The pros and cons of buying and selling wastewater plants

Many cash-strapped local governments have tried selling public infrastructure to private enterprise to generate additional funds. Former President George Bush’s 1992 Executive Order on infrastructure privatization formally introduced the concept of selling federally funded assets to generate funds without having to repay the federal investment. Since the issuance of the order, “wastewater asset sale” has become part of the privatization lexicon.

TWO CHOICES FOR PRIVATIZATION

There are two general categories of private sector participation in the provision of wastewater treatment. One is full privatization, in which a facility is privately owned and operated. Although this historically has involved the private design, financing, construction, ownership and operation of new wastewater facilities, the concept of full privatization now also includes the transfer of ownership of existing publicly owned treatment works (POTWs) to the private sector.

The other category of private participation is contract operations, maintenance and management (OM&M). With contract OM&M, a publicly owned facility is operated by a private firm. The municipality retains ownership of the facility, and the firm assumes responsibility for operating the facility and guaranteeing performance, including compliance with regulatory requirements. The contract may also include the design, construction and financing of a POTW in addition to its operation.

The emergence of contract OM&M in the late 1970s resulted in part from the passages of the Clean Water Act and the Construction Grants Program, two federal initiatives that prompted hundreds of cities and towns to build new, sophisticated wastewater treatment facilities. Private firms began offering local governments the personnel and technical expertise required to properly operate these new facilities and maintain compliance with increasingly stringent discharge requirements.

Contract OM&M brought two important private-sector concepts to the provision of public wastewater services — competition and contractual guarantees. Today there are more than 500 contracts nationwide serving facilities with rated capacities greater than 1 mgd.

The full privatization of wastewater facilities began to gain significant momentum in the early 1980s. Auburn, Ala., for example, developed a $36-million project for a private firm to design, construct, own and operate two secondary wastewater treatment plants. The city expects to save $25 million throughout the life of the 25-year contract.

CHANGES IN TRENDS

“The early privatization momentum stalled abruptly with the passage of the Tax Reform Act of 1986,” says Stanley Kramer, a partner with the finance law firm Hawkins, Delafield & Wood, New York. “The act eliminated or significantly reduced several major tax incentives for private ownership, including the 10-percent investment tax credit, rapid depreciation schedules and the availability of tax-exempt bonds to finance certain classes of privatized facilities.”

The White House’s 1992 Executive Order, however, has sparked renewed interest in the private ownership concept. Developed to establish a federal policy in favor of requests by state and local governments to sell infrastructure enterprises that have received federal grants, the order specifically included wastewater plants. By allowing municipalites to reimburse the federal government for only the “undepreciated portion” of grants financing, the order removed an important privatization impediment.

Consequently, privatizing existing public wastewater facility assets would provide several immediate benefits for local governments. “The primary motivation for selling a POTW would be to leverage all or a portion of the substantial grant equity investment,” says Sam Coxson, city manager of Franklin, Ohio. “Because it would generally not require a voter referendum or municipal bond issue, generating cash from a wastewater facility sale could represent a politically acceptable opportunity to enhance local utility service.”

By gaining access to this equity, local officials could reinvest the funds locally. Debt retirement due to the asset sale could free up municipal debt capacity for other important uses if existing debt was in the form of general obligation bonds.

But the long-term effect of these sales also must be considered. “Wastewater asset sale is still an emerging concept, and there are many questions that remain unanswered,” says Roger Feldman, a partner with McDermott, Will & Emery, a Washington law firm. “There are also certain variables, with their combined effect unique to each transaction, which should be carefully analyzed and evaluated.”

QUESTIONS TO ASK

One of the most pressing issues is construction grant repayment. A full grant repayment requirement would virtually eliminate the economic incentive for selling a wastewater asset under existing regulations. Much has changed in Washington since Bush issued his executive order. Whether the currently fiscally conservative Washington will challenge the municipal sale of substantial federal investments remains uncertain.

