The Infrastructure Crisis Is A Pricing Crisis

Domestically, the utility sectors ? water, wastewater and stormwater ? are suffering from inadequate investments in needed infrastructure and operations & maintenance (O&M), below-cost water rates, declining water consumption (not necessarily a bad thing), and the hangover of the Great Recession. Federal, state and local governments are struggling with their budgets and the long-term crisis of escalating entitlements and under-funded pension funds and health plans for public employees.

Let me state my thesis directly and up front. The federal government is broke and unlikely to come to the rescue to any meaningful extent for the foreseeable future absent serious entitlement reform. We are left with the imperative of utilities educating their customers and ratepayers as to the full value of their invaluable service, and the pressing need to support robust water rates and prices commensurate with its true value. In addition, we are going to have more fully and effectively utilize those financial assets that we already possess, specifically the state revolving loan funds under the Clean Water and Safe Drinking Water Acts.

The Problem

The investment ?gap? relative to the nation?s water and wastewater infrastructure has been documented by EPA, AWWA, NACWA, WEF, ASCE and others. Take just one example, AWWA?s 2012 report, Buried No Longer: Confronting America?s Water Infrastructure Challenge, which estimated the infrastructure replacement challenge for drinking water to be $1 trillion over the next 25 years. Estimates vary for the wastewater side of the house, but let?s call it another $1 trillion for purposes of our discussion.

I came to Washington, D.C., more than 13 years ago to run the National Water Program at EPA. I have heard many calls for a variety of proposals by Congress. If memory serves, there have been recommendations for more funding of the Clean Water and Safe Drinking Water state revolving loan funds (SRFs), a water trust fund, raising the cap on private activity bonds, federal tax credit bonds for ?watershed restoration zones? (WRZs), a ?watershed renewal bond fund program,? a water infrastructure bank, and, more recently, WIFIA ? the Water Infrastructure Finance and Innovation Act of 2013 which actually became law and is promising in its use of leverage. But WIFIA is a small-scale pilot program that will not, in and of itself, close the investment gap, at least for the foreseeable future given limited dollar authorization and small number of likely projects.

There was the momentary starburst of the $850 billion stimulus bill in 2008 that generated some spending for water and wastewater infrastructure. But we are not going to see the likes of that kind of spending anytime soon. True, Congress recently authorized the state revolving loan funds at $1.4 billion, a pleasant surprise but no real increase over prior appropriations.

The Congressional Budget Office (CBO) has offered up a very disturbing picture of America?s fiscal situation. ?Between 2009 and 2012, the federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing the federal debt to soar,? states the CBO in the 2013 Long-Term Budget Outlook. ?Federal debt held by the public is now about 73 percent of the economy?s annual output, or gross domestic product (GDP). That percentage is higher than any point in U.S. history except a brief period around World War II, and it is twice the percentage at the end of 2007.?

If current law remains the same, there would be a slight decline over the next few years relative to GDP. In truth, the deficit is now falling. But soon thereafter, things deteriorate rapidly. ?CBO projects that federal debt held by the public would reach 100 percent of GDP in 2038? ? about the time my new grandson turns 25. This projection does not account for other harmful effects to the economy stemming from this growing debt burden, says the CBO. ?Moreover, debt would be on an upward path relative to the size of the economy, a trend that could not be sustained indefinitely.?

The federal debt ?held by the public? will likely decline to 68 percent of GDP by 2018. However, this percentage rises to 71 percent of GDP by 2023 ?…mainly because of increasing interest costs and growing spending for Social Security and the government?s major health care programs (Medicare, Medicaid, the Children?s Health Insurance Program and subsidies to be provided through health insurance exchanges).? Indeed, ?CBO expects interest rates to rebound in coming years from their current unusually low levels, sharply raising the government?s cost of borrowing.?

We need to keep in the mind distinction between deficits, which are declining in the short term; the $18 trillion debt (up from $16 trillion in the last two years) and the truly frightening unfunded obligations for entitlement programs.

