A New Direction for Water Project Finance

by Fred Greguras

California Proposition 1, the Water Bond, will be on the November 4, 2014 ballot as The Water Quality, Supply, and Infrastructure Improvement Act of 2014 (the “Act”). Approval by two-thirds of both houses of the legislature and signature by the governor were the first steps. The Act still must be approved by a majority of voters. The Act illustrates the difficulty of public funding of water projects and why more incentives are needed for private sector financing of water projects. Private sector financing can be a simpler, faster and more viable alternative in many cases if the incentives described below are implemented, particularly for smaller projects

The Act authorizes $7.12B in general obligation(“GO”) bonds for state water supply infrastructure projects, such as drinking water supply and security, water recycling, flood management, ground water sustainability and river, lake, stream and watershed protection and restoration. Water storage is allocated the most funds, about $2.7B. The state commits its “full faith and credit” to repay the GO bonds from general tax revenues. Repayment is projected to require annual payments of about half a billion dollars per year which will have to come from reduced funding for other purposes or from tax increases.

While both the state and local governments may issue GO bonds under the California Constitution (the “Constitution”), state level bonds need be approved only by a majority of voters in an election while local GO bonds must be approved by 2/3 of the voters and are rare. Local governments usually need to increase property taxes to repay the bonds to the extent permitted under Proposition 13. In addition many types of fees have been redefined as special taxes, and such taxes now must be approved by two-thirds of local voters. California voters are unlikely to change the Constitution to make it easier to be taxed.

Voter approval of the Act is not a slam dunk despite the ongoing severe drought in California that threatens drinking water supplies and our agriculture industry. California voters have not passed a water bond since 2006. The Act replaces a previous $11.14B bond proposal which critics labeled as “pork-laden” and was not actually submitted to California voters in either 2010 or 2012 for fear of losing.

The 2/3rds voter approval requirement has made it very difficult for local governmental agencies to raise money for water projects using GO bonds and has caused a greater reliance on state level bonds. The Act, however, will continue to put pressure on local funding because spending under the Act requires matching funds from non-state sources in many cases.

The Act is not enough to solve the California water financing problem. The March, 2014 report, Paying for Water in California, prepared by the Public Policy Institute of California (the “Report”) indicates that, even if the Act passes, funding will, best case, cover half of the total spending gap.

The Public-Private Solution

Fixing the water quality, supply and infrastructure in the U.S. is equally as important as reducing the demand for natural resources in energy generation. Instead of proposing more income and property taxes and fees for public funding of water projects it is time to promote and enable more private sector investment by providing financing incentives to encourage public-private partnerships such as was done for the renewable energy industry. The incentives have worked nationally and in many states to drive the construction of renewable energy generation facilities. Clarification of legal authority may be needed in some states because of prohibitions on non-regulated entities performing governmental functions reserved for regulated agencies. Necessity may drive the authorization of new financing techniques since GO or revenue bond issues to finance new or upgraded water facilities may simply not be feasible.

Water scarcity is not yet a national issue but aging water infrastructure is a widespread problem. The U.S. is in one of the worst droughts in recent history. Over 30% of the country is currently experiencing at least moderate drought measured by substantial crop and pasture losses and water shortages. About 75% of all land area in California is currently under extreme drought with reservoirs at low levels and restrictions on agricultural water use have idled many California farmers.

The concern over the shortage of potable water in California has become so great that the state is investing in long-term solutions such as the Carlsbad, California Desalination Project (“Carlsbad Project”) currently under construction to reduce dependence on unpredictable snow packs and rain. The billion dollar project is being financed with over $700M in tax-exempt bonds with the rest of the financing by a private equity investor. The tax-exempt bonds were issued by the California Pollution Control Financing Authority on behalf of the project developer and the San Diego County Water Authority. The revenue stream for repayment to investors is a long term water purchase agreement (“WPA”) similar to a power purchase agreement (“PPA”) in the solar and wind energy sectors. The WPA provides a predictable source of revenue to make the numbers work for investors and provides the San Diego County Water Authority with long term certainty for water costs.