The majority of wastewater plants were built under federal and state programs, which typically funded 50 percent to 75 percent or more of construction costs. Most grants contained two provisions — the Office of Management and Budget’s Circular A-102 and the Common Rule — which mandate repayment if assets are sold. While the executive order would allow the reimbursement of the unde-preciated portion of federal grants, the U.S. Environmental Protection Agency (EPA) and state regulatory agencies have not issued a conclusive policy regarding grant repayment.

Another important question regarding grant repayment concerns a facility’s “useful life,” since the fulfillment of a wastewater plant’s useful life might exempt repayment. EPA regulations define useful life as 30 years to 50 years. The executive order, however, mandates the use of Internal Revenue Service (IRS) depreciation schedules, which sometimes can limit useful life to only 10 years or 15 years. Since construction grants were based on facilities’ plans developed in accordance with EPA requirements, the inconsistency may prove a thorny issue in a purely legal sense.

Because of the construction grants, most users of public wastewater services have not paid the true cost of these services. If repayment of all or a portion of the grants is required, replacing this capital with private capital at current market rates would produce a large increase in user rates.

Under current regulations, privatization could mean more stringent treatment standards applied to industrial dischargers and deny eligibility for low-cost state revolving funds (SRFs). The POTW exemption is therefore a necessary requirement of an asset sale. Private ownership may also require sludge residues to be regulated under the Resource Conservation and Recovery Act, increasing costs or limiting disposal options.

The domestic wastewater exclusion is another critical element of an asset sale. However, EPA has yet to issue a definitive policy regarding these issues or a number of other regulatory issues that need to be addressed.

Many questions remain regarding a municipality’s risk posture. While some risk can be shifted to the private enterprise, the public authority must indemnify the new owner from certain liabilities, such as those involving existing environmental conditions and the quality and quantity of wastewater influent after the sale.

USER RATES AND OPERATION CONTROL

Before a sale, local officials must examine who will bear the burden of the new private sector debt. Public wastewater asset sales should be carefully analyzed for their potential effect on user rates and other long-term financial implications.

User rates for most POTWs are based on a plant’s municipal debt service and OM&M costs. With an asset sale, however, the purchase price would involve an equity component; the capital structure would therefore include a combination of equity and debt. Thus, user rates under a privatesector financing would also include a return on the equity investment in addition to debt service payment. This capital charge would be recovered over time through user rates.

Standard debt redemption and/or defeasance costs would be incurred to retire any remaining debt on the facility. Additional costs depend upon the amount of outstanding municipal debt, the number of years remaining for redemption and other early debt retirement requirements. Arranging for such a debt retirement could also be lengthy, potentially delaying the asset sale. Such complex transactions typically require the services of financial consultants and legal experts, further adding to costs.

The private owner’s newly financed debt also is likely to be at a taxable interest rate higher than the facility’s existing tax-exempt municipal rate.

Full privatization also denotes an inherent loss of local control over the operation of the facility. Without significant contractual restrictions, operational decisions could be made at the sole discretion of the owner.

If the local government should decide it wants to regain control of the plant, it would have to purchase the facility back from the private owner. The local authority would then be paying for the facility twice, as it would have already paid for the private sector’s refinancing costs in the first sale. The repurchase price has to be addressed, and the municipality has to protect its exposure as best it can within the limits of applicable law.

ECONOMIC ANALYSIS

A financial model comparing existing municipal annual debt service to the annual capital charge to the municipality from the private sector owner will more clearly illustrate the implications of an asset sale.

The assumptions for this economic analysis are described in Table 1 (pg. 60) and were verified by the banking industry as reasonable. From the assumptions in Table 1, 32 different scenarios can be developed. For example, a set of variables could include: existing debt redemption, no grant repayment, municipality cash $5 million and purchase price equity/debt with tax-exempt debt financing.

All 32 scenarios were evaluated. The results are in Table 2 (above), which compares annual debt service pre-asset sale to the annual capital charge (akin to debt service) after asset sale. A positive percent difference indicates the asset sale is more expensive.