Niall Fergsuon, a Harvard economic historian and host of PBS?s television documentary, ?The Ascent of Money,? seems to agree with me. In his book, The Great Degeneration: How Institutions Decay and Economies Die (2012), he notes that ?the statistics commonly cited as government debt are themselves misleading, for they encompass only the sums owed by governments in the form of bonds.?

Continues Ferguson, ?But the official debts in the form of bonds do not include the often far larger unfunded liabilities of welfare schemes like ? to give the biggest American programs ? Medicare, Medicaid and Social Security.

?The best available estimate for the difference between the net present value of federal government liabilities and the net present value of future federal revenues is $200 trillion, nearly thirteen times the debt as stated by the US Treasury,? argues this native Scot. Ferguson also makes clear that this staggering number does not include state and local governments? unfunded liabilities estimated to be in the neighborhood of $38 trillion.

?These mind-boggling numbers represent nothing less than a vast claim by the generation currently retired or about to retire on their children and grandchildren, who are obliged by current law to find the money in the future, by submitting either to substantial increases in taxation or to drastic cuts in other forms of public expenditure,? observes Ferguson.

CBO and Niall Ferguson paint a frightening picture of the fiscal crisis facing this nation over the coming decades absent serious reform. Unfunded liabilities over the years will drive the debt burden beyond anything we can imagine, especially as interest on the debt rises once the Federal Reserve takes away the punch bowl as it inevitably must. Hence my pessimism regarding any new, significant federal outlays for water and wastewater infrastructure on the order of the old construction grants program under the Clean Water Act of 1972.

The federal budget is, increasingly, entitlement spending, interest payments on the debt and national defense. I exaggerate, but not by much. What most Americans think of as ?government? ? National Parks, the Weather Service, EPA, etc. ? is going the way of the Passenger Pigeon.

The downward trajectory of SRF funding led American Water Intelligence, the domestic spin-off of Global Water Intelligence, to speculate, somewhat harshly but presciently, ?Perhaps when cities see what is left of SRFs once a budget for 2013 is enacted, they will realize that the financial cavalry isn?t coming? (?Will the year?s SRF cuts change public sector thinking on government funding??, American Water Intelligence, March 2012, p. 4). True, level SRF funding was authorized by the recent lame duck session of Congress, but it has been steady or declining given inflation and growing needs.

Most of our water and wastewater utilities are run by local governments and municipalities and subject to political leaders who must face election every four years. For them, raising water rates is equivalent to raising taxes and therefore, a root canal. Often, they look to water systems as a source of revenue from which they can draw down funds to support, say, public pension funds or health insurance.

Even the casual reader of the trade press or The Wall Street Journal is well aware of the financial predicaments of Illinois, Puerto Rico, Chicago, Detroit, Providence, New Orleans, Jefferson County (Alabama), Harrisburg, and Allentown. All of these cases have unique circumstances, certainly aggravated by the Great Recession; but, taken as a whole, the picture they paint of municipal finance is not pretty.

A Wall Street Journal article by Mark Peters (?Pension Pinch Busts Budgets,? Oct. 30, 2013, p. A3) noted that the median spending on pensions among the country?s 250 largest cities rose to 10 percent of general budgets in 2012, up from 7.75 percent in 2007 citing Merritt Research Services LLC. Springfield, Ill., has tripled its payments to its public employee retirement system in the past decade, amounting to 20 percent of its operations budget in fiscal year 2012. In many of its neighborhoods, heavy rains overwhelm storm sewers and roads.

One observer estimates the deficit in public pension plans, nationally, at $1 trillion (Rogers Lowenstein, The Wall Street Journal, ?The Sorry Tale of Pension Promises,? Sept. 21-22, 2013, p. C3). In 2013, a second bond rating agency downgraded the city of Chicago?s debt worthiness by three notches because of its failure to address shortfalls in four pension funds (Hal Dardick and Ray Long, ?City hit with 1 more debt downgrade of bonds,? Chicago Tribune, Nov. 11, 2013).

