Close the funding gap with improved spending across the board and direct access for private investment.
Consumers, utilities, politicians, investors and international onlookers are well aware of the declining condition of the U.S. water and wastewater infrastructure. Water scarcity conditions compound the issue through the need for increased efficiency and innovation in our water systems. Chronic underinvestment has created an unprecedented level of demand to repair, expand, renovate and replace these systems. With such demand for investment in a recovering economy, why are construction forecasts in the water sector so modest?
The primary answer remains funding uncertainty. The industry needs improved spending at the federal, state and municipal levels as well as more widespread and direct access for private investment to begin to close this funding gap. In this article, we look at key funding drivers and trends for water and wastewater projects and the economic, political and social factors affecting investment.
The vast majority of water utility revenue, 80% or more on average, comes from water sales to consumers. In recent years, water expenses for the average consumer rose faster than other major utility bills, including natural gas, electricity and phone service. This trend is hitting low-income consumers the hardest and is creating public pressure to stem the tide of rate increases. According to Circle of Blue, a water industry analytical group, consumer water costs for 30 major U.S. metropolitan areas rose 33% between 2010 and 2013.1 Over the past year, U.S. water and wastewater rates rose 7%, among the highest annual rate increases compared to other developed countries (Exhibit 1). However, capital expenditures in infrastructure have not kept pace.
Rate increases continue in order to fund water system repairs and replacements as well as wastewater combined sanitary and sewer upgrades mandated by the EPA. The U.S. remains the largest water market in which the cost of wastewater services exceeds that of water services, a byproduct of these federally mandated upgrades. Despite sustained rate increases, demand overhang continues to grow. Water scarcity in many regions throughout the U.S. is complicating matters, as consumers are encouraged to reduce water consumption, which decreases utility revenue. The goal of many utilities is to increase rates in the face of decreased consumption such that there is little net effect on consumer budgets. While this tradeoff may appease the public, it will not finance the gap in spending. U.S. water and wastewater rate increases are likely to continue; however, utilities and municipalities will need to increase reliance on other funding sources to meet system upgrade demands.
Federal Infrastructure Investment
Despite the increased stress on water and wastewater systems, total federal infrastructure spending as a percent of GDP is at the lowest level in the past 20 years. The Obama administration has pushed for increased infrastructure investment, though budgetary battles in the lame duck administration have limited progress. According to research by McKinsey & Co., the U.S. government needs to increase infrastructure spending by roughly one percentage point of GDP ($150 to $180 billion annually), with increased focus on water and transportation systems, to catch up after years of underinvestment.2 As illustrated in Exhibit 2, federal spending specifically on water and sewage/wastewater systems as a percent of GDP improved in 2014. Yet government spending trends remain well below prerecession levels.
In 2014, Congress passed the Water Resources and Reform Development Act (WRRDA). Embedded within this act is the Water Infrastructure Finance and Innovation Act (WIFIA), a five-year pilot program providing $350 million in low-interest credit subsidies for large-scale water infrastructure projects. WIFIA is modeled after the Transportation Infrastructure Finance and Innovation Act, which has supported over $60 billion in transportation project investment since 1998. The hope is that WIFIA is extended and expanded to become a similar catalyst for water infrastructure spending over the long term. Interestingly, WRRDA and WIFIA encourage private investment alongside government funding.
State and Municipal Funding Channels
State and local governments rely on several financial tools to fund infrastructure projects that utilities cannot fund through revenues alone. Tax-exempt municipal bonds are a mainstay in water project finance, for example, and are used by the vast majority of utilities. Bond issuance has now declined for four straight years. Municipalities are dealing with continued budget restraint during this uneven recovery as well as a taxpaying public that acknowledges the need for infrastructure spending but is increasingly unwilling to foot the bill. Many analysts expect limited new issuance growth over the next year or two, especially if interest rates begin to rise.
State revolving loan funds, which include The Drinking Water State Revolving Fund and Clean Water State Revolving Fund, are capitalized by federal and state contributions. These funds are critical conduits for investment in water and wastewater infrastructure, but are facing dramatic reductions in funding. The 2015 federal budget reduces allocations to these funds by as much as half a billion dollars. State legislators are working to reinstate some of this funding shortfall, but face an uphill battle.
Tax-exempt Private Activity Bonds (PAB) are another financing source for water and wastewater infrastructure projects, but are underutilized due to structural constraints. These bonds compete with other state programs for room under a funding cap and will not evolve into a more potent financing source for water projects until these cap restrictions are lifted.
In many countries, public-private partnerships (P3) serve as an increasingly important solution to bridging the funding gap in water infrastructure needs. Major foreign markets, including several countries throughout the European Union, East Asia and Australia, regularly rely upon private investment in infrastructure to support water infrastructure development needs. The U.S. is behind the curve in exploiting this mechanism for various economic, political and emotional reasons. In the current economic environment, municipalities covet the stability and predictable returns provided by water utilities and hesitate to give that up. In addition, municipalities and consumers often remain skeptical about handing over control of utilities to private companies, especially foreign-based firms.
Both private and public forces are working to overcome these obstacles to facilitate more widespread adoption of private investment, though legal barriers remain. While several states, including Florida, Texas, California, Indiana and Virginia, are developing P3 programs insufficient support across all states impedes private inclusion in government projects. Currently, 14 states3 lack the legislation necessary to foster P3 investment in water infrastructure projects.
As the water industry experiences declines in government spending and municipal bond issuance, it awaits signs of growing support from the government on P3 investment. While WRRDA and WIFIA support private investment, they are limited in scope. Perhaps more promising, the Obama administration recently proposed a new class of municipal bonds called Qualified Public Infrastructure Bonds. If enacted, these bonds would extend the tax benefits of municipal bonds to private investment, thereby leveling borrowing costs with municipalities, which has been a key barrier to P3 growth.
Recent wins by the Republican Party may lead to further fiscal discipline and limit growth in federal infrastructure spending. However, the change in power may also foster stronger interest in private participation in the sector. Many industry stakeholders hope the Republican leadership will be more aggressive in legislative support for private investment due to the compelling value proposition: repair water and wastewater systems, not saddle wary taxpayers with the bill, and generate the most important political currency — jobs.
Trends in traditional federal, state and municipal funding programs for water and wastewater infrastructure are not overly optimistic for the near term. However, there are signs of improvement as politicians are increasingly vocal about the benefits of alternative investment sources to supplement traditional funding. While private investment is not a panacea, the government needs to continue working with the water industry to carve a clear and sustainable path for such outside participation. Further, if the economic recovery strengthens, then budgets throughout the water ecosystem will be able to support more capital projects. Yet history has shown that underinvestment persists even during economic expansion. The hope is that increased political emphasis, coupled with private participation and economic improvement, will create a formula for bridging the water infrastructure spending gap.
Greg Powell is a vice president with FMI Capital Advisors, Inc., FMI Corporation’s Investment Banking subsidiary. He can be reached at 919.785.9217 or via email at email@example.com. Paul Giovannoni is a research analyst with FMI Corporation. He can be reached at 919.785.9216 or via email at firstname.lastname@example.org.
1 Circle of Blue: “The Price of Water” 2014 (May 2014).
2 Source: Standard & Poor’s Economic Research: “U.S. Infrastructure Investment” (May 2014)
3 States include Idaho, Montana, Wyoming, New Mexico, South Dakota, Nebraska, Kansas, Oklahoma, Iowa, Kentucky,