CRC Memorandum

Proposal 02-02: Great Lakes Water Quality Bond Authorization Act

Public Act 396 of 2002, the Great Lakes Water Quality Bond Authorization Act, will refer to Michigan voters on the November 2002 statewide ballot the question of whether the state shall borrow up to $1 billion to assist in financing local sewer pollution control projects. Article IX, Section 15, of the Michigan Constitution requires a two-thirds majority in the House and Senate, and majority approval by voters in a general election, to pass legislation authorizing long-term state borrowing.

Local water and pollution control projects, as proposed, are sewage treatment works projects, storm water projects, and nonpoint source pollution projects.

As defined in the Natural Resources and Environmental Protection Act (PA 451 of 1994), sewage treatment works projects are "construction activities on any device or system for the treatment, storage, collection, conveyance, recycling, or reclamation of the sewage of a municipality, including combined sewer overflow correction and major rehabilitation of sewers." Stormwater projects are "construction activities of a municipality on any device or system for the treatment, storage, recycling, or reclamation of stormwater that is conveyed by a storm sewer that is separate from a sanitary sewer." A typical example is a combined sewer overflow basin, which effectively prevents combined sanitary and storm sewage from breaching natural waterways. Nonpoint source pollution projects are "construction activities designed to reduce nonpoint source pollution consistent with the state nonpoint source management plan pursuant to (federal law)." Conceptually, nonpoint source pollution is water pollution from diffuse sources, such as rain or snowmelt that becomes polluted through contact with polluted soils or surfaces.

If approved, the proposal would authorize the state to sell general obligation bonds in annual amounts up to $100 million for 10 years, with proceeds deposited in the proposed Great Lakes Water Quality Bond Fund, administered by the Department of Treasury. Ninety percent of the bond proceeds would be allocated to the existing State Water Pollution Control Revolving Fund (SRF), and the remaining 10 percent would be deposited in the proposed Strategic Water Quality Initiative Fund (SWQIF) to provide low-interest loans for nonpoint pollution control projects exclusively.

The SRF is federally subsidized and administered by the Michigan Department of Environmental Quality, and provides low interest, long term loans to municipalities and authorities with conforming sewer pollution control projects.

Tied to the ballot proposal are legislative changes and additions (Public Acts 397 and 398 of 2002) to the Natural Resources and Environmental Protection Act of 1994 that effectively allow an expansion of permissible sewer funding projects, including septic tank remediation and replacement with sanitary sewer lines.

Background

In response to a shift in federal water pollution policy in 1987, Michigan established the State Water Pollution Control Revolving Fund, also known as the State Revolving Fund (SRF), the following year. In keeping with policies of the early 1970s, the United States government ended its role as direct funder of local sewer projects by offering capitalization grants (seed capital) to states that established such revolving funds. States must provide at least 20 percent matching capital, and lend out the entire annual grant and match to local projects that conform with federal pollution control requirements.

With typical long-term interest rates of 2.5 percent over terms of up to 20 years, municipalities and authorities are able to finance sewer and pollution control projects through the SRF for much less than in private capital markets, where, depending on their debt rating, local units can expect to pay approximately double the borrowing costs of the SRF. While beneficial to local communities and authorities, better-than-prime interest rates do not afford self-sustainability for the SRF, as loans are made faster than they are paid back. Since 1989, Michigan received federal capitalization grants as summarized in Table 1.

Long-term Sewer Needs Studies

Several recent studies have made estimates of the extent of the sewer finance problem in Michigan, including Southeast Michigan Council of Governments’ Investing in Southeast Michigan’s Quality of Life: Sewer Infrastructure Needs; Public Sector Consultants’ Managing the Cost of Clean Water: An Assessment of Michigan’s Sewer Infrastructure Needs; and the Michigan Office of the Auditor General’s Performance Audit of Sewer Funding Needs, and are summarized in the matrix below:

As divergent estimates indicate, long-term prediction of major capital costs is a difficult exercise, inasmuch as financial, regulatory, and technological climates change rapidly and unpredictably. Regardless, even the lowest estimate is large when compared to the approximately $1.5 billion loaned to local governmental units by the SRF since 1989.

