EPA-600/5 77 011b
AUGUST 1977
Socioeconomic Environmental Studies Series
ECONOMIC ANALYSIS OF SELECTED FEATURES OF
MUNICIPAL WASTEWATER CONSTRUCTION GRANT
LEGISLATION
Office of Air, Land, and Water Use
Office of Research and Development
U.S Environmental Protection Agency
Washington, O.C. 20460
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ECONOMIC ANALYSIS OF SELECTED FEATURES OF
MUNICIPAL WASTEWATER CONSTRUCTION GRANT LEGISLATION
By
Marshall Rose
with
Jon Goldstein
Project Officer
Richard K. Schaefer
Environmental Protection Agency
Washington, B.C. 20460
OFFICE OF AIR, LAND, AND WATER USE
OFFICE OF RESEARCH AND DEVELOPMENT
U.S. ENVIRONMEOTAL PROTECTION AGENCY
WASHINGTON, D.C. 20460
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DISCLAIMER
This report has been reviewed by the Office of Air, Land and Water
Use, U.S. Environmental Protection Agency, and approved for publication.
Approval does not signify that the contents necessarily reflect the views
and policies of the U.S. Environmental Protection Agency, nor does mention
of trade names of comnericial products endorsement of recommendation for use.
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ABSTRACT
This report analyzes the current Federal Construction Grant Program
for funding the treatment of municipal wastewater. Four main elements
of this Federal program are evaluated: the grant formula, the allotment
funding process, grant-eligible reserve capacity, and industrial cost
recovery. Existing legal provisions with respect to each of these program
elements are shown to be deficient in terms of their ability to encourage
an efficient allocation of abatement resources and to promote an equitable
distribution of Federal grant funds. The report presents several options
within each program element for improving the principles of Construction
Grant Legislation.
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TABLE OF CONTENTS
PAGE
ABSTRACT iii
LIST OF TABLES • *
ACKNOWLEDGMENTS xi
CHAPTER
I. INTRODUCTION 1
Organization of the Report 2
Findings and Conclusions 3
II. LEGISLATIVE HISTORY OF FEDERAL WASTEWATER
FINANCING PROGRAMS 6
Public Law 80-845: 1948 6
Public Law 660: 1955-56 8
Federal Water Pollution Control
Act Amendments: 1961 11
1966 Amendments: The Clean Water 11
Restoration Act
Water Quality Improvement Act: 1968 13
Water Quality Improvement Act: 1970 13
Public Law 92-500: 1972 14
References 16
III. DESCRIPTION OF THE CURRENT FEDERAL
WASTEWATER FINANCING PROGRAM 17
Authorizations 17
Allotments 18
IV
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CONTENTS -continued
PAGE
Facility Planning 18
Grant Application and Approval 19
Grant Award 22
Project Priority Lists 22
Eligible Costs and Projects 24
Grant Percentage 30
User Fees 31
Future Chapters 33
References 34
IV. THEORY OF COST SHARING FOR MUNICIPAL
WASTEWATER POLLUTION ABATEMENT
PROJECTS 35
Alternative Implementation Mechanisms 36
Summary of Findings 39
Background 42
Cost-Sharing Model 44
Numerical Calculations 53
Conclusions 57
References 58
V. DESIGNING COST-EFFECTIVE FEDERAL
WASTEWATER GRANT PROGRAMS FOR
MUNICIPALITIES 59
Existing Cost-Sharing Biases
in Project Selection 59
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CONTENTS -continued
PAGE
Reduction in Project Selection Biases 62
Abatement Project Grants 63
Modified Construction Grants 65
O&M Performance Incentives 67
Output Subsidies 72
Conclusions 79
References 81
VI. EVALUATION OF ALTERNATIVE ALLOTMENT
PROGRAMS 82
The Current Allotment Formula and
Funding Process '. 83
Historical Bases for Allotments 83
Program Objectives 84
The Current Allotment Formula 85
Implementing Allotments Through the
Needs Survey 86
The Priority Systems 88
Summary of Problems with the Current
Funding Process 89
Alternative Formulas 90
The Inappropriateness of Conventional
Allotment Formulas 90
A Two-Part Allotment Formula 91
VI
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CONTENTS -continued
PAGE
Efficiency Considerations 92
A National Benefit - Cost Ranking 92
Estimating Benefits 93
Cost - Effectiveness Analysis 94
Desirable Elements of an Effectiveness
Index for the Wastewater
Treatment Program 95
A Possible Form for the Index 98
Feasibility of a Cost-Effectiveness 100
Ranking
Alternative Population Measures 101
Measuring the Amount of Water
Resources 103
Discounting Future Benefits 104
Equity Considerations 106
The Relevant Cost Concept 106
Measuring Fiscal Capacity 108
The Equity Index 109
The Distribution of Equity Funds
to Communities 110
Rewarding Additional Abatement HI
Summary and Conclusions 112
References 115
VT.1
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CONTENTS-continued
PAGE
VII ANALYSIS OF THE INDUSTRIAL COST
RECOVERY PROGRAM 116
Cost Recovery Model 118
Resource Allocation Effects of Cost
Recovery on Industry 128
References 137
Vlll
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LIST OF TABLES
TABLE PAGE
III-l Eligible and Ineligible Project Costs
Under the Construction Grant Program 25
III-2 Alternative Techniques for Abating
Wastewater Pollution 27
IV-1 Results of Constrained Cost-Sharing Examples 55
V-l Costs of Wastewater Treatment Alternatives:
Cleveland-Akron Area 61
V-2 Project Grant Rates Required to Maintain The
Existing Number of Annual Construction
Projects Funded 65
V-3 Sample Secondary Treatment Plant Operating Data:
New York State, 1972 69
V-4 Estimated Secondary Treatment Plant Current
Operating Results: United States, 1975 70
V-5 Results of Output Subsidy Programs 78
VII-1 Municipal Cost-Sharing Proportions 123
VII-2 Present Value of Industrial Construction
Costs Incurred in Public Treatment:
Allocable Costs = $100.00 131
VII-3 Present Value of Industrial Construction
Costs Incurred in Private Treatment:
Allocable Costs = $100.00 134
IX
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ACKNOWLEDGMENTS
The authors want to thank the following reviewers for their helpful
comments: Michael Cook, Douglas Hale, Roger Shull, Willard Smith,
and Joseph Yance. The difficult job of typing all drafts as well as the
final report was conducted by Jeanette Woods. Responsibility for the
analysis, conclusions, and any remaining errors rests solely with the
authors.
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CHAPTER I
INTRODUCTION
SECTION 317 of the Federal Water Pollution Control Act Amendments
of 1972 requires the Administrator of the U. S. Environmental Protection
Agency
".... to investigate and study the feasibility of
alternative methods of financing the cost of
preventing, controlling and abating pollution as
directed in the Water Quality Improvement Act
of 1970 (Public Law 91-224), including, but not
limited to the feasibility of establishing a
pollution abatement trust fund."
In order to respond to this directive, EPA designed and sponsored
several studies to analyze different aspects of the wastewater financing
problem. The present study represents one of those efforts.
The objective of this study is to evaluate the cost-effectiveness of
selected legislative features relating to the current Construction Grant
Program. In this program, the Federal government can subsidize
75 percent of grant-eligible capital costs incurred by municipalities
in the construction of wastewater treatment facilities. The criteria
used to evaluate the existing program, as well as to generate and
evaluate options to this program, include those of effectiveness, efficiency,
equity, Federal subsidy cost, and ease of program design and implementation.
Effectiveness is the ability of a program to encourage socially disirable
pollution control activities and levels of pollution abatement. Efficiency
refers to the capacity of a program to induce the adoption of the least
costly methods of achieving any level of pollution control. Equity
refers to the inherent fairness of a program, such as its responsibility
to distribute grant funds on the basis of factors relevant to the objectives
of the program, and in a way that will appropriately take into account
differences in fiscal capacity among communities and income classes.
The Federal subsidy cost is simply the government's share of
municipal pollution control costs. The ease of program design and
implementation refers to the data and resource requirements necessary
to initiate and operate a particular program.
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The approach taken in this study is to evaluate separately three If
major elements of the Construction Grant Program: the grant formula,
the allotment funding process, and industrial cost recovery. In this
way it is possible to analyze each of the program elements on the basis
of a reduced set of relevant criteria. Simultaneously, it is conceptually
desirable to initially design a grant program which is both efficient and
effective, as well as to consider modifications that take into account
other evaluative criteria such as equity, Federal program cost, ease of
program administration, etc. If the net social benefits generated by the
program are maximized, there is then available more net benefits for everyone,
and the distribution of these net benefits and the mechanics of implementing
and operating the program can often be determined afterwards. This
conceptualization is employed in evaluating each of the three program
elements under consideration.
One factor not considered in this report is the transition costs
resulting from changes in the existing program. Owing to this omission,
and because of certain data limitations and uncertainties, as well as
incommensurability of some of the above-stated criteria, it is not possible
to develop a cardinal ranking of the alternatives considered. Nevertheless,
we can generate sufficient information which will allow us to make reasonable
judgments concerning which options are preferable to the status quo as a
means for achieving a given objective for a designated program element.
Organization of the Report
The next chapter describes the legislative history of Federal grant
programs for funding the collection and treatment of municipal waste-
water. Specific details of the current Construction Grant Program are
discussed in Chapter III.
The general theory of Federal cost sharing of municipal pollution
control costs and projects is developed in Chapter IV. Based on
identified shortcomings of the existing Federal grant rate and grant
eligibility, Chapter V designs and evaluates alternative grant formulae.
Chapter VI analyzes the allotment funding process for distributing
Federal grants initially to the States, and subsequently from the States
to local wastewater pollution control projects. Chapter VII quantifies
the relationship between industrial participation in public facilities
and the share of pollution control costs borne by municipalities.
Modifications in the existing industrial cost recovery program element are
considered which would tend to reduce the Federal cost of the Construction
Grant Program, while at the same time improving the allocation of abatement
resources for the treatment of industrial wastewater in public and private
facilities.
I/ A fourth element, grant-eligible reserve capacity, was considered in an
~~ earlier draft but had to be omitted in the official final report. This
discussion can be obtained either by contacting the authors directly,
or by requesting the unabridged version of this study through NTIS.
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Findings and Conclusions
This report initially analyzes the ability of potential Federal waste -
water cost-sharing programs to induce municipalities to select (1) socially
desirable levels of pollution abatement for given wastewater treatment
projects, and (2) socially desirable wastewater treatment projects. The
analysis indicates that in the absence of a substantial degree of
regulation and enforcement (which is currently provided in P.L. 92-500),
Federal cost-sharing programs cannot be relied upon to adequately
promote either of the above-stated objectives.
