CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

, - • ,:

Financing Municipal Water

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MAY 1987

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SPECIAL STUDY

FINANCING MUNICIPAL WATER SUPPLY SYSTEMS

The Congress of the United States

Congressional Budget Office
NOTE

All years referred to in this report are fiscal

years unless otherwise indicated.
PREFACE

This paper assesses the extent to which the financing of local water supply

facilities will burden state and local governments in the next two decades,

and suggests alternatives by which federal, state, and local governments can

reduce water supply expenditures. This paper responds to a request by the

Senate Committee on Environment and Public Works.

Kenneth I. Rubin and Michael Deich of the Congressional Budget

Office's Natural Resources and Commerce Division wrote the report with

the assistance of Ruth Michelson. Everett M. Ehrlich supervised their work.

The authors wish to thank John Boland, Johns Hopkins University; Jerry

Cooper, Farmers Home Administration; James Groff, National Association

of Water Companies; Nancy Humphrey, Transportation Research Board;

Kyle Schilling, Institute of Water Resources, Corp of Engineers; and Jack

Sullivan, American Water Works Association for valuable comments on

earlier drafts. Patricia H. Johnston edited the manuscript, assisted by

Nancy H. Brooks. Angela Z. McCollough and Gwen Coleman prepared the

report for publication.

Edward M. Gramlich

Acting Director

May 1987

CONTENTS

SUMMARY ix

I. INTRODUCTION 1

Characteristics of Municipal Water Systems 1

The Federal Role in Municipal Water Supply 5

Recent Legislative Proposals 9

II. WATER UTILITIES' NEED FOR CAPITAL,

FISCAL YEARS 1984-2000 13

Methodology 13

Capital Expenditures for Water Supplies 14

Limitations of CBO's Capital

Spending Projections 19

III. STATE AND LOCAL OPTIONS: ALTERNATIVE

SOLUTIONS TO WATER SUPPLY PROBLEMS 23

Local Options: Demand Management 23

State Options: Alternative Supply

Techniques and Financial Intermediation - 25

IV. FEDERAL POLICY ALTERNATIVES 33

Reduce or Eliminate Federal Financial Aid

for Local Water Supplies 33

Maintain Current Support for Municipal

Water Supplies 34

APPENDIX REFERENCES USED IN CALCULATING FUTURE

CAPITAL DEMANDS 43

vii FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

TABLES

1. Size and Ownership of Municipal Water Supply

Systems, By Number of People Served 3

2. Average Water Prices, By Number of

People Served 4

3. Percent of Various Rate Structures Used

By Public and Private Utilities in

Fiscal Year 1982, By Number of People

Served 6

4. Federal Spending for Water Supply, By

Federal Agency, Fiscal Years 1986-1988 10

5. Annual Capital Spending for Municipal

Water Supplies, Fiscal Years 1977-2000,

By Region 15

6. Annual Aggregate and Per Capita

Capital Spending, By Number of People

Served, Fiscal Years 1984-2000 18

BOX DEFINITIONS OF RATE SCHEDULES USED

BY WATER UTILITIES

SUMMARY

Concern that localities would be unable to finance needed water supply

facilities prompted the 99th Congress to consider (and the House to pass)

bills that would have significantly expanded the federal role in financing

municipal water supply systems. Similar legislation is likely to be introduced in the current Congress. Paradoxically, the last Congress also

reduced funding for existing programs that support these systems. The

Administration's budget for fiscal year 1988 seeks further reductions in most

of these programs.

From fiscal years 1977 through 1983, water utilities spent an average

$4.7 billion annually to replace and expand local water supply facilities.

Nationwide, capital spending per capita averaged $25 per year. Spending

across regions varied widely, from $10 per capita in the Mid-Atlantic region

to $54 per capita in the Mountain states. The CBO projects that for the

United States as a whole, annual capital spending for local water supply will

be 11 percent less per capita from 1984 through 2000 than it was in the

1977-1983 period. In six of the nine Census regions, capital spending will

fall, declining between 3 percent in the New England area and 32 percent in

the South Atlantic region. Capital spending will rise in three regions, but in

two of these regions, the increase will be less than 10 percent. In only one

region, the Mid-Atlantic, will per capita capital expenditures rise sharply --

by over 40 percent.

STATE AND LOCAL POLICY OPTIONS

State and local governments could pursue a number of strategies to

reduce the amount of capital investment that will be needed for water

supplies. These include promoting water conservation through price

reform and consumer education, adopting less capital-intensive water

supply technologies, and taking advantage of recent financial innovations.

Reforming price schedules holds particular promise, because many

public water utilities charge prices that are less than the full cost of

supplying water. Lacking signals about the true cost of water, consumers

use more than they would if they had to pay for the full cost of their

consumption. The result is overinvestment in water supply facilities.
FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

In the 17 western states where existing water rights exceed the

average supply, state governments could also encourage more efficient use

of water by allowing markets a greater role in allocating the existing water

supply. Markets work well only if there are unambiguous, transferable, and

quantifiable property rights attached to the good being traded. Under

current law, such rights rarely exist for water. Despite the difficulties

raised by current law, voluntary water transfers do occur and have become

more common in recent years. While most transfers result from individual

negotiations among the affected parties, some fledgling water markets have

been started. That these transfers take place, despite the lack of supporting

institutions and despite the legal complexities involved, suggests that far

more transfers would occur if the legal and institutional climate were more

conducive to trade.

For most areas in the eastern United States, water is not scarce, but

simply inefficiently distributed--that is, individual systems sometimes

experience large shortfalls while the water-basin as a whole has an abundant

supply. A water-short system could build new capital facilities to import

water from outside the basin. Alternatively, the system could pursue the

less expensive method of connecting and jointly operating the individual

systems in a region. The greatest barrier to system interconnection is a

lack of information. State governments could serve the role of "honest

broker," developing and disseminating information that could be expensive

for an individual locality to acquire, but crucial to the prospects of any joint

operating agreement.

Finally, states could create a legal and institutional climate that

minimized the cost of capital for local water utilities. In general, state

governments could increase the range of financial instruments available to

local water authorities. States also could use their stronger position in

credit markets to assist localities more directly. For example, states could

establish bond pools for local issues, which would help issuers take advantage of the economies of scale that characterize credit markets.

FEDERAL POLICY ALTERNATIVES

By providing support for municipal water supplies, the federal government has sought to further several goals, including increasing the availability and quality of local water supplies, promoting efficient state and local

water supply policies, and increasing local economic development. When

considering the direction of future federal policies for water supply, the

Congress might wish to add a further goal: reducing the federal deficit.

Several approaches to meet the last goal are discussed below.
SUMMARY ri

Reduce or Eliminate Federal Grants and Loans for Local Water Supply

The Administration's budget request for fiscal year 1988 calls for a sharp

reduction of federal grants and loans for constructing facilities for municipal water supplies. The Administration's proposals would lower federal

spending by more than $200 million annually compared with spending under

current law.

Maintain Current Support for Municipal Water Supplies

By restructuring existing programs, the Congress could maintain the existing

level of federal support for municipal water supply, while furthering other

goals such as reducing the federal deficit.

Facilitate Voluntary Transfers of Federally Controlled Water. Nearly all

water rights, including rights to water from federal water projects, are held

under state law. In those states that encourage water transfers, however,

the federal role could be significant. Bureau of Reclamation projects

deliver nearly 20 percent of western agricultural water, and users of that

water must comply with federal as well as state rules governing its

distribution. Trading water rights would reduce the cost of local water

supplies (by reducing the need to build more expensive capital projects),

while increasing federal revenues by raising both income taxes and payments

to the Bureau of Reclamation.

Restructure Requirements for FmHA Loans and Grants. The Farmers Home

Administration (FmHA) provides grants and loans to small, low-income

communities in order to promote investment in water supply facilities. The

current structure of the FmHA's program unintentionally also encourages

localities both to choose inefficient, capital-intensive facilities and to

maintain those facilities poorly.

The Congress could address these problems through a number of

alternatives. First, the FmHA could provide technical and financial advice

directly to communities. The cost of this service would partially be offset

by the increased efficiency of investments by FmHA program beneficiaries.

Second, as part of the grant application, the FmHA could require communities to examine specific alternative solutions to their water supply problems. While this would bring a variety of alternatives to the attention of

local water supply officials, it might increase the importance of grantsmanship in determining which communities receive FmHA funding, making the

efficient provision of water supply facilities relatively less important.

Finally, FmHA grants and loans could be conditioned on the willingness of

recipients to comply with a specific maintenance schedule. Publishing these
xii FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

schedules would be useful for local officials unsure of the optimal maintenance timetables for their plants. The requirement that communities must

follow predetermined maintenance schedules, however, would carry with it

the danger that such schedules would disregard local conditions or be too

expensive to develop properly.

