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The Clean Water and
Drinking Water Infrastructure
Gap Analysis
       CLEAN WFER

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Message from EPA's Assistant Administrator for Water
      As our economy and population grow, we must
  periodically take a good look at the challenges ahead
  and reassess our nation's needs for infrastructure to
  ensure clean and safe water. By "infrastructure" we
  mean the pipes, treatment plants and other critical
  components that deliver safe drinking water to our
  taps and remove waste water from our homes and
  other buildings. Recognizing the importance of
  having a common understanding of the challenges
  ahead, the U.S. Environmental Protection Agency
  (EPA) undertook a "Gap Analysis" to review the
  historical patterns of infrastructure investment,
  compare it to  projections of future needs, and
  provide a transparent assessment of the gap between
  needs and spending. The result of our  effort is this
  report on the  Clean Water and Drinking Water
  Infrastructure Gap Analysis.

         In keeping with our commitment to subject
  our analysis to external scrutiny, EPA submitted the
  methods and data used in the Gap Analysis to a
  diverse panel of peer reviewers drawn from
  academia, think tanks, consulting firms, and industry.
  Overall, the reviewers commended the report as a
  reasonable effort to quantify the gap. As a result of
  the peer review process, we revised the preliminary
  projections and approaches to incorporate the
  comments and views of  these expert external
  reviewers.
       This report makes clear that there is no single
correct number to describe the gap. Any gap study
must be built using methodologies  and definitions of
need, which in turn rest on assumptions  about the
present conditions of infrastructure nationwide, and
desirable or appropriate policies to  follow in the
future. While much of the projected gap is the
product of deferred maintenance, inadequate capital
replacement, and a generally aging infrastructure, it is
in part a consequence of future trends we can
anticipate today, such as continuing population
growth and development pressures. Yet, funding
gaps need not be inevitable. They will occur only if
capital and operations and maintenance (O&M)
spending and practices  remain unchanged from
present levels. The analysis suggests that a large gap
will result if the challenge posed by an aging
infrastructure network—a significant portion of
which is beginning to reach the end of its useful
life—is ignored.

       EPA has encouraged a national dialogue  on
the appropriate roles for addressing infrastructure
needs and continues to work in  partnership with
Congress and other stakeholders in helping to define
effective approaches to meeting these emerging
challenges.  This report on the Clean Water and
Drinking Water Infrastructure Gap Analysis is one of
EPA's contributions toward an ongoing dialogue. Our
objective is to ensure clean and safe water for
generations to come. Water infrastructure is key to
that future.
                                                                    G. Tracy Mehan, III
  Office of Water (4606M)
  EPA-816-R-02-020
  www.epa.gov/safewater
  September 2002
                      Printed on Recycled Paper

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      The Clean Water and
Drinking Water Infrastructure
           Gap Analysis
                United States
           Environmental Protection Agency

               Office of Water
                 (4606M)

              EPA-816-R-02-020
               September 2002

             Printed on Recycled Paper

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                                                                                    Table of Contents
Table  of Contents
Introduction	7

Characteristics of the Clean Water and Drinking Water Industries	10

    2.0 Purpose	10
    2.1 Characteristics of the Clean Water Industry	10
    2.2 Characteristics of the Drinking Water Industry	10
    2.3 General Characteristics of Capital Stock and Impact on Operations and Maintenance	11
    2.4 Clean Water Capital Stock	13
    2.5 Drinking Water Capital Stock	15
    2.6 Costs of Providing Service 	17

Methods for Estimating Needs and Spending for Clean Water	19

    3.0 Purpose	19
    3.1 General Steps	19
    3.2 The Clean Water Capital Need	19
    3.3 Estimate Total O&M Needs	23
    3.4 Estimate Current Spending	25
    3.5 Estimate the Total Payment Gap	25
    3.6 No Revenue Growth and Revenue Growth Scenarios 	27
    3.7 Key Variables 	28

Methods for Estimating Needs and Spending for Drinking Water	29

    4.0 Purpose	29
    4.1 General Steps—Capital Needs	29
    4.2 The Drinking Water Capital Investment Need	30
    4.3 Allocate Capital Investment Need by Year	35
    4.4 Calculate Financing Costs	35
    4.5  Estimate Current Spending	36
    4.6  Estimate the Total Capital Payment Gap	38
    4.7  Estimate the Operations and Maintenance (O&M) Gap	39

Conclusion	43

    5.0 Findings	43
    5.1 Suggestions for Future Research	43

Appendix A: Comparing the Gap between Clean Water and Drinking Water: Numbers and Methodologies	45

    1.0 Comparison between the Clean Water and Drinking Water Capital Payment Gap	45
    1.1 Comparison between the Clean Water and Drinking Water O&M Payment Gap	46

Appendix B: Critiques and Comments from the Peer Review Panel	48

    1.0  The Peer Review Process	48
    1.1 Major Points about the Capital Estimates	48
    1.2 Major Points about the O&M Estimates	49
    1.3 Major Points about the Financing Forecast	50

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Figures and Tables
Figures  and Tables
Figure 1—1:     Increase in U.S. Population by Decade	8
Figure 1—2:     Projection of Increase in Biological Chemical Oxygen Demand (BOD) 	9
Figure 1—3:     Declining Trend in R&D Water Pollution Abatement Expenditures	9

Figure 2—1:     Percentage of Drinking Water Systems and Population Served by Size Class	10
Figure 2—2:     Percentage of Drinking Water Systems by Type of Ownership	11
Figure 2—3:      Example of Life Cycle Deterioration Curve	12
Figure 2—4:     Operations and Maintenance Spending from State and Local Sources (1978—1994)	12
Figure 2-5:     1996 Clean Water Needs by Category (adjusted for the SSO study)-$225 Billion in 2001 Dollars	13
Figure 2—6:     Histogram of Miles of Sanitary Sewer Pipe Installed per Decade	14
Figure 2—7:     Average Age of Wastewater Pipe Network	14
Figure 2—8:     Shift in the Likely Condition Associated with the Aging Miles of Pipe in the Network (percentage of
               pipe by classification) 	15
Figure 2-9:     Percent Needs by Drinking Water Infrastructure Category (total needs $150.9 billion)	16
Figure 2—10:    Age Distribution  of Current Inventory of Pipe for 20 Cities	16
Figure 2—11:    Projected Annual Replacement Needs for Transmission Lines and Distribution Mains, 2000—2075	17
Figure 2—12:    Change in Distribution of User Fees for Communities in Ohio between 1989 and 1999	17
Figure 2—13:    Percentage Point Change in Share of Aggregate Income  for Households	18

Figure 3—1:     Projected Capital Costs  (Average Scenario)	22
Figure 3—2:     Projected Capital Payments (Average Scenario)	23
Figure 3—3:     Annual Operations and  Maintenance Cost Measured as a Percentage of Net Capital Stock
               (Average Scenario)	23
Figure 3—4:     Projected O&M Payments (Average Scenario)	24
Figure 3—5:     Capital Payment Gap (Average No Revenue Growth Scenario) 	24
Figure 3—6:     Capital Payment Gap (Average Revenue Growth Scenario) 	24
Figure 3—7:     O&M Gap (Average No Revenue Growth Scenario)  	25
Figure 3—8:     O&M Gap (Average Revenue Growth Scenario) 	25
Figure 3—9:     Cumulative Growth in Sewerage Expenditures and Gross Domestic Product 1980-1999	27
Figure 3-10:     A Qualitative Assessment of the Sensitivity of the Gap Estimate 	28

Figure 4—1:     Pipe Replacement Model Replacement Need Estimate	34
Figure 4—2:    Projected Drinking Water Capital Spending (adjusted for privates and DWSRF ineligibilities for
              2000-2019)	37
Figure 4-3:     Capital Payment Gap (Average No Revenue Growth Scenario)	39
Figure 4-4:     Capital Payment Gap (Average Revenue Growth Scenario) 	39
Figure 4-5:     O&M Gap (Average No Revenue Growth Scenario) 	41
Figure 4-6:     O&M Gap (Average Revenue Growth Scenario) 	41

Table 2-1:     Useful Life Matrix	11

Table 3-1:     Summary of 1996  Clean Water Needs Survey	20
Table 3-2:     Investment Needs, Costs, and Payments 2000-2019 (Billions of Dollars) 	26

Table 4—1:     Reported Drinking Water Infrastructure Needs  (Billions of 1999 Dollars)	30
Table 4-2:     Adjustment of Needs (Billions of 1999 Dollars)	31

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                                                                                  Executive Summary
Executive Summary
      To gain a better understanding of the future
 challenges facing the clean water and drinking water
 industries, the U.S. Environmental Protection Agency
 (EPA) has conducted a study to identify whether
 there is a quantifiable gap between projected clean
 water and drinking water investment needs over the
 twenty-year period from 2000 to 2019  and current
 levels of spending.  The analysis found that a
 significant funding gap could develop if the nation's
 clean water  and drinking water systems maintain
 current spending and operations practices.

      However, this gap largely disappears if
 municipalities increase clean water and drinking water
 spending at a real rate of growth of three percent
 per year.  This real rate of growth represents a three
 percent per year increase over and above the rate of
 inflation and is consistent with the long-term growth
 estimates of the economy.

      The scope of this report is limited to a
 discussion of methods for calculating the capital and
 operations and maintenance (O&M) gaps for clean
 water and drinking water.  Although the findings will
 inform policy discussion,  this report confines itself
 to estimating the gap, and it does not attempt to
 discuss the array of  policy considerations  stemming
 from the  results.

      In calculating capital investment needs over the
 twenty-year period, both the clean water analysis and
 the drinking water analysis used their respective
 Needs Surveys as a starting point. Adjustments were
 made to account for under-reporting of needs,
 especially with regard to needs associated with capital
 replacement. Estimates of capital needs for clean
 water from 2000 to 2019 range from $331 billion to
 $450 billion with a point estimate of $388 billion.
 Estimates of capital needs for drinking water over
 the twenty-year period range from $154 billion to
      billion with a point estimate of $274 billion.
     The methods used several alternative
assumptions that generated hundreds of different
permutations for estimating the capital and O&M
gaps. The range represents the uppermost and
lowermost extremes of these estimates. Providing a
range explicitly acknowledges the uncertainty of the
analysis, which  stems from the limited quality of the
available data and the potential  for variance in key
factors affecting costs.  The point estimates were
calculated by taking an average of each possible
combination of assumptions.

     The analysis also compared projected
operations and maintenance (O&M) needs to
current spending.  O&M needs for both clean water
and drinking water were assumed to be a function of
capital stock. To estimate current O&M spending,
both analyses used historical O&M spending data
from the Congressional Budget Office and the
Census Bureau and held this level constant over  the
20-year period.

     The resulting O&M gap for clean water over
the next twenty years is between $72 billion and  $229
billion with a point estimate of $148 billion  for  the
no revenue growth scenario, and the gap is between
$0 billion and $80 billion with a point estimate of
$10 billion1 for the revenue growth scenario.  The
drinking water O&M gap is between $0 billion and
$495 billion with  a point estimate of $161 billion2 for
the no revenue growth scenario, and this gap is
between $0 billion and $276 billion with a point
 1 The actual range is $-55 to $80 billion with a point estimate
 of $10 billion.  Under the assumptions used for certain
 scenarios, the models predict a surplus of infrastructure funds,
 or rather, a negative gap.  In these scenarios, total spending
 and/or revenues will exceed the total need over the next 20
 years. The report excludes these negative values in the text,
 because systems generally would not collect revenues in excess
 of their current estimated infrastructure needs. However, it
 should be noted that doing so would free infrastructure funds
 for situations where gaps remain.
 2 The actual range is $-67 to $495 billion with a point estimate
 of $161 billion. See Footnote 1 for further explanation.

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Executive Summary
 estimate of $0 billion3 for the revenue growth
 scenario.

      Whereas municipalities pay O&M costs from
 current revenues, they often use debt instruments to
 finance some of their clean water and drinking water
 infrastructure investments. However, the portion of
 clean water infrastructure that is financed is
 significantly greater than the portion of  drinking
 water infrastructure that is  financed. The analysis
 assumes that clean water and drinking water systems
 will finance a significant portion of projected capital
 needs over the estimation period. Estimates of
 payments for clean water capital needs range from
 $321 billion to $454 billion, while estimates of
 payments for drinking water capital needs range from
      billion to $475 billion.
      Capital spending (payments) estimates for the
 twenty-year period were made using historical data
 from the Congressional Budget Office and the U.S.
 Census Bureau. Current capital spending for clean
 water is estimated at $13 billion per year.  For
 drinking water, current capital spending is estimated
 at $10.4 billion per year.

      The capital payments gap is equal to the capital
 payment needs less the current spending on capital.
 For clean water, estimates of the capital gap range
 from $73 billion to $177 billion with a point estimate
 of $122 billion for the no revenue growth scenario,
 and the estimates range from $0 billion to $94 billion
 with a point estimate of $21 billion4 for the revenue
 growth scenario.  For drinking water, estimates of the
 capital gap range from $0 billion to $267 billion with a
 point estimate of $102 billion5 for the no revenue
 growth scenario, and the estimates range from $0
 billion to $205 billion with a point estimate of $45
 billion6 for the revenue growth scenario.

      It is also important to note that the range of
 needs and gaps are provided to explicitly acknowledge
 variations within the estimates, but are not intended
 to support comparative analysis between the clean
water and drinking water industries. The drinking
water analysis was able to use data sets that were not
available to clean water, e.g., data sets of pipe
inventory and age of assets. These data allowed
drinking water to use four different methods to
estimate capital needs and vary assumptions within
each method, whereas the clean water analysis used a
single method and varied  assumptions within that
method. The broader array of methods available to
the drinking water analysis generated a broader range
of needs and gaps. As such, the resulting ranges
provide insight into the impact of varying
assumptions  within each industry, but the data and
methods cannot be used to conduct a valid
comparison of the funding gaps facing the clean
water and drinking water industries.

     EPA submitted the methods and data used in
this analysis to a panel of peer reviewers drawn from
academia, think tanks, consulting firms, and industry.
In general, the reviewers found that the analysis
represented a commendable and credible  effort to
quantify the infrastructure gap. EPA refined the
analysis to address comments made by the reviewers,
although implementation of some of the
recommendations would require data that are as yet
unavailable. The results, therefore, should be viewed
with the understanding  that the present body of data
constrains our ability to estimate the gap with a high
degree of certainty. This caveat aside, the  report
offers estimates to ensure that policy discussions of a
pressing infrastructure challenge will not be
forestalled while we await improvements in data
quality—rather, any refinements to the  estimates
should inform ongoing deliberations. The major
issues and concerns raised by the peer review panel
are summarized in Appendix B.
3 The actual range is $-286 to $276 billion with a point estimate
of $-58 billion. See Footnote 1 for further explanation.
4 The actual range is $-39 to $94 billion with a point estimate
of $21 billion. See Footnote 1 for further explanation.
5 The actual range is $-17 to $267 billion with a point estimate
of $102 billion. See Footnote 1 for further explanation.
6 The actual range is $-94 to $205 billion with a point estimate
of $45 billion. See Footnote 1 for further explanation.

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                                                                                         Introduction
Introduction
 1.0  Purpose

      The objective of this report is to determine
 whether a potential funding gap could emerge
 between projected needs and current spending with
 respect to clean water and drinking water
 infrastructure. The analysis presents in detail the
 methods for quantifying the gap for the purpose of
 providing transparency as to how the estimates were
 derived. The results are expressed as a range; each
 range also has a point estimate that is the  average of
 the different combinations of assumptions that could
 be used in calculating the gap.  By presenting the
 findings as a range, the report acknowledges the
 uncertainty. The report confines itself to  quantifying
 the funding shortfall  for capital and operations and
 maintenance (O&M)  investments that will be needed
 to ensure that clean water and drinking water systems
 can continue to protect the environment and public
 health. The policy implications of the funding gap
 are beyond the scope of the present analysis.  The
 remainder of this chapter provides the historical and
 technical context for  understanding the infrastructure
 issues confronting the clean water and drinking water
 industries.

 1.1  Background

      Water is life. Clean and safe water is  critical for
 human health and ecosystem health. As early as 5000
 years ago, centralized systems supplied drinking water
 to communities in parts of the Middle East.  Twenty-
 five hundred years ago, Athens, Greece rebuilt its city
 with sewers that transported sanitary waste to rural
 areas for disposal onto orchards and agricultural
 fields.  In the centuries since, these two services—
 supply of drinking water and disposal of
 wastewater—have become intrinsic responsibilities of
 communities worldwide.

