Fundamentals of Project Financing

by: Russ McIntosh


This article was published by Pennsylvania Municipal Authorities Association in the April 1997 issue of their magazine, The Authority.

Borrowing money is easy; paying it back is the hard part.

Quality Service
While money for water and sewer projects is generally available, many factors must be taken into consideration when evaluating project affordability: interest rates, repayment terms, loan conditions, and program flexibility. This is especially true if funding from a number of sources is to be combined to fund a single project.

Too often, a financial strategy is adopted because “that is how a neighboring system was financed” or because a particular program or method enjoys popularity at the moment. Although your professional advisors will research various programs, their efforts will be guided by the direction you, as the authority board, have given.

It is important that each board member keep an open mind and be aware that each financial package will contain both positive and negative elements. There is no single “best way” to finance a project, so each financing package should be compared to the project goals established by the authority. Yes, it is entirely possible that, under certain conditions, a public bond issue is more cost-effective than a public agency’s subsidized interest rate loan. It is also possible that grants may not always lower project costs or result in lower annual user fees. This may seem like heresy, but it is true for many reasons: changes in federal and state programs, the keen competition for limited funds, and administrative requirements that always accompany funding from governmental agencies. For this reason, we must all take a fresh look at how major capital projects are financed.

This isn’t Kansas anymore, Dorothy.

Choosing the most appropriate timing for your project
One of the most critical yet often overlooked elements in project financing is time. It can be both a friend and an enemy, depending upon the circumstances. It is a friend to communities when it allows them to adjust to the concept of the project, but it also an enemy if too much time elapses and the community begins to believe the project will never happen. It is a friend when it’s used to accumulate surplus revenues that can be used to reduce project costs, but it is also an enemy when construction costs are escalating on a month-by-month basis. If funding from a particular source is not available for years, the benefits of the lower interest rate or grant must be weighed against the increased cost of waiting. This is especially true if the amount of financial assistance is not likely to be increased in response to the higher cost. To determine the best timing for your project, ask yourself these questions:

(1) Without regard to financing considerations, when is the best time to undertake this project?

There is a strong incentive to undertake projects as quickly as possible and complete them as soon as possible. The authority is likely incurring an interest cost on funds advanced for the project, and this cost increases day by day until the project is completed and the authority begins collecting increased customer revenues. Also, most engineering design work is time-sensitive. Conditions change daily: New homes are constructed, property ownership changes, and other utilities may be constructed or relocated. If too much time has elapsed, additional engineering cost to update design drawings before a project can be bid is likely.

(2) Can the project be economically segmented?

Sometimes different funding sources are available for particular areas within the same township, borough, or city. We recently completed a project with a total project cost of $6.5 million that was funded through five separate programs from four state agencies. The financing we received totaled nearly $1 million. Taken as a whole, the project area would have qualified for only about a fourth of that funding. However, by carefully looking at each sub-area within the project and establishing it as its own mini-project, additional funding was obtained. Each of the project segments was bid simultaneously and even within the same bid documents, so that any additional cost would be minimal.

Project scope and timing are each very useful tools that will help make projects affordable. They rely principally on saving money, and a dollar saved is worth two dollars of debt service—even at subsidized rates. They are relatively easy to use and have an added advantage in that they provide an opportunity for each board member to become involved with the specifics of the project. Why something is being done in a certain way or why a particular strategy was adopted should no longer be a mystery to anyone. Familiarity with these details allow you to pass what I term the “supermarket” test, which is just another way of describing the many questions that you are likely to receive from members of the community. As a former authority board member myself, I can recall being stopped in my local supermarket and asked about the details of the project we were undertaking. It is truly embarrassing not to have the answers.

Deciding on the type and amount of capital charges to impose
Another area that is entirely within the discretion of the authority is the type and amount of capital charges you plan to impose on new connections to your system. While the power to impose such fees was already established in the Municipal Authorities Act, descriptions and definitions of the charges an authority could make were provided later in Pennsylvania Act 203 of 1990.

The ability to impose these charges provides a formidable means of distributing costs evenly among all those who benefit from the project. Each of the charges is designed to recover specific types of costs incurred by the authority when constructing the system. Often the design of these systems must take into consideration the individual needs of those who will be using the system. Consequently, each of the permitted charges place a different burden on different types of users.

The following is a summary of these charges along with the basis of the charge, some calculation considerations, and an explanation of how they may affect different classes of users.

1. Connection Fees:
The connection fee is designed to recover the costs of the facilities between the mains in the street and the property line. This appears pretty straight forward; however, some caution is advised. The Act permits a recovery of the actual costs incurred or the average actual costs for similar installations. This, of course, presumes that a record keeping system exists to document these costs. Such records are particularly important to authorities when these facilities are installed by authority personnel. It is even more important when a portion of the authority’s normal overheads are to be billed as part of this charge. The bookkeeping system should be reviewed to ensure that the billed charges can be substantiated.

2. Customer Facilities Charges
The customer facilities fee recovers the cost to install facilities between the structure’s plumbing and the authority’s lateral or curb stop. For the most part, it should not create any special problems since most authorities require the property owner to provide these facilities.