Revolving Fund for Local Water Supply Facilities. Current grant and loan

programs for water supply could be combined and used to capitalize a

revolving fund. The fund would make low-interest loans to states and

localities for use in expanding or rehabilitating water supply systems. Loan

repayments would be used to make further loans. Earmarking funds for

water supply would make federal subsidies more predictable. If earmarking

reduced the frequency of Congressional review, however, allocations would

be less likely to reflect Congressional spending priorities.
CHAPTER I

INTRODUCTION

Concern that localities would be unable to finance water supply facilities

prompted the 99th Congress to consider bills that would have significantly

expanded the federal role in financing municipal water supply systems.

Similar legislation is likely to be introduced in the current Congress.

Paradoxically, the last Congress also reduced funding for existing programs

that support municipal water supply systems. The Administration's budget

for fiscal year 1988 seeks further reductions in most of these programs.

This paper assesses the extent to which the financing of local water supply

facilities will impose an increasing burden on state and local governments in

the next two decades.

CHARACTERISTICS OF MUNICIPAL WATER SYSTEMS

Any governmental effort to assist the water supply industry must take account of the remarkably heterogeneous nature of that industry. This section

briefly discusses some of the financial and operating characteristics of

municipal water supply companies.

Size and Ownership. There are about 59,000 water supply systems in the

United States. A few of these systems are quite large, but most are small;

only 1.1 percent of all systems serve more than 44 percent of the population, while 65 percent of all systems supply water to less than 3 percent

of the population. II

Municipal water utilities are owned either publicly or privately. The

publicly owned municipal water supply systems provide water to the

greatest number of people, with some 26,000 systems serving 71 percent of

1. Unless otherwise noted, the information presented in this chapter comes from three

sources: Environmental Protection Agency, Office of Drinking Water, Survey of

Operating and Financial Characteristics of Community Water Systems (prepared by

Temple, Barker, and Sloan, Inc., October 1982); Environmental Protection Agency,

Office of Drinking Water, Fiscal Year 1983 Status Report: The National Public Water

Supply Program (1984); and U.S. Geological Survey, National Water Summary 1985

(1986).
2 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

the U.S. population. Of these, the largest 500 systems serve 39 percent,

while the smallest 20,000 systems together serve less than 7 percent. On

average, each publicly owned system supplies water to 7,500 people (see

Table 1).

Regulated investor-owned utilities and smaller, unregulated systems

owned by homeowners associations serve another 13 percent of the U.S.

population. These 16,000 privately owned utilities average about a third the

size of publicly owned systems. Mobile home parks, hospitals, schools, and

other institutions own and operate about 17,000 small, ancillary systems; on

average, these systems serve about 60 people each. About 15 percent of the

U.S. population has private wells, and another 1 percent has no piped water

supply.

Pricing Policies. Publicly owned utilities almost always charge less for

water than do their privately owned counterparts. The lower prices stem in

part from the tax-exempt status accorded publicly owned agencies; unlike

private firms, the production costs of public utilities include no tax payments. More important, public utilities' fees need not cover their full costs

of production; local tax revenues or intergovernmental grants can make up

any deficit.

Thus, while both public and private utilities usually set prices that are

more than sufficient to cover operating costs, only private utilities routinely

charge enough to cover fully not only operating costs but also the depreciation of capital facilities. For example, a recent survey found that the ratio

of operating revenues to operating expenses averaged only 1.19 for publicly

owned utilities, compared with 1.59 for those owned privately. 2/

Private and public utilities also differ in the relative prices that they

charge households and industrial users. Public utilities generally charge

households about 20 percent more than they charge commercial users; private firms, in contrast, charge households about 50 percent more (see

Table 2).

' Most water utilities, both private and public, use a two-tier rate

structure: customers pay both a monthly or annual flat fee and a fee per

unit of water used. Larger systems are most likely to use "declining block

rates," in which the fee for water use falls as the amount consumed rises, as

2. Environmental Protection Agency, Office of Drinking Water, Survey of Operating and

Financial Characteristics, pp. iv-10.
Chapter I INTRODUCTION 3

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TABLE 2. AVERAGE WATER PRICES, BY NUMBER OF PEOPLE SERVED

(In 1982 dollars per 1,000 gallons) g

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1,001- 3,301- 10,001- 25,001- 50,001- 75,001- 100,001- 500,001- Over >

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Residential 1.98 1.69 1.65 1.56 1.32 1.28 1.63 1.25 0.85

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Industrial 1.35 1.26 0.97 1.03 0.83 0.98 1.07 1.07 0.56

SOURCE: Congressional Budget Office from Environmental Protection Agency, Office of Drinking Water, Survey of Operating and Financial

Characteristics of Community Water Systems (prepared by Temple, Barker, and Sloan, Inc., October 1982).

to

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Chapter I INTRODUCTION 5

shown in Table 3. The accompanying box defines the various rate structures used by public and private utilities.

Sources of Capital. A variety of sources provide capital for water supply

investments. Available evidence suggests that tax-exempt bonds supply

about half of the capital used by water supply utilities. Retained earnings

make up another 20 percent to 30 percent. Intergovernmental aid, taxable

bonds, and proceeds from the sale of stock together contribute about 10

percent. Bank loans and special tax assessments provide the remainder. 3/

The source of investment funds varies with the size and ownership of

water systems. Large public utilities rely mainly on funds borrowed in the

tax-exempt bond market; their private counterparts use proceeds from the

sale of stocks and taxable bonds instead. Small public utilities rely more on

retained earnings, supplementing these with federal aid and tax-exempt

bonds. Small privately owned utilities also depend on retained earnings, but

substitute private bank loans for tax-exempt debt and federal aid.

THE FEDERAL ROLE IN MUNICIPAL WATER SUPPLY

Various federal policies subsidize both public and private water utilities.

The tax code provides the largest subsidies: the interest on state and local

bonds issued on behalf of public or private water utilities is tax exempt.

This tax exemption lowers water utility borrowing costs by about 20

percent, since tax-exempt bonds can be sold with lower interest rates than

can their taxable private counterparts. These bonds provide only limited tax

benefits to private utilities, however, since private facilities financed with

tax-exempt bonds must be depreciated more slowly than otherwise would be

true. In 1983, state and local governments issued $2.75 billion in taxexempt bonds on behalf of water utilities; $2.6 billion specifically aided

public utilities. The tax exemption on the 1983 bond issues will lower

federal revenues by roughly $100 million per year over the life of the bonds.

Direct federal spending for water supply facilities benefits only public

water utilities and has a rather narrow focus: to stimulate economic de3. Based on data from the Public Security Association; the Bureau of Economic Analysis;

Environmental Protection Agency, Survey of Operating and Financial Characteristics; and John Boland, Water and Wastewater Pricing and Financial Practices in the

U.S.(prepared for the Agency for International Development, Near East Bureau, 1983).
6 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

velopment and to help low-income communities afford improvements in

their water supply facilities. Three federal agencies administer programs

whose primary purpose is to improve municipal water supply facilities.

Three other agencies manage programs intended to promote regional

economic development generally; improving local water facilities is only one

of many purposes towards which program funds may be put.

TABLES. PERCENT OF VARIOUS RATE STRUCTURES USED BY

PUBLIC AND PRIVATE UTILITIES IN FISCAL YEAR 1982, BY

NUMBER OF PEOPLE SERVED

Small

Rate

Structure

Flat Fee

Flat Rate

Two-Tiered

Flat System

(500-

Public

13

6

29

1000)

Private

26

0

26

Medium

(25,000-50,000)

Public

4

15

28

Private

0

0

15

Large

(500,000-1

Public

5

15

10

,000,000)

Private

0

0

0

Declining Block

Pure 23 4 20

Two-tiered 15 18 20

10

54

10

25

14

29

Increasing Block

Pure 4 2

Two-tiered 0 0

2

2

0

3

0

0

0

14

Other a/ 20 8 18 35 43

SOURCE: Congressional Budget Office from Environmental Protection Agency, Office

of Drinking Water, Survey of Operating and Financial Characteristics of

Community Water Systems (prepared by Temple, Barker, and Sloan, Inc., October

1982).

NOTE: The accompanying box defines the rate schedules displayed in this table.

a. Other = rate structures not otherwise included above. Also includes systems which

have different types of rate structures for different customer classes.
Chapter I INTRODUCTION 7

DEFINITIONS OF RATE SCHEDULES USED BY

WATER UTILITIES

Flat Fee: flat fee paid monthly or annually, not based on water use.

Flat Rate: constant flat rate per unit of water use.

Two-Tiered Flat System: combination of the above rate structures- -that is, flat fee plus flat rate.

Pure Declining Block: charge per unit of water declines with increasing

water use.

Two-Tiered Declining Block: declining block rate with initial minimum

charge covering specified amount of water use.

Pure Increasing Block: charge per unit of water increases with

increasing water use.

Two-Tiered Increasing Block: increasing block rate with initial

minimum charge covering specified amount of water use.

The Farmers Home Administration (FmHA) funds the construction,

repair, expansion, and first-year operating expenses of water facilities in

rural communities with populations under 10,000. In fiscal year 1985, the

FmHA lent about 70 percent of its funds; the remainder was given as grants

to communities that could not pay "reasonable user charges" (measured by

the ratio of debt service to median local income). $! The FmHA distributes

funds based on each state's rural population and the number of its households below the poverty level. Outlays under this program peaked in fiscal

year 1979 at about $1.2 billion, and have fallen since to $470 million in 1985.

