ENVIRONMENTAL FINANCIAL ADVISORY BOARD
Members
A. James Barnes
Chair
TenyAgriss
Julie Belaga
John Boland
George Butcher
Donald Correll
Michael Cutley
Rachel Dewing
Pete Domenld
Kelly Downard
Mary Francoeur
James Gebbardt
Steve Grossman
Scott Raskins
Jennifer Hernandez
Keith Muds
Steve nonfood
Langdon Marsh
Greg Mason
Undene Patton
Cherle Rice
Helen SaM
Andrew Sawyers
Jim Smith
QregSwartz
Son/a Toledo
Jim Toad
Justin Wilson
John Wise
Stan fleUmrg
Designated
Federal Official
MAX 3 ] 2007
Mr. Ben Grumbles
Assistant Administrator, Office of Water
U.S. Environmental Protection Agency
Ariel Rios Building
1200 Pennsylvania Avenue, N.W.
Washington, DC 20460
Dear Ben:
The Environmental Financial Advisory Board (EFAB) is pleased to submit
the enclosed report, "EFAB Comments on EPA Document: Combined Sewer
Overflows—Guidance for Financial Capability Assessment and Schedule
Development" The report summarizes EFAB's review of this guidance and
provides EPA with our comments. Dr. Andrew Sawyers, Program Administrator,
Maryland Water Quality Financing Administration, and Jeff Hughes, Director,
University of North Carolina (Chapel Hill) Environmental Finance Center, were
instrumental in the development of this report. In keeping with EPA's request, the
report is limited to examining the existing components of the Financial Capability
Assessment (FCA) methodology and does not address policy issues related to
implementing EPA's Combined Sewer Overflows (CSO) regulatory approach.
The FCA Guidance has been used since 1997 as a tool to assist EPA in
assessing a permittee's financial capability to meet the terms of EPA's CSO Policy.
The Guidance outlines a two-part test in determining financial capability, with one
element addressing household impact and the second element addressing system-
wide financial capability. EFAB in this report recognizes the merits of the two-part
test. However, the Board believes that the current residential and the system
financial capability indicators used in the two part test have some significant
limitations. EFAB believes that EPA will be better able to assess a permittee's
financial capability by updating both of these indicators.
For example, the residential indicator now used to measure the impact on
individual households does not fully consider the breadth of factors that impact
household finances, particularly in communities with a high proportion of
disadvantaged households. The reliance on median household income only may
disguise the impact of income distribution and poverty rate for many utilities. In
revising the FCA Guidance, EFAB recommends that EPA develop a residential
indicator which considers actual household expenditures based on average water
use, using the rate structures expected to be in effect after the CSO improvements
are implemented, rather than assume that the entire cost of controls is spread evenly
across households. This would also allow consideration of the effect which lifeline
rates or low-income assistance programs could have on mitigating impacts.
Providing Advice oh "How To Pay" for Environmental Protection
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In looking at costs to systems, the FCA Guidance relies on a limited definition of cost that
excludes the impact of certain management strategies such as asset management, proactive cash
flow planning and rate setting strategies, and does not fully consider factors such as investment
timing, population growth, and investment options/terms. Finally, reliance solely on household
cost comparisons may neglect the effect of costs on commercial or industrial customers who in
some instances may be essential to utility financial health.
The FCA guidance currently considers the cumulative impacts of existing wastewater
treatment and proposed CSO control initiatives. EFAB understands the reasons behind this
approach, including the value of considering the impact of CSO implementation in the context of
other water pollution control costs being home by the community. However, the Board also
recognizes the value of incremental costs in providing more immediate and specific indicators of
financial stress. EFAB therefore recommends that EPA consider both the cumulative impact of
pollution control services as well as the incremental impact of CSO control initiatives.
Finally, the Board urges EPA to revisit the portions of the FCA guidance which discuss
system financial capability and include additional management indicators to better reflect advances
since the document was written in 1997. Areas outlined by the Board for improvements include
debt indicators, bond ratings, socio-economic indicators, and financial management indicators. For
example, unlike operating ratio, property tax collections do not adequately illustrate the ability of
utilities to incur debt and meet future costs.
The Board is prepared to discuss its findings and recommendations with you, answer any
questions you may have, and take any follow-up actions you would like to pursue consistent with
the Board's charter. We greatly appreciate the continuing opportunity to serve the Agency.
