19020053
                  UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
                                WASHINGTON, D»C. 20460
                                     JUN   3 2005
                                                                          OFFICE OF THE
                                                                       CHIEF FINANCIAL OFFICER
 MEMORANDUM
 SUBJECT:   EFAB Report on SRF Combined Operations
 FROM:
 TO:
Charles E. John
Chief Financial Officer
Stephen L. Johnson
Administrator
       I am pleased to transmit the attached Environmental Financial Advisory Board (EFAB)
•report, Combined Operationstoj the Clean Water and Drinking Water State Revolving Loan
 Funds (SRFs).        •"...-

       •This latest SRF report presents the Board's thoughts on improving these two important
 and successful environmental infrastructure programs by further combining their financial and
 programmatic operations.  The Board believes there are real efficiencies and economies to be
 gained at both the state and federal levels in such an effort and would be happy to assist EPA as
 needed and appropriate.

       If you have questions or comments regarding this EFAB report, please call me or have
 your staff contact Joseph Dillon of my staff at 564-9673.

 Attachment
             Recycled/Recyclable . Printed with Vegetable Oil Based Inks on 100% Recycled Paper (20% Postconsumer)

-------
   UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
        ENVIRONMENTAL FINANCIAL ADVISORY BOARD
                                 MAY  2 7 2005
 Honorable Stephen L. Johnson
 Administrator
 United States Environmental Protection Agency
 1200 Pennsylvania Avenue, NW
 Washington, DC 20460

 Deair Administrator Johnson:

       The Environmental Financial Advisory Board (EFAB) is pleased to submit the
 enclosed report, "Combined Operations of the Clean Water and Drinking Water State
 Revolving Loan Funds (SRFs)," for EPA's consideration. EFAB strongly supports these
 important and successful infrastructure loan programs and has a well-established record
 of providing advice to the Agency on ways to further improve them.

       This latest report examines the idea of more closely combining the financial and
 programmatic operations of these Wastewater and Drinking Water SRF programs. The
 report notes that while some states are already moving in this direction, there is
 significant room for further progress in this area. EFAB is convinced there are real
• opportunities for achieving efficiencies and economies by moving toward the combined
 operations of the two SRF programs at both the state and federal levels.

       The Board recognizes that additional information may be needed in order to best
 implement combined SRF operations and recommends that EPA undertaken detailed
 examination of the two programs to better determine what opportunities and advantages
 exist and how they might best be combined. EFAB is prepared to assist in such an effort
 in any way consistent with its charter.

                                Sincerely,
 Lyons Gray   .           «                   A. Stanley Meiburg
 Chair                                       Executive Director

 Enclosure

 cc:    Charles E. Johnson, Chief Financial Officer   • * -
       Benjamin H. Grumbles, Assistant Administrator for Water ,

-------
                                                                 EFAB Report
 COMBINED OPERATIONS OF THE CLEAN WATER AND
      DRINKING WATER STATE REVOLVING FUNDS
GENERAL CONTEXT
      Many studies and reports indicate that the investment needs for clean water and
drinking water facilities are large and growing.  EPA itself estimates that capital needs
for clean water will range from $331 billion to $450 billion during the period from 2000
to 2019.  For the same timeframe, EPA estimates that capital needs for drinking water
will range from $154 billion to $446 billion. (These  figures are taken from the EPA
report, The Clean  Water and Drinking  Water Gap  Analysis, September  2002.)
Obviously, whatever the exact figures may be, very substantial resources will be required
to address the environmental investment needs of clean water and drinking water.

      EFAB believes that the states, local governments, and the federal government all
have  roles  to  play  in  order  to successfully  address this  significant environmental
investment  challenge.   In particular, the Board has long supported a strong  federal
commitment to two  important  infrastructure  loan programs, the Clean  Water and
Drinking Water  State Revolving Fund (SRF) Programs.   This strong commitment
remains very important during this period of growing infrastructure investment needs and
tight government budgets.  Having noted this, the Board also believes that all  federal
programs should make  every  possible effort  to realize the maximum efficiency and
effectiveness in the use of whatever funds they are appropriated.

OVERVIEW
      EFAB is convinced there are real opportunities for  achieving  efficiencies and
economies by moving toward the combined operations of the  two SRF loan programs at
both the state and federal levels. Indeed, a number of states are already demonstrating
efficiencies both in financial and programmatic management through combined  operation

-------
                                                                   EFAB Report

of some aspects of their loan programs including financial management for purposes of
more efficient investment, bond issuance, and programmatic management. Some of these
are described below. Many other states, however, for various reasons, maintain distinctly
separate management  structures.  And  while  there are many diverse  aspects  of SRF
management, including  environmental  prioritization,  watershed planning, community
outreach, and education which each state approaches individually, the essential common
denominator of each SRF program is its financial component.

