UNDERSTANDING HOW PUBLIC FINANCING WORKS

Public financing is the way that most small rural towns and cities, water districts, and
sewer districts choose to finance their water and wastewater projects. It is a low-cost
form of financing and allows the borrower to receive grants from the same financing
agencies that are providing the loans. However, there is a lack of understanding by the
majority of borrowers as to how the financing system works. This brief explanation is an
attempt to assist the borrowers in understanding the quirks of public financing.

There are three primary sources of government funding, the USDA - Rural Development,
the Department of Economic Development and the Department of Natural Resources.
From USDA – Rural Development and the Department of Natural Resources, the
borrower can obtain both low-interest loans and grants. From the Department of
Economic Development, the borrower can obtain a grant if it has a Low to Moderate
Income status, as determined by the Census or a special survey.

If a borrower wants to obtain a low-interest loan from these funding agencies, it is a

straightforward process. The borrower has to pass a bond issue so that revenue bonds can
be used to finance the water or wastewater project. Once the funding is obtained from
one of the public financing agencies, the borrower only has to adjust the rates charged to
its users to cover the bond payments, fund a reserve account, and fund a replacement
account (assuming operations and maintenance costs are currently being covered).

The difficult part to understand is the way the public financing system works when grant
dollars come into play. For the majority of our clients this is the case because the
projects are large enough that taking out a loan only is more expensive than a
combination of loan and grant dollars.

The first myth to debunk is that a borrower can obtain 100% of the funding in grant
dollars. Before the first grant dollar is obtained, the borrower must meet the 2% of
Median Household Income (MHI) target as determined by the 2000 Census. This means
that the borrower must raise the rates to its users to 2% of MHI before obtaining the first
grant dollar. The increase over existing rates (usually significantly higher because the
borrower has not raised rates as it should over the years) is used to make payments
associated with the loan and fund operations and maintenance costs. It is surprising how
many small towns subsidize their water and sewer costs through other accounts or
sources of revenue. So you can see that in order to have access to grant money, you must
first pass a bond issue so you can obtain a loan whose payments will bring your user rates
up to the 2% of MHI threshold.

Now lets take an example to see how its works. Let’s assume that Anytown, MO wants
to make improvements on its sewer system. We go to the 2000 Census and determine
that the MHI for Anytown, MO is $22,250. This must be multiplied by .02 to get the
annual user rate of $445.00. Then we divide the annual user fee by 12 to get the monthly
user rate of $37.08. The monthly rate of $37.08 is what the funding agencies expect the
average user to pay, defined as one who uses 5,000 gallons per month.

Formula: $22,250 X .02 = $445 annual user rate for average user
$445 / 12 = $37.08 monthly user rate for average user

Let’s further assume that Anytown, MO has 500 customers, an operations and
maintenance budget of $140,000 and existing rates of $26.00 for the user of 5,000
gallons. We are also assuming that Anytown, MO is not making payments on any
previous bond issues for its sewer system.

Anytown, MO is required by the conditions stipulated by its latest Missouri State

Operating Permit to make significant upgrades to its wastewater treatment facility. The
City’s engineer has estimated the cost of these necessary upgrades is $1,000,000.
Attachment 1 shows that the City can obtain a loan from USDA Rural Development for
the full amount of the project cost and still not reach the 2% of MHI. In this case, the
City would need to raise its user rates for the average user to $31.08 as shown on
Attachment 1 to cover the cost of the loan and operations and maintenance. Since the
City is already charging the average user $26.00, the increase that would be necessary is
$5.08 ($31.08-$26.00).

Now let’s assume that the required upgrades to the wastewater treatment facility are
estimated at $1,800,000. As can be seen on Attachment 2, a loan of $1,780,000 will
trigger the 2% of MHI threshold, $37.08. Now the City has access to grant dollars and in
this case it needs $20,000 of grant funding to complete the financing of the project. Here
is where borrowers often make a mistake. They take only the money necessary to fund
the required upgrades.

There is a quirk in public financing that many borrowers do not take advantage of when
financing their projects. Once you have reached the 2% of MHI threshold, all funding
thereafter is in the form of grant dollars. It only makes sense to try and capture all the
grant dollars that you can once you have been forced to raise your rates to 2% of MHI.
So let’s assume that Anytown, MO has old deteriorated pipes that have sprung several
leaks in their sewer system. The City’s operator, with the assistance of the City’s
engineer, has identified $500,000 of costs to replace old sewer mains. In this case, the
City should go ahead and apply for the additional $500,000 because it is not going to cost
their users or the City a penny more. Attachment 3 shows the funding scenario if the City
requests $2,300,000.

Prepared by Schultz & Summers Engineering, a firm that specializes in developing water
and sewer projects for rural towns, water districts, and sewer districts. We have
specialists who can assist you in analyzing the funding options available to you and
recommended the best option for you.