4. Since 1982, FmHA has made loans at three sets of interest rates: communities with

median household income below the poverty line and with water systems that violated

state or county health codes have paid a "poverty level" interest rate; communities with

median household income between 80 and 100 percent of the U.S. median income pay

an intermediate rate; and communities with median household income above the U.S.

nonmetropolitan median income have paid a "market rate." In 1985, 42 percent of all

FmHA loans carried market rates of 8.6 percent to 10 percent, 39 percent of the loans

carried intermediate rates of 6.8 percent to 7.5 percent, and 19 percent carried the poverty

rate of 5 percent.
8 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

The Water Supply Act of 1958 authorizes both the Army Corps of

Engineers and the Bureau of Reclamation to include storage for municipal

water supplies in their ongoing multipurpose water projects. Neither

agency, however, may build single-purpose water supply projects. Funding

for the water supply portion of corps and bureau projects is provided partly

by state and local agencies. Until 1986, these agencies paid about 71

percent of the combined construction and operating costs for bureau projects and 54 percent for corps projects. The Water Resources Development

Act of 1986 requires state and local agencies to pay the entire cost of all

corps projects that they request. 5/

The Department of Housing and Urban Development administers

Community Development Block Grants (CDBGs), the largest of the economic development programs. CDBGs can be used to fund projects that aid

low- and moderate-income people or alleviate conditions that pose an

immediate threat to a community's health or welfare. The grants sometimes are used to improve public facilities like water and sewer systems.

CDBGs are distributed as entitlements to communities of 50,000 or more.

These communities receive block grants whose size depends on population,

poverty, and overcrowding in each community. Each block grant recipient

decides which projects to fund with CDBG money. Communities of fewer

than 50,000 people are eligible for CDBG "discretionary" funds. Unlike

entitlements, these funds are awarded on a project-by-project basis. During

the last several years, about $40 million to $50 million a year in block grants

and $100 million to $200 million annually in discretionary grants have been

used for water supply projects.

The Appalachian Regional Commission (ARC) and the Economic Development Administration (EDA) provide economic development funds to

needy states, counties, and cities. These funds, awarded on a project-byproject basis, can cover up to 80 percent of a project's cost. Since 1965,

annual spending for water supply projects under EDA's program has fluctuated between $35 million and $45 million, while ARC spending for water

supply has remained at about $10 million per year.

In total, direct federal spending for local water supplies averaged $738

million a year from fiscal years 1967 through 1976. Federal spending

doubled during the next five years, but then fell back to an average $785

million annually from 1982 through 1985. From 1967 through 1976, direct

federal outlays for water supply comprised about 18 percent of all public

5. For an historical perspective on cost sharing, see Congressional Budget Office, Efficient

Investments in Water Resources: Issues andOptions (August 1983).
Chapter I INTRODUCTION 9

capital expenditures for water supply. Federal outlays rose to an average

of 27 percent of public capital investment from 1977 through 1981 and then

fell to its earlier level from 1982 through 1985.

RECENT LEGISLATIVE PROPOSALS

In the last two years, the Congress has considered measures that would have

taken the federal role in water supplies in quite different directions. The

Administration's recent budget requests have consistently called for curtailing federal aid for water supply, while some Congressional proposals have

sought to increase the federal presence.

The Administration's Fiscal Year 1988 Budget Proposal. The President's

budget proposal for fiscal year 1988 would sharply reduce or completely

eliminate most of the federal programs that aid water supplies. The

Administration would eliminate EDA, ARC, and the water supply component

of FmHA, and reduce funding for CDBGs (see Table 4). By 1990, direct

federal spending for water projects would equal no more than 10 percent of

all projected public capital spending for water supply facilities.

The Water Resources Development Act of 1986. The 99th Congress passed

an omnibus water bill, the first since 1970. The act authorized the construction of a host of new water resources projects, including improvements

to inland waterways and flood control systems. The bill also changed the

formulas by which the cost of these projects is divided between federal and

nonfederal agencies. In general, nonfederal agencies will be required to pay

for a significantly larger share of costs on the projects that they request.

The House-passed version of this bill would have established a new

federal loan program, administered by the Army Corps of Engineers, to

rehabilitate municipal water supply systems. The program would have

provided low-interest loans to both public water utilities and investor-owned

water systems operating under state regulation. In general, these loans

could have covered up to 80 percent of the cost of projects that rehabilitate

or improve water systems. The loan ceiling could have been exceeded if a

project served remote areas or if the Secretary of the Army found "economic reasons" for doing so. All loans would have been conditioned on the

recipient establishing a water conservation program that included, among

other things, rate reform and education campaigns to promote water

conservation. Neither the Senate version of the bill nor the final act

included the House loan program.
10 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

Infrastructure Revolving Funds. Concern about the adequacy and efficiency

of overall federal infrastructure spending has prompted Congressional consideration of a number of bills that would have established revolving funds to

finance state and local infrastructure spending, including water supply faTABLE 4. FEDERAL SPENDING FOR WATER SUPPLY, BY FEDERAL

AGENCY, FISCAL YEARS 1986-1988 (In millions of current

dollars)

Current Policy

Federal

Agency

FmHA

Loans a/

Grants

1986

Outlays

(Actual)

170

120

1987

Outlays

(Estimated)

176

115

Administration

Proposal for

1988

Outlays

(Estimated)

0

117

HUD-Community

Development

Block Grants

Economic Development

Administration Grants

Appalachian Regional

Commission

Bureau of Reclamation

Corps of Engineers

Total

200

15

10

140

50

705

196

15

10

140

40

692

179

10

10

168

20

504

SOURCE: Congressional Budget Office.

a. New loan obligations.
Chapter I INTRODUCTION 11

cilities. 6/ Though differing in many particulars, these bills shared two

important characteristics. First, all would have provided funds for the

construction and repair of a wide variety of infrastructure projects; each

state and local government would allocate its share of this money according

to its own infrastructure priorities. Second, the revolving fund would have

assured a permanent source of infrastructure funds; loan repayments would

have been used to make further loans.

The bills often differed in other respects, such as: how to capitalize

the fund (by the federal government alone or by the federal and state

governments together); whether to lend initial funds directly or to create a

reserve fund against which larger sums could be borrowed (and then lent);

and who should administer the fund (a new independent agency or an existing

department). While none of these bills was enacted into law, Congressional

interest in such revolving funds remains high.

6. See H.R. 1776 and H.R. 2818, among others.

THTTTT

CHAPTER II

WATER UTILITIES' NEED FOR CAPITAL,

FISCAL YEARS 1984-2000

In the coming decades, municipalities will have to provide water service to

populations that, more often than not, are growing. This chapter looks at

the financial burden of supplying this water. The first section describes the

methodology used to forecast regional capital spending for water supply. A

second section presents projections of annual capital expenditures for water

supply improvements from 1984 through 2000, and compares this spending

with actual annual spending from 1977 through 1983. The chapter closes

with some notes about the limitations of the estimates.

METHODOLOGY

Water utilities' demand for capital improvements depends ultimately on the

demand for their water. Consequently, projections by the Congressional

Budget Office (CBO) of capital spending begins with estimates of water

demand. In forecasting this demand, CBO assumed that per capita usage

would not change between 1984 and the end of the century; changes in

water demand, therefore, reflect only changes in population. Using Census

Bureau population projections, CBO forecast water use in the year 2000 for

10 different sizes of water systems within each Census region.

For each system size and region, CBO considered the demand for

two kinds of capital improvements: those needed to replace existing facilities as they age, and those necessitated by growth in the demand for water.

Where population (and, by assumption, water demand) grew by less than 20

percent, CBO assumed that only replacement spending would be needed, as

the average existing system can deliver 20 percent to 40 percent more

water than it currently has to provide. I/ Where population grew by 20

1. National Association of Water Companies, Financial and Operating Data--1983

(Washington, B.C.: National Association of Water Companies, no date); and American

Water Works Association, 1981 Water Utility Operating Data (Denver: American Water

Works Association, 1981).

73-311 - 87 - 2
14 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

percent or more, CBO estimated the cost of providing additional facilities

to meet this new demand.

The CBO estimated separately the cost of treating water, distributing water, and developing new sources of water supply. Treatment costs

depended on whether the water came from a groundwater source, from a

surface water source, or from some combination of the two; a system's

water source, in turn, was a function of the system's size. The cost of both

distributing and developing new sources of water also depended on the size

of the water system. All costs were estimated using standard cost

functions found in the engineering literature (see the appendix).

In order to compute an upper bound on the amount of capital

spending that would be needed, CBO assumed that all capital spending, both

for replacement and for expansion, would take place at the beginning of the

forecast period. These costs then were amortized over the life of the

component being built to reach an estimate of annual spending. 2/

CAPITAL EXPENDITURES FOR WATER SUPPLIES

From fiscal years 1977 through 1983, water utilities spent an average $4.7

billion annually to replace and expand local water supply facilities. 3/ The

CBO estimates that these utilities will spend nearly the same amount--$4.5

billion annually--from 1984 through 2000. About 60 percent of this amount

will be used to replace existing facilities; the remainder will provide

facilities for expanded service. Whether these aggregate spending figures

represent a stable financial burden to the customers of individual utilities

depends on how this spending is distributed geographically and on the

number and incomes of the people who must foot the bill.