Financing Large Water Projects: WIFIA Program

One part of the solution may be the enactment in June, 2014, of the federal Water Infrastructure Finance and Innovation Act (“WIFIA”) financing program for large water infrastructure projects throughout the U.S. The purpose of WIFIA is to provide credit assistance to such projects that otherwise have difficulty in obtaining financing. WIFIA will provide low-cost loans from the U.S. Treasury for up to 49% of a project’s cost. WIFIA loans are intended to be combined with other financing alternatives to enable public-private partnerships for financing water infrastructure. Projects must have a revenue stream and demonstrate creditworthiness to be eligible. This requirement should reduce the federal government’s risk and also encourage private investment. Projects which are financed in part by tax exempt bonds, however, such as the Carlsbad Project are not eligible for WIFIA loans. This seems short sighted since the interest cost is lower for tax exempt bonds and a private investor is likely to want to spread the financing risk of the cost of such a large project.

According to a July, 2014 Congressional Research Service report, WIFIA is an important financing tool for large and costly projects but the majority of water infrastructure needs are for smaller projects. The Report indicates that the largest amount of funding for water projects is at the local level and not from state or federal funding.

Financing Smaller Water Projects

National level incentives such as a 30% investment tax credit (“ITC”) and 5 year accelerated depreciation (“AD”) (rather than the current 25 year depreciation) like those that spurred private investment in energy generation are needed to attract private investment to smaller water projects. California can help solve its water problem by authorizing such incentives at the state level as well. Currently, equipment and other personal property used for water desalination, remediation, reclamation, storage or other water projects are not eligible property under the IRC § 48(a) (3)(A) categories or any other IRC § 46 investment credit category.

A water project must have a meaningful revenue stream (WPA, lease payments, water fees, etc.) and demonstrate creditworthiness in order to be viable. Successful project finance depends on making the ROI numbers work for developers and investors with a high degree of predictability. The numbers must work when matching revenue streams against startup and recurring costs. The greater the ratio of equity to debt, the more likely a financing is feasible and the better the debt financing terms that are likely to be available. The availability of the ITC and AD for water projects could be monetized through tax equity investors as in the renewable energy sector. The 30% ITC is scheduled to be reduced to 10% for renewable energy generation property at the end of 2016 so tax equity investors will need to shift their focus to more viable investments.

Excluding property taxes on a water facility when owned privately and eliminating sales and use taxes on purchases of equipment and other personal property used in the facility would also help make a financing more feasible since it would reduce the amount needed to be financed. There are other ways to reduce project costs such as for equipment, construction, operation and maintenance (“O&M”), taxes and financing costs like interest payments. For example, using “bankable” equipment reduces the cost of O&M; using an engineering and procurement contractor with a strong track record reduces construction costs and using the same financing team for multiple projects reduces transaction costs.

Consider the impact of the federal incentives on the financing of a US$40M water reclamation facility. The project entity monetises the ITC and AD with a tax equity investor. The tax equity investment would be about 40% of the $40M or $16M. Assume the sponsor/developer makes an equity investment of 20% or $8M in order to satisfy investors requirements to have skin in the game. The debt financing amount would be $16M. The amount of the debt financing needed becomes smaller because of the equity investments with a resulting smaller amount of debt service that is more likely to be covered by project revenue streams. A revenue bond financing would have to be for the full $40M because of the forbearance requirements of the tax equity investor.


More public water agencies are considering public-private partnerships for financing water projects. Bond issues to finance projects may not be feasible. Congress can enact the ITC and AD which will enable water projects throughout the U.S. The California legislature can help make financings more feasible by enacting a state level ITC and AD and also excluding privately owned water facilities from property tax and the equipment and other personal property used in such facilities from sales and use tax.

For more information about this and other technology-related law issues feel free to contact Fred Greguras, Esq. at the Royse Law Firm.

Please see www.RroyseLaw.com or contact Royse Law Firm, PC at rroyse@rroyselaw.com for additional information.
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