Sincerely,
A. James Barnes A. Stanley Meiburg
Chair Designated Federal Official
Enclosure
cc: James A. Hanlon
Director, Office of Wastewater Management
Cynthia C. Dougherty
Director, Office of Ground Water and Drinking Water
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Environmental
Financial Advisory Board
EFAB
A. James Barnes
Chair
A. Stanley Meiburg
Designated Federal
Official
Members
Hon. Pete Domenici
Terry Agriss
Julie Belaga
John Boland
George Butcher
Donald Correll
Michael Curley
Rachel Deming
Kelly Downard
Mary Francoeur
James Gebhardt
Steve Grossman
Jennifer Hermandez
Keith Hinds
Stephen Mahfood
Langdon Marsh
John McCarthy
Greg Mason
Cherie Rice
Helen Sahi
Andrew Sawyers
James Smith
Greg Swartz
Steven Thompson
Sonia Toledo
Jim Tozzi
Justin Wilson
John Wise
Comments on EPA Document:
Combined Sewer Overflows—Guidance for
Financial Capability Assessment and
Schedule Development
This report has not been reviewed for approval by the U.S. Environmental
Protection Agency; and hence, the views and opinions expressed in the
report do not necessarily represent those of the Agency or any other
agencies in the Federal Government.
May 2007
Printed on Recycled Paper
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EFAB Comments on EPA Document:
Combined Sewer Overflows—Guidance for Financial Capability Assessment
and Schedule Development
Background and Introduction
Some older American communities have combined sewers that carry both sewage and wet
weather runoff. Modern practice is to build separate sewers for sewage and storm water. When the
capacity of a combined sewer is exceeded during wet weather, the excess flow, which is a mixture
of sewage and storm water runoff, may be discharged untreated to the environment. The excess
flow is called a Combined Sewer Overflow (CSO). Discharges of CSOs can create a public health
hazard and adversely impact the quality of the receiving waters.
In order to reduce the impact of CSOs during wet weather, CSO communities develop plans
to control CSOs. One critical component of such plans is a demonstration of regulatory compliance
with EPA's 1994 CSO Control Policy. Financing CSO programs in an equitable and timely manner
without placing an unreasonable burden on ratepayers is a significant and on-going challenge for
many CSO communities. The Control Policy provides an opportunity for the EPA to consider a
permittee's "financial capability" when establishing a CSO mitigation implementation schedule. In
1997, EPA published the CSOs -- Guidance for Financial Capability Assessment and Schedule
Development (FCA Guidance) to guide the process of assessing a community's financial capability.
During the August 2006 Environmental Finance Advisory Board (EFAB or the Board)
meeting, the Director of EPA's Office of Wastewater Management, Jim Hanlon, presented EFAB
with an overview of the CSO Control Policy and FCA Guidance and explained that EPA was
considering modifying the FCA Guidance. Mr. Hanlon asked EFAB to review the current FCA
Guidance and provide the agency with comments. A workgroup comprised of EFAB members and
expert witnesses was established to lead the review.
Section 1 of the FCA Guidance Document provides a general overview of EPA CSO Policy.
Sections 2 to 4 present a quantitative assessment methodology that generates "an overall assessment
of the permittee's financial capability." Section 5 provides guidance on how the financial capability
assessment and other factors including environmental considerations and secondary financial
considerations should be applied in the CSO schedule development. The Board focused most of its
attention on the existing components of the financial capability assessment methodology. We did
not attempt to address many of the larger issues related to implementation of EPA's CSO and
regulatory approach addressed in other FCA review documents such as the "White Paper" prepared
on behalf of the National Association of Clean Water Agencies.
Under the FCA methodology, a two-step process is used to categorize the burden a CSO
permittee faces as "Low," "Medium," or "High." The assessment matrix (Table 1) used to
determine the burden is founded on a single Residential Indicator and a composite Financial
Capability Indicator based, in turn, on 6 separate financial indicators. The use of this two-step
approach promotes the view that a permittee's financial capability to implement a CSO plan is
influenced by the financial impact on the permittee's residential households and the permittee's
overall financial strength.
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Table 1 FCA Matrix
Permittee
Financial
Capability
Indicators Score
(Socioeconomic, Debt
and Financial)
Weak
(Below 1.5)
Mid-Range
(Between 1.5 and 2. 5)
Strong
(Above 2.5)
Residential Indicator
(Cost Per Household as % of MHI)
Low
(Below 1.0%)
Medium Burden
Low Burden
Low Burden
Mid-Range
(Between 1 .0 and
2.0%)
High Burden
Medium Burden
Low Burden
High
(Above 2.0%)
High Burden
High Burden
Medium Burden
EFAB recognizes the merits of the two-step design, but believes that the current indicators,
the composite system financial indicator and the residential indicator, have some significant
limitations. The Board's concerns and suggestions for improving the indicators are outlined in the
discussion below.