Regional Capital Expenditures

Table 5 shows annual capital spending for each of the nine Census regions

during the 1977-1983 period. The aggregate figures give little sense of the

2. Each component was assumed to last at least as long as the forecast period. The design

lives were assumed to be 20 years for well fields, 30 years for treatment facilities, and

75 to 200 years for distribution systems (reservoirs were assumed not to need

replacement).

3. Unless otherwise noted, all dollar amounts in this chapter are measured in 1984 dollars.
TABLE 5. ANNUAL CAPITAL SPENDING FOR MUNICIPAL WATER SUPPLIES. FISCAL YEARS

1977-2000, BY REGION (Ranked by percentage change in per capita spending)

Region

Total United

States

Mid-Atlantic

West-North

Central

East-North

Central

New England

Pacific

East- South

Central

Mountain

West-South

Central

Annual Capital

Spending

1977-1983

(In millions of

(1984 dollars)

4,695.00

308.25

276.28

484.55

146.35

824.68

290.25

522.74

767.61

South Atlantic 1 , 074 . 41

SOURCE: Congressional Budget Office.

Annual Capital

Spending

1984-2000

(In millions of

1984 dollars)

4,493.00

421.00

304.00

508.00

143.00

811.00

249.00

525.00

676.00

856.00

Percent

Change

in Annual

Capital

Spending

-4.30

36.58

10.03

4.84

-2.29

-1.66

-14.21

0.43

-11.93

-20.33

Annual

Per Capita

Spending

1977-1983

(In 1984

dollars)

24.61

9.96

19.12

13.83

14.09

31.47

23.55

54.45

38.27

34.44

Annual

Per Capita

Spending

1984-2000

(In 1984

dollars)

21.80

14.27

20.57

14.53

13.60

26.34

18.70

41.60

28.95

23.57

Percent

Change

in Annual

Per Capita

Spending

-11.42

43.26

7.58

5.08

-3.49

-16.31

-20.58

-23.61

-24.34

-31.54

Forecast

Per Capita

Capital

Spending

as a Percent of

1983

Personal

Income

0.185

0.112

0.183

0.126

0.104

0.203

0.205

0.381

0.263

0.211

O

sr

I

>

8

»

3

P

a

GO

a

9

3o

58

O

|

<n
16 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

different burden that this spending imposed on each region, for the

spending was paid for by populations of quite different sizes. The data

showing spending per capita are more revealing. Nationwide, per capita

capital spending for water supply averaged $24.61 per year. Across regions,

capital spending varied widely, from $9.96 per capita in the Mid-Atlantic

region to $54.45 per capita in the Mountain states.

A number of factors contribute to this spending diversity. Most

important are regional differences in population growth. Regions often

build water supply facilities in anticipation of population gains. Thus, other

things being equal, investment per capita will be higher in those regions

expecting the most rapid population increases.

The variation in spending also reflects regional differences in the cost

of supplying water. These cost differences arise in part from the relative

scarcity of water in each region. While the need for treatment and

distribution are similar throughout the country, the cost of impounding

surface water and transporting it to the areas where it is consumed is far

greater in the West than in the East. Cost differences also rise from

regional variation in the prices of the land and labor needed to build water

supply facilities. 4/ Further, the economies of scale that characterize

water supply technology reduce the cost per gallon as the system increases

in size. Thus, water is generally cheaper to produce in those regions with a

greater share of their populations in large urban areas.

Finally, an area's economic health will affect its capital spending.

When regional income falls, capital improvements are often deferred until

better economic circumstances return. Not surprisingly, regional capital

spending on water supply from 1977 through 1983 is correlated with growth

rates in regional personal income.

The CBO projects that, for the country as a whole, annual capital

spending for local water supply will be 11 percent less per capita from 1984

through 2000 than it was from 1977 through 1983 (see Table 5). The change

in per capita spending will vary widely by region. In six of nine Census

regions, per capita spending will fall; the spending declines will range from 3

percent in the New England area to 32 percent in the South Atlantic region.

Per capita spending will rise in three regions; but in two of these regions the

increase will be less than 10 percent. In only one region, the Mid-Atlantic,

4. "Materials and Labor Cost Trends in the U.S.," Engineering News Record (March 19,

1981),pp. 132-137.
Chapter H WATER UTILITIES' NEED FOR CAPITAL 17

will per capita capital expenditures rise sharply; there they will increase

by over 40 percent.

In general, per capita expenditures will decline in those regions

currently spending the most and will rise in those regions now spending the

least. Since estimated capital spending for water supply is in large measure

a function of the size and distribution of population within each region,

CBO's projections of water supply expenditures show spending becoming

more uniform as the population distribution becomes more uniform. Those

regions where population grows and becomes more concentrated in larger

cities will be able to take better advantage of the economies of scale in

water supply facilities. Conversely, where population falls, regions will be

spreading the cost of replacing aging facilities over a smaller population,

causing per capita costs to rise.

Despite the greater uniformity in spending, substantial regional differences will remain: per capita spending in the New England region will be

only one-third as much as in the Mountain region. Whether these differences in per capita spending reflect different economic burdens depends on

the wealth of the individual regions. Correcting for differences in regional

personal income shows that there will indeed be large variations in the

individual burden imposed by capital improvements for water supply. For

example, capital spending as a percent of personal income will be three and

one-half times as great in the Mountain region as it will be in the New

England states (again, see Table 5).

The Mid-Atlantic region faces the most dramatic change in per capita

capital spending. From 1977 through 1983, states in the Mid-Atlantic region

spent $9.96 per capita; from 1984 through 2000, spending will rise to over

$14 per capita. The reasons for the magnitude of this rise remain elusive.

Most likely, the increase in aggregate spending reflects a return to the

standard replacement schedule assumed in CBO's analysis after deferring

maintenance during the 1977-1983 period--a time of urban fiscal crisis in

the region. Despite the large percentage increase in spending, however,

residents of the Mid-Atlantic will face one of the lowest financial burdens in

the nation: per capita spending, both in dollars and as a percent of personal

income, will be lower in this area than in all but one other region, and will

be only 30 percent of the amount spent by the Mountain states.

Capital Spending by System Size

The CBO's projections of aggregate and per capita capital expenditures by

system size are shown in Table 6. By themselves, the aggregate figures
TABLE 6. ANNUAL AGGREGATE AND PER CAPITA CAPITAL SPENDING, BY NUMBER OF PEOPLE SERVED,

FISCAL YEARS 1984-2000

Type of

Spending

Aggregate Capital

Spending

(In millions of

1984 dollars)

Source Development

Treatment Facilities

Distribution Systems

Total

Per Capital Capital

Spending

(In 1984 dollars)

Source Development

Treatment Facilities

Distribution Systems

Total

More than

1 million

3

24

84

111

.36

1.25

4.37

5.78

100,000 50,000-

1 million 100,000

25 12

196 137

576 310

797 459

.48 .48

3.76 5.52

11.05 12.50

15.29 18.51

Fewer

25,000- 10,000- 5,000- 2,500- 1,000- than

50,000 25,000 10,000 5,000 2,500 1,000 Total

12 14 10 8 11 13 107

195 316 228 178 174 119 1,565

428 591 387 268 104 35 2,783

635 921 625 454 289 167 4,455

.41 .40 .52 .68 1.17 2.55 .52

6.60 9.08 11.77 15.06 18.59 23.36 7.59

14.49 16.98 19.98 22.68 11.11 6.87 13.50

21.50 26.47 32.27 38.41 30.87 32.78 21.61

SOURCE: Congressional Budget Office.

06

$

O

1

so

1

1

i
Chapter H WATER UTILITIES' NEED FOR CAPITAL 19

reveal little; again, the per capita data tell a more interesting story.

Those data reflect the economies of scale that characterize water supply

technology. In general, the larger the system, the less it will spend per

person served. The difference between the largest system and the smallest

in per capita capital spending is striking: systems serving more than 1

million people will spend an average of $5.78 per person each year; systems

serving between 2,500 and 5,000 people will spend nearly 7 times that

amount. The economies of scale are more pronounced in water treatment

than in water distribution. Per capita expenses for water treatment will

average 95 percent less for the largest systems than for the smallest ones.

In contrast, per capita distribution costs will be only 33 percent less for the

largest systems than for the smallest ones.

Capital Spending by Component

Between 1984 and the turn of the century, spending by utilities on water

distribution facilities will total $2.8 billion annually, almost two-thirds of

their annual capital spending (see Table 6). Spending on water treatment

facilities will account for $1.6 billion annually, about 35 percent of utilities'

capital budget. New sources of supply will claim only 3 percent of expected

capital spending.