       Each state fund is first and foremost a loan program where the first imperative is
an understanding of the basics of loan  financing.   Whatever other disciplines  may be
involved, the SRF programs are principally banking operations and the capability to
understand the fundamentals of banking and efficient money management are essential to
an effective program.  With the maturity of these loan programs, vast amounts of money
are now circulating from loan repayments and fund investments. Annual combined loan
repayments from the two funds now exceed  $3  billion dollars and annual earnings from
invested funds exceed $500  million (net  of investments of leveraged  bond reserves).
EPA, through its own training efforts and through those financed with organizations such
as the Council of Infrastructure Financing Authorities (GIFA), has encouraged states to
improve their financial management capabilities in the loan programs.

       This  has been  salutary, but in  the  view of this  Advisory  Committee,  a
fundamental restructuring of the program in many states as well as in EPA headquarters,
has the potential to more fully achieve the advantages of efficient financial management.
At a time of budget constraints, a real potential for reduced federal grant support, and
increasing emphasis on achieving economies in the operation of governmental programs,
EFAB  believes that  many  states  could achieve  economies  in SRF management by
merging or more closely combining the operations  of their two environmental lending
programs. Moreover, in  the opinion of some state program managers we have consulted,
combined Clean Water and Drinking Water SRF operations could achieve economies in
program administration as well, especially with respect to the integration of Intended Use
Plans.

-------
                                                                   EFAB Report

       Likewise, we are of the opinion that EPA itself could achieve efficiencies in its
own Clean Water and Drinking Water SRF management by combining their operations at
headquarters where two separate  SRF operations  are  maintained within the  Office of
Water.

       EFAB urges EPA to undertake a  comprehensive review of the operations of the
SRF program in terms of its own management at headquarters and  in the regions to
determine if moving toward  a combined  operation of the two  loan programs might
achieve a more efficient and  effective use of resources, and also encourage individual
state programs to consider combined programs which could lead  to improved financial
management techniques. We appreciate that some constraints and limitations exist which
may inhibit the full integration of the two  programs, especially with regard to the separate
state and federal enabling legislation implementing the two loan programs.  Even so, the
combined or close operation of the two programs in a numbers of states offers instructive
prototypes of how efficiencies can be achieved through  more integrated management. In
recommending this action we  recognize that the Congress was not prescriptive in telling
the states how to administer the loan programs and that this has been one  of the strong
features of the program, allowing states  to adapt their  loan program implementation to
their own constructs and particular needs. It is not our  intent to suggest there is any one
prototype that  should be enforced upon  the state programs, but rather,  to suggest that
there  are efficiencies to be achieved by  combining some operations which states, with
EPA cooperation, should investigate for application to their own programs.

BACKGROUND
       In June  2001, EFAB published a report titled  "Environmental State Revolving
Funds: Developing a Model to Expand the Scope of the SRF."  The report examined the
idea of providing states the flexibility to  expand their Drinking Water and Clean Water
State  Revolving Funds  to cover projects  in all environmental media.  The flexibility to
fund all environmental  media would, in  turn, allow states the flexibility to address all
causes of pollution for the maximum environmental benefit.  The  Board  believes that if
such an environmental SRF is to become a reality, it should be built upon the success of

-------
                                                                   EFAB Report

the existing Clean Water and Drinking Water programs through additional funding for a
broader range of projects.   As a first step towards identifying the benefits associated with
an environmental SRF, EFAB undertook to identify the benefits that may result from the
combined operation of the Clean Water and Drinking Water SRFs.  In addition, EFAB
sought to identify the regulatory, statutory, organizational and programmatic hurdles that
currently prevent the Clean Water and Drinking Water SRFs from operating as a single
entity.

       EFAB members held informal discussions with a number of States to identify the
benefits and issues inherent in the combined operation of the Clean Water and Drinking
Water SRFs.  Conversations were held with SRF managers from the States of New York,
New Hampshire, Missouri, Maryland, Montana, North  Carolina and New Mexico.  The
anecdotal  information received  from these  conversations  offers  insights  into the
perceived benefits of jointly operated SRFs. This information can serve as the basis for
an in-depth analysis of the benefits of combined SRF operations across states.

OPPORTUNITIES, CONSTRAINTS AND LIMITATIONS
       EFAB explored a number of areas where  there may be obvious advantages of
combined operations.  These included fund investments, leveraging, administration and
staff expertise,  and project funding  capacity.   As mentioned previously,  EFAB  also
attempted to identify  some of the possible limitations  and constraints in implementing
such a major shift.  Both benefits  and hurdles are described in  further  detail in the
paragraphs that follow.

Administration
       The majority  of managers we spoke to believe they would  reap significant
administrative benefits if they were able to run the Clean Water  and Drinking Water
SRFs as one.  Technical project management in most states is split by fund with
coordinators and engineers working on one type of project or the  other.  Cost savings
would result from having a single SRF with a dedicated technical staff in one, as opposed
to multiple, locations. Furthermore, states mentioned they would be able to benefit from

-------
                                                                    EFAB Report

cost savings in the time staff spend on producing separate reports for each of the funds,
namely the Annual Reports and Intended Use Plans. Accounting for the funds would be
greatly simplified, as SRF monies would no longer have to be tracked separately. One
state mentioned that having a single SRF  would assist in addressing match requirements
and the accounting challenges that tracking the separate matches involves.

