only $68,000. In simple terms, it was spending $20 to earn $1.
It went downhill from there. By the close of the utility’s 2004 fiscal year, expenses had nearly doubled. Although revenues had increased to $546,000, the operating loss that year totaled $428,000. Expenses for administration and contracting alone exceeded revenues by $200,000.
By 2005, revenues from the utility’s 364 customers reached $1.4 million, but expenses increased by $512,000 over those of the previous year, resulting in yet another operating loss, according to city financial reports.
On its face, the city-owned utility had seemed like a sure thing — buy power for 6 cents per kilowatt-hour, which is about what the city pays, and sell it for at least double that.
LINKS TO REDEVELOPMENT
California real estate prices were still on the rise in 2004-05, and Hercules saw an opportunity to capitalize on that demand by transforming its vacant fields into hotels, offices and new housing. , which allows cities to capture millions of dollars in property tax revenue generated by new construction, was the tool city officials would use to craft their new vision for Hercules.
By the end of the decade, 17 percent of the land within city limits would be designated for redevelopment zones, which captured large pots of property tax revenue. All this new development presented an opportunity, and so the city set out to connect every one of those new neighborhoods and business parks to its budding utility.
It was a win-win proposition, a former assistant to the city manager told the council back in 2005. The city-owned utility could help lure new businesses to Hercules with rates lower than PG&E’s while capturing all that new revenue for reinvestment in the city.
“The road ahead will have obstacles and challenges, but in the end it will be an asset the future generations of Hercules will consider a blessing,” the former assistant, Raj Pankhania, wrote in a 2005 report. “It is an opportunity for the residents of this city to control its own destiny at least with regards to their electric utility.”
In the face of annual deficits, start-up costs in the millions and annual payments to PG&E for power transmission, it would take a pretty substantial customer base to tip the scales toward profitability. And that’s exactly what city officials were predicting back then.
Had California’s economy continued to flourish and city officials been better steeped in the ways of running an electric utility, Hercules might have blossomed.
But that’s not what happened.
Development did not occur at the pace that had been predicted, and by the end of 2008, HMU’s costs of purchasing power had so far outpaced revenues that rate increases seemed to be the only viable way of balancing the books. In January, 2009, then-City Manager Nelson Oliva asked the City Council for a rate increase.
“Providing the HMU customers with dependable service has long been the goal of the City, but as the cost of power has continued to increase the ability to serve our consumers has become more difficult,” Sakamoto wrote in a report supporting Oliva’s request.
Sakamoto was the de facto HMU manager at the time, earning $8,300 a month under a consulting contract with the city, while Reddick, an electrical engineer, ran its day-to-day operations for $10,050 a month.
“We found that rates were lower than they should have been,” Oliva told the council, explaining that the price increases would bring HMU to “parity” with its competitors. Like many key financial decisions over the years, the rate hike was approved with no discussion among the council members.
“He [Oliva] went in and sold the council on those big rate increases,” Reddick said.
HMU's prices have risen steadily since 2007, and the utility's customers in Hercules now pay more than neighbors served by PG&E. The residential customers live in new developments where HMU laid the lines; they can’t switch to PG&E.
HMU serves roughly one-sixth of the electric customers in this small city, and most are residential users. But commercial customers account for the bulk of the utility’s total electricity sales. Commercial customers who have the clout to negotiate their own rates, frequently flat rates, pay much less — 12.5 cents per kWh and maybe lower.
HMU’s three largest customers – Bio-Rad, the Pinole-Hercules Wastewater Treatment Plant and — generate almost 58 percent of the utility’s revenues, and in the numbers game of running a utility, it’s not volume that tips the scales; it’s dollars.
Big corporate customers like Bio-Rad pay less for power, because, as heavy users, they are able to negotiate flat rates. Whether the companies get better rates with HMU than with PG&E is unclear, because their bills aren't made public. Home Depot, for example, declined to discuss its rates with Patch.
Another big customer, the Wastewater Treatment Plant, had an electricity bill for one month last year that would have been almost $87,000 if the plant couldn't negotiate rates. But its actual monthly bill was about half that.
The rate hikes Hercules approved in 2009 marked a shift in thinking on the city-owned utility, which was founded on the theory of providing cheaper electricity. What was more worrisome was that continuous rate hikes and heavy subsidies still couldn't balance HMU's books.
Since 2003, in three separate bond issues, investors have sunk more than $20 million into HMU despite the fact the utility had never once posted a profit.
During that same period, the city’s General Fund has loaned or otherwise advanced more than $7.4 million to HMU. At the same time, the redevelopment agency, which was already millions of dollars in the hole, provided HMU with at least $5.4 million in cash. Hercules will pump another $600,000 into the utility within the next few weeks alone.
