Local governments face economic challenges, but it’s important to prepare now for utility infrastructure reinvestment
Local governments, and the communities they serve, continue to face economic challenges stemming from slow wage growth and increased cost of living. The result: customers have less money and are more resistant to fee increases for public services. At the same time, per capita water demand continues to fall nationwide, and yet utility infrastructure faces a critical need for reinvestment—in the billions of dollars.
I have been privileged to work with hundreds of utility service providers across the globe in capital funding optimization and utility rate setting. In that capacity, I have learned a few valuable lessons that may benefit those looking to develop the most efficient and affordable funding strategies for their next capital project(s). My list of five key considerations starts with the question of who will be served:
1. Think about the fairest way to fund/recover the cost of the improvement.
Specifically—who will be served and for how long? If it’s a short-lived asset that only lasts 10 years (like some smaller pumps for example), you probably don’t want to finance it over 20 to 30 years. So, you need to ensure you have adequate resources available to pay for the project in cash.
However, if the project is a major investment, like a new wastewater treatment plant, you may want to consider debt and loan options to align the cost of debt retirement with the use of the project by future customers.
_q_tweetable:The moral of the story is: be equitable, consider the future, think about your resources, and don’t be afraid to be a little creative._q_Either way, the proper mechanism needs to align the useful life of the project with the generation(s) of customers that will pay for it. Moreover, it if is a recurring annual need, consider cash funding versus financing; otherwise you will end up paying twice as much in annual principal and interest payments end than you would if you set up an annual cash funding strategy.
2. Begin setting aside money now to pay for the replacement of the project in the future.
Let’s say you construct a $1 million facility in 2018, and its lifespan is estimated at 10 years. Ideally, you should set aside money now (escalated by inflation) to replace that asset 10 years from now.
Is this the same as setting aside annual depreciation? In my experience, accounting depreciation often is not large enough to provide a measuring stick to help you prepare to meet future costs. While funding of annual depreciation should be respected, we should recognize that the need is likely even more. Therefore, plan to start setting aside at least the annual depreciation of the improvement immediately and consider adjusting it to account for future inflation if you want to sustainably pay for the asset’s inevitable replacement.
3. Don’t forget about annual operations and maintenance costs.
You need to factor operations and maintenance into future funding requirements, as well as project selection. A $1 million asset that costs $2 million per year to operate is more expensive overall then a $2 million asset that costs only $500,000 per year to operate. For this example, if the two assets are operated for 20 years they would have a simple life-cycle cost of $41 million and $12 million, respectively. In other words, an upfront investment of $1 million saved $29 million over the life of the assets. You must understand what the annual and total lifespan of operation and maintenance costs are with your infrastructure because these costs can easily outweigh initial capital costs and result in higher rates to customers.
4. Make sure you leave adequate financial “buffers.”
Don’t deplete your reserves just to avoid the issuance of debt. Well-managed debt is a good tool for utilities. Similarly, if you’re going to finance, make sure that it isn’t such a high amount that you don’t have any flexibility to withstand reasonable fluctuations in annual revenue and expenses, or have any capacity left for future borrowing. You need cash reserves and sufficient annual income streams to make sure you can still pay for the project (and other needs) if things don’t occur as planned.
5. It’s OK to get creative.
Look at alternative financing or funding sources, such as new federal and state loan programs and other options. Some municipal agencies are unfamiliar with and unsure of public private partnership (P3) projects. They think, what does this mean for us? Will we have to give our assets away?
P3 projects can be structured in many ways—they don’t all have to involve the same elements.
One example of an option that could be innovative but not dramatically different than more familiar options could involve performance bonds. Utilities could structure the bonds in such a way that you transfer risk if a project doesn’t deliver the intended benefit. If the project doesn’t perform as expected, the interest rate would be lower, and in return, if the project over-performs, you would pay a slightly higher interest rate and share some of the benefit with the lender. And, yes, you will still own the asset.
The moral of the story is: be equitable, consider the future, think about your resources, and don’t be afraid to be a little creative. Financial planning is a holistic process.
I’m proud to say that my clients know our financial services practice can help identify difficulties in advance, help them analyze options, and provide solutions that ensure financial sustainability in the most equitable and affordable way possible.
About the Author
Andy Burnham helps lead operations and business development activities for our Financial Services practice. Recognized as an industry leader, he has assisted with utility rate-related regulatory proceedings in multiple states and territories.More Content by Andrew Burnham