In fact, the study shows that designing an economically optimal cost-
sharing program is difficult even in theory. When real-world considerations
are taken into account, such as limited data on the value of benefits from
pollution control, the interdependent relationship among communities
between abatement and water quality, and constraints on available Federal
and local funds for wastewater treatment, it is clear that cost-sharing
programs should be formulated with more modest objectives than the
attainment of an economically optimal allocation of abatement resources.
The following objectives of a Federal wastewater cost-sharing program
appear to be most appropriate for policy-making purposes: First, the
cost-sharing program should encourage municipalities to undertake projects
that are cost-effective for society, but which would not be undertaken
in total or in part without Federal financial aid. In this way limited
cost-sharing funds would be used to supplement, rather than to substitute
for municipal funding.
Second, the cost-sharing program should provide an incentive for
municipalities to construct and operate the least costly abatement
projects, from society's viewpoint, for whatever level of pollution
abatement is achieved. Satisfaction of this objective encourages an
efficient allocation of resources utilized in controlling pollution. As a
result, any disruptive effect of pollution abatement activities on the
availability and prices of resources throughout the rest of the economy
will be kept to a minimum, and the size of the Federal cost share
necessary to support the program, may be restrained.
Third, the cost-sharing program should take into account differences
in population size and the economic status of municipalities in determining
the distribution of Federal grant funds. Ceteris paribus, it would appear
desirable that communities with the greatest fiscal capacity to pay for
pollution control costs also bear the highest proportion of these costs.
The present Construction Grant Program is deficient as a means
for satisfying any of these three objectives. A uniform subsidy rate
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for all grant-eligible construction costs and projects, as provided by
the Construction Grant Program, fails to adequately ensure that
municipalities will use Federal funds to undertake those projects that
are cost-effective to the nation, but which the communities would not
ordinarily undertake without Federal aid. Further, as a result of
subsidizing only grant-eligible construction costs, the Federal cost-
sharing program generates a preference for municipalities not to choose
the least costly pollution control projects. Existing cost recovery
provisions relating to industrial use of public facilities further magnify
the local preference to overbuild and undermaintain wastewater treatment
facilities.
The Federal grant program presently distributes authorized funds to
the States on the basis of relative capital costs needed to meet mandated
pollution control requirements. There are indications that the funding
process might be modified so that only one-half of allotments would
be distributed on this basis, and the remaining portion distributed according
to relative size of-state population. In either of these allotment programs,
there is no reason to suspect that limited Federal grant funds (1) will
be distributed nationally or even within the States on a cost-effective
basis, or (2) will be responsive to the fiscal capacity of the municipalities
within the States to pay for the required pollution control projects.
At the same time, owing in part to the cost recovery program, per
capita pollution control costs will tend to be lower in more industrialized
communities. This result is inequitable on grounds of both relevance to
the objectives of the grant program, and in terms of the fiscal capacity
of the communities to bear the burden of pollution control costs.
The analysis indicates that the following modifications in the
Construction Grant Program would ameliorate a significant portion of
the existing deficiencies:
1. Provide higher cost-sharing rates and larger funding
authorizations relative to estimated "needs" for wastewater
control projects such as secondary and higher-level treatment
plants. The benefits generated by treatment projects generally
accrue to residents living outside the local community.
Accordingly, in the absence of substantial Federal financial
aid, these projects are not likely to be voluntarily undertaken
by the local community to the socially desirable extent.
Wastewater collection projects, such as sewer systems, generate
benefits which accrue to a greater extent to residents living
within the local community. As such, these projects may be
encouraged by a lower level of Federal cost sharing than is
required for treatment plant projects.
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2. In the absence of a charge for municipal and industrial
effluents, supplement the Construction Grant Program with
either an operating and maintenance cost subsidy or a subsidy
based on the amount of abatement achieved. It is estimated
that a 25 percent operating cost subsidy program would currently
require less -than $300 million annually in grant funds allocated
to secondary treatment plants. An abatement subsidy program
costing less than $500 million annually in grant funds is expected
to reduce the existing effluent of secondary treatment p-lants by
more than 20 percent.
3. Divide the allotment of grant funds into two parts: one part
to be disbursed on the basis of an efficiency criterion, the
other part according to an equity criterion. The efficiency
criterion ranks projects and funding priorities on the basis
of the projects' cost-effectiveness. The equity criterion
ranks projects and funding priorities according to the
communities' pollution control costs relative to their fiscal
capacities.
4. Terminate local retention of industrial cost recoveries collected
against the Federal construction grant. Cost recoveries would be
returned to the U. S. Treasury or to the Construction Grant
Program for redistribution to the highest priority projects. If
local retention of cost recoveries is not abolished, then eliminate
the local discretionary fund, in which up to 20% of retained cost
recoveries can be used to pay for projects unrelated to pollution
control. Also, in order to remove the local financial preference
to use reserve funds to pay for non-grant related projects, do not
deduct the amount of funds held in reserve from grant-eligible
project costs in order to determine the size of the Federal grant.
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CHAPTER II
LEGISLATIVE HISTORY OF FEDERAL
WASTEWATER FINANCING PROGRAMS I/
This chapter summarizes the salient elements of recent Federal
legislation relating primarily to the financing of municipal water
pollution control projects. The period covered is 1948 through the
present. For our purposes the relevant differences in the Acts concern
the allocation of authorized Federal funds to the States and the distribution
of these allocated funds to municipalities based on a predetermined
Federal share of grant eligible pollution control costs.
Public Law 80-845: 1948
The current version of the Federal Water Pollution Control Act has
its roots in Public Law 80-845, passed in 1948, which authorized loans
and other assistance to States and municipalities for water pollution
abatement. Public Law 80-845 declared it to be the policy of
Congress
". . . to recognize, preserve, and protect the primary
responsibilities and rights of the States in
controlling water pollution, to support and aid
technical research to devise and perfect methods
of treatment of industrial wastes which are not
susceptible to known effective methods of treat-
ment, and to provide Federal technical services to
State and interstate agencies and to indus-
tries, and financial aid to State and interstate
agencies and to municipalities, in the formula-
tion and execution of their stream pollution abatement
programs. " [Section 1]
The Surgeon General of the Public Health Service, the Federal
Works Administrator, and the Federal Security Administrator were to
administer the program. According to Section 5 of this Act the Federal
Works Administrator was authorized to make loans to States, municipalities,
or interstate agencies to construct treatment works preventing the discharge
of untreated or inadequately treated wastes. Loans could also finance the
I/ This chapter was prepared by Meta Systems for EPA as part of their
"report entitled Evaluation of Alternative Methods for Financing
Municipal Waste~Treatment Works, EPA bUO/5-75-QOi, Washington, D.C.,
March, 1974.
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preparation of engineering reports, plans, and specifications. Loans
were to be made only if a project was part of a "comprehensive"
plan as well as approved by the Surgeon General and appropriate
State agency. Federal loans had an interest rate of two percent and
were limited to 33.3 percent of the "estimated reasonable cost" or
$250,000, whichever was smaller. Section 5 also provided that:
"... bonds or other obligations evidencing any such
loan (1) must be duly authorized and issued
pursuant to State and local law, and (2) may,
as to the security thereof and the payment of
principal thereof and interest thereon, be
subordinated [with agreement of Federal Works
Administrator] to other bonds or obligations of
the obligor issued to finance such project or
that may then be outstanding. "
The priority of projects would be determined by the "public benefit to
be derived, " the "propriety of Federal aid in such construction, "
the relation of the full costs of construction and maintaining works
to public interest and necessity, and the "adequacy of provisions . . .
for assuring proper and efficient operation and maintenance of the
works" after construction.
Public Law 80-845 authorized $22. 5 million for loans under
Section 5 of this Act for each fiscal year from 1948 to 1953 [Section
7] and $1 million during those years grants in order to complete the
preliminary planning and engineering work on approved projects. Public
Law 82-579 extended the life of 80-845 until June 1956. The funds,
however, were never actually appropriated [1].
Public Law 80-845 was substantially amended in 1955-56, 1961,
1965-66, and 1972. Since 1948, modifications to the water pollution
control legislation related to the construction of waste treatment works
have focused on several issues: (1) the proper role and authority
of States in managing their environmental affairs, particularly waste
treatment; (2) the percentage size contribution or cost-sharing proportion
the Federal government should provide to State pollution control projects
(the grant formula); (3) the distribution formula used to determine how
authorized Federal money should be allocated among States and among
municipalities of different sizes (the allotment formula); and (4) the
criteria or safeguards used to insure efficient use of Federal funds.
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Public Law 660: 1955-56
During the 1955-56 Congressional sessions, two bills (S.890 and H. R.
9540) were introduced to replace Public Law 80-845. In both bills the
Surgeon General, through the Public Health Service under the Department
of Health, Education, and Welfare (HEW), was authorized to investigate
pollution sources and causes, as well as make grants for research,
demonstration projects, and training personnel to operate and maintain
treatment plants. S. 890 of this Act provided that the Surgeon General
would
". . . from time to time make allotments to the several
States, in accordance with regulations, on the basis
of (1) the population, (2) the extent of the water
pollution problem, and (3) the financial need of the
respective States." [2]
The Surgeon General also was given the broad power of allocating money
to interstate agencies on "such basis as [he] finds reasonable and
equitable." [2]
The importance of recognizing and preserving "the primary respon-
sibilities of the States in preventing and controlling water pollution" [2]
was emphasized as was the proposed legislation to provide the support
and aid in technical research, which was seen as the most effective
stimulant to State control programs. HEW officials testified at Senate
Public Works Committee Hearings in April, 1955 that "experience with
other health programs has demonstrated the value of matching grants in
stimulating States to provide their own resources to do an effective job. "
It was purported that Federal support was most effective in planning,
research, consulting, and technical assistance on tasks which most
States could not adequately perform but which were critical to the
construction of treatment works.
Since matching funds would stimulate State involvement in pollution
control, S. 890, Section 5 of this Act constructed a formula for the
Federal share of control projects:
"The 'Federal share' for any State shall be 100 per
centum less that percentage which bears the same
ratio to 50 per centum as the per capita income
of such State bears to the per capita income in
the continental United States (except Alaska),
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except that (A) the Federal share shall in no case
be more than 66 2/3 per centum or less than 33 1/3
per centum, and (b) the Federal share for
Hawaii and Alaska shall be 50 per centum, and for
Puerto Rico and the Virgin Islands shall be 66 2/3
per centum. "
"The 'Federal share' shall be promulgated. . .
on the basis of the average of the per capita
incomes of the States and of the continental
United States for the three most recent consecu-
tive years for which satisfactory data are
available from the Department of Commerce. "
In other words, each State received a share of money based
on its average per capita income. The exact percent of project
costs that the Federal government would bear was determined by the
ratio of the State's average per capita income to the average per capita
income of the nation. No State, however, was to receive a share more
than 66. 6 percent or less than 33. 3 percent of the actual cost of the
local project.