The series of advances and loans were so complex and so poorly accounted for that not even those in charge of the managing the utility were aware of what was happening in their own accounts.
In 2009, for example, $5.4 million mysteriously appeared on the books of the utility as a “transfer in” with no explanation of its source. Wherever it had come from, the timing of its receipt was perfect because the following year the city would float two bond issues valued at more than $13 million — one to pay off previous bond debt for HMU “infrastructure” and another to fund a substation that would enable the utility to take power straight from the grid, thereby cutting its umbilical cord with PG&E.
With the new bonds in the offing, and investors closely examining the utility’s books, the $5.4 million transfer helped the utility close out the fiscal year with a little more than $9 million in “assets.”
Not even Reddick, who was in charge of the utility’s day-to-day operations, had any idea where the $5.4 million had come from or that it was even on the books.
“I saw two or three things — and that one was the whopper — where it seemed like HMU existed to move money from the (redevelopment agency) to the general fund,” he says. “Everybody kept telling me I had $6.5 million to build that substation, and I said I sure as hell didn’t.”
Former city manager Sakamoto, who was managing the utility at the time under the auspices of his firm, Municipal Management Enterprises, has declined repeated requests for interviews.
In fact, Reddick’s cupboard was almost bare. Most of the $5.4 million — almost $3.5 million — soon went straight back into the city’s General Fund, where officials recorded it as a "refund" of prior year advances for utility infrastructure.
The cash infusion had come from the proceeds of a 2005 redevelopment bond issue and amounted to little more than financial window dressing, allowing Hercules to position the utility to appear healthier than it was in case it wanted to raise more money for HMU, according to outside consultants. That was confirmed during a City Hall study session in March, when consultants hired to sort through the city’s tangled finances were directly asked to explain the transfer.
“If I understand correctly, the $5.4 million was taken from bond proceeds to make it [HMU] look good to get another bond?” Councilman John Delgado asked a Municipal Resource Group consultant at the hearing.
“Yes,” she responded.
No matter how the budgets were prepared or financial ledgers tweaked, there was one set of numbers that couldn’t be disguised —the continuing stream of HMU operating losses, which totaled $3.9 million by the end of the 2010 fiscal year. The utility had operated in the red since its inception, and had been borrowing from the city as much as $1 million a year — literally to keep the lights on.
Every time city leaders went to market to finance and refinance debt that fueled this dream of cheap power and hefty profits, investors were asked to turn a blind eye to the utility’s books and focus instead on the city’s assets and taxpayer cash to back the bonds.
“The ratings that we maintained were based on the cooperation agreements,” says Corson of Standard & Poor’s. “In this case, we considered the general fund pledge. We weren’t looking at the utility’s financials to come up with our ratings.”
HOUSE OF CARDS
With just 840 customers and no profits, HMU was proving to be a house of cards. Last summer, that house almost collapsed when Allied Irish Bank (AIB) decided not to extend a letter of credit that was the financial underpinning for $7 million in bonds sold to fund the utility’s start-up costs back in 2003. The letter of credit was essentially a guarantee to investors that bond principal and interest payments would be met.
AIB had by then earned more than $500,000 for providing its guarantee, and it is not entirely clear why they decided to bail. Key city officials and others involved in the deal have all declined to comment, and AIB’s U.S. operation is out of business.
But thanks to provisions of the 2003 bond deal, that decision could have triggered a call on the bonds. With the city’s own finances deteriorating to the point where it would soon become difficult, if not impossible, to continue subsidizing HMU, and with the impending loss of the AIB guarantee that was almost certain to trigger a default on the 2003 bonds, something had to be done, and fast. The solution: Borrow more money.
Ultimately Hercules sold only $24.9 million in bonds — $7.4 million to refund the 2003 HMU bond issue, $5.8 million to pay for construction of the HMU substation and $11.7 million for sewer system improvements.
But the way these bonds were structured added more pressure to the city’s finances and that additional stress helped push Hercules to the brink of insolvency – where it teeters today.
To underwrite the bonds, Hercules turned to Chilton & Associates Inc., a small southern California investment bank to which it would pay almost $219,000 in fees. Ultimately, city officials decided to back the bonds with Hercules’ general fund — which normally pays for services like police and parks.
Chilton reassured rating analysts who might have been antsy about the possibility that Hercules would be stuck paying off the debt larded on its still unborn power utility.
“Unless something dramatic happens, the city should not have to loan money to any of the bond issues under the cooperation agreements,” Chilton wrote to Standard & Poor’s in May 2010.
It's not unprecedented for a city to open the coffers of its general fund to guarantee the debt payments of special projects, says University of North Texas Professor Bland. But Bland believes the arrangements should be used "sparingly" because of the risk they pose to taxpayers.
