Financing America’s Infrastructure Needs: Useful Life Financing, Time to Reconsider a Smart Idea In 2005, an EPA advisory panel (EFAB) issued a white paper on financing infrastructure over the useful life of the assets1. That paper wasn’t widely distributed at the time. EPA’s senior managers hailed the analysis and called for further study of industry practices. Who would have known that within three years of its writing the municipal finance world would be severely challenged? More than ever, the concepts and analysis of EFAB’s useful life financing are worth reconsidering now. “Why would I consider or, more importantly, care about these concepts now?” When this paper was written we had yet to assess the impact of the renewed emphasis in infrastructure reporting that was spurred by GASB 34. Today we know that local governments continue to struggle to fully fund capitalization and replacement of infrastructure assets. Resistance to full cost pricing, increases in user fees and the perceived inequity of today’s customers paying for reinvestment in facilities that prior generations of users wore out were (and are, frankly) significant barriers to GASB 34 implementation. Does financing over the useful life help solve the problem of system reinvestment? Yes, we think so. And with interest costs as low as they are presently, there hasn’t been a better time to borrow for infrastructure development in a long time. What are the benefits of useful life financing? Intergenerational Fairness. Traditionally, repayment terms for loans for capital facilities have been much shorter than the useful life of those assets: 48 inch concrete pipe lasts over 90 years, yet we finance it over 20 years. Citizens making those initial investments in facilities would often retire loans well before the assets were replaced. Subsequent ratepayers benefited from those facilities and consumed services, but didn’t have the direct responsibility for retiring the debt. Extending the amortization period to more closely match the useful life of the financed assets allocates the interest costs equitably across the generations consuming using those assets. Reduction of Annual Debt Expense. Extending the debt amortization period reduces the annual debt service costs incurred by a municipality. With today’s interest rates, the difference in total interest costs between a 20 and 40 year loan is less significant than the effective difference in the annual principal and interest costs of the two loans. What does this mean to the ratepayers? First, the annual debt service cost represents a smaller percentage of the budget. More importantly, lower annual principal and interest costs means that ratepayer dollars can be redirected to asset reinvestment or funding new facilities. Maximizing the Time Value of Capital. As the amortization period is extended to 40 years the value of the dollar depreciates with inflation. A dollar in year one is worth its highest value: 100 cents. By year 40, due to the inflation, the value to a dollar will decline to 38 cents. With extended amortization periods, paying bills with 38 cents on the dollar maximizes the value of the capital investments.
Application of Useful Life Financing of Environmental Facilities, EPA Environmental Finance Advisory Board, January 2005, http://nepis.epa.gov/Exe/ZyPURL.cgi?Dockey=P100DR73.txt
Creating Opportunity for Reinvestment. Many communities have failed to fully fund capital replacement at the same time that intergovernmental resources for sustaining systems have diminished. That lack of reinvestment is like a time-bomb for future generations. Redirecting dollars to reinvestment in existing facilities (dollars that would come from a reduction in annual debt costs) is a win-win situation for the community because investment and reinvestment can both be funded. How significant is this difference? EFAB’s analysis showed that increasing the repayment period from 20 to 40 years has the effect of increasing funding 34% for additional projects. Conversely, EFAB’s analysis showed that if that same opportunity for reinvestment in additional facilities was added to a budget with a 20 year amortization of debt, ratepayers would have to have an increase of 79% in the aggregate costs. The bottom line is that short-term (20 years) financing of new or renewed facilities and funding system reinvestment can be prohibitive relative to user fee affordability – especially in an era of ratepayer sensitivity to increased fees and taxes. In useful life financing, lengthening loan amortization terms and effectively reducing annual debt costs improves “affordability”, especially when considering future reinvestment costs. Thinking Differently About Debt. The financial benefits of useful life financing will be best realized in communities that have not reinvested in infrastructure for the sake of keeping taxes and fees low. Decision makers need to be informed of the benefit of acquiring debt for the establishment and sustainability of infrastructure assets – especially those that are supported by user fees. Today’s low interest rates combined with the calculable advantages of extending amortization periods create excellent conditions for infrastructure investment that can position communities for long-term success. Conclusion. Useful life financing of infrastructure needs to be added to the toolbox of public finance tools. Where it can be calculated to be cost effective, decision makers should demand that traditional capital financing terms be modified to the intergenerational benefit of their communities. While more work needs to be done to make useful life financing a standard practice – not an exception – the concept is sound and the financial advantages are real. Authors: Kevin E. O’Brien, Director, Great Lakes Environmental Finance Center, Maxine Goodman Levin College of Urban Affairs, Cleveland State University William L. Jarocki, President, Voltaic Solutions, Boise, Idaho Kristina J. Gillespie, Chief Operating Officer, Voltaic Solutions, Boise, Idaho