      As recently as the mid-nineteenth century,
 however, drinking water supply and wastewater
disposal were largely matters of transportation—of
bringing drinking water to citizens and removing
wastewater.  In the United States, health concerns
and technological advances brought changes to
drinking water infrastructure around the turn of the
twentieth century.  In 1872, Poughkeepsie, NY
introduced slow sand filtration to reduce turbidity in
drinking water. This treatment via filtration removed
microbial contaminants that had caused typhoid,
dysentery, and cholera epidemics. In 1908, Jersey
City, NJ introduced drinking water disinfection
treatment, and chlorination further reduced drinking
water disease outbreaks.

     If a community's wastewater received any
treatment prior to  1900, this treatment consisted of
physically separating solids and floating debris from
wastewater before discharge into  a nearby waterbody.
In 1907, Gloversville, NY built the nation's first
wastewater filtration facility, and in 1916, Chicago, IL
constructed  an activated sludge treatment plant.
These advances, called secondary treatment, helped
to alleviate epidemics of typhoid, cholera, and other
waterborne diseases. This treatment also improved
ecosystem health—highlighted by resurging fish and
shellfish populations.

     In the last century, treatment of drinking water
and wastewater has become more advanced, and it
has spread to almost all systems in the country. The
1972 Clean Water Act mandated that all publicly
owned treatment works (POTWs) provide secondary
treatment of wastewater.  By 1996, fewer than 200
systems—out of 16,204 nationwide—had not met
this standard.  The 1974 Safe Drinking Water Act
established a system of nationwide standards for
drinking water contamination.  Today, the
Environmental Protection Agency regulates more
than 80 drinking water contaminants and the  vast
majority of people receive drinking water from
systems that have no reported violations of health-
based standards.
                                                                                                         7

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Introduction
 Figure 1—1: Increase in U.S. Population by Decade

      The advancement and expansion of clean water
 and drinking water systems has been worthwhile but
 costly. In the last twenty years, communities have
 spent $1 trillion in 2001 dollars on drinking water
 treatment and supply and wastewater treatment  and
 disposal.7 This spending is impressive, but it may not
 be sufficient to keep pace with infrastructure needs
 of the future. Several issues provide cause for
 concern.

      • Our systems are aging. Generally, installation of
      clean water and drinking water infrastructure has
      followed overall patterns of population growth
      in cities across the country (Figure 1-1).
      Treatment plants typically have an expected
      useful life of 20-50 years before they require
      expansion or rehabilitation. Pipes have life
      cycles that can range from  15 to well over 100
      years—with actual pipe life varying considerably
      depending on soil conditions,  pipe material,
      climate, and capacity requirements. In some
      eastern cities, systems have some pipes in use
      that are almost 200 years old.
• Populations are increasing and shifting geographically.
The 2000 Census identified a population of 281
million in the country, an increase of more than
32 million from the 1990 Census.  This change
was the largest  census to census increase in
United States history. The Census Bureau
projects a population of more than 325 million
by the year 2020. Systems will need to increase
capacity to meet the demands posed by this
growth.  To complicate the issue, population is
shifting geographically, requiring rapid increases
in system capacity in  some parts of the country
and requiring maintenance of aging systems in
other parts of the country with  diminishing
populations (and a diminishing rate base).

• Current treatment may not be sufficient.  In  1998,
states, tribes, and interstate commissions
assessed water quality in 32 percent of the
nation's estuaries and found 44 percent of the
assessed areas to be impaired. Wastewater
treatment facilities and combined (wastewater
and stormwater) sewer overflows were two  of
the leading causes of impairment. Wastewater
treatment efficiencies may be leveling off, which,
when combined with population and economic
growth, could have the effect of reversing hard-
won water quality gains.  By 2016 pollution levels
could be similar to levels observed in the mid-
1970s (Figure 1-2).

• Investment in research and development has declined.
Innovation, research, and development are
essential elements in promoting the use of more
effective, efficient, and affordable technologies
in water and wastewater treatment. A recent
EPA report on R&D expenditures (public and
private) associated with water pollution
abatement showed that expenditures decreased
by half from the early 1970s to the late 1990s
(Figure 1-3).
 7 Based on annual outlays reported in the Bureau of the
 Census Government Finances Data Series for local
 government expenditure for sewerage and the Engineering
 News-Record's Construction Cost Index (www.enr.com/cost/
 costcci.asp).
8

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                                                                                             Introduction
      25,000

  >   20,000
  ro

  !   75,000
  tfi
  c
  •^   70,000
  "Z
  S    5,000

           0
              7968   7972   7978  7996  2076   2025
Figure 1—2:  Projection of Increase in Biological Chemical
Oxygen Demand (BOD)8

     * Services are non-centralized. Twenty-five percent
     of all households in the U.S. have on-site
     wastewater treatment systems and 15 percent of
     all households receive drinking water from
     private wells. Generally, states and communities
     have not established adequate management
     programs to assure proper functioning of onsite
     systems for wastewater treatment and private
     drinking water wells. This under-investment in
     support results in poor location and design
     decisions, inferior materials, faulty installation,
     and a general lack of maintenance.  Adequate
     investment is critical to ensuring that these
     systems operate properly. At the local, state,
     and national level, more attention will have to be
     paid in the future, not only to replace and repair
     existing infrastructure, but also to establish and
     support management programs.

     • Some communities will have a difficult time meeting
     funding challenges. Some  communities, particularly
     small communities which lack the economies of
8 U.S. EPA, Progress in Water Quality: An Evaluation of the
National Investment in Municipal Wastewater ^reatment, June 2000.
9 U.S. EPA, A Retrospective Assessment of the Costs of the Clean
Water Act: 1972 to 1997, October 2000.
     scale associated with a large customer base, are
     challenged in meeting the cost of installing and
     maintaining infrastructure. The financial impact
     of the need to address aging infrastructure will
     be greater for these communities. There are
     also communities in the country that are
     unserved or underserved by clean water and
     drinking water systems  (Indian Tribes, Colonias,
     Alaska Native Villages).

     To gain a better understanding of the
challenges the clean water and drinking water
industries will face in the future, EPA has conducted
a study to identify whether there is a quantifiable gap
between the estimated investment needs for clean
water and drinking water systems and current
spending by these systems over the next 20 years.  In
order to frame the  discussion, Chapter 2 of this
report describes the characteristics of the clean
water and drinking water industries.  Chapters  3 and
4 lay out the Agency's identification of the needs and
spending associated with clean water and drinking
water infrastructure, respectively, in an effort to
identify whether there is a gap.  Chapter 5
summarizes the findings and suggests areas for
further research.
  if)  $350
  |  $300
  i  $250
  g  $200
  c  $750
  |  $700
  o   $50
  o
        0
                                                                  72 74 76  78 80 82 84 86 88 90 92 94 96
                                                                Public R&D Expenditures  Private R&D Expenditures

Figure 1—3:  Declining Trend in R&D Water
Abatement Expenditures'

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Characteristics of the Clean Water and Drinking Water Industries

Characteristics of  the  Clean Water and Drinking
Water Industries
 2.0  Purpose

      A discussion of the characteristics of the clean
 water and drinking water industries provides a useful
 context for understanding the results of the gap
 analysis. For example, the differences between the
 industries necessitated the use of different methods
 in estimating needs, costs, and payments gaps.

 2.1  Characteristics of the Clean Water
 Industry

      In the United States, there are 16,024 publicly
 owned treatment works for treating municipal
 wastewater. Although there are also some privately
 owned wastewater treatment works, most of the
 industry (98 percent) is in fact municipally owned.
 These POTWs provide service to 190 million people,
 representing 73 percent of the total population (at
 the time of the 1996 Clean Water Needs Survey
 Report to Congress).  Seventy-one percent of the
 facilities serve populations of less than  10,000 people.
 Furthermore,  approximately 25 percent of
 households in the nation are not connected to
 centralized treatment, instead using on-site systems
 (e.g., septic tanks). Although many of these systems
 are aging or improperly functioning, this analysis is
 restricted to centralized collection and treatment
 systems.

 2.2  Characteristics of the Drinking Water
 Industry

      The drinking water industry has over ten times
 the number of systems as the clean water industry.
 Of the almost 170,000 public water systems, 54,000
 systems are community water  systems, that
 collectively serve more than 264 million people. A
 community water system serves more than 25 people
 a day all year round. The remaining 114,000 water
 systems are transient noncommunity  water systems
    100
  o>
  O)
  n
 4^
  £
  0)
  u
  (5
 Q.
         <500
501 -
3,300
3,301 -
10,000
10,001 -  >100,000
100,000
Figure 2—1: Percentage of Drinking Water Systems and
Population Served by Si^e Class

(e.g., camp grounds) or non-transient noncommunity
water systems (e.g., schools).  The scope of the gap
analysis is largely confined to community water
systems,10 as these systems serve most of the
population. Small systems serving fewer than 10,000
people comprise 93 percent of all community water
systems in the nation.  However, most of the
population (81 percent) receives drinking water from
larger systems (Figure 2-1).

     In contrast to the clean water industry, only
about 43 percent of community water systems are
publicly owned. Most of these systems are under the
authority of local governments (Figure 2-2).
Ownership type varies by system size—with almost
90 percent of systems serving more than 10,000
people under public ownership.
10 The Needs Survey data also includes $3.1 billion in needs
for 21,400 not-for-profit noncommunity systems.  Therefore
this analysis includes those systems as well. It also includes
needs for Alaskan Native Villages and American Indian
systems.
10

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                     Characteristics of the Clean Water and Drinking Water Industries
  \   Private   1
  \   33%
 * Ancillary: Water
 supply is not primary
purpose of business (e.g.,
 mobile home park)
Figure 2—2: Percentage of Drinking Water Systems by Type
of Ownership

2.3  General Characteristics of Capital
Stock and Impact on Operations and
Maintenance

     The different components of capital stock that
make up our nation's clean water and drinking water
systems vary in complexity, materials, and the degree
to which they are subjected to wear and tear. The
expenditures that utilities must make to address the
maintenance of systems are largely driven by the
condition and age of the components of
infrastructure.

2.3.1  Useful Life

     The life  of an asset can be estimated based on
the material, but many other factors  related to
environment and  maintenance  can affect the useful
life of a component of infrastructure. On a national
level, it is not feasible to conduct a condition
assessment of all  clean water and drinking water
infrastructure systems.  However, approximation
tools can be used to estimate the useful life of these
infrastructure systems.

     One such approximation tool is a useful life
matrix, which can serve as a tool for developing initial
cost  estimates and for long-range planning and
evaluating programmatic scenarios. An example of a
matrix developed as an industry guide in Australia is
shown in Table 2—I.11  Although the useful life of a
                                                       (
      Table 2-1 - Useful Life Matrix
Years   Component
         Clean Water
80-100  Collections
     50  Treatment Plants - Concrete Structures
 15-25  Treatment Plants - Mechanical & Electrical
     25  Force Mains
     50  Pumping Stations - Concrete Structures
     15  Pumping Stations - Mechanical & Electrical
90-100  Interceptors
         Drinking Water
 50 - 80  Reservoirs & Dams
 60 - 70  Treatment Plants - Concrete Structures
  15 -25  Treatment Plants - Mechanical & Electrical
 65 - 95  Trunk Mains
 60 - 70  Pumping Stations - Concrete Structures
     25  Pumping Stations - Mechanical & Electrical
 65 - 95  Distribution
                        component will vary according to the materials,
                        environment, and maintenance, matrices such as that
                        shown in Table 2-1 can be used at the local level as a
                        starting point for repair and replacement, strategic
                        planning, and cost projections. The U.S. as well as
                        other industrialized countries  have engineering and
                        design manuals that instruct professional designers as
                        to the accepted standards of practice for design life
                        considerations. The U.S. Army Corps of Engineers,
                        the American Society for Testing Materials, the
                        Water Environment Federation, the American
                        Society of Civil Engineers, and several associations
                        maintain data that provides guidance on design and
                        construction of conduits, culverts, and pipes and
                        related design  procedures.

                             The useful life of pipe, which comprises most
                        of the assets of both clean water and drinking water
                        systems, varies considerably based on a number of
                        factors. Some of these factors include the material
                        of which the pipe is made, the conditions of the soil
                        in which it is buried, and the character of the water
                        or wastewater  flowing through it.  In addition, pipes
                        11 The International Infrastructure Management Manual, Version
                        1.0. Australia / New Zealand Edition, April 2000
                                                                                                       11

-------
Characteristics of the Clean Water and Drinking Water Industries
A projected deterioration pattern
for 100 year pipe
Condition Classification
p p p p
o KO *». b> bo ~>
	 — — 	 	
Excellent \ "\
-i^..
Good | \


X
Fair \ \




Poor \

\
Very Poor \\
\

2 12 22 32 42 52 62 72 82 92
Percentage of Effective Life Elapsed
       2-3: Example of Life Cycle Deterioration Curve
 do not deteriorate at a constant rate. During the
 initial period following installation, the deterioration
 rate is likely to be slow, and repair and upkeep
 expenses low. For pipe, this initial period may last
 several decades.  Later in the life cycle, pipe will
 deteriorate more rapidly. Figure 2-3 is an example of
 a deterioration classification scheme.

      The best way to determine remaining useful life
 of a system is to conduct periodic condition
 assessments. The new financial reporting
 requirements (GASB 34) of the Government
 Accounting Standards Board recognize the role
 condition assessments play in advancing its
 'preservation report' framework. At the local level,
 service providers can conduct condition assessments
 of their collection systems to ascertain their
 condition for maintenance and replacement
 purposes. It is essential for local service providers to
 complete periodic condition assessments in order to
 make the best life-cycle decisions regarding
 maintenance and replacement.
 12 Congressional Budget Office, Trends in Public Infrastructure,
 May 1999.
2.3.2 Operating and Maintaining Capital Stock

     As shown in Figure 2—4, spending in constant
dollars on operations and maintenance (O&M) for
clean water and drinking water has grown
significantly since 1970. In 1994, for example, 63
percent of the total spending for clean water was for
O&M, and 70 percent of the total spending for
drinking water was for O&M.12

     Likely explanations for the increase in clean
water and drinking water O&M costs include the
following:

     • Expansion and improvement of services,
     which translated into an increase in capital stock
     and a related increase in operations and
     maintenance costs.

     • Aging infrastructure, which requires
     increasing repairs and increasing maintenance
     costs.

     Also, increases in clean water operations and
maintenance have been  driven, in large part, by a
large number of solids handling  facilities  coming on-
line. The installation of these facilities has increased
O&M costs beginning in the mid-1980s.

     Over the next 20 years, O&M expenses are
likely to increase in response to the aging of the
capital stock: that is,  as infrastructure begins to
   g  25
   o
   •5  20
   CQ
   5  15
   o
   CM
                                                          S2
                                                          •S
                                                          "5
                                                          Q
                                                                     Water
                                                                                         Wastewater
Figure 2—4: Operations and Maintenance Spendingfrom
State and Local Sources (1978-1994)
12

-------
                      Characteristics of the Clean Water and Drinking Water Industries
deteriorate the costs of maintaining and operating
the equipment will increase. An American Water
Works Association (AWWA) study found that
projected expenditures for deteriorating
infrastructure would increase steadily over the next 30
years.13 The projected increase in O&M costs finds
support in the historical spending data, which
indicate an upward trend for O&M (Figure  2—4).
                 New   /Treatment
          Collectors/  /
         Interceptors
                 11%
 * SSO estimate includes
 Needs Survey results for
 Infiltration /Inflow correction
 and Sewer Rehab/
 Replacement
Phase I
Stormwater
4%
Figure 2—5:  1996 Clean Water Needs by Category (adjusted
for the SSO study)-$225 Billion in 2001 Dollars
     Increasing O&M needs will present a significant
challenge to the financial resources of clean water
and drinking water systems. As the nation's water
infrastructure ages, systems should expect to spend
more on O&M. Some systems might even postpone
capital investments to meet the rising costs of
O&M—assuming that their total level of spending
remains constant. The majority of systems likely
would increase spending to ensure that both capital
and O&M needs are fulfilled, and thus total spending
would increase significantly. Many systems would
recognize that delaying new capital investments would
only increase expenditures on O&M, as old and
deteriorated infrastructure would  need to be
maintained at increasingly higher costs.
2.4  Clean Water Capital Stock

     The basic components of clean water
infrastructure are collection systems and treatment
works. Systems vary across the clean water industry
as a function of the demographic and topographic
characteristics of the service area, the unique
characteristics of the particular waste stream, and the
operating requirements dictated in the permit
conditions. The type of treatment is largely
controlled by discharge limitations and performance
specified through state or federal permits.