The New York Times? Charles Duhigg reported (?Saving U.S. Water and Sewer Systems Would be Costly,? March 14, 2010) that DC Water, to its eternal credit, was seeking water rate increases so it can replace its pipes over a 100-year cycle rather than ?in three centuries? under the original budget. Still, one local resident complained, ?I don?t care why these pipes aren?t working! I pay $60 a month for water! I just want my toilet to flush! Why do I need to know how it works??

The estimable George S. Hawkins, the dynamic head of Washington?s water and wastewater system, articulates a frustration everyone in the water sector can appreciate: ?People pay more for their cell phones and cable television than for water.

?You can go a day without a phone or TV,? he adds. ?You can?t go a day without water.?

This disconnect in the mind of ratepayers, cognitive dissonance really, can be found all over the country including my wife?s home state. A 2010 study of monthly utility costs in Wisconsin demonstrated [see graphic below] that customers paid more than $140 per month for telephone service (cell and land lines combined) and over $80 per month for electric power. Wastewater charges were less than $40 per month, and water charges were less than $20 per month (MSA Professional Services, Inc., The Cost of Clean: 2010 Wisconsin Sewer User Charge Survey Report, p. 31). I dare to say that you could produce a graphic like this for most states in the Union. (My thanks to Gil Hantzsch, P.E., Vice-President of MSA Professional Services, Inc., for providing me with this information).

NOTE: View the full MSA reports on the Wisconsin Sewer User Charge Surveys from 2010 and 2013 here: http://www.msa-ps.com/News—Info/Publications.aspx.


Signs of Hope

Yet, there are signs that the nation ? its communities, its utilities and ratepayers ? are coming to appreciate the need to invest in their water and wastewater infrastructure.

David LaFrance, executive director of AWWA and a water finance expert in his own right, recently observed that ?awareness is increasing about the need to reinvest in and replace water infrastructure,? citing survey data from Black & Veatch, Xylem and AWWA itself (?Survey Says…There?s a Glimmer of Light at the End of the Tunnel,? January 2013, p. 6).

Rates have been going up the last few years although the percentages often belie the small actual amounts of the increases. But this is progress. True, the averages are lifted by big numbers stemming from consent decrees mandating massive expenditures for remediating combined sewer overflows (CSOs) in older communities. These are sizeable investments although not always cost-effective.

It is also encouraging that Texas voters overwhelmingly passed a constitutional amendment recently to finance state water projects. Proposition 6 takes $2 billion in surplus state money from the Rainy Day Fund to provide loans for water infrastructure. The measure had bipartisan support in a state where drought conditions have been persistent. Texas had not invested in water infrastructure for decades. To paraphrase Rahm Emanuel, you never want a serious drought to go to waste. The vote in Texas reminds us that states can and do play a role in financing infrastructure projects including the capitalization of their SRFs. Recall that the Erie Canal, America?s first iconic infrastructure or public works project, was funded by New York when the federal government refused.

The self-evident deterioration of our infrastructure, which is manifested, say, by water main breaks and collapsing pavement, may, finally, work its magic on political leaders and ratepayers alike. Steve Maxwell, a well-known financial analyst of the water sector, in his fine book, The Future of Water, tells the story of the Washington Suburban Sanitary Commission (WSSC), serving one of the wealthiest parts of the country, the Maryland suburbs of the nation?s capital. WSSC experienced a massive water main break just before Christmas 2008. River Road in Bethesda, Maryland, became, well, a river. A 66-in. pre-stressed concrete underground water main burst, setting off a torrential flood that deluged a major artery and stranded motorists. Helicopters, boats and fire trucks came to the rescue, and water was cut off to thousands of customers.

This was just one of 1,709 breaks that year, and WSSC was on a 200-year replacement schedule for its 5,500 miles of water mains. Earlier in 2008, WSSC?s commissioners had rejected a new fee of $20 a month per customer to accelerate pipe replacement because they said the flat fee was unfair to low-income customers. Fair enough. But they failed to change the fee to a sliding scale or block rate or come up with any subsidy program for the financially distressed.

