"Sustaining America's Water Infrastructure"

Address to the 15th Annual Federal Policy Conference
sponsored by the Council of Infrastructure Financing Authorities

Washington, DC - May 9, 2003

Delivered by G. Tracy Mehan, III
Assistant Administrator for Water, United States Environmental Protection Agency

Introduction

Thank you for this opportunity to address CIFA's 15th Annual Federal Policy Conference. It is indeed a pleasure to be here. The Office of Water has had a long and productive working relationship with CIFA. Yours is a unique national organization representing state co-regulators, local authorities and private partners who provide environmental infrastructure financing. As such, you have worked alongside EPA to maximize the financial and environmental performance of State Revolving Fund ( SRF ) monies. We are pleased to support your annual SRF training workshops – all of which have been a success for the past 12 years. With your private sector membership of financial advisors, underwriters and bond counsels, you bring a wealth of experience and expertise from the public finance community to the cause of environmental infrastructure and public health protection. So it is with you that we share the credit for the success of two SRF programs, for the $38 billion in cumulative assistance provided thus far by the Clean Water State Revolving Fund (CWSRF) program and for the $5 billion in cumulative assistance provided thus far by the Drinking Water State Revolving Fund (DWSRF) program.

President Bush's FY 2004 Budget Proposal reaffirms the federal government's commitment to the Clean Water SRF with an additional appropriation of $850 million a year during 2004 - 2011. In so doing, the President is lengthening the federal commitment to the SRF program so that the Clean Water SRF can provide average annual assistance of $2.8 billion per year, a 40% increase. For the CWSRF, this proposal extends the funding well beyond the previous commitment, which would have ended in FY 2005. In total, the Bush Administration is proposing to invest $4.4 billion above what would have been invested in the CWSRF from FY 2004 to 2011 based on previous commitments.

The President's FY 2004 Budget also extends the federal commitment to the Drinking Water SRF with annual grants of $850 million for FY 2004 to FY 2018. This brings the revolving level of the Drinking Water SRF to $1.2 billion per year, a 140% increase. Clearly, the federal government is doing its fair share to meet long-term infrastructure needs.

Environmental Finance — SRF's role

Both the Clean Water Act and the Safe Drinking Water Act set very high standards that demand a large expenditure of resources. On the clean water side, three years ago we released a study that looked at the progress we have made with our investments in municipal wastewater treatment¹. This report looks at water quality changes before and after the Clean Water Act (CWA) was passed. We found that the number of people served by Publicly-Owned Treatment Works ( POTWs ) with secondary or greater levels of wastewater treatment almost doubled from 85.9 million in 1968 to 164.8 million in 1996. At the same time, POTW effluent discharged to the nation's waterways decreased by about 45% (as measured by one measure of biological oxygen demand)². We found significant improvements in worst-case summer dissolved oxygen conditions in two-thirds of the hydrologic units studied³.

On the drinking water side, we did a similar assessment of progress under the Safe Drinking Water Act⁴. Using our Safe Drinking Water Information System (SDWIS), we can report that the percent of the population being served by community water systems with no violations of health-based standards has gone from 79% in 1993 to 94% in 2002. Given the increases in urban development, population and the numbers of contaminants regulated, this is an amazing accomplishment.

The Big Picture: How We Value Water

To maintain and build on these gains, we need to look at the big picture as well as specific issues in the water sector. For the big picture, I go back a couple of centuries to Adam Smith, the 18th c. philosopher generally credited with laying the foundation of modern economics. Smith described the paradox of diamonds and water and asked: how could it be that water, so essential to life, is so cheap, while diamonds, used only for adornment, are very costly? While Smith used the paradox to explain the basic concepts of supply and demand and to show that prices reflect relative scarcity, today the paradox provides a troubling description of the role of water in our economy. With our enormous population and economic growth, our fresh water supplies are stretched more than ever. Meanwhile, Americans spend more than ever on discretionary items. Instead of diamonds, I'll compare our water and wastewater bills to what we're paying for soft drinks. American households spend an average of $707 per year on soft drinks (carbonated) and other (non-carbonated) refreshment beverages⁵ compared to an average of $474 per year per household on water and wastewater charges. Clearly, our prices and expenditures hardly reflect the true value of water. As we spend more on non-essentials (like soft drinks) and less on essentials (like water), the paradox of diamonds and water weighs heavily on us all.

Properly valuing our water resources strikes me as a threshold issue, one that defines how we deal with water issues. Let's look at the issues in the water sector and some ways in which we can bring our prices and expenditures a little closer to the true value of water.