To make sure that the bonds would be repaid, Hercules also agreed to pay HMU rent for the equipment the utility needed to operate. The arrangement was so complicated that even John Stier, who now manages HMU as the city’s municipal services director, told Patch he was not aware of it.
Chilton reassured S&P, the debt rating agency, that Hercules fully intended for HMU to be self-sustaining financially and that the city would never have to use general fund monies to keep HMU on life support.
“It is the intent of the city to raise electric rates in an amount sufficient so that electric revenues cover maintenance and operation expenses together with debt service without ever tapping into the general fund,” Chilton explained to the firm in a July 22, 2010, email.
In an email response to Patch, Chilton declined to discuss his work for Hercules in detail, other than to say his company was “requested to submit a proposal to the City of Hercules in 2008 or 2009 and we did. Our policy is not to comment to the press or any other party in any more detail. We are not responsible for keeping the City’s records.”
The Hercules bond issues may have been the underwriter’s last. According to records at the Financial Industry Regulatory Authority, an independent regulator of securities firms and the California State Department of Corporations Securities Regulation Division, Chilton & Associates ceased being a broker last September, less than a month after the HMU bond issue was sold.
“We went out of the securities business regarding matters that had nothing do with the integrity of the business,” Chilton said.
By next year, debt service on the 2010 HMU bonds alone will approach $750,000 annually — far more than the utility will generate in operating profit and a heavy additional burden for a city that must also pay out more than $10 million annually for principal and interest payments on other borrowed money.
The impact of all of this borrowing is concrete. Consider, for example, how debt service payments stack up against spending for the Hercules police department, which has already passed out pink slips to some officers.
The police department’s entire budget this year is about $5 million —some $1.5 million less than the city needed this month alone to make bi-annual principal and interest payments on the bulk of the city’s outstanding bond debt. Of the $6.5 million Hercules paid on its debt, $328,000 was interest-only payments on HMU’s $13.2 million in outstanding bonds.
While the department budgets shrink, the debt load continues to grow such that by next February, the city and its affiliated agencies must come up with another $6.4 million for its second bi-annual debt service payments.
Yet with HMU struggling to earn a return, City Council members voted in March to scrap plans for the utility to build its own $6 million substation — even though that facility would have enabled Hercules to take power straight from the grid and deliver it to customers without using PG&E’s lines.
By the time the city canceled the substation, it had already spent close to $1 million planning it — a sum that included equipment costs, environmental studies and incomplete construction drawings.
The recommendation to scrap the plans for building the substation came from the Citizen’s Ad Hoc Financial Committee. In the best-case scenario, the committee could not see the utility being profitable before 2017, and so the recommendation was to stop building.
The decision to scrap plans for the substation raises some thorny questions, not least of which is how the city will meet growing demand in a system nearing peak capacity.
Reddick, who was then managing utility operations, made an impassioned plea to stay on track. His views were so unpopular that he said he decided to step down at the end of June.
“When we signed our inter-connection agreement with PG&E, we gave up all right to deliver (power) through their distribution system, and those contracts will expire this year,” Reddick said in March. “If we continue to pay those fees, which are subsidized through the general fund, we’re going to be operating at a loss for the next 30 years.”
The policy reversal also further clouds the financial quagmire facing the city.
Investors purchasing the HMU bonds last year were assured in the offering statement their money would be used for “certain improvements to the City of Hercules electric system, namely, an electric substation.”
With substation construction cancelled, the big question is what to do with the bond proceeds now sitting in an investment account.
“As a general rule, money obtained for specific purposes should be used for that purpose . . . but you have to examine the fine print which is generally very specific on what, if any restrictions are placed on use of the money,” says Stephen L. Larson, a CPA and partner in Larson & Associates of Newport Beach, CA.
In HMU’s case the fine print is unclear. While some documents suggest the money would be used specifically for a substation, other documents seem to allow greater leeway so long as it involves HMU. City Council members have discussed the possibility of using the substation money to retire the very bonds sold to finance the facility, but there is no clear policy direction at this point.
Beyond representations to bondholders who thought they were investing in a substation, the city’s policy reversal begs the question of how HMU will ultimately become profitable. How do you repay “revenue” bonds without revenue?
Faced with that question at a recent City Council study session, Stier spoke of pursuing parallel paths. He wants to lower rates and sign on new commercial customers while simultaneously negotiating a possible sale.
“I think it will be sold, and I think it will be sold quickly,” Stier says. “We have to fix this thing or sell it.”
Reporters Bob Porterfield and Jackie Ginley are investigating the problems in Hercules for The Huffington Post and Hercules Patch.