?They decided to ask for money from the federal stimulus package instead, however they didn?t get any,? writes Maxwell. ?Technological advances certainly matter, but what matters most is the ways in which humans use and pay for water. Right now, most people in most countries don?t value water very highly, even though they know that without it they would die.

?The most important job utilities around the world may have in the coming decades is convincing people that water is valuable ? and that it is reasonable to pay more for this luxury than the bargain prices we have traditionally taken for granted,? opines Maxwell.

In his book, Maxwell reproduced a table from Global Water Intelligence, that lists average water prices in terms of U.S. cents per gallon. It basically confirms that northern Europeans pay twice as much for water as do Americans. They also use less than half of what Americans consume. Quelle surprise. European water systems have larger capital surpluses for capital investment.

By the way, my online research revealed that WSSC?s actual rate increases were in the range of 0.0 to 3.0 percent, FY 2000 through FY 2007. From FY 2008 through FY 2012, they ranged from 6.5 to 8.5 percent. I also found an Aug. 22, 2013, letter to the Baltimore Sun from a disgruntled ratepayer from Laurel, Maryland, complaining that her monthly bills had gone up from $60 per month in 2007 to $160 per month now (Name Withheld, ?Let WSSC know how you feel about increasing water rates,? Baltimore Sun, Aug. 22, 2013).

In the long-run, America must invest in its infrastructure. There really is no choice, is there?

The Essential Task

The essential task is to educate, communicate and convince customers and ratepayers of the necessity of shifting from an overly constrained commodity model of pricing to a new and more accurate and compelling services model of pricing. Water and wastewater utilities do sell a commodity like flour or coffee beans or corn. Utilities also provide extremely sophisticated services that are highly technical, heavily engineered and capital-intensive. We need to emphasize, not just the importance of full-cost pricing, but the tremendous value, the benefits ? the services ? that water and wastewater utilities provide their customers and ratepayers. This important dimension needs to be reinforced every day, in every message, and every interaction that utility managers and personnel have with the public. The story needs to be told.

Given declining rates of water consumption and the difficulty of loading fixed costs (80 percent or more) into a variable or volumetric water rate, the service model is clearly preferable. Of course, some blending of the two might work. You should also build into rates the scarcity value of water, say, in arid or water-short regions of the country.

These vast complexes of engineering, technical, business and managerial services, which are our water and wastewater utilities, are mostly invisible to water consumers who have been spoiled by cheap water readily accessible. This blissful ignorance must come to an end. If you believe the data on the infrastructure investment gap, you have to believe we have failed to educate the public or make a compelling case to ratepayers.

I am pleased that both municipal and private water sector associations and companies have come together in the very promising Value of Water Coalition (www.thevalueofwater.org) to inform Americans of the value of water and the challenges facing the nation?s water infrastructure. When former Water Environment Federation Executive Director Jeff Eger first conceived of a public campaign like the Value of Water, he often compared the water sector?s anemic efforts with the ?Clean Coal? campaign that invests tens of millions of dollars in media and messaging. Let us pray that the new Coalition can achieve significant market penetration in the days ahead. If I have any advice for the Coalition, it is to stay focused on ratepayers.

We can also recognize the water reuse industry and its customer utilities that are pioneering sophisticated communications strategies to promote indirect potable reuse around the country. Can direct potable reuse be far behind?

We also need to pay attention to governance issues more than we have to date. In Australia, the world leader in water management, utilities are regulated by an independent price regulator who sets the Weighted Average Cost of Capital (WACC) and the model used to set prices at arm?s length from elected officials. This approach is unlikely to be adopted here in the States. Nevertheless, governance of municipal water and wastewater facilities might benefit from greater distancing from elected officials. There are many examples to choose from throughout the country. I am not advocating an unaccountable technocracy, but, rather, greater reliance on public corporations, commissions and other bodies established and appointed, but not directly controlled, by elected officials. We need to shield water pricing decisions from political interference and the undue influence of the electoral cycle.