Rising Costs for Water Infrastructure

Our pipes and plants are aging; maintenance is too often deferred; and, as a result, we can expect sharply rising future costs for repair and replacement of water infrastructure. In most cities and towns, the pipes used to distribute clean water and collect wastewater have passed their life expectancy. In fact, based on the dates when most of our water pipes were laid, we can expect a large wave of financial obligation to replace these pipes in the coming decades. Dubbed the "Nessie Curve" by the Australians, it is named after the Loch Ness Monster because so much of this financial obligation (like our pipes) lies beneath the surface.

Last September, EPA issued a report that talked about "a gap between projected clean water and drinking water investment needs over the twenty-year period from 2000 - 2019 and current levels of spending."⁷ We pointed out if investment in water and wastewater systems remains flat and does not increase, we expect a "gap" to occur. Under the flat investment or "no revenue growth" scenario, we estimated a clean water capital payment gap of $122 billion (the mid-range estimate) over the 20 year time period. Our mid-range estimate for the drinking water capital payment gap is $102 billion for the "no revenue growth" scenario.

We acknowledge tremendous uncertainty associated with the analysis. In fact, we put out the report more to encourage a policy discussion of the challenges confronting the nation's clean water and drinking water systems. Our "revenue growth scenario" is dramatically different. If, instead of flat investment, revenue and spending grow at 3%/year over and above inflation, our mid-range estimate for the clean water capital shortfall drops to $21 billion and to $45 billion for drinking water capital.

Obviously assumptions are very important – but so are choices. Where we fall between these two scenarios depends on us.

Addressing Future Challenges: Four Ways

Today's challenges demand a multi-faceted approach to managing and sustaining our infrastructure assets. Not only are we going to have to manage better in both the public and private sector, we're going to have to use less water, or at least use it more efficiently, and pay more of the full costs of infrastructure.
I'd like to offer up four directions water utilities may wish to pursue in order to deal with the challenges of increased demands and future costs:

1. Better Management
2. Efficiency
3. Full Cost Pricing
4. Watershed Approach.

Better Management

In the Office of Water, we've been looking at the potential for asset management techniques to reduce a utility's long-term costs and improve performance. This is a structured management approach that is based on information about the condition of a system's assets. Knowing the condition of your assets and linking that information to inventory, service levels, useful life, and repair costs will provide the information needed to make optimal management decisions – including decisions about funding future renewal and replacement.

Recently, the Orange County Sanitation District approved an investment of $22-38 million, over a six year period, to implement its Asset Management Plan, as part of a $2 billion investment strategy over the next twenty years. This front-end investment in manpower, planning and assistance, information systems, software, training and other process changes will yield a 20 year return on investment in the range of 9:1 to 16:1. This translates into a reduction of $150 million in their capital improvements program and a total life cycle cost savings of at least $200 million. ⁸

This 10% savings from just one utility, admittedly a very large one, is equivalent to the current full amount of the federal contribution to California's Clean Water State Revolving Fund (SRF) over two years!

Environmental management systems (EMS) are another important tool to help utilities manage better and reduce costs. The EMS approach involves a comprehensive assessment of an organization's impact on the environment followed by specific targets and objectives and continual checking to make sure the desired results are achieved. EMS and asset management can complement each other and give utilities a powerful way to continually manage for better results and greater efficiency.

Back in 1998, the National Association of Water Companies issued a report that compared the water industry to the electric and natural gas utilities⁹. One overwhelming observation from that study still stands out. The water sector is far more fragmented than the electric and natural gas utilities. There are some 54,000 community drinking water systems versus 3200 electric and 2700 gas utilities. EPA has found that, oftentimes, there are cost savings that can be achieved by small systems through consolidating ownership or management with other small systems. Although consolidation is not always a viable option, by combining resources, systems can achieve a more sustainable level of technical, financial and managerial capacity.

For instance, the system serving the city of Panora, Iowa consistently violated the public health standards for nitrate in drinking water. Rather than incur the cost of installing treatment, the city decided to purchase raw water of a higher quality from a neighboring system. In addition, the city pursued a partnership agreement with another neighboring system to assist with operating and monitoring its water treatment plant. This agreement enabled the city to take advantage of the other system's technical expertise and reduced the need for on-site operators.

Public-private partnerships and private companies have helped a number of communities provide both water and wastewater treatment at reduced cost. Whether providing basic water or wastewater treatment supplies (e.g., chemicals), maintaining a portion of the collection or treatment system under a contract, or providing contract operation and maintenance for all of a municipality's facilities, the private sector can serve an important role in the effort to maintain water quality across the country. Over the past decade, we've seen an increased interest in using the private sector to meet water and wastewater funding needs. EPA recognizes the efficiency advantages that can accompany privatization or public-private partnerships. Nevertheless, our overriding interest is in fostering management excellence in water systems – whether government-owned or investor-owned.