Administrative Conditions of Bond Proceeds. Ninety percent of bond proceeds to the proposed Great Lakes Water Bond Fund will be allocated to the State Revolving Fund, more than doubling the annual federal capitalization grant. The remaining 10 percent is dedicated to the proposed Strategic Water Quality Initiatives Fund, which would provide a separate low-interest loan fund for local units where population would not be considered as a project criterion -- unlike the SRF, which considers population. Eligible SQWIF projects would include nonpoint pollution control projects, and upgrades or replacements of failing on-site septic systems.

The main difference between the SRF and the SWQIF is that upgrades or replacements of failing septic tank systems are eligible under SWQIF. This is significant in that septic tanks are almost exclusively sited and maintained privately. Use of public dollars for direct benefit of private property is authorized only when there is legislative or judicial finding of "public purpose," and remediation of failing septic systems is recognized in this legislation as such, being crucial to public health, safety and welfare.

Project Priority Lists. The primary focus of the SRF and the proposed SWQIF is to reduce water pollution consistent with the dictates of the Federal Clean Water Act of 1972. As SRF administrator, the Michigan Department of Environmental Quality has developed a priority list of funding criteria for local unit applicants, based primarily on pollution threat severity. Under changes in law proposed by this ballot question, new sets of priority lists will be developed for each of the ballot-enunciated pollution control objectives, in addition to development of a separate SWQIF priority list.

Additionally, the proposal removes consideration of local unit population from the priority list requirements of the SWQIF, presumably to accommodate septic tank system eligibility.

State of Michigan Bonding Capacity

Although Michigan and most states project long term budget deficits, Michigan’s capacity to bond against its full faith and credit remains strong. Moody’s Investor Service assigned Michigan’s General Obligation Bonds their highest investment rating (Aaa) in June 2002, affording Michigan taxpayers low borrowing costs for the bonds. According the Michigan Office of the Auditor General, the average interest rate on the 2001 SRF issue was 4.7 percent.

General Obligation Bonds are secured by the taxing power of the state. There are no constitutional or statutory limits on state general obligation bonding capacity.

Historically, Michigan has ranked below average on general obligation debt per capita. This is changing, however, as Michigan’s net bonded debt is increasing on a real and per capita basis, as summarized in Table 2.

According to the United States Bureau of Census, Michigan ranked 36th of all states in per capita general obligation debt outstanding in 1980, 36th in 1990, and 24th in 1997, the most recent year for which general obligation debt rankings are available. In 1999, Michigan was 27th in total debt per capita, with $16.2 billion in secured and unsecured liabilities, or $1,641 per capita.

Debt Service Requirements. The Michigan Department of Treasury estimates that, at current rates of approximately 5 percent, annual debt service costs would be about $8 million initially, rising to a peak of $80 million over ten years and then declining as the initial issues are retired. According to the Michigan Senate Fiscal Agency, the debt service would increase by $8 million a year until rising to its peak, with debt service remaining at that level for 11 years, after which it would decrease gradually until all of the bonds are paid off.

Effects of Federal Funding Increase. According to the Michigan Office of the Auditor General, an additional $100 million federal grant for 5 years (approximately double the current grant level) would offer the following amounts available for loan to local units under two interest rate scenarios, assuming a maximum leveraging ratio1 of 2.5 to 1 (see Table 3).

These hypothetical examples do not illustrate loan capital flows if Proposal 02-02 passes, insofar as the ballot question proposes up to $100 annually for 10 years. These examples attempt to show that even with a comparatively significant influx of capital to the State Revolving Fund and the proposed Strategic Water Quality Initiatives Fund, Michigan will not meet long-term sewer capital resource needs, according to the Auditor General and the Southeast Michigan Council of Governments.