Wednesday, November 20, 2013

Financing a Sustainable Water Plan for Texas


In a series of three guest blogs over the next several days, Sharlene Leurig, Water Program Director for CERES, examines the details of Proposition 6, the water project financing measure approved by Texas voters on November 5th.  Proposition 6 amends the Texas constitution to appropriate $2 billion from the state’s Rainy Day Fund to seed a new water infrastructure loan fund directed to water supply projects included in the State Water Plan. 

 Sharlene’s three posts examine how this new fund will work (in concert with House Bill 4, passed in the recent session of the Texas legislature) and what it could achieve—or fail to achieve—in terms of Texas’ water security.  Today’s post focuses on the mechanics of the fund and what choices the Texas Water Development Board (TWDB) is likely to face in ensuring that the $ 2 billion appropriation is used for maximum public benefit.  The second post looks at how administration of the fund will be affected by the new project prioritization process authorized by House Bill 4, the companion legislation passed earlier this year.  The third post explores whether and how the fund can be used to support water conservation projects. 

 Installment 1: Proposition 6 and the Mechanics of

Funding State Water Plan Projects

This post examines how the new infrastructure loan fund will operate and the choices that will need to be made to ensure that the funds are allocated for maximum public benefit.  It explores the tensions between using the new fund for “state participation” in longer-term, big-ticket projects, such as reservoirs and pipelines, versus distributing funds more widely to smaller, near-term projects across the state.  (Note: the following discussion draws on an excellent analysis of the mechanics of Prop 6 and differences with existing financing mechanisms by the Energy Center at the University of Texas School of Law.)

The 2012 State Water Plan estimates that the cumulative capital cost of all recommended water management strategies through 2060 would be $53.1 billion, only $26 billion of which the Regional Planning Groups reported could be financed through local capacity.  As part of the 2012 Plan, TWDB recommended that the Legislature “develop a long-term, affordable, and sustainable method to provide financing assistance for the implementation of the state water plan.”

 This recommendation was taken up by the Legislature in the 2013 session in three pieces of legislation: House Bill 4, House Bill 1025 and Senate Joint Resolution 1. Collectively, these bills:  restructured the Texas Water Development Board (see TCPS’s post on the restructuring here), established the State Water Implementation Fund for Texas (SWIFT); and sent voters a ballot proposition to approve the transfer of $2 billion from the Economic Stabilization Fund (“Rainy Day Fund”) to SWIFT. With Proposition 6 approval, the $2 billion will be permanently transferred from the State Treasury to a trust held by the state on behalf of the Texas Water Development Board, to be used exclusively for the financing of recommended water management strategies in the State Water Plan.

TWDB is the state’s water infrastructure financing agency, providing $14.3 billion in loans for water and wastewater infrastructure across the state over the last 56 years. TWDB makes use of its superior credit rating and low borrowing costs to raise money through bond sales. It then lends that money to local sponsors of water projects at a lower interest rate than what would be available to the local if it sold its own bonds in the open market. For very small systems, the subsidized lending made available by the TWDB is especially critical as they have fewer options for borrowing money.   

 Despite this substantial amount of financing activity at the state level, Texas water infrastructure needs have been growing, while TWDB’s lending capacity has been limited by Article III, § 49 of the state Constitution, which generally prohibits the state from issuing debt without voter-approved expansion of constitutional authority.

 In 2011, Texas voters approved a constitutional amendment granting TWDB authority to issue up to $6 billion worth of debt for the Texas Water Development Fund II.  One of the issues in the Prop 6 election was the difference between the new Prop 6 funding and the previously authorized $6 billion.  The answer generally comes down to the state’s constitutional debt limit.

 While bonds sold under this new authority were considered “self-sustaining” they are counted against the debt limit of the state—which prohibits new bond issuances when the percentage of debt service payable by general revenue in any fiscal year exceeds 5% of the average unrestricted general revenue for the past three years. This can theoretically limit the ability of the TWDB to issue future bonds.  So while the TWDB technically could have $6 billion of active market debt, it is constrained in its own debt issuance by the larger set of debt obligations undertaken by other Texas agencies and by the state’s constitutional debt limit. 

 Thus, H.B. 4 and Prop 6 seek to create a self-sustaining funding mechanism for water supply projects that can grow beyond the initial $2 billion allocation without bumping up against the state’s debt limit. That is, the $2 billion can be used to fund much more than $2 billion in capital costs, but the total amount of financing will depend on how the funds are used.

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Table 1 provides a definition of some terms that are key to understanding the specifics of the new financing mechanisms.