H.R. 9540, Section 6, provided direct Federal grants to assist
municipalities in the construction of sewage disposal facilities, again
emphasizing the "established principle of recognizing the primary
rights and responsibilities of the States in controlling water pollution. "
Instead of the construction loans authorized (but never appropriated)
in 1948, this bill provided for matching grants to States, municipalities,
intermunicipal agencies, and interstate agencies, for the planning and
construction of treatment works. Grants were to be limited to 33.3
percent of the estimated "reasonable" cost of construction or $300,000,
whichever was smaller. Recognizing some large cities needed amounts
that would deplete a State's entire allotment, the legislation specified
that at least 50 percent of the funds authorized for treatment works
were to be directed to communities with a population of 250,000 or
less, with priority given to municipalities that had done advanced
planning. The then-current administration did not endorse Section
6 and took the position that the costs for treatment should be borne
by the users of the service, not by the Federal government in the
form of grants [3]. (Another bill, S. 982, provided for grants of up
to 50 percent of the cost of construction.)
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The conference and final version of the bills provided that
the Surgeon General make grants for construction of ''necessary1'
treatment works and a number of more specific criteria for the awarding
of grants. As in the original Federal Water Pollution Control
Act, no grant was to be awarded unless the project was approved by the
appropriate State water pollution control agency and the Surgeon General;
and unless it was included in a "comprehensive" pollution program no
grant was to be for more than 30 percent of the estimated reasonable cost
or $250,000, whichever was smaller. Consequently, the grantee was
responsible for the remaining cost. Applicants had to demonstrate
that there would be "proper and efficient operation and maintenance"
of treatment works after completion, and treatment operation had to
conform to State pollution control plans (Section 6(b)(3)). In making
his decision about allocations, the Surgeon General was instructed
to consider the public benefits to be derived from the project, the
relation of ultimate costs to public necessity, and the adequacy of
provisions for operation and maintenance (Section 6(c)).
Fifty percent of appropriated grant sums were to be allotted to States
on the basis of the ratio that the population of each State bore to all the
population in all States.
The other 50 percent of appropriated funds was to be allotted to each
State based on a complicated ratio formula. Each State would receive an
allotment determined by dividing the per capita income of the entire United
States by the per capita income of each State, adding all 50 quotients so
derived, and determining the ratio that each State's quotient bore to the
total of the quotients.
The Act authorized $50 million, - wherein 50 percent of appropriations
were to go to municipalities of 250,000 or less (Section 6(d)).
"Construction" was defined to include preliminary planning, engineering and
feasibility studies, and improvement or extension of treatment works
(Section 6(e)).
The 1955-56 sessions were also presented with a dozen bills providing
for the rapid amortization (60 months) by industry of the cost of industrial
treatment works, if the facilities were (1) installed on the basis of demand
from local governmental bodies and (2) part of an overall program
for pollution control. Municipalities had complained that industrial
wastes were one of the problems they could not handle through their
ordinary residential treatment works. None of these bills, however,
were incorporated into Public Law 660.
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Federal Water Pollution Control Act Amendments: 1961
In 1961 the major changes made in the Federal Water Pollution Control
Act were an increase in annual authorization of funds and a raise of the
ceiling on maximum grants to a single project. The Amendments of 1961
increased the annual authorization for construction grants on a graduated
scale from $50 million in fiscal year 1961 to $80 million in fiscal year
1962, $90 million in fiscal year 1963, and $100 million for fiscal years
1964-1967 (Section 5(d) in [4]). Again, 50 percent of the appropriated funds
were earmarked for cities of 125,000 or under. Maximum grants were
increased from 30 percent or $250,000, whichever was smaller, to 30
percent or $600,000, whichever was least expensive. (Section 5(a)).
Several other features were added to the Act. A project serving
more than one municipality could be funded by applying the grant formula
to each community's portion of the project as if it were a separate
enterprise. The sum of the maximum, grants or $2. 4 million, whichever
was smaller, was to be allocated until all applications were funded
which met the regulations in effect prior to the Amendments and which
were filed with the appropriate State agency during the first twelve
months after enactment of the 1961 Amendments.
This Act further provided that all money allotted to States which
remained unobligated for six months beyond the eighteen-month allotment
period could be reallocated to States having an excess of approved projects
(Section 5(c)). The administrative agent of the Federal Water Pollution
Control Act, as amended, was transfered from the Surgeon General to the
Secretary of HEW.
1966 Amendments: The Clean Water Restoration Act
During the 1966 session of Congress, debate over the Federal Water
Pollution Control Act Amendments focused on the formula for granting
Federal money to local projects. The testimony at hearings on the large
number of bills submitted to amend the Federal Water Pollution Control
Act presented an enormous amount of data documenting the increas-
ing demand and critical need for pollution control projects as well as the
flaws and biases of the existing legislation [5]. Witnesses described how
the 30 percent limit on grants discriminated against both the largest
communities and the smallest towns. A needs survey conducted and
presented by the Conference of Sanitary Engineers snowed that 70 projects
in the current backlog of applications would qualify for grants over
$600, 000 but under $1 million, for a total of $49. 6 million if the ceiling
11
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for grants were $1 million. Forty other projects would qualify for over
$1 million but under $2 million, for a total cost of $183. 8 million if the
ceiling were $2 million. Eighteen proposed projects were so large that
30 percent of their cost would be $2 million, with a total cost of $255
million. On the other hand, many small towns could not even qualify for
maximum grants on the basis of their population counts, nor did they have
the capability to finance treatment works on their own [5].
The time required to obtain Federal grants was repeatedly mentioned
as a deterrent, since municipalities delayed construction in the hopes
of eventually receiving Federal dollars, and approved projects could
experience lag times for nearly two years. A number of witnesses
stressed the importance of allowing swifter reallocation of monies that
were unused.
The magnitude of pollution abatement prompted the introduction of a
large number of bills directed to ease the costs of municipal financing of
treatment works. Again, on the basis of the burden industrial wastes
placed on municipal systems, 66 bills were filed to allow a tax deduction
for construction costs of treatment facilities. Another dozen were filed
to provide money to help retire municipal bonds. There was also interest in
providing money to help train people for the efficient operation and maintenance
of new facilities. Debate over several bills during hearings raised the idea of
reimbursing States for pre-financing of treatment works.
The bills which eventually became Public Law 89-753 initially authorized
increasing the authorization for construction grants to $150 million in 1967,
and up to $1. 25 billion in 1971 [6]. Again at least 50 percent of the first $100
million appropriated was to go to municipalities of 250,000 or less.
The general allotment formula to States was the same: the first $100
million appropriated during a fiscal year went to States on the basis
of population and per capita income weighted equally; sums appropriated
above $100 million were to be allotted solely on a population basis
with a 10 percent incentive for regional planning of projects. If sufficient
funds were available, State allotments were usable for the reimbursement
of State or local money used prior to June, 1971, and after June,
1966, for projects built without Federal assistance (if approved) or
with less than the allowable Federal share.
The grant allocation formula was changed substantially in this law with
a number of built-in incentives attached. The Federal government would
provide 30 percent of the cost of treatment works if the State provided
25 percent of the cost. The Federal share would be increased to 40
percent if the State financed 30 percent of the cost. If the State
adopted enforceable water quality standards for the waters which the treatment
project affected, the Federal share would increase to 50 percent if the
State contributed 25 percent. Again, the criteria established in the
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1961 Amendments for selecting projects remained the same, with emphasis
upon State determination of priority. River basin plans were eligible for
a 50 percent Federal share. The ceiling on individual projects was
eliminated, and there was a provision included for loans as much as
$250 million.
The committee report on the proposed Amendments stressed
the need for tax incentives so that industry would treat their own wastes.
The existing Act contained a provision for a seven percent investment
credit for the acquisition of air or water pollution facilities which
was retained in the Amendments with the provision that facilities met
Federal and State specifications. (S. 2857 proposed to increase the tax
credit to 14 percent, but it was not acted upon [7].)
Water Quality Improvement Act: 1968
In 1968 the grant system was altered to include contracts for
as many as 30 years to pay the Federal share of construction costs.
Contracts differed from grants in that they provided a loan which
could be issued more quickly to cities than a grant. The Federal share
could also be eventually recovered. The allotment of these contracts
remained the same as the allotment of grants. The monies available
for contracts were to be calculated according to the ratio of the population
of each State to the population of all the States, with 50 percent of
the first $100 million appropriated to go to cities of 250,000 or less.
The contracts could be used to pay off municipal bonds which had been
originally issued to finance the construction of treatment works. The Act
also approved one-time grants for improving the operation of treatment
works, on which construction was initiated after passage of the Act.
These grants were not to exceed 25 percent of the cost of operating
such treatment works, and in no event were to be over 50 percent of the
cost of improving operation during a twelve-month period. The authorization
for this grant program was $25 million.
Water Quality Improvement Act: 1970
In 1970 a variety of bills were presented to increase the Federal share
and the total and annual authorizations for pollution treatment programs.
The Administration bill (S. 3472) estimated that $1 billion Federal input
was sufficient to cover both the backlog and the increasing needs until
1974. This bill also proposed to reimburse States for prepayment from
current appropriations, while a companion bill suggested an Environmental
Financing Authority to be managed through the Treasury Department to
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assist States and localities in borrowing funds they could not obtain through
grants. The allocation of funds was to be made on the basis of a new
formula which considered population and the severity of local pollution
conditions. Sixty percent of the Federal funds was to be allocated by
population and income; 20 percent was to go to those States that paid at
least 25 percent of the cost of all assisted projects, distributed on a
population basis; and 20 percent was to be allocated on the basis of the
severity of the water pollution problems and the local ability to use funds
for basin-wide plans. The latter 20 percent was considered "discretionary
money" to offset the needs of especially large projects; first priority would
go to reimburse States that had pre-financed plans. (The 1966 Amend-
ments had encouraged a number of States and localities to pass bond issues
or arrange other means to finance the Federal share of costs in anticipation
of reimbursement so that by 1969 over $300 million in backlog payments were
due [8].)
Another bill, S. 3687, challenged the Administration estimates
by proposing to authorize $2. 5 billion annually for six years. The formula
in this bill was similar to the earlier 1955 bill with the Federal share being
100 percent minus the percentage calculated from ratios of per capita
income in individual States to the entire country. At the time, only
16 States were providing the matching shares to raise the Federal share
above 30 percent.
The Amendments of 1970 contained Title I -- the Water Quality
Improvement Act -- which made few changes in the sections related
to construction grants for waste treatment works. The Federal government's
responsibility to make grants or contracts related to training students
"to enter an occupation which involves the design, operation, and maintenance
of treatment works, and other facilities whose purpose is waterquality
control" was expanded by the stipulations in newly added Section 16.
The 1970 Amendments (Title II) also replaced the Federal Water Pollution
Control Administration with the Federal Water Quality Administration.