     The Clean Water Needs Survey collects needs
documentation from publicly owned treatment
works. Although the results likely underestimate true
needs, particularly when considering replacement of
pipes (discussed further in Chapter 3), they can serve
as an example of the components  of a system.
Figure 2—5 shows the percent of need associated
with the major needs categories in  the 1996 Clean
Water Needs Survey, adjusted based on results of the
Agency's recent cost analysis conducted to estimate
costs associated with correcting sanitary sewer
overflows (SSOs).

     Pipe networks represent the primary
component of  a clean water system.  During the last
century, as  population grew and spread out from
urban centers, the amount of pipe increased as
homes were connected to centralized treatment.
Although there is not an actual inventory of the total
amount of sewer pipe associated with wastewater
collection systems in the U.S., the American Society
of Civil Engineers (ASCE)14 has developed an
estimate based  on feet of sewer per capita—with the
average length estimated at 21 feet of sewer per
capita. The range varied from 18 feet to 23 feet per
capita. The resulting estimate is about 600,000 miles
of publicly owned pipe.

13 American Water Works Association, Daivn of the Replacement
Era: Reinvesting in Drinking Water Infrastructure, May 2001.
14 American Society of Civil Engineers, Optimisation of
Collection System Maintenance Frequencies and System Performance,
February 1999.
                                                                                                        13

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Characteristics of the Clean Water and Drinking Water Industries
      140,000
      120,000
   .& 100,000
   s. 80,000
   o
   «> 60,000
   | 40,000
      20,000
         0
^^_^_n_n_TU\ \  \ i—i
            1870   1890  1910  1930  1950  1970  1990
 Figure 2—6: Histogram of Miles of Sanitary Sewer Pipe
 Installed per Decade

      Because there is no nationwide inventory of
 wastewater collection systems, the actual age of sewer
 pipe is not known. However, it is safe to say that
 installation of pipe has followed demographic
 increases in population and growth in metropolitan
 areas associated with suburbanization. Figure 2-6
 represents an estimate of the amount of  sewer pipe
 installed per decade, using population, urban density,
 and public sewerage system data from the U.S. Census
 Bureau.

      The  vast majority of the nation's pipe network
 was installed after the Second World War, and the
 first part of this wave of pipe installation is now
 reaching the end of its useful life. For this reason,
 even if the pipe system is extended to serve growth
 and the country invests in the replacement of all pipe
 as it comes to the end of its useful life, the average
 age of pipe in the system will still increase until at
 least 2050 (Figure 2-7.)

      Although there will be differences based on pipe
 material and condition, the need to replace pipe will
 generally echo the original installation wave.  Figure 2-
 8 applies a deterioration curve to the pipe network as
 it ages from 1980 to 2020. Based on the deterioration
 projections over the next twenty years, if the pipe
 system is  extended to serve growth but there is no
 renewal or replacement of the  existing  systems, the
 amount of pipe classified as either "poor," "very
 poor," or  "life elapsed" will increase from 10 percent
of the total network to 44 percent of the total
network.

     Many of the wastewater treatment plants in the
U.S. were completely renovated with major plant
expansion and upgrade work beginning in the 1970s,
responding to new treatment requirements of the
1972 Clean Water Act and financed to a great extent
by EPA's Construction Grants program.  Although
plants have shorter useful lives than sewer pipe, plant
replacement needs are not projected to be a major
part of the renewal and replacement requirements
until after 2020.  In the near term, 22 percent of the
needs identified in the 1996 Clean Water Needs
Survey were related to treatment.

     Of course,  some of the components in the
treatment plants  (e.g., mechanical and electrical
components) will need to be replaced within the next
20 years, but relative to the collection systems, they
are much less significant.  Furthermore, there tends
to be greater awareness of the condition of the  plant
structures since they are easier to observe (i.e., not
buried underground) and are subject to more
frequent inspection. However, there are implications
to the costs associated with the plants. As the
treatment plants  continue to age, their operation and
maintenance costs will increase at a more rapid rate,
having a major impact on future operating budgets.
                                              100
                                               90
                                               80
                                               70
                                               60
                                               50
                                               40
                                               30
                                               20
                                               10
                                                0
                                                            2-7: Average Age of Wastewater Pipe Network
14

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                      Characteristics of the Clean Water and Drinking Water Industries
     (3%) Poor - N  -,- Very Poor (2%)
      (3%) Fair-^
                    ,- Life Elapsed (5%)
                   1980
,-Very Poor (2%)
\  r Life Elapsed (7%)
                                           (14%)
                                           Poor   . —   ...
                                                  ^Excellent]
                                           (18%)     (43%)
                                          '  Fair           i
                                               (17%)
                                               Goo-1
                                                                              -Life Elapsed (9%)
    2000
(13%) Poor--*
      (12%)Fair—~
               2020
                                                                                       •— Good (11%)
                                Percentage of Pipe by Classification
                 2—8: Shift in the Likely Condition Associated with the Aging Miles of Pipe in the Network
                                      (percentage of pipe by classification)
     Furthermore, because so many treatment plants
were constructed near the same point in time (i.e.,
beginning in the 1970s), replacement needs will hit at
relatively the same time. The initial treatment plant
replacement needs will occur at the same time that
many pipes installed post-WWII will begin requiring
replacement.  Deferral of timely renewal and
replacement associated with the oldest pipe over the
next twenty years will likely put a system in a difficult
financial condition. The typical system could
experience a very significant bump in expenditures
over a very short period of time to accommodate
replacement of old pipes, new pipes, and plant
structures in the same time frame.

2.5  Drinking Water Capital Stock

     The analysis in Chapter 4 discusses the needs
and spending associated with maintaining the capital
stock of public drinking water systems. The capital
stock of an individual drinking water system can be
broken down into four principal components: source,
treatment, storage, and transmission and distribution
mains. Each of these components fulfills an
important function in delivering safe  drinking water
to the public.

     While there is no study available that directly
addresses the capital make-up of our nation's
drinking water systems, a general picture can be
          obtained from the 1999 EPA Drinking Water
          Infrastructure Needs Survey (Figure 2—9). Although
          it is the least visible component of a public water
          system, the buried pipes of a transmission and
          distribution network generally comprise most of a
          system's capital value.  Transmission and distribution
          needs accounted for 55 percent of the total need
          reported in the 1999 survey. Treatment facilities
          that are needed to address contaminants with acute
          and chronic health effects represented the second
          largest category—with 25 percent of the total need.
          Storage projects needed to  construct or rehabilitate
          finished water storage tanks represented 12 percent
          of the total need.   Projects  needed to address
          sources of water accounted for six percent. The
          source category included  needs for constructing or
          rehabilitating surface water intakes, raw water
          pumping facilities, drilled wells, and spring collectors.
          Neither the storage nor source categories considered
          needs associated with  the construction or
          rehabilitation of raw water reservoirs or dams.

               The need to  replace aging transmission  and
          distribution components is  a critical part of any
          drinking water system's capital improvement  plan.  A
          recent AWWA report, Dawn of the Replacement'Era,15
          surveyed the inventory of pipe and the year in which
          15  American Water Works Association, Dawn of the Replacement
          Era: Reinvesting in Drinking Water Infrastructure, May 2001.
                                                                                                        15

-------
Characteristics of the Clean Water and Drinking Water Industries
                            Source
                            6%
                           Treatment
                              25%
                                    Storage
                                    12% "
 Figure 2—9: Percent Needs by Drinking Water Infrastructure
 Category (total needs $150.9 billion)

 the pipe was installed for 20 cities in an effort to
 predict when the replacement of the pipe would be
 needed.  While the 20 cities in  the sample were not
 selected at random, the cities likely represent a broad
 range of systems of various ages and sizes from
 across the country.  More importantly,  the study
 provides the only available data on the  age of pipe
 from a reasonably large number of systems.  Figure
 2—10 shows the distribution of  the age of pipe
 currently in the inventory of these 20 cities.

      While Figure 2—10 presents the distribution of
 the age of pipe for  the 20 cities, the data do not
indicate when the pipe would need to be replaced.
Age is one factor that affects the life expectancy of
pipe.  A simple aging model, therefore, was
developed to predict when pipes for these 20 cities
would need to be replaced. It was assumed that pipes
installed before 1910 last an average of 120 years.
Pipe installed from 1911 to 1945 is assumed to last an
average of  100 years. Pipe installed after 1945 is
assumed to last an average of 75 years. In estimating
when the current inventory of pipe will be replaced,
the model assumes that the actual life span of the
pipe will be distributed normally around its expected
average life; that is, pipe expected to last 75 years will
last 50 to 100 years, pipe expected to last 100 years
will last from 66 to 133 years, and pipe expected to
last 120 years will last 80 to 160 years.

     This assumption greatly simplifies reality, as the
deterioration rates of pipe will vary considerably as a
function not only of age, but also of climatic
conditions, pipe material,  and soil properties. Pipe  of
the same material, for example, can last from 15
years  to over 200 years depending on the soil
characteristics alone. In the absence of data that
would allow for the development of a model to
estimate pipe life (i.e., accounting for local variability
of pipe deterioration),  the application of a normal
distribution to an average life expectancy may
provide a reasonable approximation of replacement
Percentage of Inventory
2.0%
1.5%
1.0%
0.5%
0.0%
18

^"\
J \
, — -, / ^~x
/ \/\
7 "^jvT ^^7"~-\
r~\ /
\ /
••"7 	 w^«-^— -^— .
/X / V
	 ,J. 	 .\^. 	

70 1890 1910 1930 1950 1970 1990
Year Installed


              Figure 2—10: Age Distribution of Current Inventory of Pipe for 20 Cities
16

-------
                     Characteristics of the Clean Water and Drinking Water Industries
                        2000   2070    2020   2030   2040   2050   2060    2070
                                                    Year
            Figure 2—11: Projected Annual Replacement Needs for
            Mains, 2000-2075
          ission Unes
rates.  This model also does not account for other
factors, most notably inadequate capacity, that may
have equal or greater importance than deterioration
in determining pipe replacement rates.

    Applying this simple aging model to the
historical inventory of pipe for the 20 cities reveals
that most of the projected replacement needs for
those cities will occur beyond the  20-year period of
the analysis—with peak annual replacement occurring
in 2040 (Figure 2—11).  This conclusion makes sense
considering that most of the nation's drinking water
lines were installed after the 1940s.

2.6 Costs of Providing Service

    Although many water and wastewater providers
obtain funds from the federal government to finance
the costs of capital improvements, most of the
funds that systems use for both capital and
operations and maintenance come from revenues
derived from user fees. As utilities look to address
Drinkin
.2 700
."*•*
1 12°
| 80
0 60
"o 40
% 20
I '
g l/l/afer Fees in
Oh/0 (2007 $)
| 1989
•
L
r

l_








0 1999
	 cn.._.
f

1

J"
1


dl dn

<$200 $200- $30t- $40t- $507- $607+
300 400 500 600
Annual Average Fee
                                                        Wasfeivater Fees in Ohio (2001 $)
                                                              C$200  $200- $30?- $40?- $50?-  $60?+
                                                                    300   400   500  600
                                                                    Annual Average Fee
    Figure 2—12: Change in Distribution of UserFees for Communities in Ohio between 1989 and 1999
                                                                                                   17

-------
Characteristics of the Clean Water and Drinking Water Industries
_ 10
0) 5
D)
a 0
o
- -5
01
ft.
-75
D 7967- 7980
D 7980 - 7992
• 7993 - 7998

•
1
I IT

	
..^...._






[_
—
Lowest Second Third
7.5 -4.6 -2.3
-77.6 -8.7 -6.5
0 0 -0.7

Fourth
2.9
-2.8
-1.3
Highest
-0.2
7.3
0.6

Aggregate Income for Households
(by category)
 Figure 2—13: Percentage Point Change in Share of Aggregate
 Income for Households (measuredfrom initial year in range)

 future capital needs and increasing O&M costs, they
 may need to increase fees to obtain the funding
 needed for these activities.

      While there is no complete source of national
 data on how rates have changed through time, the
 State of Ohio has information that can serve as  an
 example  for the purposes of a simple discussion. For
 more than 15 years, the State has conducted an
 annual survey of water and sewer rates for
 communities  in the state. Data from communities
 that reported rates for both 1989 and 1999 reveal that
 there has been an upward shift in the number of
 communities  paying higher  annual fees with time
 (Figure 2-12).

      User rates that are needed to meet the cost of
 providing service have the potential to negatively
 impact those  segments of the population with low
 incomes. Data from the Census Bureau16  show that
 between  1980 and  1998, incomes at the lower range
 (as a percentage share of aggregate income for
 households) declined or stagnated (Figure 2-13). If
 rates increase to fund  increasing needs, utilities may
 be challenged to develop rate structures that will
 minimize impacts on the less affluent  segments  of
 society.

 16 U.S. Census Bureau, The Changing Shape of the Nation's  Income
 Distribution, U.S. Census P60-204, Current Population Reports
 Series, June 2000.
18

-------
                          Methods for Estimating Needs and Spending for Clean Water

Methods  for Estimating Needs  and Spending for
Clean Water
 3.0  Purpose

      The purpose of this analysis is to quantify the
 relationship between the estimated infrastructure
 needs of clean water systems over the next 20 years
 and current levels of spending. The limitations of the
 data necessitate reporting the results of the analysis
 as a range. A range explicitly acknowledges the
 uncertainty of the analysis, specifically, the different
 underlying assumptions that can be used (with no
 clear distinction of validity) to estimate the capital
 and O&M needs. Within each range, however, the
 analysis provides  a point estimate, which represents
 the average of the hundreds of different scenarios
 that can be generated for each combination of
 assumptions.

 3.1  General Steps

      The method for estimating the difference
 between needs and current spending involves five
 primary steps, each of which is described in the
 following sections.

      1. Estimate the total capital investment needs
      for the next 20 years using data from the 1996
      Clean Water Needs Survey, add a modeled
      estimate of Sanitary Sewer Overflow needs, and
      then adjust the analysis for underreported
      replacement needs.

      2. Calculate the impact of financing the capital
      investment needs to determine the total capital
      cost and the total capital payments from 2000-
      2019.

      3. Estimate the total O&M needs for the next
      20 years using data from the Bureau of the
      Census Government Finances Data Series for
      local government expenditure  for sewerage.
     4. Considering historical spending, develop
     base levels of current annual capital spending
     and current annual O&M spending. Historical
     data on local government expenditures for
     sewerage are taken from the Bureau of the
     Census Government Finance Data Series.

     5. Compare the projected annual needs to
     current annual spending estimates, considering
     both capital needs and O&M needs, and project
     the annual payment gap in clean water
     spending.
3.2 The Clean Water Capital Need

3.2.1 Clean Water Capital Investment Needs

    The 1996 Clean Water Needs Survey (CWNS)
provides data to estimate the total capital investment
need over 20 years. The CWNS identifies a total
capital investment need of $156.9 billion.17 Table 3—
1 summarizes the results of the needs survey.

    A few factors may lead the CWNS to
underreport needs at wastewater facilities over the
next twenty years.18 First, the CWNS mainly
identifies capital investment needs related to
compliance, not needs related to service levels.
Second, the CWNS includes only needs that can be
justified by project-specific documentation that
describes the nature of the problem, recommended
solutions, and the basis of the cost estimate.  Survey
information is collected through a buildup  of state
and local estimates, which are subjected to quality
control review techniques to assure consistent
17 All figures in Chapter 3 are adjusted to 2001 dollars using
the Engineering News-Record's Construction Cost Index
(www.enr.com/cost/costcci.asp).
18 An updated needs survey, the 2000 Clean Water Needs
Survey, will be submitted to Congress in August 2002.
                                                                                                   19

-------
Methods for Estimating Needs and Spending for Clean Water
Capital Needs Identified in the
1996 Clean Water Needs Survey
(in Billions of 1996 Dollars
Adjusted to Billions of 2001 Dollars)
Needs Category
I. Secondary Treatment
II. Advanced Wastewater Treatment
Sewer Infiltration/Inflow Correction
& Replacement/Rehabilitation
IV. New Collector/Interceptor Sewers
TJ Combined Sewer Overflows
(modeled estimate)
VI. Stormwater (modeled estimate)
Wastewater/Infrastructure Related
Subtotal
^jjj Various nonpoint source controls
(modeled estimate)
Total
1996
$26.5
$17.5
$10.3
$21.6
$44.7
$7.4
$128.0
$11.5
$139.5
2001
$29.8
$19.7
$11.6
$24.3
$50.3
$8.3
$144.0
$12.9
$156.9
  Table 3—1: Summary of 1996 Clean Water Needs Survey

  treatment of data. The documentation requirement
  provides assurance that the needs and costs derived
  from different sources can be aggregated since they
  are developed using similar criteria and applying a
  common standard. Where little documentation exists
  across a need category, such as costs for controlling
  combined sewer overflows, sanitary sewer overflows,
  and storm water, EPA develops estimates using cost
  models.