 
Table 1. Glossary of Key Terms (adapted from Investopedia)

 

Term
Brief definition
Revolving Loan Fund
A fund that is structured so that repayments can be used to make more loans. As borrowers repay their loans, this money is made available to new applicants. A fund has fully revolved when all of the original principal lent has been repaid
Bond
A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bond buyers are repaid both principal and interest
General Obligation Bond
A municipal bond backed by the credit and "taxing power" of the issuing jurisdiction rather than the revenue from a given project. Also called a “GO” bond. Most bonds issued by the Texas Water Development Board have been GO bonds.
Revenue Bond
A municipal bond supported by the revenue from a specific project, such as a wastewater treatment plant or reservoir. Revenue bonds are municipal bonds that finance income-producing projects and are secured by a specified revenue source. Most locally-financed water infrastructure in the United States is financed by revenue bonds repaid by payments from water or wastewater system customers.
Credit Enhancement
A method whereby a borrower attempts to improve its debt or credit worthiness. Through credit enhancement, bond buyers are provided with reassurance that the borrower will honor the obligation. Credit enhancement can take many different forms, including additional collateral, insurance, or a third party guarantee to pay a defined amount of principal and interest. Credit enhancement reduces credit/default risk of a debt, thereby increasing the overall credit rating and lowering interest rates for the borrower.
Deferred principal/interest loans
Loans can be structured using terms that allow the borrower to defer payments for a specified period of time. Lending terms can defer principal payments, interest payments or both. For example, a loan with a 10-year deferred principal period would mean that for the first decade, the borrower would pay only interest on the amount borrowed, and not begin paying down the principle until after the 10-yr period.
 
Leverage
Leverage is a technique for multiplying limited funding by using those funds as collateral for debt issued. For many years, the Texas Water Development Board has used leverage to amplify the amount of funding it receives from the Environmental Protection Agency under the EPA’s State Revolving Funds for water and wastewater projects. TWDB issues bonds secured by its State Revolving Fund allocation. The proceeds of those bonds are then used to lend money to local water project sponsors to comply with drinking water and surface water standards. The money received from the EPA is invested by the TWDB in low-risk securities, like Treasury bonds. That investment is pledged as collateral to bond buyers, thereby securing a strong credit rating and low borrowing cost for TWDB. In addition, the interest gained by its investments is used to subsidize the interest rate for TWDB’s borrowers. Through leverage, TWDB is able to make more money available to its borrowers

 
SWIFT AND SWIRFT

Prop 6 enables the TWDB to expand the amount of loans available to local sponsors applying for financial support for water supply projects, by creating two separate but related funds: 1) the State Implementation Fund for Texas (SWIFT) and 2) the State Water Implementation Revenue Fund for Texas (SWIRFT). Though the latter has received less media attention, it is actually the more important of the two when it comes to the matter of growing the $2 billion seed fund.


SWIFT exists to subsidize loans made by the TWDB to local sponsors of water supply projects—it is simply a dedicated pool of money to allow TWDB to lower the effective interest rates paid by its borrowers. SWIFT can only be used to subsidize lending through five of TWDB’s funding programs.  Four of these programs are briefly described in the table below; the fifth, SWIRFT, is described in Table 2.

 
Table 2.  TWDB Water Financing Programs

Eligible
TWDB Program
 Purpose of Program
Water Infrastructure Fund
Subsidized and deferred loans for state political subdivisions and water supply corporations, for projects in SWP or approved regional water plans
Rural Water Assistance Fund
Loans for political subdivisions and nonprofit water supply corporations, for infrastructure or for consolidation or regionalization
Agricultural Water Conservation Fund
Loans for political subdivisions, colleges, interstate compact commissions and nonprofit water supply corporations, for conservation projects
State Participation Program accounts in Texas Water Development Fund II
Deferred interest obligations to repurchase TWDB’s temporary ownership interest in facilities, for political subdivisions and water supply corporations

 
These four programs are funded by the TWDB through the sale of general obligation bonds, which are then used to create revolving loan funds (meaning that as borrowers repay their debts to the board, the fund is replenished to be made available to other beneficiaries).  

At its heart, SWIFT is a means of subsidizing these revolving loan funds. There are four types of subsidy SWIFT can provide: 1) low-interest loans (TWDB may lend at as little as 50% the rate of interest at which it borrows); 2) longer repayment terms for loans; 3) incremental repurchase terms for projects in which the state owns a share; and 4) deferral of loan payments. For example, under Option 1, if TWDB can borrow money at 3%, SWIFT funds could be used to lower the interest rates of the TWDB’s own lending programs to as little as 1.5%. An example of Option 4 would be TWDB purchasing up to 80% of a water supply facility, with no principal repayment due from the borrower for as long as 20 years.