Authorizations remained at the level voted in 1966, or $1 billion for the
fiscal year ending June, 1970 and $1. 25 billion for the fiscal year ending
June, 1970 and $1. 25 billion for the fiscal year ending June 30, 1971.
Public Law 92-500: 1972
The next major alteration of the Federal Water Pollution Control Act
came in 1972. Title II, called "Grants for Construction of Treatment
Works, " expanded the purposes of the Act and specified goals for
new technology (including reclamation and recycling). Although Federal
financial assistance is not limited to this revised Act (nor were its
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predecessors the sole source of Federal grant funds for wastewater treat-
ment expenses), the new Act has taken precedence over most other
funding sources. Responsibility for administration of the Act has been
vested to EPA.
Several new yet general conditions were placed by the 1972 Amendments
on the allocation of grants after June 30, 1974, including that:
Projects provide for the application of the best-'
practicable waste treatment technology over
the life of the works;
Projects will consider and allow for the appli-
cation of new technology for reclaiming or
recycling water; and
Each sewer collection system discharging into
the treatment works is not subject to excessive
infiltration.
The Amendments as finally adopted and passed over the President's
veto provide for 75 percent Federal grants for facility construction with
no specified State participation required. (The Senate bill provided for
a 70 percent Federal grant if the State participated with a 10 percent
grant- the House bill provided for a 75 percent Federal grant if the
State participated with a 15 percent grant or loan. No State participation
would have led to Federal grants of 60 percent under either bill.) The
Amendments further provide for an Environmental Financing Authority
in order to assure municipal access to funds for financing its share
of project costs as well as the allocation of funds among States according
to their need for treatment plant construction.
In the next chapter, a more extensive discussion is provided of
P L 92-500 That discussion will lay the foundation for analysis of
those elements of the present financing program which appear in most
need of careful scrutiny.
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References: Chapter II
1. Hearings of the Senate Committee on Water and Air Pollution Control.
U. S. Senate, 84 th Congress, 1st Session, Government Printing Office,
Washington, B.C., 1964, p. 52.
2. Water Pollution Control Act Amendments of 1956. Public Law 660,
84th Congress, Chapter 518, 2nd Session, S. 890, Government Printing
Office, Washington, B.C.
3. Congressional Record. Government Printing Office, Washington, D.C.,
June 13, 1956, p. 10240 ff.
4. Federal Water Pollution Control Act Amendments of 1961. Public
Law 87-88, 87th Congress, H.R. 6441, Government Printing Office,
Washington, B.C., July 20, 1961.
5. Hearings. U.S. Senate Committee on Public Works, Government Printing
Office, Washington, B.C., May 19, 1964.
6. Clean Water Restoration Act of 1966. Public Law 89-753, 89th Congress,
S. 2947, Title II, Section 205, Government Printing Office, Washington,
B.C., Novembers, 1966.
7. Congressional Record. 89th Congress, Government Printing Office,
Washington, B.C., October 17, 1966, p. 27247.
8. Senate Public Works Committee Hearings. Subcommittee on Air and
Water Pollution, Government Printing Officer, Washington, B.C.,
April 20, 1970, p. 250.
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CHAPTER III
DESCRIPTION OF THE CURRENT FEDERAL WASTEWATER
FINANCING PROGRAM !_/
Grants for construction of municipal wastewater treatment works are
presently authorized under Title II of Public Law 92-500, officially
designated as the Federal Water Pollution Control Act Amendments of
1972. Hereinafter, this legislation is referred to as the 1972 Act or the
1972 Amendments. According to Sec. 201(g)(l),
"The administrator is authorized to make grants to
any State, municipality, or intermunicipal or
interstate agency for the construction of publicly
owned treatment works. "
In addition to the enabling legislation, the grant process is further
governed by regulations contained in the Code of Federal Regulations
under Title 40, Sec. 35. 900 et seq. (Final Construction Grant Regulations
appear in [1]. )
As expressed in EPA literature, the objective of the Construction Grant
Program is "to assist and serve as an incentive in construction of
publicly owned treatment works which are required to meet State and
Federal water quality standards [2], " This objective is satisfied
by the sharing of construction costs of wastewater treatment
facilities with municipalities (i.e., cities, towns, boroughs, counties,
parishes, districts--except school districts), associations, management
agencies, and other public bodies created by or pursuant to State law
and having jurisdiction over disposal of sewage.
The most significant features of the current Construction Grant Program
are authorizations, allotments, facility planning, application and approval
of grant awards, project priority lists, eligible costs and projects, grant
percentage, and user fees. Each of these elements are discussed briefly.
Authorizations
The 1972 Act provided for authorizations of $5, $6, and $7 billion for
fiscal years ending June 30, 1973, 1974, and 1975, respectively. However,
!_/ The material in this chapter derives from two original works: The
"previously cited Meta Systems study on alternative financing methods,
and a report written for EPA by the National Bureau of Standards entitled
Analysis of Cost Sharing Programs for Pollution Abatement of Municipal
Wastewater, EPA-600/5-74-031, Washington, D.C., November, 1974.
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one-half of these authorizations, that is $9 billion, were impounded
by the President. The U. S. Supreme Court has recently ruled that
the impoundment of these funds was illegal. Consequently, $9 billion
in supplemental authorizations will be made available for construction
grants during the period 1975 through 1977.
Allotments
Grant awards for 1973 and 1974 fiscal year Federal funds are
to be allocated among the States in the ratio of the estimated cost
of constructing all needed publicly owned treatment works in each State
to the estimated cost of construction of all needed publicly owned treatment
works in all of the States (Public Law 92-500, Section 205(a)). Cost
estimates are to be based on a "Needs Survey" for public wastewater
treatment works taken in 1971, and published in the House of Public
Works Committee Print 92-50.
The allotment of fiscal year 1975 Federal funds has been revised as
follows [3]: half of each State's share is based on the ratio of the
individual State's total construction needs up to 1990 to the total of all
States total construction needs. The other half is based on the ratio
of the individual State's costs to all State's cost for the following three
specific categories of pollution control facilities: secondary waste treatment
plants; advanced waste treatment facilities to meet water quality standards;
and new interceptors, forced mains, and pumping stations. In
addition, the formula provides that no State will receive less funds
than it received in fiscal year 1972. Cost estimates are to be based
on the 1973 "Needs Survey" [4].
State allotments are available for a period of one year following
the close of the fiscal year in which the sums were authorized. Funds
remaining unobligated at that time are reallocated to the other States
on the basis of the most recent allotment ratio. Funds obligated but
remaining after final payment or project termination are credited
to the State as an additional allotment sum. An evaluation of the present
allotment formula-and suggestions for alternatives are presented in
Chapter VI.
Facility Planning
The EPA Grant Program makes awards for any or all of the following
three steps: (1) Facilities Planning, during which the applicant's problem
is investigated in detail, existing facilities are assessed, alternative
approaches to problem solving are evaluated, and environmental impact
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and cost-effectiveness studies are made; (2) Preparation of Detailed Construction
Plans and Specifications, during which the facilities are planned, public
hearings are held, and blueprints prepared; and (3) Construction, during
which the facilities are built.
Grants may be awarded for Step 1, Step 2, and Step 3, or occasionally
for projects that combine Steps 2 and 3. However, Step 2, Step 3, or
Step 2 and 3 projects may be funded only if facilities planning (Step 1)
requirements have been previously satisfied.
Facilities planning requirements include description of the complete
wastewater treatment system; sewer system evaluation; cost-effectiveness
analysis including an environmental assessment, comments of agencies
with reference to specified planning requirements; description of public
reaction; legal, financial, and managerial capabilities statement; and,
a civil rights statement.
Best-practicable waste treatment technology must serve as the
minimum basis for planning and design in order to obtain grants from
funds authorized for any fiscal year beginning after June 30, 1974. In
cases where the application of best-practicable treatment would not meet
water quality standards, the plan must provide for that level of treatment
which will meet the standards.
Grant Application and Approval
The application and approval process is such that after determining
that a problem exists, the applicant, perhaps a town represented by
its mayor, makes an initial inquiry in its State water pollution control
agency. (The title of the State office varies from State to State; e.g., in
Alabama it is the Water Improvement Commission; in Kansas, the Division
of Environmental Health, State Department of Health; and in Washington, the
Washington State Department of Ecology.) The State office hears the inquiry
and ordinarily suggests that the applicant make a formal application for
a Step 1 Grant. Upon approval, the town assesses its existing wastewater
disposal facilities, existing and projected waste loads, and alternative
approaches which it might utilize to deal with its problem--typically
alternative plant processes and facilities. The plans are submitted to
the State agency which evaluates them. It is also responsible for coordinating
them with other wastewater disposal efforts in the area. Grants for
subsequent steps may be made either as amendments to the original
grant application or separately. The State office and /or the EPA regional
office may complement the award process with an investigation pertaining
to the functioning of the facilities which were constructed.
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Many requirements must be met in order to obtain grant
approval. Generally, these requirements include the presentation of
plans which (1) meet certain grant and physical plant criteria;
(2) consider priority and allotment conditions; (3) ensure that the
necessary permits have been secured and relevant regulations and
laws complied with; (4) do not violate certain cost specifica-
tions. A more detailed list of requirements is outlined below:
(a) A facilities plan has been approved before award of Step 2 or
Step 3 grant funds.
(b) Proposed works are in conformity with any approved Section
303(e) basin plans.
(c) The priority of proposed works is State certified.
(d) A grant award will not augment the total of all grants to that
State's applicants to more than the State's allotment.
(e) The applicant agrees to pay all non-Federal project costs.
(f) A copy of the National Pollutant Discharge Elimination System
(NPDES) permit will be provided.
(g) User charge and industrial cost recovery regulations will
be complied with.
(h) The proposed site will be available and the Relocation and
Land Acquisition Policies Act of 1970 as well as other Federal
regulations or statutes will be complied with.
(i) National Environmental Policy Act (NEPA) environmental impact
assessments have been performed.
(j) The Civil Rights Act of 1964 has been complied with.
(k) Satisfactory provision has been made to assure that the operation
and maintenance monitoring program will comply with applicable
permit and grant specifications.
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(1) If the project includes sewage collection system work,
such work is either for replacement or major rehabilitation of
an existing sewer system and is necessary to the performance
of the wastewater treatment works, or is for a new sewer
system in a community in existence as of October 18, 1972, (where
the bulk of the expected flow in the system will originate from the
community habitation in existence on that date) with sufficient
existing or planned capacity to adequately treat such collected
sewage.
(m) Fiscal year 1975 or later grants are for the best-practicable waste -
water treatment technology over the lifespan of the works.
(n) Project costs do not include costs allocable to treatment of
pollutants in industrial wastes unless the applicant is required
to remove such pollutants introduced from non-industrial sources;
costs allocable to treatment of wastes from Federal government
activities which another Federal agency has agreed to pay.
Eligible project costs are reduced by the unexpended balance
of the amounts retained by the applicant for future reconstruction
and expansion pursuant to industrial cost recovery regulations,
together with interest earned thereon.