      Third, the need is only defined as a need if it
  exists on January 1 of the needs survey year (e.g., I/
  1/96 for the  1996 survey). In other words, to have a
  future need recognized, it must be tied to a current
  need. The fourth factor is the planning period used to
  estimate needs. Historically, clean water infrastructure
  needs were planned and implemented based on a 20-
  year planning period. More recently,  communities
  have been using a shorter planning period (e.g., 5 to
  10 years), so  the estimates they report for the Clean
  Water Needs Survey likely do not include the full cost
  needs associated with the 20-year period. This
  analysis assumes that modeling Sanitary Sewer
Overflow needs and developing an underreported
replacement estimate will capture many, if not most,
of the underreported needs relating to existing
infrastructure.

     The clean water capital investment need is
estimated in the following manner.

     1. The CWNS identifies a total capital
     investment need of $156.9 billion for 20 years.

     2. CWNS-identified needs for activities related
     to nonpoint source (e.g., agriculture, silviculture,
     urban runoff, estuaries, wetlands, and
     groundwater) (Category VII—$12.9 billion)  are
     eliminated from the analysis.

     3. The CWNS also identifies infrastructure
     needs for infiltration/inflow correction and
     sewer replacement/rehabilitation (Category III).
     These needs ($11.6 billion) are replaced in this
     analysis by modeled estimates ($92.1 billion)
     developed by EPA to better estimate the costs
     associated with correcting existing SSO
     problems in existing wastewater  collection
     systems and bringing them into compliance with
     existing regulations.  EPA based  the SSO needs
     estimate on data from the 1996 Clean Water
     Needs Survey database and case  studies from 65
     municipalities. The methodology to estimate
     capital costs associated with reducing SSOs
     included a hydrologic model.  The model
     simulates the effects of wet weather on each
     separate sanitary sewer system; a set of cost
     functions associated with infiltration/inflow
     reduction, storage, and treatment; and  an
     optimization routine to determine  the least
     costly combination of infiltration/inflow
     reduction, increased storage, and increased
     treatment.

     4. This analysis then adjusts for underreported
     replacement needs. The development  of this
     underreported replacement needs estimate is
     somewhat complex. This analysis assumes that
20

-------
                          Methods for Estimating Needs and Spending for Clean Water
     capital stock (wastewater treatment facilities,
     sewer systems, and rolling stock) has an average
     depreciation period of 60 years, an assumption
     developed by the Bureau of Economic Analysis.
     To model this assumption, this analysis assumes
     a replacement need of 3.3 percent (1/30) of net
     capital stock on an annual basis (roughly equal
     to 1.6 percent (1/60) of the non-depreciated
     capital stock constructed in the 60-year
     depreciation period). To  simulate the turnover
     in capital stock over different periods of time,
     this analysis also developed scenarios in which
     net capital stock is replaced at annual rates of 4
     percent and 2.9 percent, which translate  roughly
     into a turnover of capital stock in 50 years and
     70 years, respectively. The additional scenarios
     show how aggregate estimates  are affected if the
     capital stock turns  over at different rates.

          Before this underreported replacement
     needs estimate is completed, however, it is
     reduced to  account for replacement needs that
     are reported in the CWNS and modeled in the
     SSO estimate. Alternative scenarios used in this
     analysis assume that %, Va, or 3A of the SSO
     estimate reflects replacement costs.

          Data on the net capital stock from 1972—
     1990 are derived from the Consolidated
     Performance  Report, a report that incorporates
     data  from the Bureau of the  Census
     Government  Finances Data Series.19 The
     analysis uses an iterative process to  derive net
     capital stock values for each year by adding new
     stock and depreciation to the previous year's net
     capital stock value.20
19 Corps of Engineers, Consolidated Performance Report on the
Nation's Public Works: An Update (IWR Report 94-FIS-13,
December 1994).
20 Equation for Net Capital Stock
K = K  + I - D*K
  t    t-i   t     t-i
Where: K  = net capital stock in year t,
       I = capital investment (i.e., need) in year t, and
       D = annual depreciation of net capital stock
       (expressed as a fraction)
     Equation for each year's Underreported
Replacement Needs Estimate

     R = D*K - S*A/T
     Where:
              R — replacement need
              D = depreciation rate for net capital
              stock
              K = net capital stock
              S = replacement costs in SSO
              estimate
              A = annual reported capital
              investment needs
              T = reported capital investment
              needs for 2000-2019

     In this analysis, the 20-year clean water capital
investment need estimate ranges from $331 billion to
$450 billion.

3.2.2  Capital Financing Costs And Payments

     While some systems may purchase
infrastructure with current revenues, many use debt
financing for at least a portion of their infrastructure
investments. According to the Bureau  of Economic
Analysis, clean water systems have historically used
debt to finance 90 percent of their capital stock with
municipal bonds or government loans.  In this
analysis, alternative scenarios assume that 75 percent,
85 percent, or 95 percent of capital investments will
be financed.

     This analysis distinguishes between capital
investment needs (discussed in section 3.2.1), capital
costs  (including financing costs), and expected
payments for capital investments  (a measurement of
cash flow needs).  Although considerations of
payment needs are most important for this
infrastructure challenge, each estimate has value in
policy discussions. However, investments must be
                                                                                                        21

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Methods for Estimating Needs and Spending for Clean Water
      40
    I 3S
    Q 30
    § 25
    .3 20

    I1S
    M 10
       s
       0
   g»n? 5-/: Projected Capital Costs (Average Scenario)
  compared with investments, costs with costs, and
  payments with payments.

      To estimate payments for capital investments
  and the resulting financing costs, the model makes
  the following assumptions:

      1.  Systems use municipal bonds or government
      loans  to finance 75 percent, 85 percent, or 95
      percent of their capital investments.

      2.  Systems borrow at a real interest rate of 2.5,
      3.0, or 3.5 percent.

      3.  Loans have a term of 20, 25, or 30 years.

      4.  Systems will make level debt service payments
      over the life of the loan.  The payment is given
      by:
                      k*(1 +r)n
               P =
                     f(1+r)«-1\
      where:
               p = the amount of the annual
               payment;
               k - the value of the infrastructure
               purchased;
               r - the real interest rate; and
               n - the duration of the loan.
     5.  Each annual investment is simulated as a
     separate bond.

     6.  Debt service for old debt instruments does
     not include investments paid with EPA grants.

     7.  The amount not financed (for example, 15
     percent of the total each year) is paid for in the
     year in which the infrastructure is  purchased.

     With these varied assumptions, if associated
financing costs are accounted towards the year in
which an investment is made, the capital financing
cost ranges from 21.4 percent to 60.0 percent.21  As a
result, the capital cost estimate (including financing
costs) ranges from $402 billion to $719 billion (Figure
3-1).

     The term "payment" is used to indicate cash
flows, e.g., when debt service payments for the
investments are actually  paid.  Since a portion of the
total need is purchased each year over the 2000—2019
period, and since a portion of each year's purchase is
financed over a 20-year period, all interest and
principal payments are not paid for in full by 2019.
However, an estimate of payments for capital
investments must also include payments related to
existing debt (Figure 3—2).  The estimate of payments
for capital investments in this twenty-year period
ranges from $321 billion to $454 billion. These
payments service existing debt, service  debt incurred
from 2000—2019, and cover pay-as-you-go
expenditures. The total estimate of payments needed
for capital investments is compared to current
spending levels in section 3.6 to estimate clean water's
capital gap. It is important to note that these
21 For example, if annual capital financing needs are $100, and
75 percent of these needs are financed at a real interest rate of 3
percent over twenty years, an amortization schedule with level
debt service will result in total payments of $100.82. The cost
of borrowing ($100.82 - $75.00 = $25.82) is 25.8 percent of the
annual capital financing needs.  This ratio holds for any volume
of annual capital financing needs.
22

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                          Methods for Estimating Needs and Spending for Clean Water
      40
a   35
o
Q
   (B

   .0
30

25
20
15
10
 5
 0.
              Pay As You Go

              New Debt Service

              Old Debt Service
Figure 3—2: Projected Capital Payments (Average Scenario)
estimates assume that the local governments fund the
entire increase in projected capital costs. Should state
or federal sources provide local governments with
grants or low-cost loan assistance, the total projected
local payments would decrease because less capital
would need to be financed.
                        3.3 Estimate Total O&M Needs

                            This analysis estimates future O&M needs by
                        considering the ratio of O&M expenditures to net
                        capital stock.  According to O&M outlay data derived
                        from the Bureau of the Census Government
                        Finances Data Series for local government
                        expenditure for sewerage, this ratio grew in linear
                        fashion from  1972-1996.  O&M needs grew from 3.7
                        percent of net capital stock in 1972 to 7.4 percent of
                        net capital stock in 1996.  This linear trend might be
                        expected to continue if O&M costs were  to continue
                        to largely reflect service and treatment costs—and
                        net capital stock were to continue to grow due to
                        increasing service and treatment. However, this
                        model assumes that O&M costs related to the
                        maintenance of aging systems will increase, and it
                        assumes that capital stock increases will increasingly
                        reflect a different kind of expenditure—the eventual
                        replacement of aging infrastructure.

                            By itself, an aging infrastructure should result in
                        increasing O&M expenditures because of the
                        increased need for repairs. However, a model that
                        estimates O&M as a fixed percentage of net capital
                        stock would project declining O&M as the net value
                        of an  aging capital stock declines, exactly the
                        opposite of what should happen. Assuming an
                        increasing ratio of O&M to net capital stock, which
      Historical O&M Costs

        •    Documented

      	  linear Trend

      Projected O&M Costs

            Upper Bound

      —•—  Base Case

            Lower Bound
                                 12%
                        ^  10%
OH
CS
U
+J

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Methods for Estimating Needs and Spending for Clean Water
      (B
      *4
      C«
      O
     Q
     T-H
     o
     o
     a
 Figure 3—4: Projected O&M Payments (Average Scenario)
                                  opposite of what should happen.  Under this
                                  scenario, a decreasing ratio of O&M to net capital
                                  stock is arguably most appropriate.

                                       However, given the uncertainty about what will
                                  actually happen in practice to the ratio of O&M to
                                  net capital stock, the base case of this analysis
                                  assumes that the ratio of O&M to net capital stock is
                                  frozen at the level from the last actual data on O&M
                                  and net capital stock (Figure 3-3).  The upper bound
                                  case assumes a linear increase over the 20-year period
                                  to a level in 2019 that is one percent above the base
                                  case O&M to  net capital stock ratio, while the lower
                                  bound case assumes a one percent decline in the ratio
                                  over the 20-year period.
 is consistent with recent data, can overcome this
 problem.

      Conversely, a major pipe replacement campaign,
 as contemplated in the capital needs assessment,
 should moderate the growth in O&M expenditures
 because old leaky pipes are being replaced by new
 lower maintenance pipes.  In this case, however, a
 model that estimates O&M as a fixed percentage of
 net capital stock would project increasing O&M
 because the projection is driven by the major
 increases in net capital stock from the pipe
 replacement program.  Again, this is exactly the
                                       In this analysis, the O&M needs estimate for
                                  2000-2019 ranges from $406 billion to $562 billion
                                  (Figure 3-4). This analysis assumes that clean water
                                  systems will not finance any O&M costs. The
                                  estimate of payments  needed for O&M is compared
                                  to current spending levels and to a baseline of
                                  revenue growth in section 3.6 to estimate clean
                                  water's O&M gap.
 o
Q
T-H
O

 «
• i-t
 s
 o
40
35
30
25
20
15
10
 5
 0
                Projected Capital Gap
                (No Revenue Growth)
             D Current Capital
                Payments
              111
tilllll
1
       13—5: Capital Payment Gap (Average No Revenue
  Growth Scenario)
                                      o
                                      Q
01
o
40
35
30
25
20
15
10
 5
 0
                                                   Projected Capital Gap
                          (Revenue Growth)
                       D Projected Revenues for Capital
                                    Figure 3—6:  Capital Payment Gap (Average Revenue
                                    Growth Scenario)
24

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                          Methods for Estimating Needs and Spending for Clean Water
40
03 35 -
| 30-
s 25"
1 20.
_C
03 I-* '
| 10-
« 5-
0









• Projected O&M Gap
(No Revenue Growth)
D Current O&M
z
•


1


^ ^JV
Figure 3-7: O&.
Scenario)
1


4



*
|


*
|


?fc
|



>
r





II



*
Payments
1
j








- - -



/^vw


M Gap (Average No Revenue Growth
3.4  Estimate Current Spending

     In order to calculate the gap, the projected
payments for capital investments and O&M are
compared to current levels of spending.

3.4.1  Payments for capital investments

     In 2001 dollars, historical payments for capital
investments from local government have been
relatively flat. This analysis uses an estimate of FY
1996 capital payments ($13.0 billion) to establish a
current level of spending. This figure is based on (a)
data for local government capital investments from
1973—1996 derived from the Bureau of the Census
Government Finance Data Series for local
government expenditures, (b) estimates of federal
grants based on annual appropriation bills and the
CRS report Water Infrastructure Financing: History of
EPA Appropriations 1986-1998, and (c) an assumption
that historical capital investment has been financed as
described in section 3.2.2.

3.4.2  Payments for O&M needs

     As discussed in section 3.5, O&M spending has
steadily increased over the past two decades. For this
reason, this analysis uses estimated FY 1996 O&M
      40
      35
      30


      20
  '«  15

  I  10
                                                       o
• Projected O&M G
(Revenue Growth)
D Projected Revenue
ap
s
for O&M
_







--



•








•









.




|=




=




_




i




i




•




-




:




. r




:




^


















Figure 3—8:
Scenario)
                                                                       Gap (Average Revenue Growth
spending ($16.7 billion) as the baseline for current
spending. Spending for O&M needs from 1973—
1996 is reported in the Bureau of the Census
Government Finance Data Series for local
government expenditures.