Considerations in Assessing Residential Household Impact
The current residential household impact measure is calculated by dividing an estimate of
the average aggregate wastewater and CSO cost per household by the median household income
(MHI) for the permittee's entire service area. We have concerns about both the denominator and
numerator used to calculate this metric. Secondly, we question the prudence of using a single
metric to assess residential impact.
Average Costs Per Household Versus Estimated Average Household Expenditures
The FCA Guidance states that the purpose of the first phase test ("Residential Indicator") is
to identify control costs on "individual households." The current approach assumes the entire cost
of the controls is spread evenly over all households. However, in reality, the cost actually incurred
by households will depend on the type of rate structure employed by the utility and the service
usage of the households. For example, a utility system with an increasing block rate structure
would see residential customers with large consumption incurring a much larger cost than
customers with low consumption. A recent EFAB paper on affordability highlighted the
importance rate structures have on distributing and allocating costs to individual households
(Affordable Rate Design for Household, February 2006). A strategic rate structure change or a
relatively modest subsidy targeted to assist the households with the greatest need (e.g. creation of
emergency assistance funds) may greatly mitigate the financial impact on the most financially
disadvantaged households in a community.
The Board suggests the methodology take into consideration the amount the permittee
anticipates having to charge a household, based on average water use per equivalent dwelling
unit (e.g. 5,000 to 6,000 gallons/month) and using the rate structure expected to be in effect
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after the CSO improvements are implemented. If other non-user charge revenue options such as
sales tax or property value based assessments generate a significant amount of wastewater treatment
and CSO revenue, the permittee should consider this expenditure as well. If household affordability
is a significant concern for the permittee, it is possible that the rate structure already takes this into
consideration. In this case (e.g. a different/lower rate structure for low income households), the
permittee should provide that information as well.
Estimating average household expenditure information may require more advanced cash
flow and rate planning than calculating an annualized cost per household based solely on overall
cost information. However, given the high stakes involved in negotiating CSO schedules, it is hard
to imagine a permittee going into the negotiation process without a financial management plan that
could be used to generate this estimate.
It is also likely that the permittee's rates will be increased substantially in the future to meet
wastewater treatment and CSO requirements. Ideally, EPA should consider the magnitude of the
increases by allowing the permittee to calculate and present the household indicator at different
years or by presenting some type of average household expenditure over a given time period. For
example, a permittee's rate structure and financing plan might result in a household using 6,000
gallons a month paying $400 per year initially, rising to $800 by year five. The FCA for step two
specifically requires that a permittee take into consideration future changes when calculating the
system financial capacity indicators. It seems reasonable, therefore, that future changes should also
be considered in calculating the residential household indicator.
Expanding the Definition of Costs
If the FCA methodology continues to rely on utility costs instead of household expenditures,
the Board suggests that EPA revisit the definition of cost used in the current FCA document. The
current methodology defines cost as "current annual wastewater operating and maintenance
expenses (excluding depreciation) plus current annual debt service (principal and interest)." The
methodology goes on to state "Expenses for funded depreciation, capital replacement funds, or
other types of capital reserve funds are not included in current wastewater treatment costs because
they represent a type of savings account rather than an actual operation and maintenance expense."
This definition does not seem to take into consideration some of the fundamental principles
of proactive Asset Management, an approach strongly promoted by EPA. This approach urges
utilities to move to a financial framework that incorporates the use of capital reserve funds and
adequate budgeting for replacement. The interpretation of these funds and reserves as "a kind of
savings account" is incorrect. They represent, instead, a smoothing of actual replacement and
extraordinary operating costs over time. A utility that has incorporated advanced asset management
into its financial plan most likely has incorporated it into the rate structure as well and the impact on
customers should not be ignored.
The Board suggests the definition of cost be broadened to take into consideration
additional cost components if the permittee can demonstrate that these costs will indeed be
passed on to the customer (for example, if the permittee has an approved Capital
Improvement Plan (CIP) and expenditure history that demonstrates the use of capital reserve
funds and significant capital rehabilitation and replacement expenditures).
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Consideration of the Impact of Capital Investment Planning and Financing Options on Cost
A multi-year financial plan should also take into consideration key planning issues such as
when investments are made, population growth and capital financing options. A metric that does
not take into consideration these issues is likely to misrepresent the actual financial impact on
households. Ideally, a permittee should be required to present estimated household
expenditures on sewerage service as projected in an approved CIP or financial plan. If key
factors influencing the household expenditures are uncertain, then the permittee could present
different scenarios along with an explanation. Over time, a fast growing community with excess
wastewater treatment capacity is likely to see the impact on their customers change much less than a
slow growing (or shrinking) community with similar CSO control costs. Similarly, the availability
of extended term financing (30 to 40 years) compared to shorter term financing (20 years) could
have an impact on rates.
