How Can Federal Government Strengthen Policies to Encourage More P3s in the Water Sector

How Can Federal Government Strengthen Policies to Encourage More P3s in the Water Sector

The National Association of Water Companies (NAWC) represents the private water utility industry, comprised of those professional water service providers that own regulated water and wastewater utilities, partner with municipalities in a form of public-private partnership (P3s), or operate systems as a contracted service provider. Our member companies have longstanding experience with P3s and attest that water P3s have benefited communities by combining the best practices, skills, assets, and resources of both government and private sectors to deliver superior water service or efficiently maintain a water facility to meet the growing demands of citizens. They reduce municipal costs and shift debt burdens allowing municipalities to the ability to address other important city priorities.

What are P3s

There is a growing interest among local governments today in entering into long-term management or concession-lease agreements as a means of improving the management, financial and operational condition of their drinking and wastewater systems. There are 3 basic P3 models today. 1) Servicing/Consulting Arrangements; 2) Operations and Maintenance Agreements, which include qualified management contracts; and 3) longer-term concession-lease agreements. The first three models are the most commonly employed which basically contracts day-to-day management, operation and maintenance responsibility to a private partner under a fee arrangement—contract terms range from 5-20 years. Our companies have entered into more than 2,000 such P3s. There are barriers, however, to long-term contracts which are discussed below.

Benefits of P3s with long-term lease contracts

The concession-lease agreement is a relatively new model in the U.S. water sector but has been used effectively for other types of infrastructure projects. Water utilities are, by far, the most capital intensive services that a local government manages and is the most expensive asset to maintain. The concession model for the water sector offers many benefits to debt constrained cities or townships as the private entity would make both private capital investment into the system, and an upfront payment to the city in the beginning of the contract (a fee for the real property interest in return for the right to operate the facility or system for a

specified long-term period (usually 30 years or longer). The payment may consist of one upfront payment or a stream of periodic payments, such as lease rents, over the

life of the agreement, which allows the local government to shore up its municipal balance sheet. While the private firm assumes responsibility for all water system operations and for providing financial capital for infrastructure maintenance and upgrades, the public authority continues to retain legal ownership of the assets and contractual oversight.

In essence, a concession agreement provides local governments with the ability to extract value from their water and wastewater assets which helps restore their budgets for other important public expenditures and permits the city to avoid adding to its own long-term debt obligations. All this while they continue to grow their tax base as concession agreements ultimately create new jobs as a result of the water system upgrades that ensue as part of the transaction.

Barriers to P3s with long-term contracts.

This type of contract is construed by the IRS as private business use and thus contaminates the tax exempt status of the facility. This means that the all outstanding tax exempt municipal debt must be defeased. The redemption and remediation requirements are often cost-prohibitive, imposing substantial costs on the municipality. These costs range up to 15-20 percent of the total value of the P3 transaction. One of the remedial actions allowed under Section 141 of the IRS Code would be for the private entity to issue private activity bonds (PABs) to cover the cost of the outstanding municipal tax exempt debt. However, since there is a cap on the use of PABs for water, there is no assurance that enough PABs would be available at the state level to cover the cost of such costs.

See more below under (2) of “Necessary Federal Actions”

Necessary Federal Actions

Federal policy plays an important role in establishing incentives for water investment. Below are some recommendations that could unleash the vast potential of private capital and P3s in much-needed water infrastructure improvement projects.

1. Remove state volume caps on private activity bonds (PABs) used for water projects. One of the most effective financing tools of the federal government in providing long-term, capital-intensive infrastructure projects is the PAB—a form of tax-exempt financing for state and municipal governments that want to partner with a private entity to meet a public need. The partnership approach makes infrastructure repair and construction more affordable for municipalities and ultimately for users or customers. The use of PABs spurs capital investment in public projects during a time when governmental budgets are tight; investors prefer PABs because interest accrues tax-free.

Current federal tax law limits the amount of tax-exempt PAB debt that may be issued annually in a state to fund water infrastructure projects. Historically, most of the tax-exempt funding has been allocated to politically attractive, short-term projects such as housing and education loans. The annual volume cap hinders the use of PABs for water and wastewater infrastructure, which generally are multi-year projects in terms of planning. By the time the project reaches the stage where it is ready to seek PABs from the state, they may not be available as they have already been granted for use by short-term public projects. As a result, only a small percentage of all exempt facility bonds are issued to water and wastewater projects. If the annual volume cap was lifted it would provide more certainty that they are available and encourage greater use of PABs for water projects, as well as P3s.

2. Remove regulatory tax barriers to P3s. Most municipal infrastructure projects are financed by tax-exempt municipal bonds and these benefits may only be used by public entities. Treasury regulations require that when a government entity transfers tax ownership of an asset such as a water system to a private entity, that the outstanding debt be defeased. This rule, however, inadvertently deters beneficial P3 concession agreements (or major capital investments in a qualified management contract) as its redemption and remediation requirements are often cost-prohibitive, imposing substantial costs on the municipality. These costs range up to 15-20 percent of the total value of the P3 transaction.

Current remediation provisions of the Treasury regulations are simply not feasible in the current low interest rate environment, and therefore, NAWC seeks a narrowly-tailored revision of Treasury rules on debt defeasance reflecting the current economic circumstances that were not present at the time the regulations were first written.

NAWC believes the fundamental goal of any federal program should be to fill market gaps and leverage federal funds and private co-investment to provide additional investment in America’s water infrastructure. No sector, whether public or private, can solve the nation’s water infrastructure challenges on its own. P3s can reduce costs and create opportunities for innovative solutions.