Increasing the Impact of Federal and State Funds for Water Infrastructure

A How-To Guide for Active Asset Management

SOURCE: iStockphoto

The EPA estimates that over the next 20 years, more than $600 billion in water system infrastructure improvements will be necessary. But state drinking and clean water revolving loan funds subsidize a portion of the project costs by offering low-interest loans to water authorities and water companies for these improvements.

By Donna Cooper, Jordan Eizenga | August 2, 2011

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The Environmental Protection Agency estimates that over the next 20 years, more than $600 billion in water system infrastructure improvements will be necessary. Much of the cost of these improvements will be borne by consumers. But state drinking and clean water revolving loan funds do subsidize a portion of the project costs by offering low-interest loans to water authorities and water companies for these improvements.

These state water revolving loan funds administer loans and deliver low-cost capital to local governments and other qualified entities responsible for drinking and sewer water systems. Still, federal law establishes a number of requirements by which state revolving funds can set up state-level programs and deliver low-cost capital to local governments and other qualified entities responsible for drinking and sewer water systems. These requirements include:

• Loans with terms of up to 20 years
• Purchase of municipal debt obligations
• Direct guarantee of obligations
• Investment in reserves to secure bonds
• Limitations on amount of funds used for direct grants
• Restriction on interest earnings from invested public funds

The state loan funds traditionally invest their unused funds in short-term, conservative assets so they can meet their borrower’s future financing needs with low-risk and highly liquid investments. This conservative investment approach means the funds forgo billions of dollars in earnings and weak capital growth, and as a result limit the amount of funds available for additional water infrastructure projects.

Two reports from the EPA’s Environmental Finance Advisory Board show how innovative asset management strategies are being employed by some water funds, thereby boosting funds available for water infrastructure improvements. The advisory board outlined three steps state revolving funds can take to free up capital for infrastructure improvements:

Step 1: Transition from a direct loan model to a leveraged loan model

State revolving funds receive 83.3 percent of their funds from the federal government in the form of grants known in the field as “equity.” The remainder of their equity comes from state matching grants.

Most revolving funds use a direct loan model in which, net of set asides for administration and technical services, this public money is loaned at below-market rates to municipalities for eligible infrastructure projects.

The “leverage model” taps the tax-exempt bond market to increase the reach of public funds. That is, the state revolving fund issues tax-exempt bonds that are secured by equity reserves. Bond proceeds are used to make loan payments to local water project sponsors. The bonds are paid off with loan repayments, with the reserves available to cover any shortage caused by loan defaults.

Meanwhile, the reserve funds earn the maximum level of interest permitted by federal law. The result is that the state revolving fund earns interest on both the loans it makes and the reserve funds it invests. As long as those combined interest earnings have a yield higher than the interest it pays to bond holders, the state revolving fund’s financial condition is improved.

Step 2: Issue general revenue bonds instead of general obligation bonds

Where state revolving loan funds use the leverage model and borrow by issuing general obligation tax-exempt bonds, they are subject to federal tax laws that limit the amount of interest that can be earned on their reserves. This rule, called the “arbitrage restriction,” limits returns on reserve funds to the interest rate paid on the tax-exempt bonds. This means reserve funds are only able to invest in low-yield investments.

State revolving funds can issue general revenue bonds that are not secured by any specific asset but by a “sinking fund,” in which the revolving fund regularly deposits a set of amount of money sufficient to meet bond payments. While the sinking fund itself must comply with “arbitrage restrictions,” principal and interest collected by the state revolving fund can be invested on an unrestricted basis in conservative yet higher-yielding instruments.

Step 3: Adopt pension-fund-like investment strategies

With a portion of equity unconstrained by the arbitrage restrictions, revolving fund administrators are able to adopt portfolio management methods similar to that of education endowments and pension funds. That is, they can invest in broader asset classes capable of generating higher returns.

New York’s revolving fund has adopted similar strategies. Today, its portfolio consists of highly rated taxable municipal securities, all of which are higher-yield investments. This investment strategy has allowed capital savings in the clean water fund to grow at a rate of greater than 25 percent per financing structured. Capital savings are immediately available to support additional projects.

By following the above three-step blueprint, state revolving funds can leverage public money, deploy alternative bond-finance methods, and use modern portfolio management strategies to free up significant capital for water infrastructure investment.

Donna Cooper is a Senior Fellow and Jordan Eizenga is a Policy Analyst with the Center for American Progress.

See also:

• Let It Flow by Donna Cooper and Jordan Eizenga