Efficiency

In addition to managing better, we're going to have to learn to use water more efficiently.
With 8% of the world's fresh water, the United States is relatively blessed; yet even our eastern states are beginning to suffer water quantity problems; and on both coasts, we're reaching the end of the era in which we could always expand water supply. At the very least, the marginal cost curve for expanding our water supply is very steep indeed.

Demand side management is needed to complement our supply side approach. During the next 100 years, we're going to have to become experts on the demand side of the equation: conservation, recycling, reuse and improved water-use efficiency. If we can reuse our treated wastewater for beneficial purposes such as irrigation, manufacturing or groundwater recharge, the environmental and economic benefits are manifold. If we can bring metering to those communities that still lack the means to measure their consumption, then we've provided a basis for price incentives to begin to work. For example, Westfield, Massachusetts went from no meters to a fully metered system. The installation of meters enabled the city to set a metered water rate that allowed for complete cost recovery of its existing and projected expenses. Also the city found that it could abandon plans to develop a new surface water source, as its customers began to conserve water. Imagine the water savings if cities the size of Chicago and Sacramento fully metered their systems.

Metering and reuse aren't the only ways to save water. Other options include: plumbing retrofits, leak detection and repair, irrigation improvements, water-saving appliances, landscaping measures and public education. Using these measures, a number of American cities have reduced their water use by as much as 20% and still haven't exhausted all their conservation options. Many of these cities are featured in our publication, Cases in Water Conservation¹⁰.

EPA has a number of resources available to assist water efficiency efforts. We published the Water Conservation Plan Guidelines in 1998 for public water systems and we sponsor a voluntary partnership program for businesses and institutions called WAVE (Water Alliances for Voluntary Efficiency). On our website¹¹ you can also find a number of other publications and links to WaterWiser, the water conservation clearinghouse that we started in conjunction with the American Water Works Association.¹²

Full Cost Pricing

The most obvious way to address the discrepancy between the value of water and its price is through the price mechanism. At a minimum, we're going to have to pay more of the actual costs of maintaining our water systems over time. A cost-based rate structure that incorporates all of the costs of building, maintaining and operating a system into the price is called full cost pricing. We regard this as essential for sustainable infrastructure. When cost-based pricing is supplemented with incentives for consumers to conserve, we move into conservation pricing, on which we provide some information on our website¹³. Full cost pricing is always a fiscal necessity. Conservation pricing is often an environmental necessity.

The Congressional Budget Office (CBO) recently issued a report entitled Future Investment in Drinking Water and Wastewater Infrastructure (November 2002) which points out that increased future infrastructure costs will either have to be paid by taxpayers or ratepayers¹⁴. To quote CBO: "Ultimately, society as a whole pays 100 percent of the costs of water services, whether through ratepayers' bills or through federal, state, or local taxes." CBO raises strong efficiency arguments for ratepayers picking up the increased costs rather than taxpayers. Certainly the most direct route for funds to flow is straight from the ratepayer to the utility. In addition, we know that when prices rise, quantity demanded falls. Moreover, in this same report, CBO estimates that combined water and sewer bills currently average 0.5% of income in this country (i.e. one half of one percent of average household income). There appears to be room for higher water bills among most households. In a recent draft report from the Organization for Economic Cooperation and Development¹⁵, the United States had the lowest percentage of income going to water charges among the 18 OECD countries for which data was available. CBO, in its report, calculated that even if future infrastructure needs fall into the very high range, average water bills will still only account for 0.9% of income on average. In a recent article, Harvard economist Robert Stavins describes our water prices as "muffled".¹⁶ He suggests that ratepayers need to hear stronger price signals so that they see a connection between their consumption and their water bill.

The Clean Water SRF program ushered in an era in which we were to replace grants with loans -- with the goal of improving on the shortcomings of the grants-based approach. Unfortunately, Congressional earmarks have kept the grant system going. Many communities will hold out and wait and see if they can get a Congressional earmark rather than applying for an SRF loan which must be repaid. Congressionally-designated water infrastructure projects continue to be funded via the yearly Appropriations Act. Mostly recently in FY03, over 490 projects were funded for over $326 million. Not only do these earmarks often reduce EPA's operating budget, they undermine the effectiveness of the SRF loan program by weakening demand. They also distort clear price signals.