3.5  Estimate the Total Payment Gap

     The annual capital payment gap is the
difference between the estimated payments and
projected spending in each year. The total payment
gap over the 20 years is the sum of the annual
payment gaps. In this analysis, the estimates of the
clean water capital payment gap range from 73
billion to 177 billion with a point estimate of $122
billion for the no revenue growth scenario (Figure 3-
5), and the estimates range  from $0 billion to $94
billion with a point estimate of $21 billion22 for the
revenue growth scenario (Figure 3-6).
22 The actual range is $-39 to $94 billion with a point estimate
of $21 billion.  Under the assumptions used for certain
scenarios, the models predict a surplus of infrastructure funds,
or rather, a negative gap. In these scenarios, total spending
and/or revenues will exceed the total need over the next 20
years.  The report excludes these negative values in the text,
because systems generally would not collect revenues in excess
of their current estimated infrastructure needs. However, it
should be noted that doing so would free infrastructure funds
for situations where gaps remain.
                                                                                                       25

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Methods for Estimating Needs and Spending for Clean Water
(1)
Capital
Investment
Needs
(not financed)—
w/o Revenue
Growth
Assumptions:
(2)
Capital
Costs
(financed)—
w/o Revenue
Growth
Assumptions:
(3)
Operations &
Maintenance
Costs —
w/o Revenue
Growth
Assumptions:
(4)
Payments —
w/o Revenue
Growth
Assumptions:
Capital
Capital/O&M
(5)
Payments —
w/ Revenue
Growth
Assumptions:
Capital
Capital/O&M
The total capital investment need is derived from the Clean Water Needs Survey and analytic
adjustments that account for costs that are generally not captured in the survey process.
Needs (20 years)
Range
$331 to $450
Average
$388
Gap (20 years)
Range
$158 to $277
Average
$215
Average Annual Needs Gap
Range
$8 to $14
Average
Of-] -1
$1 1
Capital costs financed are an estimate of the present value of the infrastructure investments. These
estimates include all capital and finance costs, regardless of when these costs are incurred.
Total Costs (20 years)
Range
$402 to $719
Average
$532
Total Costs Gap (20 years)
Range
$192 to $442
Average
$295
Average Annual Cost Gap
Range
$10 to $22
Average
^1 £
$l j
Future O&M needs are established by extrapolating from historical data. All O&M costs are
considered paid from current year revenues and not financed.
Total O&M (20 years)
Range
$406 to $562
Average
$482
Total O&M Gap (20 years)
Range
$72 to $229
Average
$148
Average Annual O&M Gap
Range
$4 to $11
Average
Of~7
|/
Payments are a measurement of cast flow. The annual payment gap is the difference between yearly
projections of payments and current spending. The total payment gap over 20 years is the sum of the
annual payment gaps.
Total Payments (20 years)
Range
$321 to $454
$736 to $1007
Average
$381
$862
Total Payment Gap (20 years)
Range
$73 to $177
$154 to $397
Average
$122
$271
Average Annual Payment Gap
Range
$4 to $9
$8 to $20
Average
$6
$14
The payment gap in this scenario assumes that the economy grows at a real rate of growth of three
percent, and municipal wastewater expenditures grow at an identical rate. A real rate of growth is a
rate of growth above inflation.
Total Payments (20 years)
Range
$321 to $454
$736 to $1007
Average
$381
$862
Total Payment Gap (20 years)
Range
$0 to $94 23
$0 to $143 25
Average
^91
tyZl
OfT.-]
$Jl
Average Annual Payment Gap
Range
$0 to $5 24
$0 to $7 26
Average
^1
|1
at9
|Z
    Table 3—2: Investment Needs, Costs, and Payments 2000—2019 (Billions of Dollars)
       The estimates of the O&M payment gap range
  from $72 billion to $229 billion with a point estimate
  of $148 billion for the no revenue growth scenario
  (Figure 3-7), and the estimates range from $0 billion
  to $80 billion with a point estimate of $10 billion27
  for the revenue growth scenario (Figure 3-8).

       This analysis considered three possibilities for
  six assumptions (e.g., real interest rates for municipal
  borrowers of 2.5 percent, 3.0 percent, and 3.5
  percent). The analysis considered all of these
  possibilities to generate hundreds of permutations of
these payment gaps.  A point estimate was obtained
23 The actual range is $-39 to $94 billion with a point estimate
of $21 billion.  See Footnote 22 for further explanation.
24 The actual range is $-2 to $5 billion with a point estimate of
$1 billion. See Footnote 22 for further explanation.
25 The actual range is $-94 to $143 billion with a point
estimate of $31 billion.  See Footnote 22 for further
explanation.
26 The actual range is $-5 to $7 billion with a point estimate of
$2 billion. See Footnote 22 for further explanation.
27 The actual range is $-55 to $80 billion with a point estimate
of $10 billion.  See Footnote 22 for further explanation.
26

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                         Methods for Estimating Needs and Spending for Clean Water
           I
           I
           I

           S
           ••a
           •S
           "3
           u
200%

775%

750%
700%

 75%

 50%

 25%

  0%
                               GDP
                       	AMSA Annual Service Charge Index
               Sewerage Capital and O&M

         -V- W-  Sewerage O&M
                         1986
                 1988
1990
1992
1994
1996
1998
2000
         Figure 3—9: Cumulative Growth in Sewerage Expenditures and Gross Domestic Product 1980-1999
by simply taking an average of all of the scenarios.

     This report characterizes a "Gap" in the
context of asset management practices.  The annual
capital payment gap and annual O&M payment gap
identified above best represent this "Gap."  Other
reports have considered the "Gap" using a capital
cost gap.

     Each of these different estimates is represented
in Table 3-2. Although the infrastructure challenge
is best evaluated by considering the flow of
payments, i.e., when and how much systems invest
(in the table, row 4), the gap can also be evaluated by
considering total capital needs (1), total capital costs
(2), and O&M costs (3).

3.6 No  Revenue Growth and Revenue
Growth Scenarios

     The no revenue growth and revenue growth
scenarios in this analysis provide different
alternatives for viewing the potential gap in
spending. The no revenue growth scenario shows
how much additional funding would be required to
address projected needs without considering
potential  growth in revenues.  However, that
scenario does not consider how sewer revenues will
increase if the national economy grows.
                                        The revenue growth scenario provides this
                                   perspective, although it includes two types of
                                   uncertainties. The first is whether or not the
                                   economy grows, as projected, with a three percent
                                   real annual growth rate in gross domestic product
                                   (GDP). Although this growth rate is uncertain, it is
                                   consistent with (actually slightly below) the growth
                                   rate projections currently being used by both the
                                   Office of Management and Budget and the
                                   Congressional Budget Office. The second type of
                                   uncertainty is whether or not municipal spending on
                                   wastewater will actually keep track with the pace  of
                                   growth in GDP.

                                        While the actual outcome  will reflect municipal
                                   policy decisions on the relative  demands for various
                                   types of local services, recent historical experience
                                   (see Figure 3-9) has shown that overall sewer
                                   expenditures have tracked fairly closely with growth
                                   in GDP.  Given that wastewater O&M costs  have
                                   been exclusively a local responsibility and that capital
                                   conveyance system (pipe) projects have historically
                                   been largely a local responsibility, it is not
                                   unreasonable to assume that localities would make
                                   significant wastewater needs a priority to maintain
                                   their share  of municipal revenue in a growing
                                   economy.  It should be understood that neither the
                                   revenue growth scenarios nor the no revenue growth
                                   scenarios imply that needs and  revenues are
                                   uniformly distributed across the country.
                                                                                                    27

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Methods for Estimating Needs and Spending for Clean Water
 3.7 Key Variables

      This analysis indirectly considers many factors
 that impact expenditure estimates in a positive or
 negative fashion.  Figure 3—10 is a qualitative
 assessment that describes some of these factors. By
 far the most important factors listed are estimates of
 repair costs and maintenance costs—estimates that
 reflect assumptions about the current condition of
 the nation's wastewater infrastructure.
         Factors likely to
    decrease the estimate
Factors likely to
increase the estimate
ate
   Decreasing labor costs due
     to integration of services

       Regionalizing services

        Competitive practices

  Asset management strategies

      Technology innovations

      Life extension strategies

 Growth in domestic economy
Increasing costs of
chemicals and power

Increasing requirements

Increasing repair costs

Increasing maintenance costs

Population growth

Economic expansion
  Figure 3—10:  A Qualitative Assessment of the Sensitivity of
  the Gap Estimate
28

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                     Methods for Estimating Needs and Spending for Drinking Water

Methods  for Estimating Needs  and Spending for
Drinking Water
4.0 Purpose

    The purpose of this analysis is to quantify the
relationship between the estimated infrastructure
needs of drinking water systems over the next 20
years and current levels of spending. In estimating
future capital needs, the analysis excludes capital
projects related to Drinking Water State Revolving
Fund (DWSRF) ineligible needs, such as dams and
future growth.  The lack of a defensible means to
quantify these costs is the primary reason for their
exclusion. Although the following sections are
limited to DWSRF eligible capital needs and
spending, the potentially substantial costs associated
with ineligible needs, most notably, future growth,
should be borne in mind when considering the
broader financial challenge with which water systems
will need to contend.  It is also important to note
that the analysis excludes needs associated with
regulations that EPA has not yet proposed.

    The focus on capital needs and spending
mirrors the level of federal involvement in drinking
water infrastructure in terms of funding assistance.
The DWSRF provides loans and other forms of
financial assistance to water systems for capital
improvement projects, consolidation, acquisition of
existing infrastructure, and refinancing loans. The
DWSRF does not provide loans for O&M.
Nonetheless, water systems will face mounting costs
related to O&M as the capital stock ages and as new
infrastructure is added to the network. In recognition
that the costs associated with O&M allow for a more
complete picture of the challenges facing water
systems, the last section of the chapter provides an
analysis of the needs and  spending associated with
O&M.
    The limitations of the data necessitate reporting
the results of the analysis as a range. A range
explicitly acknowledges the uncertainty of
assumptions that can be used (with no clear
distinction of validity) to estimate the capital and
O&M needs. Within each range, however, the
analysis provides a point estimate  that represents the
average of the hundreds of different scenarios that
can be generated for each combination of
assumptions.

4.1 General Steps-Capital Needs

    The method for estimating the difference
between capital payment needs and capital spending
involves five primary steps, each of which is
described in the following sections.

    1. Estimate the total capital investment need
    for the next 20 years based on one of four
    scenarios, each of which uses some portion of
    data from the 1999 Drinking Water
    Infrastructure Needs Survey.

    2. Allocate the total capital investment need by
    year.

    3. Estimate capital cost and the capital payment
    needs by calculating debt service financing for a
    percentage  of the capital investments.

    4. Using data from the Congressional Budget
    Office, estimate current capital spending.

    5. Compare the annual capital payment needs
    to annual capital spending. The difference is
    the annual capital payment gap.
                                                                                                29

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Methods for Estimating Needs and Spending for Drinking Water

Transmission and distribution lines
Large systems
Medium systems
Small systems
Non-community water systems
American Indian/Alaskan Native
Subtotal
Treatment, storage, source and other needs
Large systems
Medium systems
Small systems
Non-community water systems
American Indian/Alaskan Native
Subtotal
Cost of future regulations
Total
Total cost of regulations within total
Current
Need

28.7
17.9
14.1
0.3
1.1
62.1

18.6
11.9
8.2
0.9
0.9
40.5
0.0
102.5
16.6
Future
Need

8.3
6.2
2.0
0.1
0.1
16.6

6.4
7.2
6.9
1.9
0.1
22.5
9.3
48.4
14.7
Total
Need

36.9
24.1
16.1
0.4
1.2
78.7

24.9
19.2
15.1
2.7
1.1
63.0
9.3
150.9
31.2
       Table 4—1: Reported Drinking Water Infrastructure Needs (Billions of 1999 Dollars)
      4.2  The Drinking Water Capital
      Investment Need

      4.2.1  Treatment, Source and Storage Needs
      ("non-pipe" needs)

           The 1999 Drinking Water Infrastructure
      Needs Survey (DWINS) provides data to
      estimate the total capital need over the next 20
      years. The total need is $150.9 billion in 1999
      dollars. Table 4-1 summarizes the results of the
      needs survey.

           Several adjustments to the reported need
      are necessary to capture more completely the
      capital needs over the estimation period. The
      estimation of annual non-pipe capital needs
      involves 4 steps.
1.  The DWINS identifies non-pipe needs of
$63.0 billion (for information about the annual
allocation of non-pipe needs from 2000—2019,
see section 4.3.)

2.  The DWINS also identifies infrastructure
needs required to comply with recently
promulgated and proposed regulations: $9.3
billion. Because most systems had not yet
identified the infrastructure needed to comply
with these new regulations, the Needs Survey
used the Economic Analyses, which EPA
published when proposing or finalizing the
regulations, to estimate compliance costs. The
analysis assumes that water systems will need to
install the infrastructure to comply with these
regulations before the statutory compliance
dates of the rules, i.e., within the next 5 years.
30

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                 Methods for Estimating Needs and Spending for Drinking Water
3.  The analysis then adjusts the DWINS
estimates to account for under-reporting. The
methods used by the DWINS yield a
conservative estimate of need. EPA sent
questionnaires  to a random sample of 2,556
medium sized systems serving between 3,300
and 40,000 people and to all 1,111 large systems
serving more than 40,000. In completing the
survey questionnaire, many of these systems
relied exclusively on planning documents, such
as  Capital  Improvement Plans (CIPs), that often
covered just one to five years, rather than the
20-year scope of the survey. Thus, these systems
likely overlooked eligible projects that will be
needed beyond the time frame of their planning
documents. In  addition, planning documents
generally reflect the financial resources available
to  the systems. Therefore, even though a system
may need  to replace most of its deteriorated
distribution mains over  the next 20 years, the
CIP may include  a much smaller portion owing
to  the projected availability of funding.

In 1997, EPA conducted 200 site visits to
medium and large water systems that had
responded to the first Needs Survey, which was
completed in 1995. The purpose of the follow-
up study was to investigate the accuracy of the
responses. The study quantified the extent to
which medium and large systems under-
reported their needs in comparison to the
needs identified during the site visits. The
estimate of need for medium and large systems
is multiplied by 1.49 to account for under-
reporting. This adjustment was developed
directly from the follow-up study (i.e., systems
under-reported the needs associated with
treatment, storage, and source needs by a factor
of 1.49). The total non-pipe capital need  (for
current and future needs of small, medium, and
large systems), as adjusted for under reporting,
is $84.4 billion. The adjustments are shown in
Table 4-2.

EPA conducted site visits to assess the needs of
small systems serving fewer than 3,300 people,
as these systems generally lack the specialized
personnel and planning documents required to
complete a questionnaire. Because professional
water system engineers conducted on-site
inspections of small systems, it is assumed that

Pipe Needs
Large systems
Medium systems
Small systems
Subtotal
Non-Pipe Needs
Large systems
Medium systems
Small systems
Subtotal
New Regulations
Total Need
Total Need (2001 Dollars)
Unadjusted Need

$36.9
$24.1
$17.7
$78.7

$24.9
$19.1
$18.9
$63.0
$9.3
$150.9
$157.2
Adjustment Factor

1.61
1.61
NA


1.49
1.49
NA

NA


Adjusted Need

$59.2
$38.7
$17.7
$115.6

$37.0
$28.4
$18.9
$84.4
$9.3
$209.3
$218.0
 Table 4-2: Adjustment of Needs (Billions of 1999 Dollars)
                                                                                                31

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Methods for Estimating Needs and Spending for Drinking Water
     the estimate of the need for small systems
     requires no adjustment for under-reporting.

     4. The 1999 DWINS needs are reported in 1999
     dollars.  After adjusting the reported need for
     inflation to 2001  dollars, the total non-pipe need
     is $97.6 billion.

4.2.2 Transmission Lines and Distribution Mains

     The analysis developed four options to estimate
transmission line and distribution main needs.

     1. In the first option, pipe needs were obtained
     from the 1999 Needs Survey. Transmission lines
     and distribution mains account for most (55
     percent) of the reported need.

     The transmission and distribution needs are
     multiplied by 1.605 to account for under-
     reporting. This factor was derived from  the 1997
     follow-up study (i.e., systems under-reported
     their transmission and distribution needs by a
     factor of 1.605).  The adjustment of the
     transmission and distribution needs (for
     underreporting and adjustment to 2001  dollars)
     yields an estimate of $120 billion over the next
     20 years. By comparison, AWWA uses a pipe
     replacement model that produces a total need of
     $250 billion, but over 30 years.28 Using AWWA's
     methods to determine the value  of pipe
     replacement over the next 20 years generates an
     estimate of $52 billion (i.e., most of the need
     falls beyond the next 20 years).

     The advantage of using the Needs Survey is that
     it reflects actual needs identified  and
     documented by water systems, as opposed to  a
     pipe replacement model which would substitute
     these needs with  a modeled estimate. Also, the
     set of assumptions required to build a pipe
     replacement model simplify reality without
     necessarily contributing more worth to the
                                                           analysis. The disadvantage of this method is that
                                                           the estimates can only be apportioned into
                                                           current and future needs. Thus, the option will
                                                           not reflect the aging in capital stock that is
                                                           expected to occur over the next 20 years, and
                                                           instead distributes the total need according  to a
                                                           specified time frame.

                                                           2.  For option 2, the analysis substitutes the
                                                           transmission and distribution need from the
                                                           1999 Needs Survey estimate with an estimate
                                                           based on a pipe replacement model. The non-
                                                           pipe needs estimated by the Needs Survey would
                                                           be adjusted for under-reporting and added to
                                                           the modeled pipe estimate to obtain the total
                                                           capital need. The non-pipe needs are distributed
                                                           according  to current/future time  frames or
                                                           spread evenly over 20 years.

