Much has been written about the funding gap America’s infrastructure is facing. For water and wastewater infrastructure alone, the five-year gap was estimated at $108.6 billion by the American Society of Civil Engineers in 2009, compared to a five-year $255 billion need. The federal government has taken a swing at meeting the funding challenge by infusing an additional $6 billion above the regular appropriation into the Clean and Drinking Water State Revolving Funds (SRFs) through the American Recovery and Reinvestment Act (ARRA) of 2009. In addition, the federal appropriation to the SRFs for the 2010 fiscal year (FY2010) and the requested federal SRF appropriation for FY2011 are above funding levels in recent years. Despite these efforts, the gap remains and continues to grow.
As a result, community leaders continue to be faced with the challenge of meeting system needs associated with repair, rehabilitation, and new improvements driven by regulatory mandates or expanding service areas. Most systems do not have annual revenues and/or adequate reserves to keep up with replacement needs, much less completely fund new infrastructure. It is often not practical to wait for grant funds to get a project off the ground. As a result, it is often necessary to utilize debt as a means for funding capital improvements.
Common Debt Approaches
Depending on system size, socioeconomic make-up of the user base, and other factors, there are a number of programs to which utilities can turn when considering debt financing. To bridge the funding gap using debt financing, there are essentially two considerations to address – how to fund infrastructure today and how to repay debt tomorrow. This article illustrates the net effect on users under two common funding alternatives available to systems of all sizes – State Revolving Funds and Revenue Bonds.
State Revolving Fund (SRF) loans are administered through the states as a result of authorization of the Clean Water Revolving Fund in the Clean Water Act of 1987 and the Drinking Water State Revolving Fund in the 1996 Safe Drinking Water Act Amendments. The SRFs provide low-interest loans to political subdivisions for projects driven by public health and regulatory compliance issues. Projects eligible for funding through the SRFs generally include wastewater treatment facilities, non-point source pollution control projects, and public water systems. Recent historical rates have ranged from 1.5 to 3.75 percent. The amortization schedule for SRF loans is generally 20 years, although 10-year schedules can be obtained in some states and disadvantaged systems can apply for an extension of up to 30 years. A Coverage Ratio ranging from 110 to 125 percent is normally required, and loan recipients are required to build a reserve fund within the first five years following the completion of construction.
A Coverage Ratio is defined as the ratio of pledged revenues available annually to pay debt service to the annual debt service requirement. This ratio is one indication of the availability of revenues for payment of debt service. The formula for determining coverage, often referred to as “debt service coverage” or the “coverage ratio,” is as follows:
Systems are required to have engineering plans approved by the SRF program, complete an environmental review, certify that the utility has certified staff, and demonstrate technical and managerial capability. Reporting requirements associated with the SRF program can lead to additional administrative responsibilities. Because each state administers its own SRF program, interest rates, administrative fees, and other specific requirements may vary from one state to the next.
Each state has an application process that must be completed before financing can be secured. This generally includes applying for inclusion on the Project Priority List (PPL) based on a ranking obtained after review of the project details as they relate to specific need-based criteria. Each year, the SRF programs develop an Intended Use Plan (IUP) of prioritized projects ready to initiate in the next fiscal year. Once on the IUP, systems can complete the loan paperwork. Certain types of projects are not eligible for SRF loans, or at a minimum will receive a very low priority ranking if requesting SRF assistance. Examples of these include projects: primarily driven by economic development or growth, related to fire suppression needs, completed by systems that cannot demonstrate financial capability, and stormwater projects that cannot show an environmental benefit.
Revenue Bonds are bonds issued by a public authority to be paid for from a specific source of revenue. Interest rates for revenue bonds are generally higher than for SRF loans. In addition, associated issuance costs and coverage requirements may be greater than for SRF loans. Typically the required debt service reserve for a revenue bond is capitalized into the bond issue, thereby increasing overall issuance size and long-term interest cost for obtaining the bond. With an overall higher cost, however, comes greater flexibility. Unlike loans from an SRF, revenue bonds can be structured with amortization schedules of varying lengths, most commonly 10 to 40 years. The flexibility in amortization schedules can be advantageous as it allows for a repayment schedule closely matched to the expected life of the infrastructure. A longer amortization schedule also spreads the cost of funding the reserve over a longer period than for an SRF loan, which requires funding of the reserve within the first five years of repayment. Revenue bonds typically have a required coverage ratio of 125 percent and the community must demonstrate financial viability of the project to the underwriters. There are typically no restrictions on the type of projects that can be funded. In addition to amortization length, debt schedules can also be structured to include interest-only payments or capitalized interest in the early years of loan repayment. This can be beneficial to a utility that needs time to gradually increase rates to the level needed to support the full annual repayment cost.