Incremental vs. Cumulative Financial Impacts
One of the core questions for any financial impact metric is whether the metric is measuring
the cumulative financial impact of a group of initiatives/services including the "new" or "added"
service or if the metric is focused on the incremental impact of the environmental service or
improvement being considered. In the case of the CSO FCA Guidance, the current approach is to
consider the cumulative impacts of existing wastewater treatment and proposed CSO control
initiatives. This follows a similar approach found in the existing Small System Variance National-
Level Affordability Methodology. The Agency has proposed replacing the cumulative impact
approach now used to evaluate Small System Variance requests with an incremental test (Federal
Register/Volume 71, No. 41 p. 10671). This new approach follows a recommendation by the
National Drinking Water Advisory Council and should be at least considered as the Agency revises
the CSO FCA Methodology.
In considering the possible shift from a cumulative to an incremental indicator, the Board
finds that each approach has potential application within the FCA. The use of a cumulative
indicator is consistent with the view that the impact of CSO implementation should not be
considered in isolation from other water pollution control costs. It also tends to take account of the
degree to which a community may have already borne large wastewater management costs (or other
environmental costs), a possible factor in setting priorities for further requirements. The principal
concern commonly expressed regarding the cumulative approach is the question of which services
should be included in cumulative costs. Should the metric include just wastewater and CSO costs
(as it does at present)? Should it include any costs related to complying with the Clean Water Act?
What about the cost of providing safe drinking water or even non-water environmental services?
The incremental cost indicator, on the other hand, provides a more immediate and specific
indicator of financial stress. It measures the additional burden that will be placed on residential
users in the community as a consequence of implementing a CSO control plan. This indicator
reveals the relative cost-effectiveness of CSO control in different communities. Since both
financing policy and economic efficiency suggest that, other factors being equal, the most cost-
effective measures should be implemented first, an incremental measure is also relevant to priority
setting. The Board concluded that cumulative and incremental residential indicators each have a
particular role to play. It is recommended, therefore, that both cumulative and incremental
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residential indicators be calculated. They can be considered separately, or combined in a
composite indicator as described in the next section.
Reliance on Single Indicator to Assess Residential Household Impact
Given the diversity of communities, EFAB does not believe that reliance on a single
indicator, particularly one that is based on median household income, adequately describes the
financial impact facing households. One of the most common objections to the use of median
household income is that for many communities it masks the impact on low-income households.
The Board suggests EPA consider a composite residential indicator similar to the composite
system financial indicator. The composite indicator could include poverty rate and/or income
distribution information. For example, a permittee with a poverty rate within a specific percent of
the national or state average poverty rate would be considered "mid-range;" a permittee with a
poverty rate significantly below the average would be rated "low" and significantly higher than
average would be rated "high." The MHI indicator and this new poverty rate indicator could be
converted to an aggregate point scale system similar to the composite system indicator. Poverty
rate, like MHI, is readily available from the US Census. Income distribution information is also
available from the census, but is more difficult to obtain and calculate.
Commercial Customer Impact
Another drawback of the residential indicator metric is that it does little to assess the
financial impact of CSO control policy on commercial customers. In some cases, the impact on
these customers, especially in regions of the country where manufacturing sectors are struggling,
may be just as important as, or more important than, the impact on a residential customer. If a
system's rate structure is designed to place more of a revenue reliance (burden) on commercial
customers than residential customers, the relative financial impact on commercial customers may be
much higher than for residential customers. Given the variation in commercial customers,
establishing a standard universal "commercial indicator" metric is likely to be more difficult than
for residential customers and it may be more practical to include commercial customer impact data
as supplementary finance data rather than designing an additional indicator.
Considerations in Assessing System Financial Capacity
The second step of the existing FCA approach requires the calculation of a composite
system financial capacity indicator based on a series of six metrics in three general categories. The
methodology was intentionally designed to resemble methodologies used by credit rating agencies.
As with credit ratings, the assessment score may have more to do with perceived credit worthiness
than actual ability to "finance" improvements. For example, a permittee with a poor credit rating in
a state that maintains a large subsidized water and sewer loan program may have more of a chance
of financing CSO improvements than a permittee without access to subsidized credit. Despite this
limitation, the Board understands the need to have some type of objective assessment.