(o) Initiation of construction has not occurred.
(p) The applicant is the designated Section 208(d) area wastewater
treatment management agency if one has been so designated.
(q) The proposed treatment works will comply with all Federal and
State environmental laws, including the Clean Air Act.
(r) Each sewer system discharging into the treatment works is not
and will not be subject to excessive infiltration and inflow.
Validation requires an infiltration/inflow analysis and, when
necessary, a sewer system evaluation survey followed by rehabilitation
of the sewer system.
(s) A sewer use ordinance will be enacted and enforced which prohibits
any new connections from inflow sources into the sanitary sewer
portions of the sewer system and ensures that the new sewers
and connections are properly designed and constructed.
(t) Industrial pre-treatment requirements will be met.
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Grant Award
Eligible public bodies apply for grants through their State water
pollution control office. The State office must review each
application, coordinate the plans outlined with other relevant projects
in the State, make recommendations for changes and, if the plan is
approved, then place the application on a priority list which shall be
sent to the EPA Regional Administration. There are ten EPA regional
offices from which the grant award is made. The total amount of grants
made to applicants in a State is limited by the State's allocation of
grant funds.
Approval of a grant application constitutes a contractual obligation
of the Federal government to pay its share of eligible project costs.
Grants are made directly to the municipality.
In addition to the grant conditions already enumerated, further conditions
are imposed on grant awards: these include provision for an operation
and maintenance plan, including a manual, an emergency response program,
properly trained personnel, adequate budget, operational reports, and
laboratory testing; as well as the institution of a program for the
utilization of small and minority businesses in the case of grants over
$10,000,000.
Project Priority Lists
The order of priority for grants received by applicants is ordinarily
determined by the State priority ranking criteria. Evaluations and priority
line-ups made by the State water pollution control offices are based on EPA
guidelines and State guidelines which have been approved by the EPA
Regional Administrator. Provisions of the 1972 Act and EPA regulations
and guidelines establish some mandatory criteria for project approval as
well as certification of priority for grants by State offices, allowing other
criteria to be determined by the State with the concurrence of EPA.
For the most part, the State options are intended to allow for environmental
or other relevant distinctions among areas.
Preparation of the priority list involves five stages: (1) Annual
State assessment of water pollution problems and control strategies;
(2) Ranking of State water segments taking into account severity of
pollution problems, population affected, need for preservation of high-
quality waters, and other national priorities; (3) Submission of the
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municipal discharge inventory list prepared according to Section 303(e)
guidelines; (4) generation of criteria for project selection, reflecting
water segment factors; and (5) Application of stage 4 criteria to the
stage 3 discharge inventory, but including only projects that can be
funded from current allotments.
Regional Administrators have been advised to accept or reject project
priority lists depending upon whether the States have ranked projects in a
manner that is generally consistent with the following sequence [5]:
(a) Projects which are required in order to meet existing water
quality standards or otherwise comply with the enforceable
provisions of the law--i.e. , treatment works that provide
secondary treatment or any higher level of treatment dictated
by standards. Included in this category are ancillary
improvements which must be done in conjunction with an award,
such as a cost-effective solution to certified, excessive infiltration
into sewers.
(b) Projects which are not required to meet water quality standards
but which must be installed to comply with the enforceable provisions
of the law--i.e., treatment works that provide secondary treatment.
This would include ancillary improvements as described in class (a)
above.
(c) Projects against which the enforceable provisions of the law,
best practicable treatment, will not be applied until 1983, or against
which many water quality standards will not be applicable until 1983--
storm and combined sewers. Storm and combined sewer projects
will be subject only to the treatment requirements necessary to meet
water quality standards. At the request of a State, projects to correct
combined/storm sewers if necessary to achieve existing water quality
standards, where this is cost effective and practical by the 1977 date
for achievement of standards, can be given a higher priority in the
FY 1975 list.
(d) Projects which are not discharges --e. g., collection sewers or
recycled water supply facilities -- are to receive lowest priority.
Collection sewers can be given higher priority when there is
an existing groundwater contamination, or problem when they
are an integral part of a waste treatment system (which
includes a treatment plant) for a community which previously
was without such a system.
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Furthermore, it is specifically stated that this ranking "does not mean
that all projects in class (a) must be funded before initiating projects in
class (b), and so forth; nor does it mean that projects must be funded in
sequential order. "
Public hearings must be held on project priority lists and subsequent
modifications thereto. (This requirement is waived for fiscal year
1974 fundings if time is insufficient, and may be waived for modified
lists in the future. ) The lists are submitted to Regional Administrators
within 60 days of any allotment of funds to the States; the Regional
Administrator has 30 days to act.
Eligible Costs and Projects
Those project costs which are eligible for funding in the current Federal
grant program include: salaries and consultant services; materials and
laboratory supplies; preparation of construction reports and drawings;
planning, compliance, and evaluation costs; as well as costs related to
physical relocation, construction, and landscaping. Costs that are not
eligible are for expenses not directly related to the project. They include
project completion bonuses; personal injury compensation; fines, penalties,
or interest; local operating and maintenance expenses; and site acquisition.
Complete lists for both eligible and ineligible costs are presented
in Table III-l.
In reference to eligible projects, an important issue is whether nonplant
wastewater treatment techniques are fundable under the construction grant
program. Nonplant technique's are defined as abatement methods applied
outside of the treatment plant and the main interceptors leading into the
plant. These techniques, among many, are (1) control and modification
of the non-interceptor sewer system, (2) separation of storm and wastewater
collection systems, (3) land disposal, and (4) community septic tanks. A
complete list of both plant and nonplant abatement techniques is presented in
Table III-2.
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Table III-l.
Eligible and Ineligible Project Costs
Under the Construction Grant Program
1. Eligible Costs:
Costs of the grantee which are reasonable and necessary are eligible.
Necessary costs may include but are not limited to:
(a) Costs of salaries, benefits, and expendable material incurred by the
grantee for the project.
(b) Costs under construction contracts.
(c) Professional and consultant services.
(d) Facility planning directly related to the treatment works.
(e) Sewer system evaluation.
(f) Project feasibility and engineering reports.
(g) Relocation and land acquisition costs required pursuant to the
Uniform Relocation Assistance and Real Property Acquisition
Policies Act of 1970, 42U.S.C. 4621 et seq. , 4651 et seq. , and
regulations issued thereunder.
(h) Costs of complying with the National Environmental Policy Act,
including costs of public notices and hearings.
(i) Preparation of construction drawings, specifications, estimates, and
construction contract documents.
(j) Landscaping.
(k) Supervision of construction work.
(1) Removal and relocation or replacement of utilities, for which the
grantee is legally obligated to pay.
(m) Materials acquired, consumed, or expended specifically for the
project.
(n) A reasonable inventory of laboratory chemicals and supplies necessary
to initiate plant operations.
(o) Development and preparation of an operation and maintenance manual.
(p) Project identification signs.
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Table III-I. (Continued)
2. Ineligible Costs:
Costs which are not necessary for the construction of a treatment
works project are ineligible. Such costs include, but are not limited
to:
(a) Basin or areawide planning not directly related to the project.
(b) Bonus payments not legally required for completion of construction in
advance of a contractual completion date.
(c) Personal injury compensation or damages arising out of the project,
whether determined by adjudication, arbitration, negotiation, or
otherwise.
(d) Fines and penalities resulting from violations of, or failure to comply
with, Federal, State, or local laws.
(e) Costs outside the scope of the approved project.
(f) Interest on bonds or any other form of indebtedness required to
finance the grantee's share of project costs.
(g) Ordinary operating expenses of local government, such as salaries
and expenses of a mayor, city council members, or city attorney;
except as provided in Section 35. 940-4 of the Grant Program Regulations,
for allowance of indirect costs of the grantee in accordance with an
indirect cost agreement negotiated and incorporated in the grant
agreement.
(h) Site acquisition (for example, sewer rights-of-way, sewer treatment
plant sites, sanitary landfills and sludge disposal areas); except as
provided in Section 35. 950-3(a) for land which will be an integral part of
the treatment process or that will be used for ultimate disposal of
residues resulting from such treatment, if approved by the Administrator.
(i) Costs for which payment has been or will be received under another
Federal assistance program.
(j) Costs of equipment or material procured in violation of Section 35. 938-4(b),
which provides for award to the low responsive, responsible bidder.
Source: Reference [1].
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Table III-2.
Alternative Techniques for Abating Wastewater Pollution
I. Wastewater Prevention, Control, and Reduction Techniques
A. Prior to Discharge into Waterway
1. Reduction in Water Use
2. Active Control and Modification of the Sewer Collection
System
a. Injection of High Molecular Weight Polymers into the
Collection System
b. Selective Retention and Control of Flow in the Collection
System
c. Pretreatment in the Collection System.
d. Controlled Flushing of Sewers
3. Enhancement of New and Rehabilitation of Existing Collection
Sewers
a. Enlargement of Sewers
b. Separation of Storm and Wastewater Collection Systems
c. Design and Construction of Collection System to Prevent
Infiltration and Inflows
4. Control and Restrictions on the Release of Certain Substances
into the Sewer System
5. Influence on Decisions of Households and Industry to Connect to
the Municipal Sewer System
B. During and After Discharge into Waterway
1. Selective Routing of Effluent Discharge
2. Low-Flow Augmentation of Receiving Waters
II. Wastewater and Effluent Treatment Techniques
A. Prior to Discharge into Waterway
1. Treatment in Conventional and Advanced Waste Treatment
Plants
2. Land Disposal of Wastewater
3. Community Septic Tanks
4. Raw Sewage Lagoons
B. During and After Discharge into Waterway
1. In-stream Aeration
2. Treatment of Overflow
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A review of the Act reveals a number of passages which suggest
inclusion of nonplant techniques for grant consideration. Recalling
that the Act authorizes grants for construction of publicly owned
treatment works, consider how "treatment works" are defined in Section
212(2)(A):
"The term 'treatment works' means any.devices and systems
used in the storage, treatment, recycling, and reclamation
of municipal sewage or industrial wastes of a liquid nature . . .
or necessary to recycle or reuse water at the most economical
cost over the estimated life of the works, including intercepting
sewers, outfall sewers', sewage collection systems, pumping
power, and other equipment, and their appurtenances; extensions,
improvements, remodeling, additions, and alternations thereof;
elements essential to provide a reliable recycled supply such
as standby treatment units and clear well facilities; and any works,
including site acquisition of the land that will be an integral part
of the treatment process or is used for ultimate disposal of
residue resulting from such treatment. "
Section 212(2)(B) adds the following items to the definition of treatment:
". . . any other method or system for preventing, abating, reduc-
ing, storing, treating, separating, or disposing of municipal
waste, including storm water runoff, or industrial waste,
including waste in a combined storm water and'sanitary sewer
systems."