Capital spending for distribution systems will be divided fairly evenly

between replacement of existing facilities and additions of new facilities to

meet growing water demand. In contrast, less than 20 percent of the

spending for water treatment will be to add new capacity. These numbers

again reflect the greater economies of scale that characterize water

treatment: as population rises, the per capita increase in spending will be

less for treatment than for distribution. Of all capital spending for water

supply, about 60 percent will be used to replace existing facilities; the

remainder will be used to provide water to a larger population.

LIMITATIONS OF CBO'S CAPITAL SPENDING PROJECTIONS

The capital spending estimates presented in this paper are the first ever

made at this level of detail. 51 To make the forecasting problem tractable,

5. Earlier estimates can be found in American Water Works Association, AWWA

Infrastructure Survey of the 50 Largest Water Utilities (Washington, D.C.: AWWA, 1983);

and The President's Intergovernmental Water Policy Task Force, Urban Water Systems:

Problems and Alternative Approaches to Solutions (Washington, D.C.: Water Policy

Task Force, 1980).
20 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

CBO made a number of simplifying assumptions. Most of these simplifications worked to exaggerate the changes, both positive and negative, in each

region's capital spending.

One problem arises from the assumption that per capita water use will

remain unchanged. Water use can be constant only if there is no change in

either the price of water or the way in which water is used. 6/ In fact,

numerous new water conservation techniques have recently become available, often in direct response to increasing water prices. And, of course,

capital spending does influence water prices, especially for regulated

private firms, whose prices are explicitly tied to capital costs. Thus, even

in a world without technological change, rising per capita spending will

increase prices and decrease the demand for both water and further capital

improvements in water supply. Conversely, in regions where per capita

spending falls, price declines will increase both water consumption and the

amount of capital spending required. Had capital spending estimates taken

account of the price sensitivity of water demand, neither the projected rises

in capital spending nor the projected declines would have been as great.

In a similar vein, CBO assumed that all replacement and expansion will

be done with current standard engineering techniques. Yet water, like most

other goods, can be produced using a variety of technologies. As capital

spending (and thus the price of water) rises, production managers will come

under pressure to substitute less capital-intensive production techniques for

existing methods.?/ Thus, again it is unlikely that changes in capital

spending will be as great as envisioned in the CBO forecast.

Finally, CBO assumed that national cost functions can adequately

measure costs in each of the different regions despite evidence that the cost

of water supply differs by region. To the extent that regional costs do

differ, CBO projections will understate the expenses faced by the high-cost

regions and overstate the expenses of the low-cost regions. Therefore,

while CBO projects that capital spending will fall in the high-cost areas and

rise in the low-cost ones, both the projected increases and the projected

declines in spending are overstated.

6. The effect of price changes on water use is discussed in Kenneth Frederick, ed., Scarce

Water and Institutional Change (Washington, B.C.: Resources for the Future, Inc., 1986),

pl!6.

7. Some alternative approaches to water supply problems are discussed in Chapter III.
Chapter H WATER UTILITIES' NEED FOR CAPITAL 21

While all of the simplifications noted above bias CBO's forecast of

regional capital spending, at least the direction, if not the magnitude, of

their bias is clear: all cause the capital spending projections given here to

overstate the change in each region's spending. A final simplification

understates the spending that will be needed in each region: the estimates

do not reflect the cost of complying with the standards now being developed

pursuant to the Safe Drinking Water Act of 1984.

CHAPTER III

STATE AND LOCAL OPTIONS: ALTERNATIVE

SOLUTIONS TO WATER SUPPLY PROBLEMS

The analysis in Chapter II shows that capital spending for water supply will

rise substantially in only one Census region through the rest of this century.

The aggregate data used in that analysis, however, disguise the fact that

individual communities in other regions also may face large increases in

capital spending. In many instances, part of these increases could be

avoided. Some state and local agencies have recently begun to pursue new

methods to meet the demand for water. This chapter discusses some of

these options, including water conservation strategies, water supply

technologies that require less capital spending than do current methods, and

financial innovations that reduce the cost of borrowing for the capital

requirements that remain.

LOCAL OPTIONS: DEMAND MANAGEMENT

Faced with demands for greater water supplies, water authorities must

either increase supplies or help users find ways to use existing supplies more

efficiently. Among the methods that local authorities could use to reduce

water consumption are rate reforms and education campaigns.

Reforming price schedules holds particular promise. While most public water utilities charge prices that are more than sufficient to cover operating expenses, few charge enough to cover the depreciation of capital

facilities as well. Charging prices below the real cost of providing water

leads to overconsumption. Without signals about the true cost of water,

consumers demand more than they would if they paid the full cost of their

consumption. The result is overinvestment in water supply facilities.

In designing rate structures that reflect costs, utilities need to

consider not just average prices, but also the time of day and/or the season

in which water is consumed. Because utilities must invest in enough

capacity to meet demand at peak times, they would need fewer facilities--

and thus less investment--if some customers switched their consumption

from peak to off-peak periods. Recognizing this, the City of Los Angeles
24 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

recently began to charge higher prices in the dry season in hopes of reducing peak demand.

Evidence on the effect of price changes on water demand suggests

that the savings from proper pricing policies can be significant. Studies of

urban water supply show that a 10 percent rise in price will cause consumption to fall between 3 percent and 11 percent. I/ International comparisons

reflect a similar price sensitivity of urban water demand. In the United

States, where water costs about $1 per 100 gallons, per capita consumption

averages about 100 gallons per day; in most European cities, where water

generally costs more than twice as much, consumption is about half of the

U.S. level. 2/ A recent study of the Metropolitan Water District of

Southern California illustrates the,size of potential savings that could result

from prices that fully reflect the cost of providing water. Although the

population of this district is expected to grow dramatically in the next 15

years, it would need no new water supplies until 2000 if it charged prices

that reflected the true cost of furnishing water. 31

In addition to reducing the demand for water, price reform could bring

water utilities more capital at lower interest rates. As higher rates increase utilities' revenues, investors become more willing to finance capital

improvements. For example, a recent survey of the largest publicly owned

water systems found that rate increases could secure more money at lower

interest rates than would otherwise be available. 4/

Finally, some utilities can reduce demand by educating consumers

about conservation techniques. Education campaigns have been successful

both as short-term responses to drought and as a means of altering long1. See the studies cited on p. 116 of Kenneth Frederick, ed., Scarce Water and Institutional

Change (Washington, B.C.: Resources for the Future, Inc., 1986).

2. See Association of the Proprietors of Waterworks Companies in the Netherlands,

Waterworks Statistics 1979 (The Netherlands: Association of the Proprietors of

Waterworks Companies in the Netherlands, 1984); and Kenneth Frederick, ed., Scarce

Water, p. 6.

3. Richard Wahl and Robert Davis, "Satisfying Southern California's Thirst for Water:

Efficient Alternatives," in Scarce Water.

4. American Water Works Association, AWWA Infrastructure Survey of the 50 Largest

Water Utilities (Washington, B.C.: American Water Works Association, 1980).
Chapter m STATE AND LOCAL OPTIONS 25

term water use habits. 5/ The city of Madison, Wisconsin provides an

example of the extent to which education campaigns can affect demand.

Madison ran a campaign that informed residents of the capital expenditures

that would be needed if peak demand did not fall, and urged them to shift

some water use from peak consumption times. The $40,000 campaign

lowered peak demand enough to allow the city to forgo a new well system,

thus saving $175,000 in construction costs and $60,000 in annual operating

expenses. 6/

STATE OPTIONS: ALTERNATIVE SUPPLY TECHNIQUES

AND FINANCIAL INTERMEDIATION

Local water authorities have limited options for solving water supply problems, as they operate within a legal and institutional environment created

by state governments. State law influences local water supplies directly

through rules on water use, the distribution of water rights, and the regulation of local water utilities and indirectly through control of local jurisdictions' power to tax, incur debt, and assess user fees. Because their

influence over local water utilities can be substantial, state governments

could play a major role in fostering new approaches to the water supply

problems of local utilities.

Trading Water Rights

In 17 western states, current water users hold rights to more water than is

available in an average year. Supplies to meet the growing demand for

water will have to come either from conservation or from reallocation of

the rights to existing supplies. This section examines the prospects of

alleviating water supply problems by establishing markets in which water

rights can be traded.

Markets work well only if there are unambiguous, transferable, and

quantifiable property rights attached to the good being traded. Such rights

for water rarely exist under current law. The ambiguity of property rights

arises in part from administrative policy and in part from the fact that a

5. Mark Hoffman and others, "Urban Drought in the San Francisco Bay Area: A Study

of Insitutional and Social Resiliency," in Water Conservation Strategies (Washington,

B.C.: American Water Works Association, 1980).

6. Larry Diebert, "Fiscal Planning and Water Conservation in Madison, Wisconsin," in

ibid.

TTR1T'
26 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

body of water may be subject to the (sometimes conflicting) laws of more

than one state, the federal government, and various international treaties.

(Especially problematic are treaties between the federal government and

various Native American nations, treaties whose provisions are currently

being adjudicated.) 7/ When more than one body of law may apply, assured

property rights await interstate compacts, Congressional action, and/or

court rulings. Until the rights to water are made unambiguous, the transfer

of water rights will be discouraged by the uncertainty surrounding the

legality of such trades.