Twenty of the 32 scenarios result in a higher annual capital charge. Private sector OM&M savings can offset this economic disincentive and still result in overall savings; however, if OM&M savings are not sufficient to offset this differential, rate increases would result. All the economically advantageous scenarios had five years outstanding debt.

Also, it must be recognized that the interest rates for the existing annual debt service values used in this analysis (1985 and 1980 debt issues) reflect a time when tax-exempt rates were the highest in recent memory. This helped make asset sales more attractive in the scenarios shown in Table 2. In general, if the tax-exempt rate is lowered to 7.5 percent to 8 percent, most scenarios will result in higher annual capital charges. Without any consideration to OM&M savings, the sale of the asset would be an economic disadvantage if the interest rate on the existing municipal debt is 8 percent or less.

SUMMARY OF POINTS TO CONSIDER

Before a sale, municipal officials must conduct full economic analyses and thorough evaluations of other issues. For instance:

* Municipalities must make sure they are entitled to sell a useful and performing asset and, if so, what procedures should be followed. Legal impediments do exist, whereby public assets can only be sold if they are determined to be excess or non-performing assets. Also, state law may require a public sale go to the highest bidder.

* Most, if not all, purchase price financings will be project financed with a combination of debt and equity unless the private sector owner wishes to take the debt on its balance sheet. Under the existing legal framework, the debt portion will always be taxable unless 15 percent or more of the purchase price is allocated to asset improvements (replacements/upgrades/expansions) and a state volume cap allocation is obtained for taxexempt private activity bonds.

* The economic analysis indicates that if the selling municipality is looking for a substantial cash out, it will face little or no savings and even a rate increase due to the increase in the capital charge. For example, if the cash out amount were increased to $15 million, in all 32 scenarios the asset sale would be more expensive.

* The municipality must set a fair price for the plant, recognizing its perpetual and intrinsic monopolistic value; the new owner might be underpaying for such a valuable asset. If the true fair market value is sought and it results in a politically unacceptable rate increase, the municipality must decide whether to sell it for less just to achieve acceptable user charge.

* The municipality must recognize the sale of the asset does not relieve it of all risk. For example, the risk for change in law and other unforeseen events and the quantity and quality of the influent wastewater still rests with the municipality. The municipality may have to indemnify the new owner for all environmental liability prior to the sale. The risks of the private owner’s nonperformance and possible resultant breach of contract and termination needs to be carefully negotiated to ensure proper municipal protection.

* Regulatory issues still exist, the major ones being the grant repayment issue, the long-term availability of the private sector owner to receive and sustain the POTW exemption and the municipal wastewater exclusion. The latter two issues are “deal breakers,” and the underlying transaction documents would have to contain “unwind” provisions in the event negative impacts to the municipality would result from a future change in policy or law with regard to these issues.

* The transaction may fall under the jurisdiction of the state public service commission. If so, the attractiveness of the asset sale would be diminished for the private sector.

* The impact of property taxes on rates needs to be addressed. The new private owner would, unless an exemption exists, be subject to property taxes, and such taxes would be passed through to the municipality in the service charge to be paid by the users. While a benefit in that a new tax-paying entity would be realized, it is a tax burden that would be carried by the users.

* With the sale of the asset, the municipality surrenders its ability to take advantage of any federal or state funding mechanisms for future upgrades or expansions. Presently, the right to SRF financing would be lost. The only way to take advantage of such funding in the future would be for the municipality to buy back the facility.

* The time and costs necessary to implement an asset sale need to be realistically assessed. This includes the need for technical, legal and financial advisors.

* The municipality must, through the terms and conditions of the service agreement, keep or maintain some amount of control. For instance, the service agreement must be detailed enough to protect the longterm interests of the municipality with regard to future rate increases for expansion, upgrades and replacements and the rights the municipality would have in this regard.

A municipality considering a wastewater, or even drinking water, treatment facility asset sale must assess these issues and determine if the sale truly is in its best interests. Only after a careful evaluation is performed, based on specific circumstances and using all available economic data, can an intelligent decision be made.