Paying for Infrastructure
Paying for Infrastructure
Perhaps the most important financial indicator for water and sewer systems as well as and other capital-intensive public services is the ratio between reserves to operating revenue. This indicator is helpful when comparing systems but does not speak to the mechanics and methodology by which reserve set asides are incorporated into annual budgets. The below article was written by Director of Capital Planning Ashley Lucht and first appeared in the Summer 2012 edition of the Drinking Water and Groundwater Protection Division’s “Waterline” publication. The original article was modified given the widespread applicability of the concepts for all types of government entities.
Generally, communities have four options when considering how to pay for new capital.
- - Pay as you go (PAYGO)—current budget
- - Save in advance—reserves
- - Pay later—loans
- - Let someone else pay—grants and subsidies
- The first question for a community to answer is why they want to save for infrastructure given the myriad funding and financing options available. But once a community determines that reserves are a good idea, inevitably the follow-up questions will be:
- - How much should be put away?
- - Are there rules for reserves?
- - Are there rules for spending reserves?
Should a community save money?
With shrinking federal and state loan assistance programs, a community may think that it is more important than ever to have funds on hand to ensure system sustainability. However, depending on the type of assets being funded, reserves may only be part of the answer.
A community can think about infrastructure investment in three buckets:
- - Short-lived asset (0 to 5 years)
- - These are expenses that occur frequently, like chemicals, vehicles/heavy equipment, inexpensive machinery
- - Medium-lived asset (5 to 20 years)
- - Determine which assets have a relatively medium-lived life: meters, pumps, vehicles/heavy equipment, paving
- - Long-lived asset (Greater than 20 years)
- - Long-lived assets include those with the durability to be used for decades including brick and mortar facilities, and distribution and collection systems
The above asset types may warrant different approaches. On one hand, short-lived assets can often be absorbed within an annual budget; however, a dedicated reserve for things like equipment can smooth out the annual impact and avoid the need to borrow for unexpected replacement costs. Reserves also provide a buffer for communities to help address revenue shortfalls, expense overruns, emergency repair or replacements, and economic downturns.
For longer term assets, the questions are more complicated. Long term planning for accumulating capital reserves may lower the tax impact of capital spending while also allowing communities to minimize financing costs. This approach comes with trade-offs—most notably, it burdens prior or current users of the assets with its costs despite the fact they will be used by children, grandchildren, and great grandchildren of the current tax or rate payers. The concept that future users of infrastructure should also pay its costs is referred to as “intergenerational equity” or “intergenerational fairness” in public finance.
This concept is complicated in many places in Vermont due to on-going demographic challenges in which the loss of taxpayers due to population decline may create a higher burden on future users unless communities contribute upfront financial equity. Fortunately, this prospect is remote given current interest rates but remains an important consideration.
How much should a community save?
While any amount of saving is a good start, determining the amount of reserves should be rooted in capital planning and asset management. Without that effort completed, the amount saved may be too much or too little, resulting in complications in either direction.
Statutory regulations for communities provide some guidelines on the establishment of reserves.
A surcharge fund and can be used by a water, wastewater or stormwater utility and is simply a line item in the annual budget that cannot exceed 15% of O&M plus debt service, and can be used for all manner of utility needs except for system expansion. Funds can be kept separate from the operating fund, but most choose to account for the funds separately and hold all cash in one account. If the community is feeling particularly brazen, it could invest the reserves, however this comes at a risk, and the money should be accessible in the event of an emergency.
Another option is to have a straight annual contribution amount, $10,000 a year, for example. This is a capital reserve fund and must receive annual budget appropriation, either through Australian ballot or governing body action, and must have a defined purpose even if that purpose is for general maintenance, repair, or replacement of assets. This type of reserve fund may also be established for the sole purpose of expanding the utility. The purpose and amount must be clear and must be authorized every year. The governing body can only expend funds for the purpose for which it was authorized.
As a matter of practice, a community could also use a percentage annual contribution, for example, 10% of O&M; this would ensure that as the budget increases, the contribution to the reserve also increases.
Or the community could choose to put any budget excesses into a reserve account.
Another option may be to fund depreciation. This number is found in the annual audit and represents the theoretical value an asset has used up during a period of time. Using this number as a proxy for reserve contribution can provide a starting point for reserves by adding that number as an expense in the budget. Stay tuned for more information on depreciation.
A community, however, cannot have a fund which balance exceeds the cost to replace the item(s) the fund was initially designed to replace. One could argue, however, that costs to repair, replace and maintain basic infrastructure are infinite and only a fund created to cover the cost to replace a specific asset could reach a limit. Accordingly, it is advisable to be very general in stating the purpose for which the fund is created.
Any other advice a municipality should consider before beginning the fund creation process?
A community should seek advice from counsel before proceeding with setting up any of these funds. They will want to be sure that the fund is being set up for a legitimate purpose, and it has sufficient oversight and management controls.