                                                           The advantage of this option is that pipe
                                                           replacement needs can be assigned to each  year
                                                           in the estimation period  according to the
                                                           projected aging of the transmission and
                                                           distribution network. The disadvantages are that
                                                           the assumptions required to build the model
                                                           represent a simplification of reality and that the
                                                           estimates substitute actual needs identified by
                                                           water systems with modeled needs.

                                                           For option 2, the need for transmission lines
                                                           and distribution mains was estimated using  a
                                                           pipe inventory model instead of the DWINS
                                                           results. The steps involved in  modeling the
                                                           replacement of pipe include (A) estimating the
                                                           current inventory of  pipe, (B) estimating its
                                                           vintage (i.e., the year in which  each mile of  pipe
                                                           was installed), (C) estimating the year the pipe
                                                           must be replaced as a function of its age, and
                                                           (D) estimating the cost of replacing the pipe.
                                                      28 American Water Works Association, Dawn of the Replacement
                                                      Era: Reinvesting in Drinking Water Infrastructure, May 2001.
32

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             Methods for Estimating Needs and Spending for Drinking Water
A. The current inventory of distribution
mains is estimated using data from the
1995 Community Water System Survey
(CWSS).  The CWSS reports the miles of
distribution mains in place for a
representative sample of community water
systems.  The total miles  of pipe in place is
estimated to be approximately 1.5 million
miles.

The CWSS does not ask water systems to
provide data on transmission lines. To
account for transmission lines, the miles of
pipe need reported in the DWINS for
transmission lines  are compared to the
miles needed for distribution lines. The
ratio of total  miles of pipe to distribution
mains in  the DWINS is 1.25. Therefore,
the length of distribution mains reported
in the CWSS  is multiplied by  1.25 to
produce an estimate of the total inventory
of pipe currently in place: 2.0 million miles.

To verify the  model, the results were
compared to  the AWWA estimate of pipe
inventory for large systems serving over
50,000 people.29 AWWAs estimate of
650,000 miles for these systems compares
favorably to the model's  estimate  of
610,000 miles.

B. To  approximate the age of the current
inventory of  pipe, the model used the age
distribution of replacement pipe values
reported for 20 cities in the AWWA report
Dawn of the Replacement Era.30 While the 20
cities in the sample were  not  selected at
random, the cities  likely represent a broad
range of  systems of various ages from
across  the country. More importantly, the
study provides the only available data on
the age of pipe from a number of systems.
The analysis assumed that the age of pipe
nationally is distributed identically to the
         age of pipe in the 20 cities in the AWWA
         report.  Figure 2—11 shows the assumed
         distribution of the age of the pipe
         currently in inventory.

         C. Age is an important determinative
         factor in governing when pipe must be
         replaced. This method assumed that pipes
         installed before 1910 last an average of 120
         years. Pipe installed from 1911 to 1945 are
         assumed to last an average of  100 years.
         Pipe installed after 1945 are assumed to
         last an average of 75 years.  In estimating
         when the current inventory of pipe will be
         replaced, the model assumes that the
         actual life span of the pipe will be
         distributed normally around its expected
         average life; that is, pipe expected to last 75
         years will last 50 to 100 years, pipe
         expected to last 100 years will last 66 to
         133 years, and pipe expected to last 120
         years will last 80 to 160 years.

         This assumption greatly simplifies reality,
         as the deterioration rates of pipe will vary
         considerably as a function of climatic
         conditions, pipe material, soil  properties,
         and corrosiveness of the drinking water.
         Pipe of the same material, for example,
         can last from 15 years to over 200 years
         depending on the soil characteristics alone.
         In the absence of data that would allow
         for the development of a national model
         to estimate pipe life (i.e., accounting for
         local variability of pipe deterioration), the
         application of a normal distribution to an
         average life expectancy provides a
         reasonable approximation of replacement
         rates.
29 American Water Works Association, Infrastructure Needs for
the Public Water Supply Sector, December, 1998.
30 American Water Works Association, Dawn of the Replacement
Era: Reinvesting in Drinking Water Infrastructure, May, 2001.

-------
Methods for Estimating Needs and Spending for Drinking Water
                 Q> .TO
                 Q> o
                 5 W
                 Q> C
                 0|
                "5.1B
                 Qi &
                o:^
20

16

12

 8

 4

 0
                                  ..{204$}..
                                                     Year
           Figure 4— 1: Pipe Replacement Model Replacement Need Estimate
           In this analysis, when pipe reaches the end
           of its life, based on the year of its
           installation and its expected life span, it is
           removed from inventory and replaced. The
           model thus provides an  estimate of the
           total amount of pipe that must be replaced
           over the next 20 years as well as an estimate
           of the amount  of pipe that must be
           replaced each year. (Note: the model
           actually provides estimates of the amount
           of pipe required through 2075).

           The pipe replacement model considers one
           factor: physical deterioration.  The model
           does not account for other factors, most
           notably inadequate capacity, that may have
           equal importance to or greater importance
           than deterioration in determining pipe
           replacement rates. In the 1999 Drinking
           Water Needs Survey, many systems cited
           inadequate capacity to serve existing
           consumers as the reason for pipe
           replacement. As communities grow, pipe
           installed decades ago can no longer deliver
           the quantity of water necessary to satisfy
           the present demand—let alone future
                                       growth. Even though the physical
                                       condition of the pipe may be excellent, its
                                       lack of capacity requires its replacement.
                                       The use of a normal distribution around
                                       the average design life may unintentionally
                                       account for  some degree of replacement
                                       arising from under-capacity. This method,
                                       however, likely understates the true pipe
                                       replacement need due to the exclusion of a
                                       capacity-related variable.

                                       D.  The total capital need for transmission
                                       lines and distribution mains is calculated by
                                       multiplying the length of pipe replaced in
                                       parts A through C by the cost per foot of
                                       pipe.  The cost per foot, derived from the
                                       DWINS, is $58.1, including valves, meters,
                                       and other pipe-related equipment that are
                                       installed with the pipe.  Figure 4-1 shows
                                       the model's estimate of the cost of the
                                       pipe that will need to be replaced each year
                                       through 2075.  The last year of the
                                       estimation period, 2019, is marked with a
                                       line on the graph.
34

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                  Methods for Estimating Needs and Spending for Drinking Water
     The simple aging model applied to the
     historical inventory of pipe reveals that
     most of the projected replacement needs
     occur beyond the 20-year period of this
     analysis—with peak annual replacement
     costs of $11.4 billion occurring around
     2040. According to the model, most of the
     pipe replacement needs occur beyond the
     next 20 years. Through 2019, the total cost
     of replacing transmission lines and
     distribution mains is $52 billion.  The cost
     increases to $249 billion if the timeframe is
     extended to 2029. Through 2075, the cost
     is over $540 billion. This finding helps to
     explain the relatively low pipe replacement
     needs that  are forecast to occur within the
     estimation  period under option 2.

3.  Under option 3, the analysis applies a
constant replacement rate to  the total inventory
of pipe, as determined under option 2. This
method assumes that pipe will require
replacement every 50, 75, or 100 years (which
translates into replacement rates of 2  percent/
year, 1.3 percent/year, and 1 percent/year,
respectively).  The total inventory of pipe is
multiplied by the replacement rate to estimate
the annual replacement need.  The amount of
pipe is then multiplied by the average  cost per
foot as derived from the Needs Survey.  Option
3 uses the 1999  Needs Survey data, with an
adjustment for underreporting, to estimate non-
pipe needs.

4.  Option 4 uses the estimate from the AWWA
survey of pipe replacement needs.31 In this
study, AWWA estimated that  the total pipe
replacement need  over the next 20 years is $352
billion. The methods AWWA used to obtain
this estimate are similar to those discussed under
option 3, except that AWWA used different
estimates of total inventory and cost per foot.
Option 4 uses the 1999 Needs Survey, as
adjusted for underreporting, to estimate non-
pipe needs.
4.3 Allocate Capital Investment Need by
Year

    To apportion the total capital investment need,
including all pipe and non-pipe components, over
the estimation period,  some scenarios use the
distinction between current and future needs
identified in the 1999 Needs Survey.  Current
investment needs are spread evenly over the 2000—
2003 period—i.e., 25 percent of the current need is
purchased each year through 2003. The future need
is then spread evenly over the next 16 years, or 6.25
percent per year. There is no empirical basis for
these timeframes other than that they serve to
distinguish between current and future needs.  The
cost of complying with recently promulgated or
proposed regulations is spread out over the next  5
years, or 20 percent per year through 2004.

    Alternate scenarios distribute non-pipe needs
evenly  over the 20-year period.  These scenarios may
provide a more realistic investment profile, given that
the cur rent/future split would have systems investing
at a rate far greater than present levels. However,
this approach ignores the timing of the needs as
identified and documented by water systems for the
Needs  Survey.

4.4 Calculate Financing Costs

    While some systems may purchase
infrastructure out of current revenues, many will
finance at least a portion of the purchase through
borrowing.  According to the 1995 Community
Water System Survey (CWSS), approximately 35
percent of the capital purchased between 1987 and
1995 was financed through borrowing from private
sources or through government loans.
31 American Water Works Association, Infrastructure Needs for
the Public Water Supply Sector, December, 1998.
                                                                                                35

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Methods for Estimating Needs and Spending for Drinking Water
      To estimate the cost of financing the capital
 investment, the model makes the following
 assumptions:

      1.  Systems will rely on government loans or
      private sector borrowing to finance 35 percent
      of the capital investment. While the share of
      capital investments financed may increase above
      the historical rate as the need for investment
      grows (although some systems would increase
      revenue by increasing user rates), the analysis
      assumes the historical rate would continue. This
      assumption will tend to produce conservative
      estimates of the cost of capital. As an
      alternative option, the analysis assumes that in
      response  to the greater need for capital
      investment, systems will increase the proportion
      of needs  that  are financed to 75 percent.

      2.  Systems will borrow at an average nominal
      interest rate of 5.9 percent, which, with an
      annual inflation rate of 2.8 percent, yields a real
      interest rate of 3.0 percent. The nominal interest
      rate is derived from an average of the Federal
      Reserve Bond Buyer Index for general
      obligation debt over the past 10 years. The
      annual inflation rate is determined  by taking the
      average rate of increase in the construction cost
      index over the last 10 years.

      3.  The terms of the loans will be 20 years. As
      an alternative  option, the term of the loans will
      be 30 years.

      4.  Systems will make constant payments over
      the life of the loan.  (For the sake of simplicity,
      it was assumed a single payment is  made each
      year.) The payment is given by:
            P =
                   k*(1
n
     where:
         p = the amount of the annual payment;
         k - the value of the infrastructure
         purchased;
         r - the real interest rate; and
         n - the duration of the loan.

     5. The amount not financed is paid for in the
     year in which the infrastructure is purchased.

     Because a portion of the total need is purchased
each year over the 2000-2019 period, and because a
portion of each year's purchase is financed over a 20
year period, the total cost of the capital, including all
interest and principal payments, is not paid for in full
by 2019.  For example, capital purchased in 2019 that
is financed with a loan will not be paid for in full until
2038. Estimates of the capital payments (2000-2019)
for new infrastructure range from $178 billion to
$475 billion with a point estimate of $310 billion
($15.5 billion per year).

 4.5 Estimate Current Spending

4.5.1 Capital Spending

     In order to calculate the gap, projected payment
needs are compared to current spending. To quantify
the relationship between needs and spending over
time, the analysis takes current spending, calculated as
the average spending over the last 10 years, and
assumes no real growth.  The spending projections
are not an estimate of what spending will be; rather,
they are simply a baseline to which the projected
need may be compared (Figure 4-2).

     By holding capital spending constant, the
analysis describes how the projected need compares
to current spending, for example, if the projected
need is $13.2 billion per year, how does that compare
to what water systems presently spend?  The method
implies that systems would spend the same resources
they spend today without making assumptions about
how they would increase (or decrease) their spending
36

-------

                      Methods for Estimating Needs and Spending for Drinking Water
   12,000 -

   10,000 -

|   8,000 -
 o
Q
'o   6,000  -

    4,000  -

    2,000 -

        0
                                                                      1 Actual
                                                                       Projected
                     1980
                          1990
2000
2010
2020
         Figure 4—2: Projected Drinking Water Capital Spending (adjustedfor privates and DWSRF ineligibilities
         for 2000-2019)
with regard to need.  This is equivalent to how OMB
and CBO project discretionary spending for baseline
budget estimates.

     The level of certainty associated with the
annualized projections of spending, and thus the
funding gap, decreases considerably over the 20-year
estimation period. To a large extent, this decline owes
to the assumption that spending will remain constant
over the next 20 years. This assumption likely will
underestimate the actual future spending. Actual
spending on capital should reflect the need for such
spending. Therefore,  if the  expectation that a large
portion of the nation's capital stock will require
replacement is correct, then this prediction should be
mirrored in the spending data: that is, water systems
will need to, and thus will, spend more to replace or
operate and maintain an increasingly deteriorated
capital stock. The spending projections will not
capture the increased rates of spending that
presumably will occur in response to the  aging capital
stock. However, the method provides a baseline
against which to compare the need for greater
investment with current levels of spending.
                                              An alternative option would increase spending
                                         based on a linear regression of historical rates. This
                                         method, however, should not be considered, in a
                                         technical sense, a baseline for spending. The problem
                                         is that the real growth of the last 10 to 20 years
                                         stems from the decisions of systems regarding their
                                         needs. These are essentially policy decisions—and if
                                         the spending projections assume real growth based
                                         on historical trends, then the projections would
                                         reflect future policy decisions.  This, in turn,
                                         complicates the evaluation of the future need
                                         predicted by the model as the analysis would
                                         compare future need to some unknown set of policy
                                         decisions,  rather than to the more straight-forward
                                         baseline of current spending. Also, if the analysis
                                         reveals that no capital gap exists, it then could be
                                         reasonably, but erroneously, inferred that the status
                                         quo for spending would suffice  to meet future capital
                                         investment needs. This conclusion, however, would
                                         ignore the fact that in reality systems would need to
                                         increase their spending to eliminate the gap.
                                                                                                      37

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Methods for Estimating Needs and Spending for Drinking Water
      The method for estimating current spending is
 as follows:

      1. The first step is to estimate the amount of
      capital that would be purchased. Government
      spending for drinking water data from the
      Congressional Budget Office's report Trends in
      Public Infrastructur/2 forms the basis of the
      projections. Data on government spending on
      infrastructure for 1977 through 1995 are
      adjusted to constant dollars using the
      construction cost index, published by the
      Engineering News-Record. Government
      spending is increased by 1/3  to account for
      private sector spending, as described earlier. This
      adjustment is based on the ratio of households
      served by public and private systems, as
      described in the November 1998 Regulatory
      Impacts Analysis of the Stage 1 Disinfection By-
      Products Rulemaking analysis.

      2. Capital spending is then adjusted to account
      for "unallowable" spending. This adjustment is
      necessary so that the analysis can compare the
      needs from the Needs Survey to the spending
      data. Without this adjustment, the spending data
      would contain spending on projects that would
      not have been accepted by the Needs Survey
      due  to their ineligibility for Drinking Water State
      Revolving Fund (DWSRF) assistance. Such
      projects include dams, raw water reservoirs,
      future growth, and fire flow. Consequently, the
      spending data are reduced by 20 percent, based
      on a review of 20 capital improvement plans
      that were submitted by water systems for the
      1999 Needs Survey. It is important to recognize
      that although water systems may have
      considerable capital needs related to DWSRF
      ineligible projects, the gap analysis excludes these
      needs.33

 4.5.2  Capital Payments

      The estimate of capital spending is a projection
 of the annual investment in the capital stock based on
 an average of the last ten years. As with the future
capital need, systems may choose to finance a
portion of this investment. In order to compare
future needs to the projection of current spending, it
was assumed that the projected spending would be
financed in a similar manner: that is, 35 percent or 75
percent would be financed at a real interest rate of 3
percent per year over a 20- or 30-year period. To
account for debt service payments for capital
purchased before 2000, this method assumes that
past capital purchases were financed in a similar
fashion.  These payments are included in both
current spending and the total need because the
future need will include this debt service on past
investments.

