While budget shortfalls and funding constraints have significantly increased the deferred asset maintenance for already aging water infrastructure, there is an inevitable need to seek out new sources of financing and replace shortsighted historical water policies.

In this article, we’ll look at the scope of distributed water management systems, the complexity of these projects at the local and state level, the role of muni bond financing, and how investors can seize the opportunity to contribute and invest in the revamping of the existing water infrastructure.

As communities around the United States saw the severe impacts of events like droughts in western states and the water crisis in Flint, Michigan, they became more cognizant of the reliability and safety of their own water supplies at the local and state levels. These valid concerns have galvanized water experts to propose new strategies that deviate from traditional water management systems to a more practical decentralized system.

The conventional water management system is the old way of distributing water to communities through centralized infrastructures, typically owned by the utilities. This entails moving a huge volume of water from a single source and distributing it to many customers through a linear system. When constructing this traditional infrastructure, utilities always stayed cognizant of population growth and increase in water demand.

This caused them to build larger infrastructures than necessary at the time in order to stay ahead of the demand, thus tying up a significant chunk of the financial resources. It also dramatically increased the maintenance cost for infrastructures that are not even being used to their full capacities.

Distributed water management is an innovative approach to making water infrastructure more flexible for a diverse use of equipment. The decentralized approach for production, distribution and consumption is tailored to meet local demand, with the infrastructure often distributed across several properties.

Research shows that for utilities the distributed approach to manage water demand and conserve stormwater with new techniques is far less expensive than constructing a whole new infrastructure.

Some local governments have adopted this as a tool to take strain off the centralized infrastructures. For instance, drought-resistant landscaping, stormwater basins, and point-of-use water catchment and treatment systems have helped tremendously in conjunction with centralized systems.

Drought-stricken states in the U.S. like California and Nevada have successfully employed these strategies to conserve and reuse their water supplies.

In the public finance space, water utilities are considered public entities and municipal debt has been the primary financing source. Check out the different muni bond terminologies to familiarize yourself with the muni bond market.

From a legal point of view, the public finance laws for water utilities are written for traditional infrastructure financing that includes centralized pipes, pumps, and treatment plants. It is interesting to note that several water utilities trying to employ various distributed management tools are relying solely on cash for these projects and reserving debt for traditional projects.

However, some cities have pursued different avenues, like institutional funding. Philadelphia, for example, used private equity funding to fund its “Clean Water” initiative. Because there are not enough distributed management or “green” projects, the market for institutional funding is currently pretty illiquid.

So the question arises: How can public finance laws be interpreted when it comes to funding distributed water infrastructure projects with municipal debt?

Since distributed infrastructure encompasses and extends into private properties (i.e. business and parking lots), it creates a legal dilemma for utilities when issuing any tax-exempt debt. Public funds or issuance of debt is meant to be used for public benefit, and its use for private properties is a gray area. This will require states to amend their constitutional clauses to permit financing for distributed infrastructure.

Also, in order for these bonds to maintain their federal tax-exempt status, the utility must maintain control and take care of the asset being financed.

However, some states have led the way with the issuance of green munis to highlight their efforts of reducing water usage and conserving stormwater. The Southern Nevada Water Authority of Las Vegas has taken proactive steps toward water conservation by planning to convert turf to drought-resistant landscaping using over $30 million of bond proceeds. You can check out the 5178406B5 and 517840Q80 CUSIPs to learn more about these bonds. Also, be sure to check out the muni bond trades for water-, sewage- and power-based projects from California and Nevada.

California, a state severely impacted by droughts in recent years, is another leader relying on green munis for modern water infrastructure projects. For instance, Los Angeles and San Francisco have employed LID (Low-Impact Development) strategies under which they put emphasis on stormwater management through small-scale drainage features that capture urban runoffs to replenish local water sources and promote water reuse.

Speaking of green investing, you can see for yourself the rationale behind the issuance of green bonds. Explore our Market Activity section to see muni bond trades, including those meant for water-based projects.

As U.S. cities start using muni financing for their green projects – for example, New York City’s toilet buybacks and Seattle’s distributed infrastructure – state and local governments will need to consider state-level law amendments to combat the strain on traditional water infrastructures.

As mentioned above, local entities that have used green muni bonds for their distributed infrastructure efforts and overcome the legal barriers have emerged as leaders for other entities to follow.

As governments are starting to recognize the urgent need to adopt these measures, public finance laws will be reshaped to allow the use of muni bond funding. Until then, entities will have to constrain themselves and their work within the legal parameters (like New York and Seattle) to fund their green endeavors.

Also, public-private partnerships and the increasing volume of green transactions will make the green muni markets more liquid and provide easy access to funding.

Although local utilities have explored various funding sources, like private equity financing or strict cash financing, they aren’t a substantial enough solution to combat the problem.

First, this is a brand-new space for private funding sources, which has historically been funded by municipal debt, so there aren’t enough utilities seeking this form of funding. Provided the laws are made favorable, muni bonds (i.e. enterprise revenue) can be the main solution because of adequate liquidity for such bonds. The sheer volume of debt transactions and municipalities seeking funding on a daily basis makes these markets very accessible.

In addition, if there is a municipality that has risen out of their financial trouble, due to low credibility, it will have a very hard time raising capital outside of municipal debt markets.

A major dilemma that most utilities have to overcome is maintaining the tax-exempt status for distributed infrastructure muni bonds. For this, the utilities need to pass either the “private business use” test or the “private payment” test.

In the first case, utilities have to make sure that less than 10% of the cost of improvements financed by a bond issue are used in a private business. In the second case, the benefited private business must not be responsible for more than 10% of the water revenue payment.

One of these two constraints must be met for utilities to issue tax-exempt municipal debt.

Cities like New York, Seattle and LA have already been successful in working around these regulations to issue municipal debt for their green infrastructure efforts. So there are reasons to believe that, given the acute and essential nature of the water infrastructure management in the U.S., other states are likely to follow suit in one way or the other.

Across the U.S., as utilities become more committed to their green efforts of conserving water, reusing stormwater and reducing wastewater, the markets will become more liquid for the new wave of enterprise revenue bonds.

States that have struggled with the effects of climate change will be the ones for investors to keep an eye on since they will be taking the lead on distributed infrastructure efforts in the nation.

Check out our Muni Bond Investing Strategies section to stay up to date.