This is indeed a very broad definition which would appear to include
practically every technique imaginable by which water pollution from
municipal waste and storm water could be abated. - Similarly, the
definition of construction, as given in Section 212(2), does not limit
grants to a particular kind of treatment works. °
Other passages of the 1972 Act emphasize that projects for which
grants are awarded should use the most cost-efficient alternatives
(See, for example, Section 212(2)(c)). The intent appears to be to
encourage the most efficient technique, regardless of whether it be
"plant" or "nonplant. "
There are, however, other passages in the 1972 Act which might be
interpreted to prohibit consideration of some nonplant techniques.
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Most important to the restrictive interpretation of eligibility are the
requirements in the law for a non-polluting discharge and provision of
the best-practicable waste treatment technology (now generally defined
as secondary treatment) before any discharge into receiving waters.
The requirements are contained in the following passages:
Section 201(b): "Waste treatment management plans and practices
shall provide for the application of the best practicable waste
treatment technology before any discharge into receiving waters, . . "
Section 301(b)(l): "There shall be achieved . . . for publicly owned
treatment works in existence on July 1, 1977, or approved . . .
prior to June 30, 1974 . . . effluent limitations based upon secondary
treatment. . . "
"Before any discharge into receiving waters" is sometimes interpreted
to mean disallowing grants for techniques whose application occurs after the
sewer outfall system. Accordingly, low-flow augmentation and in-stream
aeration are ineligible for grants.
The above sections place significant emphasis on treatment as opposed
to other forms of abatement. This an interpretation might result from
the fact that a specified level of treatment is explicitly required by
the law with much attention given to improving the quality of the effluent
discharge. The focus on treatment before discharging might tend to
lessen attention to techniques aimed at prevention, control, and reduction
of wastewater, as well as treatment techniques applied in the stream.
An alternative interpretation of eligiblity as defined in the 1972 Act
is the following: emphasis on treatment techniques is inherent in the
legislation, insofar as goals and requirements are sTated in terms
for achievement of non-polluting discharges and minimum treatment
standards. Similarly, emphasis is on action prior to effluent discharge.
Nonetheless, the legislation does ITbt appear to exclude from grant
eligibility the nonplant techniques previously mentioned. The exceptions
are techniques requiring expenditures for collection systems in new
communities, grants implicitly prohibited by Section 211 of the 1972
Act; as well as low-flow augmentation and in-stream aeration.
In conclusion, subject to the noted exceptions, nonplant techniques
appear eligible for grants in the 1972 Act. In particular, techniques
such as land disposal and community septic tanks, which car provide
the equivalent of secondary treatment with no direct discharge into
a waterway, satisfy the tenets of the 1972 A~cT. Techniques which prevent
or reduce the generation of wastewater also comply with the law by
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reducing the discharge of pollutants into waterways. Nonplant treatment
techniques, which alone or in combination with other nonplant or plant
techniques are able to fulfill water quality standards, likewise are
compatible with the law.
Another type of eligibility issue relates to project size. For a given
expected growth in demand for waste treatment services, projects having
longer design periods imply that higher levels of reserve capacity are
needed. ' :" '
Historically, construction costs for (1) treatment plant projects having
a design period of up to 20 years, and (2) interceptors having as long as
50-year.design periods, were eligible for a grant award. Evaluation of
alternative grant-eligible design periods is presented in Chapter VII.
Grant Percentage
According to Section 202(a) of the 1972 Act, the Federal grant rate
is 75 percent of the cost of construction of a treatment works. This
appears to be the current legal maximum cost sharing proportion.
One may ask if this is the minimum legal cost-sharing proportion.
The response depends upon the definition of "treatment works. " Until
recently, as reflected in the interim grant program regulations, it
was required that a fundable Step 3 project result in an operable treatment
works. Thus, under the former interpretation, the legal minimum, as well
as maximum Federal cost-sharing proportion was 75 percent of total
eligible construction costs of a completed facility.
However, program requirements for a minimum grant of 75
percent of total construction costs were criticized and have since been
changed. According to the Senate Committee on Public Works [6],
this requirement did not allow a State the flexibility "to use its annual
allocation of grant funds among as many projects on its priority list
as it wishes, on the basis of what can be accomplished in a given
year, rather than to tie up all its funds in a few large projects at
the top of a State's priority list. " The committee further stated that
"phased funding, " whereby a portion of a total facility would be approved
for a grant would not,under the 1972 Act, commit the grant program to
eventual funding of the total facility nor create a pool of reimbursable claims
against the grant program 'for an ultimate grant of 75 percent of the full
construction costs of the completed facility.
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Section 203 of the 1972 Act has since been interpreted to permit States
to divide individual treatment works into separate parts for the purpose
of funding. This new interpretation is reflected in the final program
regulations which provide for grants of 75 percent of the construction
cost of segments of treatment works. "Segment" is defined as "any
portion of an operable treatment works" and its completion need not
result in an operable treatment works.
In summary, one may conclude that under the present grant program
the Federal share must comprise a minimum 75 percent share of
the eligible construction costs of an approved project, but that the
approved project no longer need result in a completed facility.
Alternatives to this program are considered in Chapter VI.
User Fees
With respect to legislative requirements for user fees, Section
204(b)d)(A) of the 1972 Act states the following:
". . . the Administrator [of EPA] shall not approve any grant
for any treatment works . . . unless . . . the applicant . . . has
adopted or will adopt a system of charges to assure that each
recipient of waste treatment services within the applicant's
jurisdiction . . . , will pay its proportionate share of the costs
of operation and maintenance ..."
In effect, this section provides for collection of user fees to repay
O&M expenses from, all recipients of services.
Section 204(b)(l)(B) requires that the Administrator shall also
have determined that the applicant has done the following:
". . .made provision for the payment to such applicant by the
industrial users of the treatment works, [sic] of that portion of the
cost of construction of such treatment works (as determined
by the Administrator) which is allocable to the treatment of such
industrial wastes to the extent attributable to the Federal share
of the cost of construction. . . "
Specifically, fees will be collected from industrial users to pay
that portion of the grant amount allocable to treatment of industrial
waste. However, industry is not required to pay an interest charge on
their portion of the Federal grant.
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It is further specified in Section 204(b)(3) that the grantee do the
following:
". . . retain an amount of the revenues derived from the payment
of costs by industrial users of waste treatment services, to the
extent costs are attributable to the Federal share of eligible
project costs pursuant to this title as determined by the Adminis-
trator, equal to (A) the amount of the non-Federal cost of such
project paid by the grantee plus (B) the amount, determined in
accordance with regulations promulgated by the Administrator,
necessary for future expansion and reconstruction of the project
except that such retained amount shall not exceed 50 per centum
of such revenues from such project. "
In effect, this last section provides that the grant recipient will retain
50 percent of the amount recovered from industrial users against the
Federal grant. The 50 percent limit is the effective rule for retention
of industrial user fees because the sum of the non-Federal capital cost
and the amount necessary for future expansion and reconstruction,
under normal circumstances, will exceed 50 percent of the amount
recovered from industrial users against the Federal grant.
In consequence of differences in rates of industrial participation
among municipal treatment facilities, the retention of one-half of the
Federal grant portion applicable to industry is an important determinant
of unequal cost-sharing proportions across communities. The impact
of industrial participation and cost recovery requirements on municipal
and industrial cost shares is quantified in Chapter VIII.
Nonetheless, Federal regulations [1] pursuant to the 1972 Act stipulate
that a minimum of 80 percent of the retained amounts, plus appropriate
interest, must be set aside in a reserve fund for future expansion and
reconstruction. Regulations allow the remaining 20 percent of retained
amounts to be allocated by the grantee, upon his own discretion.
The reserve fund may be used only for eligible project costs related to
expansion and reconstruction of the original project and only with written
approval of the Regional Administrator. The holder of a reserve fund may
apply that fund to project costs for which a grant is requested or may use
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it to pay for project costs apart from any grant request. However,
if a grant is forthcoming, it is required that the amount in the reserve
fund be deducted first from eligible project costs for the purpose of
determining the size of the grant.
Subsequently, Section 35.927-17 of the Grant Program Regulations
provides the following:
"...allowable project costs (are to be) reduced by an
amount equal to the unexpended balance of the amounts
retained by the applicant for future reconstruction and
expansion ... together with interest earned thereon."
Thus, whenever a grant is to be provided, the holder of a reserve
fund has no choice but to apply the amount then in the fund to that
project, and have the amount of the grant eligible costs thereby reduced;
however, he need not have held the fund until a grant is forthcoming.
Future Chapters
This chapter has described some important elements of the current
Federal Construction Grant Program. Future chapters will focus in
more analytical depth upon several of these program elements.
The structure of an economically desirable cost-sharing program
is developed in the next chapter. Afterwards, in light of (1) those
findings, (2) constraints inherent in the present program, and C3)
second-best considerations, separate chapters are devoted to designing
a cost-effective Federal grant program, with specific emphasis upon
the grant formula, the allotment formula, and industrial cost-recovery
requirements.
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References: Chapter III
1. "Final Construction Grant Regulations, Construction Grants for
Waste Treatment Works. " Federal Register, Volume 39,
Government Printing Office, Washington, B.C. , November
29, February 11, 1974.
2. "Federal Assistance Programs of the Environmental Protection Agency. "
Reprinted from the Catalog of Federal Domestic Assistance, Section
66.015, Government Printing Office, Washington, D.C., June , 1973.
3. Public Law 93-243. 93rd Congress, S. 2812, Government Printing
Office, Washington, B.C., January 2, 1974.
4. Costs of Construction of Publicly Owned Wastewater Treatment Works:
1973 "Needs " Survey. U.S. Environmental Protection Agency,
Washington, B.C., November, 1973.
5. Water Quality Strategy Paper. U.S. Environmental Protection Agency,
Washington, B.C., March 15, 1974, pp 41-42.
6. Waste Treatment Fund Allocations. Senate Committee on Public
Works, Report Number 93-630, Calendar Number 604, 93 rd Congress,
1st Session, Government Printing Office, Washington, B.C., Becember
13, 1973, pp 9-11.
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CHAPTER IV
THEORY OF COST SHARING FOR MUNICIPAL WASTEWATER
POLLUTION ABATEMENT PROJECTS
During the past 25 years, the Federal government has chosen to
"finance" the cost of municipal wastewater pollution control through
the process of cost sharing. Also known as matching grants, cost
sharing has traditionally involved the subsidization by the Federal
government of a predetermined percentage of eligible construction
costs.
Cost sharing serves two major functions. First, it reduces the
local cost burden of adopting any level of pollution control, when the
method of control satisfies the eligibility requirements for the Federal
grant. Second, cost sharing serves as an inducement for communities
to adopt the level and type of abatement activities that are considered
socially desirable.