Debt Indicators
The Board has specific comments relative to how Bond Ratings are presented in the FCA
document; these are provided in Enclosure 2. Secondly, the reliance on a debt metric based on
property value seems questionable given the availability of other debt indicators that are more
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directly tied to revenue and/or system assets. Alternatives that may be better suited for this type of
assessment include Total Outstanding Debt to Net Plant Assets or Total Outstanding Debt per
Customer/Account. The interest rate and term of issued debt has an enormous impact and should
probably be considered as well, possibly through an indicator measuring the percentage of revenues
that are required to service debt. Of course, no single metric will be entirely appropriate for all
permittees. For example, a debt per customer metric for a wholesale wastewater provider with a
few dozen accounts should not be used. In situations like this, the permittee could be allowed to
base the metric on some type of equivalent residential unit (ERU) measure.
Socioeconomic Indicators
The Board's views concerning the limitations of MHI are outlined in the discussion of the
residential indicator. We strongly believe that assessment of socioeconomic conditions should not
rely on MHI alone. At a minimum, another indicator such as poverty rate should be added to this
section to more accurately portray socioeconomic conditions.
Financial Management Indicators
Some of the indicators that focus on non-user charge information seem out of place for
evaluating a sewer utility's financial capacity given the current reliance on user fees as opposed to
general tax revenue. EPA should consider alternative management indicators that consider the
collection of sewer and water fees (collection rate or bad debt ratio) instead of property tax
collection. Given the importance of operating margin or operating ratio in illustrating the ability of
a utility to incur debt and meet their costs, EPA should consider incorporating this indicator into the
composite index either as a financial management indicator or as a debt (capacity) indicator.
Clarifying Policies and Approaches Related to Financial Capability and Affordability
The Board suggests that EPA take into consideration other EPA policies and guidance
related to financial impacts when modifying the FCA Guidance document, or at least when
disseminating any potential modifications to the document. We are concerned that state and local
officials may have difficulty distinguishing between the purpose and substance of different policies
related to financial capability, capacity, and affordability. Similar, but distinct policies may include:
1. CSO Financial Capability Guidance and indicators;
2. National-Level Affordability Methodology for Small Drinking Water System Variances;
3. State implemented criteria for qualifying for Drinking Water SRF Disadvantaged Program
Assistance; and
4. State implemented criteria for eligibility for more favorable Clean Water SRF financing
terms.
These financial assessment policies share a common theme in their attempts to help assess
"ability to pay" for environmental objectives/services; however they are applied under very
different circumstances. The first two assessment policies involve triggers for alternative (and in
some cases less stringent) regulatory treatment, whereas the SRF assessments are used to determine
a community's access to public funding assistances (grants and subsidized loans). It may be
reasonable to set regulatory relief triggers at a higher bar than grant eligibility metrics given the
6
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public health stakes; however, at a minimum, the Agency should make a concerted effort to
reconcile or link the CSO financial capability assessment indicators and methodology with the
Small Drinking Water System Variant Affordability indicators or clearly explain the justification
for their differences.
Conclusions
The 1997 EPA Guidance for Financial Capability Analysis and Schedule Development has
been, and remains, an important tool to help assess a permittee's financial capability to meet the
terms of EPA's Combined Sewer Overflows (CSO) Policy. The core of the Guidance is the two-
part test used in determining financial capability, with one part addressing household (residential)
impact and the second part addressing system-wide financial capability.
EFAB's review suggests that both the current residential indicator and the system financial
capability indicators used in the two-part test have significant limitations and should be improved.
The Board believes that EPA would be better able to assess a permittee's financial capability by
incorporating the suggestions for updating these indicators contained in this report. This, in turn,
would provide a stronger financial negotiating foundation for all parties regarding EPA's CSO
Policy. EFAB appreciates the opportunity to provide the Agency with these comments on this
important Guidance.
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UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
WASHINGTON, D.C. 20460
JUL 2 3 2007
OFFICE OF
WATER
MEMORANDUM
SUBJECT: Receipt of EFAB' s Review of EPA Document: Combined Sewer
Overflows—Guidance for Financial Capability Assessment and Schedule
Development (1997)
FROM: Benjamin H. Grumbles
Assistant Administrate
TO: Lyons Gray
Chief Financial Officer
I am writing today to acknowledge receipt of your report summarizing the
Environmental Financial Advisory Board's (EFAB) review of, and comments on, the
above-referenced EPA guidance document.
I would like to thank you and the members of EFAB for your thoughtful review
and analysis of the guidance document. As you know, we are undergoing an assessment
of the guidance, and are considering revising it. Your thoughtful comments and
recommendations will be taken into consideration as part of this assessment.
If you have any questions or comments regarding this guidance, please contact me
or have your staff contact Don Brady at 564-0642.
Internet Address (URL) • http://www.epa gov
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