Advocating for full cost pricing and for loans (instead of grants) should not preclude our considering the affordability problems that low-income households may face. To alleviate these hardships, communities can offer rate structures that mitigate impacts on low-income customers. The most prominent example is "lifeline rates" where the charge for an amount of service considered non-discretionary (the minimum sanitary requirement) is kept low, but then higher unit charges are levied on water consumption beyond that amount. Affordability programs are offered by only 14% of water utilities¹⁷. There is still much to learn from the gas and electric utilities in their many years' experience in offering low-income assistance. We want rates that are affordable for most households, but not so "muffled" that we can't hear a price signal, a signal which conveys important information on the condition of the infrastructure which it supports. Differential pricing would reconcile equity and efficiency.

The Watershed Approach: SRF opportunities and trading

Finally, in addition to managing better, using less and adequately pricing services, we're going to have to use the watershed approach to target strategic, cost-effective actions to meet water quality standards. The watershed approach is a term generally invoked to mean broad stakeholder involvement, hydrologically defined boundaries, and coordinated management across all aspects of policy that affect water. EPA views watersheds as the basic unit to define and gauge the nation's water quality and we view the SRF as central to fostering and funding watershed projects.

State SRF programs have utilized their unique flexibility in the SRF program to advance the watershed approach in a number of ways. There are many outstanding examples:

1. Ohio's Restoration Sponsor Program. Ohio offers a reduced interest rate incentive for communities who are willing to couple watershed restoration with wastewater treatment system improvements. As a result, Ohio communities have used $24 million of CWSRF loan funds to protect and restore 1,850 acres of riparian lands and wetlands and 38 miles of Ohio's stream corridors in the last two years. Typically interest rates fall from 3.8% to 0.2% when a community undertakes a restoration project in combination with a wastewater treatment improvement.

2. Maine's DWSRF Land Acquisition. Maine made a DWSRF loan to the Auburn Water Department for $570,000 to acquire 434 acres of land in the watershed of the "Basin," a small pond which drains directly into Lake Auburn. Lake Auburn serves as a source for two water systems. By protecting land around Lake Auburn, the water systems are able to maintain water quality standards and avoided building a filtration plant which would have been more than $30 million in capital costs with an additional $750,000 in annual operating costs.

More generally, state SRF programs have unique opportunities to target and prioritize their funding decisions based on watershed information. On the clean water side, the 1987 Amendments to the Clean Water Act allowed for funding nonpoint and estuary projects. Some 19 states use an integrated planning and priority setting approach so that nonpoint source and estuary projects are ranked alongside wastewater treatment and the highest priority water quality problems are addressed first with Clean Water SRF funds.

On the drinking water side, the Safe Drinking Water Act (SDWA) Amendments of 1996 also encourage a watershed approach to drinking water protection. As directed by the SDWA Amendments, a state may set aside funds from its capitalization grant to conduct activities and establish and implement programs that place a strong emphasis on preventing contamination problems through source water protection and encourage better system operations through enhanced water system management. Protecting drinking water sources from contamination in the first place has been shown to reduce costs significantly. An EPA study has shown that prevention can be up to 40 times more cost effective than remediating or finding new drinking water sources.¹⁸

Clearly, targeting our assistance to control nonpoint sources and to protect source waters are promising ways of using SRF funds for the greatest watershed benefits.

We also view Water Quality Trading as an innovation that can help lower costs and foster watershed management. Watershed-based trading is ideal for experimenting with market-based incentives; and our Water Quality Trading Policy released on January 13th of this year renews our efforts to pursue water-quality trading for nutrients, sediments and other pollutants to reduce the cost of compliance with water-quality based requirements. With this policy, we are supporting States and Tribes in developing trading programs that meet the requirements of the Clean Water Act. A water quality "credit" could be created by reducing pollution loads beyond the level required by the most stringent water quality standard. For example, an unregulated landowner or a farmer could create credits by changing cropping practices and planting shrubs and trees next to a stream, reducing nutrient runoff and sedimentation. A municipal wastewater treatment plant then could purchase and use these credits to meet water quality limits in its permit. Trading for TMDL implementation offers particular promise for its water quality and economic benefits. Our policy supports trading among and between regulated and unregulated sources.

In its analysis of the Clinton Administration's Clean Water Initiative, EPA concluded that the total potential savings from all types of trading range from $658 million to $7.5 billion annually. A current example of a successful trading effort, between point sources only, can be found on Long Island Sound where nitrogen trading among publicly owned treatment works in Connecticut is expected to save over $200 million in control costs.