Markets also require property rights that are transferable. The

transferability of water rights varies by state and, in general, depends on

which one of two principles is used by state water law. 8/ In the East, water

law generally follows the "riparian" or "correlative" rule--that is, surface

water can be used only on land abutting a water flow; groundwater can be

used only on land overlying an aquifer. Riparian law grants the right to

water only for "reasonable and beneficial" use. Where claims exceed the

available water, all users must share the water equitably. Riparian law does

not readily accommodate water transfers; selling water rights is often ruled

out by the prohibition against using the water on land that is neither

adjacent to the surface water nor overlying the aquifer. Where riparian law

applies, trading water rights offers little promise for efficient distribution

of water use. (Methods more useful in these areas are discussed in the

following section.)

In western states, the doctrine of "appropriative" rights governs the

use of surface water. Here, rights are established on a first-come, firstserved basis: the right to use water accrues to the entity that first puts the

water to "reasonable and beneficial" use, even if the use is on land far from

the water source. Those who subsequently seek water may establish "junior"

water rights. These junior rights are filled each year only if water remains

after the holders of more senior rights receive their full quota. Once established, a water right remains with the original holder as long as the water

continues to be used "beneficially."

Appropriative rights were designed to bring about the settlement and

agricultural development of the West. By allowing water to be transported

from those areas in which it was abundant to the large tracts of open, arid

7. See, for example, the discussion of water rights in the Columbia River Basin in Kenneth

Frederick, Scarce Water, Chapter 2.

8. Water law is governed by both principles only in California. See ibid., Chapter 4.
Chapter m STATE AND LOCAL OPTIONS 27

land that were common in the West, the law helped to accomplish exactly

what it was intended to do. But the requirement that the right to water

remains with those who continue "reasonable and beneficial" use works

against any change in the original distribution of water. Until transferring

the right to water is designated explicitly as a "reasonable and beneficial"

use, uncertainty over the legality of trades will stand in the way of establishing water markets.

If transfers are not regarded as a beneficial use of water, then appropriative water law provides large incentives against conservation. Water

not used by the entity originally entitled to it becomes "surplus" water to

which others can establish appropriative rights. Thus, those conserving

water save only the cost of the water not used; they gain nothing from the

fact that the water can be used by others who attach a far higher value to

it. One cost of this arrangement is that, in water-short years, senior water

holders who receive their full quota have no incentive to share that water

with the holders of junior rights who receive no water.

A final complication arises from the nature of water itself: transferring water from a stream or an aquifer can affect third parties-those

downstream and those who share use of the aquifer. Markets for water

rights would work efficiently only if trades take into account the effect of

water transfers on third parties.

Despite these difficulties, voluntary water transfers do occur under

current law, and in recent years they have become more common. While

most transfers result from individual negotiations among the affected parties, some fledgling water markets have been started. These markets are

limited in scope. Trade usually occurs only between members of the same

water district, and often the price is set by an administrator at the cost of

supplying water, not by the market at the level people are willing to pay for

water. 9/ That these transfers occur despite the lack of supporting institutions and despite the legal complexities involved suggests that much more

could be gained were the legal and institutional climate made more

conducive to trade. 10/

9. For a survey of current water transfer agreements, see Richard Wahl and Frank

Osterhoudt, "Voluntary Transfers of Water in the West," in U.S. Geological Survey,

National Water Summary 1985 (Washington, D.C., 1986).

10. Ibid. Chapter IV of this paper discusses changes in federal policy that could promote

markets for water rights.
28 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

System Interconnection and Joint Operation

For most areas in the eastern United States, water is not scarce, but simply

inefficiently distributed. The water utility industry has a strong tradition of

local autonomy. Even small jurisdictions within larger metropolitan areas

usually have locally owned and operated water systems. Because localities

within a water basin often develop at very different rates, individual systems may face large shortfalls while the basin as a whole has abundant

supplies. One solution for a water-short system would be to build new facilities to import water from outside the basin. But water resources engineers

have recently developed techniques to use a less expensive alternative:

connecting and jointly operating the facilities of all individual systems in a

region, jl/

In the greater Washington, B.C., area, for example, the Washington

Suburban Sanitation Commission (WSSC) has operated such an interconnected water supply system since 1982. This regionally coordinated system

obviated the need for between $200 million and $1 billion in capital

investment that earlier had been proposed as a solution to the rapid growth

in the region's water demand. 12/ Similarly, a recent study concluded that,

to meet future water demand, Virginia Beach, Virginia, could save half the

cost of importing water from another basin by coordinating water use among

the local systems in its area. 13/

The greatest barrier to system interconnection is a lack of information. Local systems will agree to interconnection and joint operation only if

each locality is convinced that its water supply will be assured. In the

absence of good information about the effects of joint operation, each

locality would be encouraged to adopt a "worst case" scenario in its negotiating stance with the others. In these situations, state governments could

serve the role of the honest broker, developing and disseminating information that could be expensive for an individual locality to acquire,

11. For a description and application of these techniques, see Daniel P. Sheer, "Managing

Water Supplies to Increase Water Availablity," in U.S. Geological Survey, National

Water Summary 1985.

12. Ibid.

13. Leonard Shabman and William Cox, "Costs of Management Institutions: The Case of

Southeastern Virginia," in Kenneth Frederick, Scarce Water.
Chapter JH STATE AND LOCAL OPTIONS 29

although it would be crucial to prospects for any joint operating

agreement. 14/

System interconnection is only the most dramatic example of a larger

set of improvements in the yields of existing water supply systems that can

be achieved by applying advanced engineering techniques. Systems with

more than one facility could maximize the yield of the entire system by

coordinating reservoir releases or calculating the minimum flows needed for

maintaining environmental quality. Similarly, ground and surface water

systems could be operated conjunctively, allowing groundwater to substitute

for absent surface water during dry seasons and using peak surface water

flows to allow aquifers to recharge during wet seasons. An application of

this technique in rural Maryland proved more cost effective than all potential new surface construction. 15/

Financial Intermediation

Each state sets the financial rules by which the localities within it must

operate. The state decides the level and kind of taxes that localities can

levy, the amount of debt that they can incur, and the terms under which

they can assume that debt. The state may even determine the kind of prices

that local water utilities can charge for water. States could use these

sweeping powers to create a legal and institutional climate that minimizes

the cost of capital to local water utilities.

In general, states could increase the range of financial instruments

available to local water authorities. Many cities operate under financial

strictures imposed by state legislatures in the wake of widespread municipal

bond defaults during the Great Depression. Since then, of course, localities

have become far more fiscally sound and local government administrators

have become more sophisticated about financial management. Thus, a

Public Works Task Force established by Washington state found that

restrictions on localities' freedom to tax and to incur debt raised the local

cost of capital for water supply improvements. 16/ A review of laws in

14. See Chapter 4 of Kenneth Frederick, Scarce Water for an example of the difficulty in

arranging joint operating agreements in the absence of good information that is accepted

by all parties.

15. See Nancy N. Ehrlich, Managing the World's Largest Reservoir (Columbia, Md.: Water

Resources Management Inc. 1986).

16. Washington Planning and Community Affairs Agency, The Washington State Public

Works Report (1983).
30 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

other states might show a similar need for financial flexibility at the local

level.

Specifically, state governments could use their stronger position in

credit markets to assist localities more directly. Such direct assistance

would be of most help to smaller jurisdictions, which face three handicaps in

credit markets. First, many of the costs of borrowing (such as fees for bond

counsel, printing, receiving a rating from investment companies, and obtaining some form of credit insurance) cost more per dollar borrowed as the

amount borrowed decreases. Second, the smaller the borrower, the lower its

credit rating usually is. Lower ratings follow from the higher risk of default

that lenders perceive in jurisdictions with economies that are smaller, less

diverse, less wealthy, and growing less quickly than larger and more

prosperous government units. Finally, smaller systems are likely to seek

credit at less frequent intervals and to have less of a credit history.

Lenders are chary of unknowns; thus, when small cities are able to obtain

credit at all, it is more expensive than the credit available to borrowers

with more established records, but otherwise similar characteristics.

Because state governments face none of the handicaps discussed

above, they could help to lower local capital costs in a number of ways. A

few states borrow directly on behalf of localities. When these states back

their bonds with "full faith and credit" (which allows lenders to seek courtordered taxes to make good on any default), they assume the risk of default

by localities. As such, state borrowing on behalf of localities could make it

more expensive for the states to borrow for their own purposes.

States could aid local jurisdictions at less cost to themselves by establishing bond pools for local issues. Bond pools could help small issuers in a

number of ways; most important, larger issues could take advantage of the

economies of scale that characterize credit markets. Also, while small,

infrequent issuers individually might lack credit histories, the large pools

that combine the issues of an ever-changing set of small issuers could

quickly establish the needed history.

One way for state governments to establish bond pools at little or no

cost to themselves would be to set up "bond banks" to act as intermediaries

between local issuers and credit markets. A state bond bank would issue

bonds and use the proceeds to purchase locally issued debt. The local debt

would carry an interest rate equal to that paid by the bond bank to its

lenders, plus an amount needed to cover the bank's administrative costs.