4.6 Estimate the Total Capital Payment
Gap

    The annual payment gap is the difference
between the estimated payment need and current
spending in each year. The total gap over the 20
years is the sum of the annual gaps. This analysis
estimates that the drinking water capital payment gap
is between $0 billion and $267 billion with a point
estimate of $102 billion34 in the no revenue growth
scenario (Figure 4-3), and it estimates that the gap is
between $0 billion and $205 billion with a point
estimate of $45 billion35 in the revenue growth
scenario (Figure 4-4). Using all of the possible
32 Congressional Budget Office, Trends in Public Infrastructure,
May 1999.
33 By statute, the Needs Survey is used to allocate DWSRF
monies to the states. In general, the eligibility criteria developed
for the DWSRF are intended to promote the public health
objectives of the Safe Drinking Water Act.
34 The actual range is $-17 to $267 billion with a point estimate
of $102 billion. Under the assumptions used for certain
scenarios, the models predict a surplus of infrastructure funds,
or rather, a negative gap. In these scenarios, total spending and/
or revenues will exceed the total need over the next 20 years.
The report excludes these negative values in the text, because
systems generally would not collect revenues in excess  of their
current estimated infrastructure needs. However, it should be
noted that doing so would free infrastructure funds for
situations where gaps remain.
35 The actual range is $-94 to $205 billion with a point estimate
of $45 billion.  See Footnote 34 for further explanation.
38

-------
                      Methods for Estimating Needs and Spending for Drinking Water
cs
O
O
o

•^H
G
O
a
s
40
35
30
25
20
15
10
 5
 0
               Projected Capital Gap
               (No Revenue Growth)
            D Current Capital
              Payments
Figure 4-3: Capital Payment Gap (Average No Revenue
Growth Scenario)

combinations of assumptions described earlier, the
analysis generated 216 permutations for estimating
the capital payment gap. The extreme values of these
scenarios comprise the lower and upper limits of the
range. A point estimate was obtained by simply taking
an average of all of the scenarios.

     In understanding the significance of the
findings, it is important to recognize that the analysis
holds spending constant based on the average
spending from the last ten years. Therefore, any
funding gap that is forecast by the analysis ought not
to be considered an inevitability, but rather a
potential  outcome should water systems not make
the investments that will be required to replace and
maintain their aging capital stock.

4.7  Estimate the Operations and
Maintenance (O&M) Gap

     Developing a defensible, quantitative
relationship between O&M needs and capital stock
presents a challenging task. However, as discussed in
Chapter 2, it is important not to discount the
significance of O&M needs when discussing the
financial viability and operating challenges
confronting drinking water and clean water  systems.
ir
Billions in 2001 Dollar s
=> * s £ g t



X
-•-


Projected O&M Gap
(Revenue Growth)
Projected Revenues for Capital
III






.


.


-


1


p









_





















^vvv^vvv

                                                  Figure 4-4:  Capital Payment Gap (Average Revenue
                                                  Growth Scenario)

                                                  Therefore, this analysis attempts to quantify the
                                                  O&M needs, spending, and gap.

                                                  4.7.1 General Steps-O&M Needs

                                                       The methods for estimating the difference
                                                  between O&M needs and spending involves three
                                                  primary steps.

                                                       1. Estimate annual operations and maintenance
                                                       needs (O&M) as a function of the capital stock,
                                                       which itself is a function of the projected
                                                       capital need.

                                                       2. Using data from the Congressional Budget
                                                       Office, assume that current levels of O&M
                                                       spending will continue through the estimation
                                                       period.

                                                       3. Compare the annual need for O&M to
                                                       spending. The difference is the annual gap.

                                                  4.7.2 Estimate O&M Needs

                                                       The analysis assumes that O&M needs are a
                                                  function of the future capital stock. The projection
                                                  of future O&M needs involves three steps.
                                                                                                    39

-------
Methods for Estimating Needs and Spending for Drinking Water
      1.  The analysis quantifies the historical
      relationship between O&M spending and the
      total value of the drinking water capital stock.
      The Census Bureau provides data on O&M
      spending. The data of the drinking water capital
      stock were obtained from the Bureau of
      Economic Analysis  (BEA). The data cover the
      period from 1979 to 1997 and are limited to
      publicly owned water systems. These data are
      increased by 1/3 to  account for privately owned
      systems.

      O&M spending is calculated as a proportion of
      the total capital stock for each year from 1979
      through 1997. The historical relationship
      between O&M spending and capital stock is
      projected through 2019, using a simple linear
      regression. The model predicts O&M spending
      as  a share of the capital stock to be 11.9 percent
      in  2000, and projects that the proportion will
      increase only slightly to 12.4 percent by 2019.

      Alternative scenarios adjust this relationship to
      phase in a 10 percent efficiency increase over a
      10-year period. Anticipated efficiencies include
      staff reductions, outsourcing, consolidation, and
      other operational improvements in the industry,
      although these factors are expected to be
      somewhat offset by increased demands related
      to  an aging infrastructure.

      2.  The next step is to estimate the future capital
      stock. The capital stock in any given year is
      equal to the capital stock in the previous year
      plus new investment minus depreciation:
           K  = K  + I - D
                K  is the capital stock in period t,
                I  is capital investment (i.e., need) in
                period t, and
                D   is depreciation in period t-1.
     The model starts with the current capital stock.
     New investment is equal to the capital need
     estimated in steps 1 and 2, which is added to the
     current stock.  Depreciation is then deducted.

     Data from BEA are used to estimate annual
     depreciation of the net capital stock. BEA
     provides data on depreciation for publicly
     owned systems, which is increased by 1 /3 to
     account for privately owned systems. A
     depreciation rate is estimated as a proportion of
     the net capital stock.  As with the O&M
     spending data in the previous step, a linear
     model is used to project the depreciation rate
     through 2019.  Annual depreciation is then
     calculated as the product of the depreciation
     rate and the net capital stock. The net capital
     stock depreciates at approximately 1.5 percent
     per year.

     3. The final step calculates the  annual O&M
     need as the product of  the O&M percentage
     calculated in the first step and the capital stock
     estimated in the second step.

4.7.3 O&M Spending

     The method for estimating baseline O&M
spending is similar to that of capital  spending, except
that there are no DWSRF eligibility adjustments for
O&M spending. The analysis assumes that all O&M
spending will be required to ensure the continued
provision  of drinking water.  Some portion of the
O&M spending will occur for DWSRF ineligible
projects (e.g., maintenance of dams). However, the
additional assumptions required to eliminate ineligible
O&M spending from the analysis would not be
justified, given that these expenditures likely represent
a small fraction of total O&M spending. As with
capital spending, the O&M spending is held constant,
and thus the same caveats apply that were discussed
earlier.
40

-------
                       Methods for Estimating Needs and Spending for Drinking Water
50

40
            Projected O&M Gap
            (No Revenue Growth)
          Q Current_Q&M_P_ay:rnents_
   o
  Q
     1 4-5:
Scenario)
Gap (Average No Revenue Growth
4.7.4 The O&M Gap

     This analysis estimates that the drinking water
O&M gap is between $0 billion and $495 billion with
a point estimate of $161 billion36 in the no revenue
growth scenario (Figure 4-5), and it estimates that the
gap is between $0 billion and $276 billion with a
point estimate of $0 billion37 in the revenue growth
scenario  (Figure 4-6). As with the methods for
estimating the capital gap,  the analysis generated 216
permutations for estimating the  O&M payment gap
based on all of the different  combinations of
scenarios resulting from the different assumptions
outlined  earlier. The  extreme values of these
scenarios comprise the lower and upper limits  of the
range. A point estimate was obtained by taking an
average of all  of the scenarios.

     It is important to recognize that the O&M gap
exists as  an artifact of the methods used to estimate
the capital gap. The O&M needs increase
substantially over the estimation period, due to the
extent to which the capital stock increases. The
capital stock, in turn, increases as a result of the new
capital investments needed by water systems.
However, the  size and timing of these capital
investments are determined by the methods used to
                                                           100
                                                            80
                                                 o
                                                 Q
                                                 T-H
                                                 O
                                                 o
                                                 «
                                                 a)
                                                 C
                                                 _0
                                                 i   20
                                                 CQ
                                                            60
                                                            40
             • Projected O&M Gap
               (Revenue Growth)

             D Projected Reyenue for O&M

Figure 4-6:
                                                                Gap (Average Revenue Growth Scenario)
                                                estimate the capital need. Also, the O&M gap will be
                                                larger if capital needs are purchased earlier in the
                                                projection period (i.e., applying the current/future
                                                distinction from  the Needs Survey). Purchasing
                                                capital early in the estimation period increases the
                                                capital stock. This, in turn, will increase the O&M
                                                need throughout the period.

                                                     Also, although we would expect O&M needs to
                                                increase in response to an aging capital stock, the
                                                method for estimating O&M needs uses the
                                                historical relationship between O&M spending and
                                                capital stock as the basis for projecting future costs.
                                                Thus, while O&M needs increase, as will likely occur
                                                given the aging of the nation's infrastructure, the
                                                driver for this increase in the analysis is the annual
                                                capital need, and not an accelerating replacement
                                                rate of the existing stock. The  constraints imposed
                                                by the limited data prevent the development of a
                                                quantifiable relationship between O&M needs and
                                                36  The actual range is $-67 to $495 billion with a point
                                                estimate of $161 billion. See Footnote 34 for further
                                                explanation.
                                                37  The actual range is $-286 to $276 billion with a point
                                                estimate of $-58 billion.  See Footnote 34 for further
                                                explanation.
                                                                                                         41

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Methods for Estimating Needs and Spending for Drinking Water
  the national capital stock inventory; for this reason,
  the analysis uses the method described earlier.

      In addition, the analysis assumes that the
  historical proportion of O&M spending to capital
  stock is a reasonable predictor of the future
  proportion of O&M spending to capital stock. One
  complicating factor is that new capital stock would
  require less O&M spending than the historical
  projections would predict (i.e., new equipment
  requires less O&M than older equipment).
  Alternatively, the O&M spending required for the
  existing capital might increase at a faster rate than
  that predicted by historical trends, particularly if a
  large proportion of the capital stock reaches an age
  at which greater O&M must be invested. The
  difficulty of quantifying these factors necessitates the
  simplifying assumption that the historical rate of
  O&M spending to capital stock represents a
  reasonable, but approximate, basis for estimating
  O&M needs. It is significant to note that the clean
  water and drinking water analyses assume that
  systems will realize efficiencies in O&M that will
  reduce the proportion of O&M spending to net
  capital stock. Thus, the analyses presume that
  improvements in O&M practices will offset the
  effects of an aging capital. Without this assumption,
  the O&M needs would increase greatly in magnitude
  over the estimates presented here.

      In understanding the significance of the
  findings, it is important to recognize that the analysis
  holds spending constant based on the average
  spending from the last ten years. Therefore, any
  funding gap that is forecast by the analysis ought not
  to be considered an inevitability, but rather a
  potential  outcome should water systems not increase
  spending to meet increased levels of O&M needs.
42

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                                                                                             Conclusion
Conclusion
 5.0   Findings

      This report estimates the gap between the
 projected need and current spending for clean water
 and drinking water infrastructure over the next 20
 years using data available from EPA, the Census
 Bureau, and the Congressional Budget Office. In
 broad terms, the gap analysis concludes that clean
 water and drinking water systems will need to use
 some combination of increased  spending and
 innovative management practices to meet projected
 needs. This analysis estimates that the clean water
 capital payment gap is between $73 billion and $177
 billion with a point estimate of $122 billion in the no
 revenue growth scenario, and it estimates  that the
 capital payment gap is between $0 billion to $94
 billion with a point estimate of $21 billion38 for the
 revenue growth scenario.  The analysis estimates that
 the drinking water capital payment gap is between $0
 billion and $267 billion with a point estimate of $102
 billion39 in the no revenue growth scenario, and it
 estimates that the gap is between $0 billion and $205
 billion with a point estimate of $45 billion40 in the
 revenue growth scenario.

      It is important to recognize that the  funding
 gaps occur only if capital and O&M spending
 remains unchanged from present levels. This
 assumption clearly understates future spending and
 ignores other measures, such as asset management
 processes or  capacity development, that systems
 could adopt to  reduce both capital and O&M costs.
 In reality, increasing needs will likely prompt
 increased spending. However, the analysis presents
 an approximate indication of the funding gap that
 will result if we ignore the challenge posed by an
 aging infrastructure network; a significant portion of
 this infrastructure network is beginning to reach the
 end of its useful design life.

      A panel of industry experts evaluated a draft of
 this report, and to the extent possible,  the panel's
 critiques and comments are incorporated into this
 final report. The major points made by the reviewers
are summarized in Appendix B.  The reviewers
agreed that the Gap Analysis provides an important
starting point for the discussion about the magnitude
of drinking water and clean water infrastructure
funding issues.  The general consensus was that the
document represents a reasonable effort to quantify
the infrastructure gap, given the limitations imposed
by the available data. This praise, however, also
contains the principal criticism of the analysis; the
poor quality of the data severely constrains any effort
to quantify the infrastructure funding gap with great
accuracy. EPA acknowledges the uncertainty
associated with the analysis. Nonetheless, in
proposing these provisional estimates, the report
encourages a policy discussion of the challenges
confronting the nation's clean water and drinking
water systems.  Most experts familiar with the
industry agree that these challenges must be met if
we are to continue to advance environmental and
public health protection.

5.1  Suggestions for Future Research

     In developing this analysis and reading the
comments from the peer reviewers, EPA noted that
further research would help future efforts to quantify
the infrastructure gap.  Although far from an
exhaustive list, the research areas identified below
38 The actual range is $-39 to $94 billion with a point estimate
of $21 billion. Under the assumptions used for certain
scenarios, the models predict a surplus of infrastructure funds,
or rather, a negative gap. In these scenarios, total spending
and/or revenues will exceed the total need over the next 20
years.  The report excludes these negative values in the text,
because systems  generally would not collect revenues in excess
of their current estimated infrastructure needs. However, it
should be noted that doing so would free infrastructure funds
for situations where gaps remain.
39 The actual range is $-17 to $267 billion with a point
estimate of $102 billion. See Footnote 38 for further
explanation.
40 The actual range is $-94 to $205 billion with a point
estimate of $45 billion.  See Footnote 38 for further
explanation.
                                                                                                          43

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Conclusion
 offer opportunities to improve the estimates.

      • The inventory of the nation's clean water and
      drinking water capital stock and the condition
      of the capital stock should be more fully
      explored.  Data providing an improved picture
      of the remaining life of these critical capital
      assets and data identifying the different classes
      of inventory (e.g., treatment, pipe, storage)
      would provide a foundation for progressing to
      the next step—assessing the condition  of the
      nation's infrastructure. These data would greatly
      improve decision-making about investment
      needs for maintaining, upgrading, and expanding
      infrastructure.

      • The relationship between O&M needs and
      capital stock is not fully understood. A more
      refined approach than the one adopted in this
      analysis would investigate how O&M needs vary
      as a function of gross (not net) capital  stock and
      the age or condition of the capital stock. These
      data, other than in purely speculative form, are
      not yet available.

      • Clean water and drinking water systems will
      incur significant costs over the next 20  years as
      they expand capacity to serve current and future
      growth. Methods for estimating capital
      investment needs associated with growth and
      changes in service standards were excluded from
      the analysis.

      • This analysis would benefit from research into
      an array of issues that ultimately will determine,
      or at least influence, the scale of future capital
      investment needs.  These issues will also
      determine how future capital investment needs
      are met. These issues include, but are not
      limited to, topics such as the following:

           • Implementation of best management
           practices, including asset management
           processes and capacity development
• Restructuring, integrating, and
amalgamating service providers to seek
economies of scale in the provision of
services

• Pricing policies and their effect on
demand elasticity for water

• Demographic shifts within the United
States

• Efficiencies gained or lost due to the
installation of the latest technology

• Trends in operating costs (e.g.,  of
chemicals and energy)

• Criticality analysis (i.e., which
components of a system should take
precedence for investment due to age,
condition, and importance)

• Effects of non-like-for-like replacement
of assets
44

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   Comparing the Gap between Clean Water and Drinking Water: Numbers and Methodologies
APPENDIX A
Comparing the Gap  between Clean  Water  and
Drinking Water:  Numbers  and Methodologies
 1.0 Comparison between the Clean Water
 and Drinking Water Capital Payment Gap

     This analysis estimates that the clean water
 capital payment gap over the next 20 years is $122
 billion in the no revenue growth scenario and $21
 billion in the revenue growth scenario.  The analysis
 estimates that the drinking water capital payment gap
 is $102 billion in the no revenue growth scenario and
 $45 billion in the revenue growth scenario. These
 figures represent point estimates within a range,  as
 described in Chapters 3 and 4.