In reference to the first function of cost sharing, the rationale for the
Federal subsidy rests upon issues relating to property rights and equity
considerations. Since some pollution control measures are mandatory,
it can be argued that the Federal government, as a result of potential
infringement of community property rights, should bear some portion of
treatment costs. Otherwise, communities may be hard pressed to pay
for the required pollution control activities. In addition, benefits from
abatement are often wide-spread, extending beyond the local jurisdiction,
so that it is not unreasonable for society to pay for these external
benefits through Federal cost-sharing subsidies.
The reasoning behind the second function of cost sharing is rooted
in the relationship between the Federal subsidy arid the issue
of externalities. An external diseconomy exists when party A imposes
costs on party B, but these costs are not taken into account by party A.
In the presence of pollution damages imposed on downstream
communities, an externality will be generated if inter-community
negotiations or government intervention does not take place. In these
cases, each community will choose a level of pollution abatement which
is locally but not socially optimal. (Throughout the study, "social"
refers to the sum of the relevant local and non-local factors. )
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The objective of this chapter is to investigate the ability of cost
sharing to encourage local communities to make socially desirable
abatement decisions. Initially, a brief discussion is provided of alter-
native pollution control implementation strategies. Afterwards, a
detailed study of cost sharing is conducted.
The analysis shows that for reasons discussed later, cost-sharing is
not well suited for inducing communities to achieve socially desirable
levels of pollution abatement. However, cost sharing is well suited,
in conjunction with mandated abatement requirements, to encourage
communities to select socially cost-effective pollution control projects.
To accomplish this, the government could provide higher Federal cost-
sharing rates and relatively larger funding authorizations for those
projects which are socially desirable, but which the locality would
not ordinarily choose to undertake on its own.
Alternative Implementation Mechanisms
The most common implementation method for inducing pollution
control is the regulatory approach in which certain abatement standards
are mandated by Federal law. This is the primary policy in the United
States as well as in other parts of the world. The regulatory approach
for implementing environmental policy has the appearance of being equitable,
and is generally favored by governments owing to the belief that it is easier
to administer and requires less information than alternative implementation
strategies.
A second implementation method involves the use of pollution related
effluent charges. A polluter is required to pay a fee to a central i
authority, the size of the fee being related to the volume and intensity
of the effluent. It can be demonstrated that an effluent tax encourages
an outcome wherein the resulting level of effluent abatement is achieved
at least aggregate abatement cost by the polluters subject to
the effluent tax. This outcome is unlikely to occur under a system
in which abatement requirements are imposed on individual polluters.
There are additional advantages that derive from use of effluent
charges. One which is quite important and often overlooked has been
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suggested by Tullock [1]. He points out that while ordinary forms of
taxes (income, sales, etc. ) tend to distort relative prices and hence
resource allocation, effluent taxes encourage a more efficient use of
resources for controlling pollution and for producing final products.
At the same time, effluent taxes result in public revenues. Therefore,
effluent taxes generate an "excess benefit", because the revenues
collected can be used to replace the proceeds that derive from other
forms of resource-distorting taxes.
It has been pointed out by Rose [2] that in the absence of a price
for remaining discharges, pollution related products (in this case
sewer services) will be underpriced and overproduced. Rose also
maintained that even when standards are being met and marginal pollution
damages are zero the residual charge serves the important function
of allocating the assimilative capacity of the receiving water in an
efficient way among dischargers.
For example, suppose that each discharger has an effluent limitation
based on a given stream standard. As the number of dischargers
increases, the effluent allotment to each will have to decrease. An
appropriately set effluent tax would reflect the marginal control costs
imposed by each discharger on the others. As a result, those dischargers
who could further treat their wastewater at relatively low cost would
tend to do so, while those who would incur large incremental treatment
costs would choose to pay the effluent tax. Hence, a given level of
total effluent would tend to be achieved at minimum aggregate abatement
cost.
As indicated previously, there exists the belief on the part of
program administrators that the regulatory appraoch is easier to administer,
requires less information, and is more equitable than alternative imple-
mentation strategies such as effluent charges. Those who have investigated
alternative implementation strategies in some detail do not necessarily
concur with these conclusions.
A discussion by Kneese and Bower [3], later supplemented by Rose [2],
indicates that determination of appropriate effluent standards requires
more information about control costs of polluters than is needed to set
appropriate effluent charges. This is the case because the regulatory
approach requires information specific to each of the individual polluter's
cost of control function, while the effluent-charge approach requires
information essentially contained in the polluters' aggregate cost of
control function.
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Preference for the regulatory approach over the effluent-charge
approach on the basis of equity considerations appears to be unfounded.
A system of uniform or proportional abatement requirements tends to
favor the largest communities and the worst polluters, which can hardly
be termed equitable. For example, the larger communities generally
have the lowest cost per unit of abatement, owing to economies -of-
scale, industrial participation, and favorable financing terms. A system
of standards generally will fail to take these factors into account, and
accordingly will require too little abatement from larger communities
and too much abatement from smaller communities.
At the same time, since the standards do not require payment for
any remaining discharge, the worst polluters will be allowed to generate
the highest levels of uncompensated ecological damages on the receiving
waters. In fact, under direct regulation, none of the polluters will be
assessed a charge for the pollution damages which they impose on society.
Conversely, an effluent charge system allows each polluter the
flexibility to decide how and to what extent to control pollution, depending
upon the size of the discharge fee and upon the polluters' costs of
controlling pollution. Also, an effluent fee placed on remaining discharge
provides that each polluter is treated fairly, in the sense that each
pays the same price per unit of discharge.
A frequent criticism of effluent charges is that they are
"licenses to pollute. " Perhaps so, however the present regulatory
system provides a "license" to pollute which is free, as long as the
standards are complied with. Even if the standards are not being met,
legal and economic penalties often prove ineffective. The effluent charge
provides a continuing incentive to seek improved treatment methods
(as opposed to legal delays) which achieve discharge reductions in excess
of the level implied by a system of standards [4].
Critics of effluent charges occasionally contend that the resulting
pollution level is too uncertain in the presence of effluent charges.
Nevertheless, the potential adverse effects of such uncertainty could be
easily reduced by simply raising the fee per unit of discharge. Alter-
natively, these effects could be completely eliminated by adopting a
system of marketable discharge permits [5].
It is sometimes maintained that a system of effluent charges
imposes higher costs on polluters than does a system of standards.
However, this depends upon the levels of the standards, the parameters
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of the effluent charge system, and the polluters' abatement cost functions.
Theoretically, an effluent charge system can always be designed which
would be less costly even from the polluters' viewpoint than a system of
standards. This can be accomplished by returning the effluent charge
payments to polluters, with the size of the individual rebates independent
of the resulting levels of pollution.
In spite of the foregoing arguments in favor of effluent charges, it
should be recognized that in many cases municipalities are presently
operating under significant economic hardships. The imposition of effluent
charges may contribute to further erosion of a municipality's ability to
raise funds needed to provide social services. Also, there are constitu-
tional and political constraints which currently prevent imposition
of Federal effluent charges on municipalities.
Subsidies are the third implementation mechanism for encouraging
socially desirable municipal pollution control actions. A subsidy program.
may take several forms. However, in practice, subsidy programs for
municipalities have traditionally been limited to the cost sharing of
grant-eligible abatement expenses.
By focussing upon subsidizing selected inputs, such as capital resources
existing cost-sharing programs tend to bias local project selection to-
wards the use of those techniques and factor inputs which have the highest
Federal cost-sharing proportions. As we shall see, even if Federal
grants were not biased towards specific cost categories, communities
may respond to cost sharing by selecting projects that are locally but not
necessarily socially desirable.
Nevertheless, despite these inherent shortcomings, the current
municipal wastewater Construction Grant Program is of a cost-sharing
nature. Thus, the remainder of this chapter investigates the theoretical
foundations of cost-effective municipal subsidy programs that can
be classified under the cost-sharing rubric; and examines the efficacy
of cost-sharing as an instrument for inducing communities to adopt the
socially desirable levels of pollution control.
Summary of Findings
In the present municipal wastewater Construction Grant Program, a
single Federal cost-sharing rate of 75 percent is applicable to
the capital costs of eligible construction projects. This rate applies
uniformly across different communities and alternative grant-eligible
construction projects.
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The present Construction Grant Program also requires that minimum
Federally mandated levels of wastewater treatment be achieved by grantees,
Thus, grant-recipient communities are not free to choose a level of
wastewater pollution control below the minimum level allowed.
An additional element of the present program, is the manner in which
Federal grant funds are allotted to the States. Although distribution of
grant funds within a State to wastewater treatment projects is supposed
to be made on a cost-effective basis, this is not the case for distribution
of limited Federal grant funds among the States.
The grant program also stipulates that communities are required to
recover from industry the portion of the Federal grant applicable to
industrial use of municipal facilities. One-half of this recovered amount
is retained by the communities and the remainder is returned to the
U. S. Treasury. Thus, even though the nominal Federal capital grant
rate is equal among communities, the effective "project" grant rate
will differ, depending essentially upon the relative degree of industrial
participation and the ratio of grant-eligible capital costs to total project
costs (capital, land, operation and maintenance).
Tn addition, .given any proportion of wastewater treatment costs
borne by the Federal government (i.e., the cost-sharing proportion),
communities may be limited by their local budget or by political and
legal factors from choosing the socially desirable levels of abatement.
Under these conditions, there is sufficient justification for concluding
that abatement resources will not be allocated to pollution control projects
such that the difference between social abatement benefits and costs is
maximized. Moreover, the resource costs required to generate the
resulting level of social and local abatement benefits will not be
minimized, i.e. , abatement resources will not be efficiently allocated.
Each element of the Construction Grant Program discussed above
contributes to this economically inefficient outcome. -Nevertheless,
an important question is: Under the most favorable conditions, is it
generally possible to achieve an efficient allocation of abatement
resources with a Federal cost-sharing program ?
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To answer this question, a model is designed which removes the
obstacles to an efficient allocation of abatement resources inherent in
the present Construction Grant Program. In this model, construction
grants are replaced by project grants, applicable to total costs, in
order to eliminate the local bias to prefer capital intensive projects.
More importantly, the project grant rate is allowed to vary by
community and may be set by the grantor at a rate consistent with
achieving a socially desirable level of abatement.
In addition to these important departures from the present program,.
direct Federal grants to projects are assumed to replace the allotment
of Federal grant funds to the States, and the relationship between units
of pollution abatement and the resulting dollar value of abatement benefits
is assumed to be known. Also, the model assumes the absence of
(1) Federally mandated levels of treatment and (2) local funding constraints
for abatement activities.
The results generated by the model show that variable cost-sharing
proportions can be found which will encourage a socially optimal allocation
of abatevnent resources, if sufficient Federal funds are available to
subsidize the appropriate amount of abatement resources requested
by each of the individual communities at the optimal cost-sharing
rates. !_/
When cost-sharing funds are constrained, so that the socially optimal
abatement resource levels cannot be Federally funded in all commimities,
it is obviously not possible to induce on optimal allocation of abatement
resources with a cost-sharing program as defined herein. More surprisingly,
there also does not exist a set of cost-sharing rates which will generate
an efficient allocation of abatement resources. In other words, the real
resource cost of achieving any level of pollution control will not be
minimized.