Bond banks usually back their debt in three ways: with payments they

receive on the local bonds (in the case of water utilities, these payments

usually come out of local utility revenues); by a lien on state-aid payments
Chapter m STATE AND LOCAL OPTIONS 31

to localities; and with a presumption by the lender that the state has a

"moral obligation" to repay the bond bank debt in case localities default. Ill

Since 1969, seven states have established bond banks. 18/ Early

evaluations show that these banks have had two effects: the bank has made

credit available to some localities that previously could not have borrowed

at all, and those jurisdictions that could have borrowed on their own were

able to do so at a lower cost. On average, the banks lowered local borrowing costs by 4 percent. 19/

The traditional form of bond bank has its limits. First, the bank is

most useful when the bank's credit rating is higher than that of the participating localities. 20/ In order to preserve a high rating, a bond bank

might need to exclude those localities least able to obtain credit on their

own (and consequently most in need of the help that a bond bank could

provide). Second, because lenders presume a moral obligation on the part of

the state to make good on any bond bank default, the state's ability to get

credit for its own purposes might be affected by the credit-worthiness of

the bond bank that it sponsored.

States could address both of these concerns by securing bond bank debt

with some form of credit enhancement (in which a third party accepts the

risk of default in exchange for a fee from the borrower). In return for such

guarantees, the bank might need to back its most risky local issues with a

reserve fund equal to the size of those issues. 21/ This arrangement would

have the twin advantages of making bond bank debt available to those

localities most in need of it while simultaneously insulating the state's own

credit rating from the credit history of the bond bank. At the same time,

however, the bond insurance fee would raise the cost of bond bank debt to

17. The state's "moral obligation" to back the bank's bonds with general revenues is

presumed by the lenders, but carries no legal force.

18. The state with bond banks are Alaska, Arkansas, Indiana, Maine, New Hampshire,

Nevada, and North Dakota.

19. Martin Katzman, "Municipal Bond Banking: The Diffusion of a Public-Finance

Innovation," National Tax Journal, vol. 33 (June 1980).

20. Even if the rating of the bank and its members were the same, the local governments

could benefit from the economies of scale that the bank could provide.

21. Reserve funds usually equal one year's debt service payments. As the bond bank

established a credit history, the insurer might accept decreasing the size of the reserve

fund.

TWIT
32 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

localities, and the unusually large reserve fund would limit the number of

local issues that bond bank could assume. 22/

The state and local options discussed in this chapter would require

little or no outlays on the part of state or local agencies. In the absence of

increased state and local spending, federal capital grants might continue to

play an important role in the water supply investment of some localities.

The next chapter discusses ways to make these federal programs more

efficient.

22. Nancy Humphrey and Christopher Walker, Innovative State Approaches to Community

Water Supply Problems (Washington, D.C.: Urban Institute, 1985), p. 45.
CHAPTER IV

FEDERAL POLICY ALTERNATIVES

By providing support for municipal water supplies, the federal government

has sought to further several, sometimes conflicting, goals. These goals

have included increasing the availability and quality of local water supplies,

promoting efficient state and local policies to provide water supplies, and

furthering local economic development. When considering the future direction of water supply policy, the Congress may wish to add a further goal:

reducing the federal deficit. This chapter examines several alternatives for

federal policy, including reducing federal support for municipal water

supplies, as called for in the Administration's most recent budget request,

and maintaining the existing level of support either through current

programs or through new federal initiatives.

REDUCE OR ELIMINATE FEDERAL FINANCIAL AID

FOR LOCAL WATER SUPPLIES

The Administration's budget request for fiscal year 1988 calls for sharply

reducing federal grants and loans for municipal water supplies. Specifically,

the 1988 request would reduce Community Development Block Grants

(CDBGs) and eliminate the water supply grant and loan programs of the

Farmers Home Administration (FmHA), Economic Development Agency

(EDA), and the Appalachian Regional Commission (ARC). The Administration's proposals would lower federal spending by more than $200 million

annually over the 1988-1992 period, compared with spending under current

law.

The effect of these cutbacks on the availability and quality of local

water would depend in part on how much local entities increased their

spending as federal funding was reduced. Evidence from other federal

programs suggests that local sources would replace about 70 percent of any

reduction in federal funds. I/ In addition, state and local governments

might seek to obviate the need for many spending increases by exploring

1. See Congressional Budget Office, Federal Policies for Infrastructure Management (June

1986), pp. 80-86.

rrra
34 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

more fully alternative supply methods like those discussed in Chapter III.

These included various demand management techniques, state efforts both

to improve local access to capital and to lower its costs, and state help to

increase the role of markets in determining the allocation of water supplies.

These state and local options could mitigate to some extent the effects of

reduced federal spending for water facilities.

MAINTAIN CURRENT SUPPORT FOR MUNICIPAL WATER SUPPLIES

The Congress may wish to maintain the existing level of federal support for

municipal water supplies. If, as shown in CBO projections, per capita

spending declines in most regions through the rest of the century, continued

federal support would allow nonfederal agencies in most areas of the

country to reduce their per capita capital spending. This section considers

policies that would continue current federal support for municipal water

supplies while furthering other goals, such as reducing the federal deficit.

Facilitate Voluntary Transfers of Federally Controlled Water

In the 17 western states where current water rights exceed the average

annual supply, the demand for water continues to rise. 2/ A few states have

sought to meet this growing demand by establishing laws and institutions

that encourage the exchange of water rights. Facilitating the exchange of

water rights allows water to be allocated first to those who value it the

most. Most of these transfers have involved the purchase of water by

municipal and industrial (M&I) users from agricultural users who hold senior

rights. Because agriculture currently consumes such a large fraction of

western water, small reductions in agricultural use (through conservation,

for example) have permitted increases in M&I use that are proportionately

far larger. Given current consumption rates, a 5 percent reduction in

western agricultural use of water, for instance, would permit a 50 percent

increase in western M&I use. 3/ Because of the high price that M&I users

often are willing to pay for water, agricultural users might find it profitable

to conserve and then sell the saved water to M&I users.

2. Much of the information in this section is drawn from Richard W. Wahl, "Promoting

Increased Efficiency of Federal Water Use Through Voluntary Water Transfers,"

(Washington, D.C.: Resources for the Future, 1986, review draft).

3. Calculated from data in ibid., p. 48.
Chapter IV FEDERAL POLICY ALTERNATIVES 35

State governments have primary responsibility for deciding the extent

to which water transfers are allowed, as nearly all water rights, including

rights to water from federal water projects, are held under state law. In

those states that encourage water transfers, however, the federal role may

be significant: nearly 20 percent of western agricultural water is delivered

by Bureau of Reclamation projects, and users of that water must comply

with federal as well as state rules governing its distribution.

Currently, both reclamation law and the administrative practices of

the Bureau of Reclamation impede the trading of water rights. Most of the

limitations arise from restrictions written into the long-term contracts that

control the use of bureau-delivered water. A small number of these contracts ban outright the resale of water; most others hinder water transfers

in lesser ways. For example, many contracts allow bureau water to be

resold, but then minimize the incentive for doing so by restricting (and

sometimes eliminating) the amount of profit that bureau customers can

make from such sales. A majority of the contracts also limit both the lands

on which the project water can be used and the purposes toward which the

water can be put. (Most often, use is limited to irrigation.)

Some of the restrictive provisions in bureau contracts can be changed

only by an act of the Congress. For example, many of the limits both on the

lands served by bureau projects and on the end-use of bureau water are

contained in the authorizing legislation for particular projects. Other

contract restrictions could be removed by bureau action alone. These are

restrictions that reflect the Congressional intent of an earlier era; as the

Congress broadened the purposes of various reclamation projects, many already existing contracts were not amended to reflect the evolution of

Congressional intent. The bureau could remove these impediments to water

transfers simply by offering to amend those contracts that were written in

what is now an unnecessarily restrictive fashion.

Some limits on water transfers arise from the administrative practices

of the bureau itself. One problem lies in the lack of an explicit bureau-wide

policy on water transfers. The absence of such a policy has led to practices

that' vary widely across projects. At the Central Valley project in California, water can be transferred, but profiting from such transfers is

prohibited; in Idaho, a state water bank allows the sale of water at prices

set by an administrator; and finally, water from the Big Thompson project in

Colorado is traded freely in a true market for water. As these varying

practices illustrate, the lack of an explicit policy does not stop trading, but

it does make trading more difficult. Since agreements cannot be structured

to comply with explicit guidelines, traders must negotiate transfer terms
36 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

while somewhat in the dark about what the bureau will approve, and then

hope that those terms will be acceptable. The uncertainty surrounding such

approval lessens the number of people willing to incur the cost of negotiating a trade.

Similar uncertainty is created by the bureau's retention of state water

rights to some bureau-delivered water. The bureau currently holds water

rights to about 85 percent of the water that it delivers. 4/ Some bureau

officials hold that transferring those rights to its customers would not expedite the development of water markets. And indeed, some users of bureau

water have traded not the water right itself, but instead the contract that

entitles the holder to bureau water; in essence, these users have

"subcontracted" bureau water. Continued bureau possession of the rights to

this water, however, raises the possibility that the bureau someday might

attempt to restrict such "subcontracting." While transferring rights to other

customers is not necessary for transfers, it definitely could encourage trading by reducing the associated uncertainty.