     The methods used in this analysis (e.g., the
 modeled replacement need) preclude the  calculation
 of standard errors about these estimates to determine
 whether the difference between the drinking water
 and clean water gaps are statistically significant. The
 difference in gaps likely reflects differences in the
 methods applied by the analyses. The following
 sections discuss the similarities and differences in the
 methods used by the clean water and drinking water
 analyses in calculating the funding gap.

     The methods for estimating the capital gap for
 clean water and drinking water, as described in
 Section 5.1, were harmonized to the extent to which
 the data allowed for consistencies between the two
 analyses. As Section 5.2 explains, however, limitations
 of the available data necessitated the use of divergent
 methods for estimating needs and spending.

 1.0.1  Similarities in Methods

     With respect to the similarities, both analyses
 used their respective Needs Surveys as  a starting point
 for identifying capital needs. The clean  water analysis
 used the results from the 1996 Clean Water Needs
Survey (the next survey is due out in 2002), while the
drinking water analysis used the data from the 1999
Drinking Water Needs Survey. These surveys
produce highly credible data, as each need submitted
by a system was accompanied by  documentation
describing the purpose of the project. The
documentation requirement imparts a conservative
bias to the estimates, but it also allows EPA to
determine whether each need meets the eligibility
criteria for State Revolving Fund assistance; this is
critical for the drinking water program, as the law
requires EPA to use the survey results to allocate SRF
monies to the states.

    The  treatment of spending data is also similar
between the clean water and drinking water analyses.
Data from the Congressional Budget Office and the
Census Bureau are used to determine historical levels
of spending on capital. The drinking water analysis,
however, applies an adjustment factor to account for
privately owned systems and Drinking Water State
Revolving Fund (DWSRF) ineligible projects. Both
of the analyses hold spending constant over the
estimation period, which allows for the comparison
of projected needs to baseline  spending. Both
analyses also use a real rate of growth of three
percent when considering revenue growth scenarios.

1.0.2 Differences in Methods

1.0.2.1 Capital Needs

    The  analyses differ in the  methods used to
calculate capital needs. Clean water capital need
estimates  are derived from a single method that
determines needs  using the Clean Water Needs
Survey, a Sanitary  Sewer Overflow needs estimate,
and a modeled replacement need  estimate based on a
                                                                                                45

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Comparing the Gap between Clean Water and Drinking Water: Numbers and Methodologies
 constant replacement rate for the net capital stock.
 The clean water analysis assumes that the needs
 survey fails to capture the true extent of the 20-year
 need associated with replacement.  The analysis
 considers a range for many key variables; for
 example, the analysis considers scenarios in which
 clean water systems finance 75 percent, 85 percent,
 or 95 percent of capital needs.

      The drinking water estimates  use four
 approaches to calculate replacement needs. A full
 description can be found in Chapter 4.  One option
 adjusts the results of the Drinking Water
 Infrastructure Needs Survey based on the results of a
 follow-up survey. Three other options replace the
 DWINS estimates of transmission and distribution
 needs with estimates from pipe inventory models.

      The use of these replacement estimates differs
 from the clean water approach in that only the pipe
 portion of the total infrastructure  need is modeled.
 Pipes comprise the majority of a system's capital
 stock, and thus modeling the replacement of pipe
 likely captures most of the needs associated with
 replacing old and deteriorated equipment. The non-
 pipe needs are derived from the Needs Survey with
 an adjustment for underreporting.   The difficulty of
 distinguishing between new and replacement needs in
 the Needs Survey explains the  decision not to  model
 non-pipe needs in a manner similar to the clean water
 approach. A replacement term could be developed
 for these needs; however, the  documented needs
 from the Needs Survey were considered a more
 accurate, and less speculative, measure of non-pipe
 needs.

      It is important to note that the range of needs
 and gaps are provided to explicitly acknowledge
 variations within the estimates, but are not intended
 to support comparative analysis between the clean
 water and drinking water industries. The drinking
 water analysis was able to use data sets that were not
 available to clean water, e.g., data sets of pipe
 inventory and age of assets. These data allowed
 drinking water to use four different methods to
estimate capital needs and vary assumptions within
each method, whereas the clean water analysis used a
single method and varied assumptions within that
method.  The broader array of methods available to
the drinking water analysis generated a broader range
of needs and gaps. As such, the resulting ranges
provide insight into the impact of varying
assumptions within each industry, but the data and
methods  cannot be used to conduct a valid
comparison of the funding gaps facing the clean
water and drinking water industries.

1.0.2.2 Financing Costs

     The clean water and drinking water  methods
assume that systems will finance a proportion of
their capital needs and spending.  The drinking water
analyses use a real interest rate of 3.0 percent, while
the clean water analyses consider real interest rates
of 2.5 percent, 3.0 percent, and 3.5 percent. The
drinking water analysis assumes that the average loan
term is 20 years or 30 years, while the clean water
analysis considers average loan terms of 20 years, 25
years, and 30 years. The drinking water analysis
assumes that water systems will finance either 35
percent or 75 percent of their capital needs; the
clean water analysis assumes that clean water systems
will finance 75 percent, 85 percent, or  95 percent of
their capital needs.

1.1 Comparison between the Clean Water
and Drinking Water and O&M Payment
Gap

     The analysis estimates that the O&M gap for
clean water over the next 20 years is $148 billion for
the no revenue growth scenario and $10 billion for
the revenue growth scenario. The drinking water
O&M gap is $161 billion in the no revenue growth
scenario and $0 billion41 in the revenue growth
scenario.  These figures represent point estimates
within a range, as described in Sections 3 and 4.
46

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  Comparing the Gap between Clean Water and Drinking Water: Numbers and Methodologies
1.1.1  Similarities in Methods

     The clean water and drinking water analyses use
similar approaches for estimating O&M needs. Both
analyses  assume that the ratio of O&M spending to
net capital stock will remain constant through the
estimation period, and this ratio is multiplied by the
projected capital stock to calculate O&M spending
for each  of the next 20 years.

     The treatment of spending data is also similar
between  the clean water and  drinking water analyses.
Data from the Congressional Budget Office and the
Census Bureau are used to determine historical levels
of spending on O&M. Both  of the analyses hold
spending constant over the estimation period, which
allows for the comparison of projected needs to
baseline  spending. In the revenue growth scenarios,
both analyses use a real rate of growth of three
percent.

1.1.2 Differences in Methods

     There are two major factors that explain the
difference in drinking water and clean water O&M
estimates. First, much of the difference between the
O&M needs  for drinking water and those of clean
water results from the  different methods used to
allocate capital needs over the estimation period. To
understand the meaning and  validity of these results,
it is necessary to revisit the discussion in the previous
section.

     In describing the  methods used to calculate the
O&M needs, Chapter 4 cautioned that the  drinking
41 The actual estimate is $-58 billion. Under the assumptions
used for certain scenarios, the models predict a surplus of
infrastructure funds, or rather, a negative gap. In these
scenarios, total spending and/or revenues will exceed the total
need over the next 20 years. The report excludes these
negative values in the text, because systems generally would not
collect revenues in excess of their current estimated
infrastructure needs. However, it should be noted that doing
so would free infrastructure funds for situations where gaps
remain.
water O&M gap may exist largely as an artifact of
the methods used to estimate the capital gap. For
clean water and drinking water, the O&M needs
increase substantially over the estimation period, due
to the extent to which the capital stock increases.
The capital stock, in turn, increases as a result of the
new capital investments needed by water systems.

     It is important to recognize that the scale and
timing of new capital projects are  determined by the
methods used to  estimate the capital need. Under
one scenario  for estimating the capital needs of
drinking water systems, the analysis applies the
current/future  distinction from the 1999 Drinking
Water Needs Survey. The clean water analysis cannot
use this distinction, as the 1996 Clean Water Needs
Survey did not differentiate between current and
future needs. The clean water analysis, however, does
account for the timing of certain needs by using of a
replacement model that predicts the costs  of
replacement will increase over the  next 20 years.

     The upper bound of the range for O&M needs
for drinking water greatly exceeds that of clean water
largely due to the timing of new capital investments.
In the upper bound scenarios, most of  the new
capital investment occurs within the first 5 years for
drinking water, whereas the highest levels of
investment occur at the end of the estimation period
for clean water. The "front-loading" of needs means
that the drinking water capital stock increases
significantly over  the first 5 years in contrast to the
steady, but more modest, increase in capital stock
(i.e., new capital needs) for clean water.

     Thus, the  upper limit of the O&M need for
drinking water is larger than for clean water, because
capital needs are purchased earlier in the projection
period. Purchasing capital earlier in the  estimation
period increases the capital stock. This, in turn,
increases the O&M need throughout the period.
When the drinking water analysis distributes the
needs evenly over the 20-year period, the O&M gap
declines significantly.
                                                                                                         47

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Critiques and Comments from the Peer Review Panel
APPENDIX B
Critiques  and Comments from the  Peer Review Panel
 1.0  The Peer Review Process

      EPA submitted the methods and data used in
 this analysis to a panel of peer reviewers drawn from
 academia, think tanks, consulting firms, and industry.
 The peer reviewers submitted more than 50 pages of
 comments to EPA. In general, the reviewers found
 that the analysis represented a  commendable and
 credible effort to quantify the infrastructure gap, but
 this appendix summarizes the critiques and
 comments of the peer review panel.

 1.1 Major Points  about the Capital
 Estimates

      The basic need estimates were based, in some
 measure, on 1- to 5-year capital works programs
 rather than 20-year assessments.  Given the level of
 documentation required by the Needs Surveys, some
 form of adjustment is necessary. Experience with
 capital works programs suggests that even with a 5-
 year capital program,  years 1 -3 are usually sound, but
 the proposals for years 4 & 5 fall-off as it is too far
 away for people to  focus on those needs. Therefore
 it is common for models to take over from the
 established plan as  early as the fourth year and
 definitely for the 5-20 year window.

      When the gap analysis establishes future needs
 for capital investment and O&M, it assumes that
 historical investment trends will continue. This
 assumption may be faulty. Significant additional
 modeling to assess  the sensitivity of investment
 requirements to age, condition, and criticality would
 shed light on the priority and risk-based nature of
 decisions responding to the  anticipated investment
 spike.
    The practice of adjusting historical
infrastructure expenditures to today's dollars can
provide very misleading signals regarding asset
replacement.  Original sites may have changed
markedly with respect to access, work site
congestion, or other cost drivers, and as a result, the
replacement cost of an asset may have increased.
For this reason, additional repair and/or operating
costs may be economical alternatives to replacement.

    The data sets used in the analysis are, for the
most part, those that are generally used in a high-
level study of this nature. The findings of the
analysis paint a reflective, high-level picture. The use
of "useful life" matrices for water utility assets could
be greatly improved by moving towards "survival
curves" for various asset classes. The  'Kanew'
technique (from an AWWA Research Foundation
project in the mid-1990's) and the 'Nessie Curve'
approach to investment decision-making are
reflected  in the approach to the analysis.  These
approaches form a good starting point for an
understanding of the investment waves, which will
travel through the utility in time. The report
generally  postulates that the need to replace pipe will
generally  echo the original installation wave.
However, while this is true for age-based
replacement strategies in which each pipe material
has the same lifecycle properties, it may not
adequately model the effects of non-like-for-like
replacement of assets that incorporates the effects
of innovation. Some innovations will result in
shorter or longer lifecycles.

    Depreciation  and replacement rates are not the
same thing. A composite depreciation rate (which
drives the estimates in this report) masks important
variations that are relevant to this analysis. An asset
can be fully depreciated on the books  and still fully
functional, or an asset can have significant remaining
48

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                                    Critiques and Comments from the Peer Review Panel
book life and be unable to perform its service
function. There are alternate ways to calculate the
depreciation rate of a class of assets, some of which,
such as optimal deprival value, are based upon the
criticality of the asset to the operation of the system.
To properly value the asset base, criticality of risk-
based factors should be featured in the calculation.
This change would improve the quality of the
estimates.

     Comprehensive capital estimates should assess
the interaction between water infrastructure
investment and growth. Initial capital costs of
infrastructure and life cycle costs of infrastructure
can be significantly impacted by patterns of
urbanization.

     This analysis fails to ascertain the overall impact
of regulations and how such changes in regulation
might impact costs factors associated with meeting
service and environmental objectives.

1.2  Major Points about the O&M
Estimates

     It is generally accepted that the ratio of O&M
costs to capital investment increases as the system
ages. It is also true that as this aging infrastructure is
renewed, the O&M costs of the renewed system will
frequently be reduced. In this report, the estimates
for O&M may be reasonable on an aggregate basis,
considering that the analysis makes assumptions
based on the entire clean water and drinking water
industries.  However, if certain components  of these
industries, e.g., very small systems, are isolated for
analysis, then it might be argued that O&M needs are
higher for those  groups than the pro rata portion of
the expenditures presented in the  report.

     The analysis develops a relationship between net
capital stock and O&M expenditures that is
problematic. While there may be a good correlation
between net capital stock and O&M at this time, and
while that relationship may hold for some time to
come, this relationship will almost certainly break
down when main replacement needs start to escalate.
Furthermore, the out-year O&M estimate is very
much influenced by the changes in capital stock. If
investment plans do not materialize in accordance
with the planned capital expenditures, the effect on
O&M expenses is difficult to model, if not
impossible. To the extent that relevant data  is
available, it would be more telling to model  O&M
expenditures as a function of gross capital stock and
separate the data between main and non-main
expenditures.

     There may be a case for a significant reduction
in O&M costs, which may be achieved relatively early
in the modeling period. However,  any reduction is
likely to come off a baseline that is almost certainly
trending significantly upwards. Further, some costs
such as  energy and chemicals that are significant
elements in a utility's cost structure may increase, not
fall.  The mix of these  cost components will vary
significantly depending upon the 'age' of the system
(in simplistic terms), the rate at which it is adding or
losing customers, and the 'mix' of assets employed
(network versus treatment).  It is true that if old pipes
are replaced, O&M will decline. However, clean
water and drinking water systems will replace only a
small percentage of the nationwide pipe network
from 2000-2019. The  bulk of the  pipes in  the system
will age but remain in place.  As a whole, the pipe
network will be older, and therefore nationwide
O&M costs should increase.

     The use of net capital stock as a predictor of
O&M is somewhat troubling. O&M is a variable cost
and capital stock is only one determinant. Demand is
the big variable and demand is a function of a range
of factors. Per-capita demand has  flattened, and this
affects these ratios.

     More attention should  be paid to the impact of
cost  reduction opportunities, in at least five  areas:
efficiency practices (least-cost), technological
innovation (capital & O&M), market-based
approaches (bidding), industry restructuring
(consolidation), and integrated resource management
(supply and demand side).
                                                                                                       49

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Critiques and Comments from the Peer Review Panel
      In the future, reserves will be tougher to
 establish and maintain as operating costs increase,
 and citizen backlash against rate increases may also
 limit the appropriate accumulation of reserves for
 capital replacement. In addition, states have become
 more prescriptive regarding the establishment of
 system development charges (impact fees and the
 like).

 1.3  Major Points about the Financing
 Forecast

      While a huge overnight change in the  market
 structure is unlikely, private sector finance in the
 form of acquisitions, delegated services contracts,
 build-operate-transfer, concessions, etc. will increase
 over the period covered  by the analysis.  This may
 reduce the cost of capital for some water utilities
 because risk is deflected onto a third party  (the
 'concessionaire').

      The  suggestion that a significant portion of
 clean water and drinking water spending must be
 funded from revenues, i.e., from working capital,
 should be seriously questioned. Any movements in
 rate structures, demographic changes, funding of
 unforeseen events, etc. may have a major impact
 upon the ability of utilities to fund investments from
 working capital.  It is inevitable that some proportion
 of costs will be financed, in order to 'smooth-out'
 the price shocks—shocks likely caused by treatment
 plants rather than the mains networks. Consequently,
 it is appropriate to recognize financing as a
 mechanism without dealing with how that financing
 will be achieved or supported (i.e. debt to equity
 treatments, including the use of retained earnings)
 ahead of the other report.
50

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United States
Environmental Protection
Agency
Washington, DC 20460
                                        *  2002  *
                                       THE YEAR OF
                                       CLEAN WATER
Office of Water (4606M)
www.epa.gov/safewater
Printed on Recycled Paper
EPA-816-R-02-020
  September 2002

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