A study of three watersheds in Minnesota, Michigan and Wisconsin by the World Resources Institute (2000) found that the cost of reducing phosphorous from point sources, traditional pipe-in-the-water dischargers, was considerably higher than those based on trading between point and non-point, or diffuse, sources of runoff which are not regulated by the Clean Water Act¹⁹. The estimates for point source controls ranged from $10.38 per pound of phosphorus in the Wisconsin watershed to $23.89 in the Michigan watershed. Using trading between point and non-point sources, these costs could be lowered to $5.95 per pound in Wisconsin, a reduction of over 40%, and to $4.04 in Michigan, a reduction of over 80%.

Conclusion

In conclusion, I've suggested 4 broad directions that both privately owned and publicly owned water utilities should pursue in order to better capture the true value of water: better management, efficiency, full cost pricing and the watershed approach. Those of you involved in funding water projects probably have numerous other ideas for enhancing our stewardship of America's water resources, and I'd be interested in hearing from you. The provision of clean and safe water for the 21st century is sufficiently challenging as to demand the energy, talent and creativity of both the private and public sectors. I welcome your contribution to this important work.

Thank you.

¹ EPA-832-R-00-008, Progress in Water Quality: An Evaluation of the National Investment in Municipal Wastewater Treatment, June 2000.

²BOD or "Biochemical Oxygen Demand" is a measure of the oxygen-consuming organic matter and ammonia-nitrogen in wastewater. The higher the BOD loading, the greater the depletion of oxygen in the waterway.

³ The analysis in Progress in Water Quality only relates to those water receiving discharges from point sources.

⁴ EPA 816-R-99-007, Twenty Five Years of the Safe Drinking Water Act, EPA Office of Water, December 1999. Available online at http://www.epa.gov/safewater/sdwa/trends.html.

⁵ Total retail sales for bottled beverages in 2001 were obtained from the Beverage Digest Fact Book 2002, Beverage Digest Company, Bedford Hills, NY. Website: http://www.beverage-digest.com. Total retail sales for 2001 carbonated, non-carbonated and bottled water was $82 billion. Dividing $82 billion by 116 million households in U.S. (obtained from U.S. Census information at http://quickfacts.census.gov/hunits/states/06000.html) yields spending of $707 per household per year. These calculations were made by Holly Stallworth, Ph.D., EPA Office of Water economist.

⁶ Raftelis Financial Consulting 2002 Water and Wastewater Rate Survey reports an average of $474 per household per year for combined water and sewer bills. http://www.raftelis.com/survey.htm

⁷ EPA-816-R-02-020, The Clean Water and Drinking Water Infrastructure Gap Analysis, Office of Water, September 2002. Website: http://www.epa.gov/owm/gapreport.pdf (PDF file)

⁸ The full text of this plan can be found on the Orange County Sanitation District website at http://www.ocsd.com/about/reports/special_studies.asp.

⁹ National Association of Water Companies and Beecher Policy Research, The Water Industry Compared: Structural, Regulatory, and Strategic Issues for Utilities in a Changing Context, September 1998.

¹⁰ EPA-832-B-02-003, Cases in Water Conservation, Office of Water, July 2002. Website: http://www.epa.gov/OW-OWM.html/water-efficiency/utilityconservation.pdf (PDF, 325KB)

¹¹ The Office of Water's website is http://www.epa.gov/ow/.

¹² WaterWiser is a water efficiency clearinghouse and website initiated with funding from EPA and maintained by the American Water Works Association. http://www.waterwiser.org/

¹³ Holly Stallworth, Ph.D., Office of Water, EPA, "Conservation Pricing of Water and Wastewater," http://www.epa.gov/owm/water-efficiency/water7.pdf. (PDF, 2MB)

¹⁴ Congressional Budget Office, Future Investment in Drinking Water and Wastewater Infrastructure, November 2002, ISBM 0-16-01243-3.

¹⁵ OECD, 11-20-02 Draft, "Social Issues in the Provision of Water Services" Table 2-2.

¹⁶ Sheila M. Cavanagh, W. Michael Hanemann, and Robert N. Stavins, "Muffled Price Signals: Household Water Demand Under Increasing-Block Prices," December 31, 2001 ASSA Paper.

¹⁷ Raftelis Financial Consulting, 2002 Water and Wastewater Rate Survey. Ordering information for this publication is available from http://www.raftelis.com/.

¹⁸ EPA-813-B-95-005, Office of Water, Benefits and Costs of Prevention: Case Studies of Community Wellhead Protection - Volume I. 1996.

¹⁹ Paul Faeth, Fertile Ground: Nutrient Trading's Potential to Cost-effectively Improve Water Quality, Washington, D.C.: World Resources Institute, 2000.

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