       Moreover, moving toward  consolidation of the two  SRF programs would be
complementary to EPA's efforts over the last several years to approach water pollution
control on a more integrative, watershed basis.  Recognizing the need to bring non-point
source controls into the equation has  caused the Agency to foster more emphasis on a
watershed approach to planning and implementation of strategies for both point and non-
point  control and safe  drinking water supply.  The closer integration of the two water
infrastructure financing programs at the state level would help facilitate this watershed
approach, allowing states to identify the most efficient and effective use of expenditures
for both control and supply.  A fully integrated loan program where available money was
fungible  would provide the state with the flexibility to direct  loan  funds to the most
environmentally strategic projects in  a watershed.  To  fully achieve  this objective of a
common pooling arrangement and a common  Intended Use Plan, would require some
modest changes in federal statute in both the Clean Water and the Safe Drinking Water
Acts.  It would be important to maintain the current categorical appropriations so that the
set-asides for  state program administration  as well  as those for  basic  drinking water
assessments would be sustained roughly in proportion to the administrative needs of the
two programs.

Cost-of-Funding
       Many states that leverage their SRFs already sell a single issue of bonds to fund
both Drinking Water and  Clean Water.   These bonds are  jointly  secured or  cross-
collateralized by the assets of both SRFs and generally achieve AAA ratings - the highest
rating assigned to municipal bonds. SRF  managers are able to sell  bonds jointly secured
by  the  assets of  both SRFs by  complying  with the proportionality  or  investment
provisions in each Act.

-------
                                                                     EFAB Report
       Aside from advantageous borrowing levels, which the majority of SRFs enjoy by
virtue of their ratings, most managers view a single pool of funds as a financial advantage
for both the SRF and the projects funded.  For instance, a single municipality or entity
applying for both drinking water and clean water loans would be able to receive funding
under  a single loan application.  This would simplify the  legal work that must be
undertaken by both borrower and lender, resulting in lower legal and trustee fees.

Fund Investments
       As permitted by EPA, most investment managers treat funds under each SRF as
fungible for investment purposes, although they must separately account for the assets of
each SRF.  The ability to account for SRF federal and state contributions in one common
equity fund is an area where benefits can be significant.  Several  states consulted on this
project jointly manage their own investments, finding it preferable to state  investment
pools where  returns and flexibility  of investment  products are often  limited.  Since
anticipated cash-flow   needs  for  constructions  draws,  new  lending and possible
administrative costs are critical factors of short term fund investing, the capacity to  shift
available fund from one category to another is essential to achieving better returns. Quite
simple, returns are generally directly proportionate to the amount and duration of money
invested and the ability to combine available funds in one managed investment pool can
significantly enhance returns.

Barriers to Implementation
       The  most  frequently cited  hurdle  to  combined operations  is the  different
institutional arrangements that currently exist between the state agencies responsible for
the implementation  and oversight of each SRF.  Characterized by one state administrator
as "institutional drag" this may also be an issue for EPA, where different divisions  have
responsibility  for the  Clean Water  and Drinking Water programs. Even  at the
Congressional level,  two  separate  House Committees  assert jurisdiction  over the
Drinking Water SRF, a complicating factor in achieving any statutory modification.

-------
                                                                    EFAB Report

Furthermore, there is concern within EPA that combined operations could have a least
common denominator effect, with the loss of flexibilities currently enjoyed by one or the
other fund  (e.g., funding for  disadvantaged communities or  coverage  of technical
assistance costs).

       While there  are legal  constraints at the federal level for implementing a jointly
operated SRF, constraints at  the  state level  are tied to how each state is  organized to
manage the SRFs.   Federal  authorization of a common SRF would require states to
review state laws as well as  the powers of their current managing institutions.  In this
respect, some states have cautioned about the advisability  of going to their legislature
with requests for basic legislative change; concerned that opening up the loan program
for legislative modification would unduly expose it to legislative tinkering and possible
mischief and might result is  some efforts to expropriate the loan funds for other state
financing needs.  They advised that often state legislatures have little understanding of
the SRF program  and any invitation for statutory  changes could open the funds to
politically motivated  actions.  However, tightly crafted federal  legislation could limit
attempts by state legislatures to divert SRF funds.

EFAB RECOMMENDATIONS
       We recommend that  EPA, perhaps  in cooperation with EFAB, undertake an
examination of the two programs to determine what opportunities and advantages exist
for combined SRF operations. To undertake this in any comprehensive fashion is a big
job and we obviously do  not have the resources. But evidence from our observations and
consultation  with   several state programs   indicates  wisdom  in moving, however
incrementally, toward a more fully integrated program.  The question is not whether the
programs could be  combined, but rather how best can they be  combined and to what
advantage and perhaps at what cost.

-------