Because SWIFT subsidizes revolving funds (repayments from existing borrowers are used to make new loans), SWIFT could enable more than $2 billion worth of projects over time as loans are repaid with interest.  Combined with SWIRFT, however, SWIFT can, in theory, be leveraged to provide substantially greater amounts of financing.

SWIRFT is one of the funds that may receive disbursements from SWIFT.  Like SWIFT, SWIRFT can only be used to finance water projects in the State Water Plan, through same set of existing TWDB loan programs to which SWIFT is targeted (those in the table above). Unlike the other funds eligible for SWIFT subsidies, SWIRFT is capitalized through new revenue bonding authority granted under H.B. 4, meaning it is totally free of any constraints related to the state debt limit.  Also, unlike the other four programs eligible for SWIFT subsidies, SWIRFT revenue bonds can be used for an expanded set of financial assistance tools, including direct loans to local water project sponsors, purchasing of debt obligations from these local sponsors, or credit enhancement for TWDB’s own funding programs.

SWIRFT thereby opens a new chapter in the board’s financing programs. The credit enhancement component of SWIRFT is especially important to understand because of its potential for amplifying TWDB’s lending capacity. Under H.B. 4, TWDB may pledge SWIRFT as collateral for the debts it incurs through the funding programs eligible for SWIFT support. In this way, SWIRFT could increase substantially the amount of debt TWDB could sell, as bond buyers would be promised revenues from borrower repayments and have as added security access to SWIRFT funds in the event that borrower repayments fell short of TWDB’s own obligations.

This credit enhancement authority under SWIRFT, combined with its revenue-backed bond authorization collectively create the potential for TWDB to multiply the $2 billion authorized by voters to provide up to $26 billion in total financial support.  That is an important figure only in as much as it is the full amount of state financial support requested by Regional Planning Groups in the 2012 State Water Plan. (Whether the political subdivisions and water authorities who participate in the Regional Planning Groups will ever ask the Board to make the full $26 billion available to them is another matter entirely, and will be discussed more fully in the second blog in this series.)

 However, there are a number of factors that will determine how much the $2 billion appropriation to TWDB will actually grow over time.  That will in turn determine how well the new funds can be used to support the wide range of needs in the State Water Plan, from conservation and reuse, to smaller scale projects in rural areas, to larger, longer-term projects proposed for growing urban areas.

 As one option, TWDB could simply move the $2 billion through SWIFT, bypassing SWIRFT, and directly support its existing funding programs. While the money would be repaid to SWIFT over time, it would not necessarily take advantage of leverage to grow the $2 billion.  It would then be simply be a $2 billion revolving loan fund, recapitalized as borrowers repaid their debts to the board, with (subsidized) interest. In addition, if SWIFT is managed to provide financing subsidies (cash outflows) that outpace the value gained in the fund through market investments (cash inflows), the $2 billion could be substantially drained.

Another option would be for TWDB to put the lion’s share of the $2 billion into the State Participation Program fund.  This fund is generally used for longer-term, big-ticket projects, such as reservoirs and pipelines, a number of which are proposed in the 2012 State Water Plan.  The State Participation Program allows TWDB to purchase a temporary ownership stake in a water project, with the idea that the loan would be paid back after the project was built and operating near capacity.  Nearly 30% of funds the state has already made available to projects in the State Water Plan have been through programs with deferred repayment, including some $93 million through the State Participation Program in which repayment of the principal typically is deferred for 20 years, and $189 million through the Water Infrastructure Fund Deferred program, which defers principal and interest for up to 10 years.

This approach, however, would tie up most of the money in deferred loans, as illustrated by a January 10, 2013 memo to the Members of the State House of Representatives from H.B. 4’s sponsor, House Natural Resources Chairman Allan Ritter:   loans with 20-year deferred repayment periods would prevent SWIFT from fully revolving for more than 30 years.  

If most of the SWIFT seed funds were sent directly to the state participation programs with deferred payments, then these few borrowers would receive the greatest benefit, and the opportunity to use the Prop 6 funds to shore up water security throughout the state could be compromised.  In essence, a “big dog eats first” approach to using the new funds would mean that smaller projects for meeting real short-term water needs in smaller communities, including throughout rural Texas, could be undermined.  On the other hand, a more balanced approach, more equitably distributed among different financing options, would allow greater leverage for the $ 2 billion and cover more water needs throughout the state. 
 
The TWDB now has the task of balancing these competing interests, all of which will take place in the context of the project prioritization process set up by HB 4.  We’ll look at that topic in our next blog.

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