Water and Sewer Bonds: A Low-cost, Low-risk Way to Fund Water Infrastructure
February 28, 2017
Background. Repairing water and wastewater infrastructure is an issue throughout the Commonwealth. In Warren, Pennsylvania, a town on the Allegheny River, 36% of children tested had high lead levels, leading to the school’s closure, the firing of the District Superintendent and a federal lawsuit. Pennsylvania’s Department of Environmental Protection published The Pennsylvania Water and Wastewater Gap Study in 2015, concluding that the total funding gap was $15.5 billion for drinking water infrastructure and $28.3 billion for wastewater infrastructure. Despite these deficiencies, the Governor’s Budget announced this week makes a 2% cut in funding for water and wastewater investment to $723,429,000.
The Opportunity. It will require a number of sources of capital to remedy this hole in the Commonwealth’s infrastructure. One of the safest and most efficient financial instruments to remedy this infrastructure shortfall is tax-exempt water and wastewater bonds issued by local municipal authorities.
Benefits of Tax-Exempt Bond Financing. With historically low interest rate levels, tax–exempt bonds provide municipal authorities with the ability to lock in a fixed interest rate for up to thirty years, with an ability to refinance after ten years if interest rates have dropped sufficiently. Further, the Internal Revenue Code provides an added tax benefit for financial institutions buying water and sewer bonds from an issuer of up to $10 million of bonds in any calendar year (the “small issuer exemption”). This benefit is above and beyond the exemption from income tax under Federal and Pennsylvania law for interest earned on bonds.
Due Diligence. Conducting due diligence is of course a preliminary step in the funding or acquisition of any water or sewage system. There can be many elements of a system that can significantly affect its value. Top elements to evaluate include the following:
- Technical – physical elements, operations, policies and procedures, maintenance manuals, drawings and GIS databases, staffing, contracts
- Legal – historic and current compliance, licensure, permit status, obligations for improvements, insurance and indemnification
- Financial – balance sheet, existing debt, fee system, account records, credit rating, capital improvement fund, possible synergies, consolidations, and cost-savings
- Future use – excess capacity, projected demand, anticipated increased regulatory constraints, ability to increase rates
- Management – governing structure, staffing, contracts, cooperative agreements
- Cybersecurity – most utilities are required to develop and maintain written security, emergency response and business continuity plans, and file an annual self-certification form with the PUC.
Of course, assembling the right due diligence team is critical to sufficiently conducting due diligence.
Special Issue for Sewer Authorities. With respect to regulatory compliance and capital improvements, of particular concern for many sewer authorities is how to comply with requirements related to Total Maximum Daily Loads ("TMDL"). TMDLs are set on a stream-by-stream and pollutant-by-pollutant basis, and establish the maximum amount of each pollutant that can enter that stream from all sources each day. To meet TMDLs at each stream, dischargers are assigned a maximum Waste Load Allocation ("WLA") for each pollutant, and then have to create a plan for reducing their load to meet each WLA. This can result in extremely costly facility upgrades. Another example of a burgeoning obligation is the recent disinfection requirements adopted in early 2016. Additional obligations loom on the horizon.
Continuing Disclosure Obligations. SEC Rule 15c2-12 requires issuers of tax-exempt bonds to file annual reports to be posted on an SEC website. It may be important to engage a continuing disclosure agent to assist the authority in meeting these continuing disclosure obligations, since the SEC has stepped up enforcement in this area.
Conclusion. Under the right circumstances, tax-exempt bonds can provide an efficient, inexpensive solution to the infrastructure needs of water and sewer authorities throughout the Commonwealth. Proper due diligence and continuing disclosure help ensure that the bonds will be a secure investment with liquidity for the investor in the secondary market.