Varied Debt Structures to Match Varied Rate-Setting Constraints
A project funded with revenue bond proceeds most often will cost more in the long run than a project funded through an SRF. However, a loan with a longer amortization schedule may result in a lower annual cost in the near-term. When it comes to rate setting, this can be an important consideration if a community is reluctant to or unable to significantly increase its rates in a single year. Each community needs to decide where it stands.
- Do you have enough revenues or reserves to fund the necessary project? If the answer is “yes”, then you are in good shape and likely don’t need to explore debt options at this time.
If the answer is “no”, then move to question number 2.
- Can you delay the project until you can generate enough revenues or reserves to pay for the project? If the answer is “yes”, then you should immediately evaluate how long you can wait and what kind of rate increases you will need to implement each year between now and then. You may want to consider placing the revenue from the rate increases into a dedicated capital reserve fund to ensure that the money is available for the project when you think you will need it.
If the answer is “no”, then move to question number 3.
- Can you raise the rates enough to cover the annual cost of debt to fund the project? If you answered “no” to numbers 1 and 2, hopefully you can say yes to this one. The follow-up question is:
- How much can you raise the rates? At this point, the answers are not black and white. The approach to rate setting and acceptable charges for utility services vary by community. The best answer would be “enough to cover annual debt payment and reserve requirements associated with debt”. That would allow you to comfortably pick the debt solution that overall yielded the lowest cost to the users. However, for many reasons there are times when decision makers look for the lowest incremental impact to users. In such a situation, you may desire a debt structure that you can ease into, and correspondingly ease your users into the necessary rate increases over five to 10 years. An attractive option may be to consider a revenue bond with interest-only or capitalized interest on the front end of the amortization schedule, or a revenue bond with a 30-year or longer repayment term.
For the purpose of illustration, a simple graph has been developed for a theoretical $10 million project that would serve 12,000 user accounts. The figure below depicts the monthly cost of such a project for each account or bill, in future dollars, under an SRF funding scenario and under a two Revenue Bond funding scenarios. The assumptions for the two amortizations are shown in the table below.
The figure shows that for the first five years of the amortization period, the revenue bonds yield a lower cost per account/bill than an SRF loan. This is due to the required funding of the SRF debt service reserve in the first five years. After the first five years, however, the annual cost per account for the revenue bonds exceed the annual cost for the SRF loan, and extends for 10 to 20 years beyond the repayment term for the SRF loan.
Crossing the Bridge
So which is a better approach? It depends upon the needs and ability of the utility. If lower overall cost ranks as most important, the SRF loan appears to be the less costly approach. If minimizing the annual impact to users in the initial years of the project and giving the utility more time to implement increases to the rate structure, then the revenue bond approach is a valid consideration.
The water industry has long advocated that rate-setting for water and wastewater utilities should promote self-sustainability. It has also advocated that each generation pay for its own use of the infrastructure. That being said, debt repayment matched to the expected life of utility assets makes perfect sense. When maintenance is deferred, a generation potentially misses out on paying its share, thereby passing more cost on to the next generation.
Debt financing is a practical and often necessary means of bridging the funding gap for utilities faced with infrastructure investment needs. Different debt options are available to utilities and can be structured to fit various rate-setting objectives.
Although debt associated with the SRF programs and Revenue Bonds were highlighted in this article, there are other public and private entities available to assist systems in obtaining project financing. If you are not yet faced with looming improvements, then now is a good time to evaluate the condition and age of your system and make preliminary plans as to how you will address capital funding requirements when they arise. This will help you to ensure the funding solution you implement best matches the needs of your utility.