3. Tapping Fees
The tapping fee is comprised of a series of component parts: the capacity part, the distribution/collection part, the special purpose part, and the reimbursement part. The first two parts (capacity and distribution/collection) relate to the authority’s overall system, while the second two parts (special purpose and reimbursement) will generally relate only to specific facilities or particular areas.

The capacity part recovers the cost of capacity facilities, water and wastewater treatment plants, pumping and lift stations, major transmission mains and interceptors, and other similar facilities. The distribution/collection part recovers the cost of collection mains and related facilities, but care should be taken not to include the cost of water service lines or sewer laterals in this fee since these costs are to be collected as a connection fee. Also, if property owners were assessed a portion of the cost of these mains when they were constructed, the amount of those assessments must be subtracted from the cost of the facilities before calculating this part of the tapping fee. The value of facilities constructed by developers and dedicated to the authority may not be included when computing the fee, and some or all of the tapping fee must be waived if the authority requires a developer to construct and dedicate the necessary service facilities.

4. Other Charges
It should be noted that the Act only allows for the imposition of charges enumerated by the act. This is important because authorities commonly bill other charges when an application for service is received. For example, an administrative processing fee, inspection fee or other similar charges are each established to reimburse the authority for certain costs that it will incur. It may be necessary to include the cost of these services into one of the enumerated charges in order to conform with the act and guarantee that the costs supporting the fees are properly documented.

Front Foot/Benefit Assessments
Authorities may also finance the cost of water and sewer mains by assessing a portion of their cost against the owners of the property that abuts them or benefits from their construction. Most assessments are computed using the front foot rule; which calculates a cost per front foot and requires property owners to pay an assessment based upon the number of front feet of main abutting their property. When this method does not produce a fair and equitable assessment, benefit assessments are used instead. These assessments are established either by agreement with the property owner or by a board of view appointed by the court.

Only specific costs relating to the water and sewer mains can be included in the assessment, and a number of calculations need to be performed for the final report, which is generally completed by the authority’s engineer. The governing body of the municipality in which the property to be assessed is located must approve the authority’s plan of assessment. However, because of its complexity and the unpopularity of assessments in general, this method of financing has become less and less popular. It is, however, being used as a means to lower quarterly utility rates over the long term or to equalize per-customer investment between new and existing users. Many authorities are imposing assessments and allowing property owners five or even ten years to pay them off, generally charging a low rate of interest.

Each of the above charges will have a different effect on different users or beneficiaries of the system. For example, the connection fee can only recover the cost of the lateral or water service line. Obviously, for a single family household, this may be a smaller amount than the cost to install similar facilities to accommodate a multi-family apartment building, a large commercial structure, or an industrial facility. However, the charge cannot exceed the cost of providing those facilities. Therefore, a charge for a 10-unit apartment building is not likely to be 10 times as great as the cost for a single family home; indeed, it may be the same.

Tapping fees, on the other hand, do reflect the new connection’s capacity requirements and impact on the system. It is reasonable to expect a 10-unit apartment building, for example, to pay 10 times the tapping fee as the single family home because 10 families will be placing approximately 10 times the burden on the system as a single family. There are some who argue that this is not the case since multi-family residential units use less water than single family homes. But then, not all single family homes use the exact same amount of water. These are individual fairness items that each authority must decide.

It is likely that the authority will not impose the maximum fees allowed under the law. When there is discretion as to how much of a particular fee should actually be adopted, the authority may wish to consider how this impacts different types of customers. For example, if it is determined that a $1,000 tapping fee per EDU (equivalent dwelling unit) is to be collected, then each home, each apartment, and each EDU would be billed $1,000 and the 10-unit apartment building would pay $10,000. If the charge was divided between a $500 connection fee and a $500 tapping fee, the single family home would still pay a total of $1,000. But, a 10-unit apartment would pay a total of only $5,500 ($500 x 10 units = $5,000 + $500 connection fee = $5,500).

Assessments, too, help to distribute the burden of the system cost differently than either connection or tapping fees. Assessments affect the owners of property whether its improved or unimproved, while connection and tapping fees are collected from only those who are actually connecting to the system. In order to reduce the cost to users for systems that accommodate a substantial number of vacant lots, assessments can be very useful since they will provide funds from property owners who would otherwise not make any payments until they develop their property and begin using the system. During this interval, the users of the system would be paying quarterly charges that include debt service on unused capacity. These are always difficult decisions, and the unpopularity of assessments must be weighed against the promised benefit of reduced user fees. But, like any other financing alternative, they need to be carefully evaluated.

Developer Contributions
Developer contributions are another avenue for authorities to explore to reduce project costs. Often, owners of large tracts of land are interested in selling the land for development purposes. Because the availability of municipal water and sewer service on that land enhances its value and makes it more attractive to a buyer, property owners may be willing to provide a significant contribution to the project. They may also be willing to provide a long-term, low-interest (or even no-interest) rate loan to help advance a project that would benefit their property. This method of financing has been used successfully on several occasions involving relatively small contributions to hundreds of thousands of dollars.

For more information on the financial decisions that face municipal authorities, contact Russ McIntosh For information on water/wastewater treatment engineering, contact Ed Ellinger