Trading water rights would not only reduce the cost of local water

supplies (by eliminating the need for more expensive capital projects), but

also would increase federal revenues by raising both payments to the Bureau

of Reclamation and federal income tax revenues. The federal government

initially pays for bureau projects; the users of water from these projects

then pay back some fraction of that cost. The fraction repaid varies with

the use to which the water is put. Because M&I users pay substantially more

than agricultural users, water transfers would increase payments to the

bureau. 5/ Water transfers also would increase income tax payments, as, by

allocating water more efficiently, such transfers would increase national

income. Studies have estimated the income gain from trading water rights

would be between $51 million and $370 million per year in California

alone. 6/ Presumably, this increase would be subject to personal or corporate income taxes.

4. Ibid, p. 23.

5. Ibid, p. 36. Preliminary estimates show that, at current interest rates, M&I users would

repay more than twice as much as agricultural users.

6. See D. Erkenkotter, "Should California Agriculture Receive Preferential Water Rates?"

Working Paper No. 285 (Los Angeles: University of Calif., Western Management Science

Institute, 1978); R.E. Howitt and others, "The Economics of Alternative Institutions

for Allocating California's Water" (Riverside, Calif: University of Calif., Resources

and Environmental Economics Public Policy Group, 1982); and C.E. Phelps, "Efficient

Water Use in California: Water Rights, Water Districts and Water Transfers," Rand

Publications Service R-2386-CSA/RF (Santa Monica, Calif.: Rand Corp., 1978).
Chapter IV FEDERAL POLICY ALTERNATIVES 37

Restructure Requirements for FmHA Loans and Grants

The FmHA provides grants and loans to small, low-income communities in

order to promote investment in water supply facilities. The current

structure of the FmHA's program, however, unintentionally encourages

localities both to choose inefficient, capital-intensive facilities and to maintain those facilities inefficiently. Typically, grant recipients choose projects that minimize the costs that localities must pay, rather than those that

cut total costs. Because FmHA grants and loans can be used for capital

expenditures but not for ongoing maintenance, local costs are minimized by

building facilities that are more capital-intensive and require less maintenance. As a result, FmHA capital grants are higher than they would be if

the grant money could be used for both capital and maintenance expenditures. Further, subsidizing only capital expenditures makes it relatively less

expensive for communities to forgo maintenance, in that money saved from

forgone maintenance is more likely to exceed the money lost when poor

maintenance requires earlier replacement of neglected facilities.

FmHA's grant procedures may also discourage proper maintenance.

For the last several years, applications for FmHA funding have exceeded the

FmHA budget authorization. In deciding which among the qualifying

applicants will get funds, FmHA gives priority to those communities with

water systems that violate state or county health regulations. This gives

communities an incentive to allow their water systems to deteriorate

enough to receive priority in funding for FmHA.

A recent survey of FmHA grant and loan recipients in New York state

showed that inadequate maintenance is indeed widespread.?/ A large

majority of the grant and loan recipients indicated that the poor maintenance stemmed in part from a lack of information--that is, the FmHA

program is targeted to small communities, which can be hard pressed to find

the technical and financial information needed to make efficient water

supply investment decisions. These officials particularly desired information about water conservation strategies, alternative supply technologies,

optimal maintenance strategies, and available capital financing-techniques.

Thus, even when they receive FmHA money, some communtites might find

it difficult to spend efficiently.

7. Clifford V. Rossi, "An Institutional and Economic Analysis of Rural Water Supply

Infrastructure Deterioration in New York State" (Ph.D. dissertation, Cornell University,

1986).

'TT
38 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

The Congress could address these problems through a number of

alternatives. First, the FmHA could begin to provide technical and financial

advice directly to communities; alternatively, the Congress could authorize

recipients to use FmHA grants and loans to purchase necessary consulting

services. The cost of providing this service would partially be offset by the

increased efficiency of water supply investments made by FmHA program

beneficiaries.

Second, as part of the grant application, the FmHA could require

communities to examine specific alternative solutions to their water supply

problems (as the Urban Mass Transit Administration (UMTA) currently

requires of its grant applicants). This approach would have the advantage of

bringing a variety of specific alternatives to the attention of local water

supply officials. Yet this alternative has the drawbacks of increasing the

importance of grantsmanship in deciding which communities receive FmHA

funding and of reducing the relative importance of providing efficient water

supply facilities.

Finally, FmHA grants and loans could be conditioned on recipients'

willingness to comply with a specific maintenance schedule. Publishing

these schedules would be useful for local officials unsure of the optimal

maintenance timetables for their plants. The requirement that communities

follow predetermined maintenance schedules, however, carries with it the

danger that such schedules would be inappropriate for local conditions or

that they would be too expensive to develop properly.

Revolving Fund for Water Supply Facilities

The federal government now supports water supply facilities through a

variety of direct grant and loan programs. The Congress may wish to

consolidate these programs and establish a revolving fund for financing local

water supplies. This fund would become a permanent pool of capital from

which localities could borrow at below-market interest rates; repayments of

the initial loans would in turn be lent to others for further water supply

investments.

Two characteristics make the establishment of a revolving fund problematic: the time between Congressional reviews and the amount of the

subsidy provided by low-interest loans. Less frequent Congressional reviews

of the funding level and purposes of the fund would promote greater

predictability of resources that would be provided by the fund. Proponents

of less frequent reviews argue that funding stability would allow localities
Chapter IV FEDERAL POLICY ALTERNATIVES 39

to take a long-term view in deciding when they should make capital improvements. Funding stability would allow localities to apply for federal

assistance when they think it best to make capital improvements, not when

federal assistance happens to be available. Yet the greater the time

between Congressional reviews, the greater the likelihood that the resources

available through the fund would not reflect Congressional spending priorities (either among different kinds of infrastructure or between infrastructure and other needs).

The low-interest loans made from the revolving fund would provide

localities with smaller subsidies than they usually receive from federal grant

programs for water supply. Lower subsidies might encourage more efficient

project selection, for previous research has shown that lowering the federal

share of project capital costs encourages localities to seek less capitalintensive solutions to their water supply problems. 8/ The higher federal

shares available through grant programs, however, sometimes are necessary

to elicit the water supply improvements that the federal government seeks.

For example, some state programs that provide subsidized loans have found

few takers among the intended beneficiaries--the small, low-income communities with the most pressing water supply problems. 9/ This suggests

that a revolving fund might be most useful if the subsidy were tailored to

each community's income and the condition of their water supply facilities

as is now done with current FmHA grants and loans for water supply.

8. See Congressional Budget Office, Efficient Investments in Wastewater Treatment Plants

(June 1985).

9. See Nancy Humphrey and Christopher Walker, Innovative Approaches to Community

Water Supply Problems (Washington, B.C.: Urban Institute, 1985), pp. 46-47.

nmmrr
11II1ML
APPENDIX
iLi.
APPENDIX

REFERENCES USED IN CALCULATING

FUTURE CAPITAL DEMANDS

Population Projections

U.S. Department of Commerce, Bureau of the Census, Provisional Projections of the Population of States by Age and Sex: 1980 to 2000

(1983).

U.S. Department of Commerce, Bureau of the Census, 1980 Census of the

Population, Number of Inhabitants, U.S. Summary (April 1983).

Water Use

U.S. Geological Survey, Estimated Use of Water in the United States in

1980 (1983).

Water Treatment

American Water Works Association, 1981 Water Utility Operating Data

(1981).

Distribution Systems

Port Authority of New York and New Jersey, Regional Economic Develop-

• ment Task Force, The Condition of Urban Infrastructure in the New

York -New Jersey Region (May 1979).

Cost Equations

R. C. Orrin, Determining the Budgetary Cost of Municipal Treatment

Plants and the Cost of Treated Water (M.S. thesis, University of

Tennessee, Knoxville, 1971).

'TMliil
44 FINANCING MUNICIPAL WATER SUPPLY SYSTEMS May 1987

Illinois State Water Survey, Cost of Reservoirs in Illinois, Technical

Letter 8 (April 1968).

Illinois State Water Survey, Cost of Water Treatment in Illinois,

Technical Letter 11 (1968).

American Water Works Association, AWWA Infrastructure Survey of the

Fifty Largest Watger Utilities (1983).

American Water Works Association, 1981 Water Utility Operating Data

(1981).

Robert M. Clark and Paul Dorsey, "The Costs of Compliance: EPA

Estimates for Organics Control," Journal of the American Water

Works Association (August 1980).

Price Elasticity of Water Demand

R. Bruce Billings and W. Mark Day, "Elasticity of Demand for Residential

Water: Policy Implications for Southern Arizona," Arizona Review,

vol. 31 (March 1983).

Army Corps of Engineers, Influence of Price and Rate Structures on

Municipal and Industrial Water Use, The Institute for Water

Resources, Report 84-C-2 (1984).

O