Better Utilization of Resources at Hand

Given the financial challenges to water and wastewater investment financing, we need to take a second look at the state revolving loan fund (SRFs) under the Clean Water and Drinking Water Acts. These are substantial resources of which we are not taking full advantage.

Michael Curley, Visiting Scholar at the Environmental Law Institute, a former bond attorney, law professor and all-around financial wizard, has outlined some of the possibilities. A former member of EPA?s Environmental Financial Advisory Board for many years, he is one person who did not go to law school to avoid taking math or calculus. Curley once served as president and CEO of the New York Job Development Authority, the state?s economic development bank, and authored the Handbook of Project Finance for Water and Wastewater Systems (1993). Rumor has it that this latter volume will be republished in the not-too-distant future.

I first made the acquaintance of Michael Curley after reading his truly stunning article, ?The Gold Mine? (The Environmental Forum, March/April 2012, pp. 24-28) in which he single-handedly solves the so-called water infrastructure investment gap by demonstrating how the $100-plus billion in federal and state dollars, more than $40 billion in net assets, parked in Clean Water Act State Revolving [loan] Funds, could be leveraged in the debt markets to meet most, if not all, of our infrastructure needs. The key is to utilize the principal of insurance and transform the SRF loan program into a guaranty program with 30-year instead of 20-year terms at minimal additional cost. This could be done right now, state by state. Moreover, there would be plenty of money available for other environmental needs if Congress broadened the uses of these funds.

The CWASRF funds are under-performing assets that need to be leveraged, energized for the good of the cause. In his new book, Finance Policy for Renewable Energy and a Sustainable Environment, Curley elaborates on why this guarantee approach would work so well: ?Standard & Poor?s (S&P) has studied the default histories of municipal bonds for almost a century. The default history on bonds issued to fund public wastewater projects is approximately 0.4 (or 2,500:1). In January of 2011, S&P published a document requesting comment on, inter alia, a new total leverage ratio for anyone guarantying public wastewater project debt. S&P said that if the guarantor wanted to maintain its highest investment-grade credit rating (AAA), the maximum leverage ratio could be no higher than 75:1. With $40+ billion of net assets, at a 75:1 leverage ratio, the CWSRF has the potential to leverage $3 trillion.?

$3 trillion.

Curley emphasizes that the 51 CWSRFs have the legal authority to issue guarantees. ?And, theoretically, their collective guarantees, up to a total of $3 trillion, would be rated AAA.? OK, maybe the reader believes 75-1 ratio is just so much pie-in-the-sky. But, even at 25-1, we could find another trillion dollars for the good of the cause.

Also, keep in mind that using the SRFs guarantee function does not interfere with the stream of subsidized loans through the existing program.

I recently heard Paul Marchetti, who runs Pennsylvania?s SRF programs, discuss an expected guarantee application from a town that would not qualify for a subsidized SRF loan for stormwater investments. However, the guarantee will still provide the town with a subsidy but about one-third of the subsidized loan (which ain?t nothin’). This shows how we could get more bang for our SRF bucks.

Conclusion

I hope I have provided a realistic assessment of the water sector?s current predicament while discerning a path forward to greater investment in its infrastructure. I share the view of Clifford Winston of the Brookings Institution, who, in commenting on the transportation sector, claimed we were not in an infrastructure crisis as much as a pricing crisis. And to quote James Pethokoukis of the American Enterprise Institute, ?If we can get the prices right, that will do an awful lot to improve the condition and service of our infrastructure.?


EDITOR?S NOTE: This column is based on the author?s speech at the UIM/SWIM Conference on Dec. 4, 2014, in Arlington, Va.

G. Tracy Mehan, III is a former assistant administrator for water at U.S. EPA, the current interim president of the U.S. Water Alliance and an adjunct professor at George Mason University School of Law. He is also a member of EPA?s Environmental Financial Advisory Board.

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