The reason for this inefficiency is that not only are Federal funds
constrained, but the cost-sharing rates apply to the total costs of
controlling pollution and not simply to incremental costs. Thus, in order
to induce higher levels of clean-up, higher cost-sharing proportions must
be provided for both existing as well as for incremental abatement costs.
W While the current Construction Grant Program also induces variable
cost-sharing rates among communities, these rates bear no obvious
relation to the achievement of an economically efficient (or equitable)
abatement solution.
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This inherent inflexibility of cost sharing, in the presence of a
Federal funding constraint, means that resources cannot be easily
rearranged at the margin to encourage an efficient solution. That is,
although the incremental resource costs of small changes in abatement
may also be small, the Federal costs of these small changes are
relatively high. This "lumpiness" of Federal costs will ensure that
the benefits obtained under a constrained cost-sharing program could
have been secured at lower resource cost either by direct enforcement
or through alternative abatement incentive programs such as effluent
charges.
Of course, the situation deteriorates considerably when the
idealistic assumptions described previously are relaxed, and some
real-world conditions which are not incorporated in the model are
taken into account. Thus, while traditional cost-sharing programs
provide some incentive for communities to undertake additional abate-
ment, they are not "efficient" mechanisms for doing so.
Despite their shortcomings as a means for inducing appropriate
levels of abatement, cost-sharing programs can be designed to encourage
communities to undertake socially cost-effective abatement activities.
These activities include the proper mode of treatment and collection
of wastewater; utilization of the appropriate level and mix of resource
inputs for the mode selected; provision for sufficient but not excessive
reserve capacity; and maintenance of the performance integrity of the
pollution abatement system. Chapters V through VII are concerned
with the specific elements of a cost-sharing program which will achieve
these pollution control objectives.
Background
The Federal Water Pollution Control Act Amendments of 1972
authorize the Administrator of the Environmental Protection Agency
to make grants for the construction of publicly owned waste treatment
works. Those projects selected for an award are provided with a
Federal grant equal to 75 percent of eligible construction costs.
Federal cost-sharing programs such as this one have been
criticized previously in the literature. For example, Fox and
Herfindahl (6) argued that there exists a tendency to encourage the
overbuilding of wastewater treatment facilities because, inter alia,
the beneficiaries of the projects usually bear a relatively small portion
of construction costs.
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Regan [7] recognized that the attainment of an efficient allocation
of resources was sensitive to cost-sharing arrangements. However,
his prescription that ". . . it would seem necessary to provide that
marginal benefits from each purpose accruing to each participant
be sufficient to cover the corresponding marginal costs borne by each'
is not particularly helpful, since each participant can be expected to
attain this position on their own, with or without cost sharing.
Loughlin [8] suggested that different cost sharing policies within and
among various Federal agencies lead to inefficient project choices with
regard to techniques, scale, and utilization. A recent study by the
National Water Commission [9] has found that existing cost-sharing
arrangements encourage the adoption of control methods which may be
cost-effective for the local community, but which are not the least -
costly solutions for society.
Formalization of the relationship between cost sharing and economic
efficiency when third-party effects are generated was first undertaken by
Marshall [10, 11]. In these studies, Marshall considered the design of
cost-sharing rules which would induce communities to choose levels of
pollution abatement that are socially optimal.
In the presence of external effects and in the absence of Federal
government (grantor) intervention, Marshall showed that the local
community would not adopt the socially optimal abatement level. However,
Marshall argued that this optimal level could be encouraged by setting the
cost-sharing rate such that the ratio of local to social costs is equal,
at the margin, to the ratio of local to social benefits at the margin. "Social"
refers to the sum of local and non-local factors. This cost-sharing rule,
that is, where costs are shared in proportion to benefits at the margin, was
called the Association Rule by Marshall. (Note that the optimal grant rate
applies to all relevant abatment costs and may vary across communities.
This concept is quite different from the uniform rate applicable only to
construction costs which exists in the present Federal wastewater grant
program. )
In order to apply this rule, the socially optimal level of abatement
is ordinarily determined first. Then the ratio of local to social benefits
at the margin is calculated. Finally, the grantor cost-sharing proportion is
set equal to one minus this marginal benefit ratio. If the ratio of marginal
local to marginal social benefits is constant at all relevant levels of abate-
ment, the appropriate grantor cost-sharing proportion can be calculated
directly from the marginal benefit ratio, without first computing the optimal
level of abatement.
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Application of the Association Rule to optimize resource allocation
for pollution control is critically dependent upon the satisfaction of
several assumptions not made explicit by Marshall. One of the most
important implicit assumptions is that sufficient funding is available
to pay the federal government's share of costs at the socially optimal
abatement levels.
The model developed in the next section allows for relaxation of this
assumption. When Federal cost-sharing funds are constrained, two
important conclusions emerge.
First, in these cases there are no simple (i.e., independent) cost-
sharing rules that can be specified to allocate the available grantor funds
among communities in a manner that will maximize the difference between
social abatement benefits and social abatement costs, subject to the
cost-sharing constraint. Thus, the constrained optimal levels of abatement
(and hence the appropriate cost-sharing proportions) have to be
simultaneously determined for all relevant communities.
Second, due to the inherent inflexibility of cost sharing as a
pollution abatement incentive mechanism, those cost-sharing proportions
which do maximize the difference between social abatement benefits and
social abatement costs, subject to the Federal funding constraint,
generally do not also ensure that social abatement benefits associated
with the resulting level of abatement costs are maximized. That is,
even after application of and response to the constrained optimal
cost-sharing proportions, a reallocation of the abatement resources
among projects could increase social abatement benefits without increasing
abatement costs. However, to do so would result in a violation of the
constraint on available grant funds.
Cost-Sharing Model 2/
The objective is to determine the set of cost-sharing proportions
that will maximize the difference between the benefits and costs of
abatement across communities. The cost-sharing proportions can vary
among communities and they apply to all relevant abatement cost categories.
2/ Portions of this section were recently published in Land Economics,
~ Volume 52, No. 4, November, 1976, by Marshall Rose, under the title
"A Note on Cost Sharing of Municipal Wastewater Pollution Abatement
Projects," pp. 554-558.
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The approach developed herein can also be applied to the case in
which only designated capital costs are eligible to receive a Federal
grant. The abatement cost functions would then be separated into
two parts, denoted by grant-eligible and grant-ineligible costs.
Equivalently, the benefit functions could be redefined as being benefits
net of grant-ineligible costs. Subsequently, the analysis would coincide
with the approach taken in the remainder of this section for cases in
which all abatement costs are eligible for a Federal grant.
Implicit in the analysis to follow is the assumption that each
community has only a single feasible abatement project. Alternatively,
we could assume that if the community has to choose among more than
one wastewater treatment project, differentiated perhaps by project
location, then each alternative has equivalent total and local benefit
functions, expressed in terms of units of abatement. As a result,
local choice of the most appropriate project will coincide with the socially
preferred project. Complications which can arise when this assumption
is not satisfied are considered in the penultimate section of this chapter.
Several terms require careful definition. Net social abatement
benefits refers to the difference between societal benefits and costs that
derive from a given level of pollution abatement. A socially optimal
allocation of abatement resources occurs when the level of pollution
control adopted among communities (projects) maximizes net social
abatement benefits. An allocation of abatement resources is said to
result in a constrained optimal solution if net social benefits are
maximized subject to the Federal cost-sharing constraint. Finally,
abatement resources are efficiently allocated if net social benefits
cannot be increased by reallocating the existing level of abatment
resources among projects. Equivalently, an efficient allocation implies
that the resulting level of social abatement benefits is achieved at least
social cost.
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An optimal allocation of resources clearly must also be an efficient
allocation. However, a constrained optimal allocation of abatement
resources need not be an efficient allocation.
The following assumptions are made:
1. Abatement cost and benefit functions are independent among
communities under consideration for cost-sharing funds.
2. Costs, benefits, and available Federal grant funds are
expressed in equivalent dollar terms, either on an
annualized or present value basis.
3. Abatement costs are defined to include all costs associated
with abatement, e.g., capital, operating and maintenance,
land acquisition, etc. All abatement costs are eligible for
a Federal grant.
4. Abatement costs are a continuous function of abatement units,
and approach zero as the level of abatement approaches zero.
In other words, the resources required to achieve any level of
abatement are perfectly divisible. Otherwise, a community may
prefer a zero level of abatement if the resources associated with
initial levels of abatement are not perfectly divisible. In these
cases, there may be no cost-sharing rate (uniformly applied at
any level of cost) which will satisfy both total and marginal
conditions for inducing the socially desirable level of abatement.
5. Abatement benefit and cost functions possess continuous first-
and second-order derivatives.
6. Marginal abatement benefits are a constant or a monotonically
decreasing function of abatement units for the given size of
the waste load influent to be treated).
7. The size of the local pollution waste load influent is independent
of the Federal cost-sharing rate.
8. Local pollution control decisions take into account the abatement
costs borne by all users of the public facility.
9. No negotiations take place between polluters (grantees) and
recipients of pollution, and Federally mandated abatement
requirements are absent.
46
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10. Federal grant funds may be distributed periodically or at one
time. In the former case. Federal funding must be provided
to the entire set of relevant grant recipients, at the appropriate
cost-sharing proportions, each time Federal payments are
forthcoming. Thus, grant recipients are funded in parallel
rather than sequential fashion, and analytical complications
caused by inter-temporal distribution of grant funds can be safely
ignored.
11. Each community's abatement objective is to maximize net local'
abatement benefits.
The following symbols are defined for each of the i = 1, 2, .. . ., m
communities:
Q. = units of pollution abatement.
B.(Q.) = social benefits (dollar value) resulting
1 ' from local abatement.
b.(Q.) = abatement benefits accruing to the local community.
C-(Q.) = social costs of local abatement.
^i = local cost-sharing proportion, i.e., the fraction of
social abatement costs to be borne by the local
community.
c.(Q.) = local costs of abatement, equal to social abatement
1 ' costs multiplied by the local cost-sharing proportion.
S = amount of available Federal cost-sharing funds.
We first determine the appropriate cost-sharing proportions when
sufficient Federal funding is available to pay for the socially optimal
treatment levels. Marshall [10] solved an equivalent problem using a
different approach than is presented here.
The socially optimal abatement levels, Q; = Qj*, occur at the
point where social marginal abatement costs equal social marginal
abatement benefits:
-------
dci dBi
"From, the definitions of social and local abatement costs, we can write
dci dS. (2)
Each community will abate up to the point at which local marginal costs
are equal to local marginal benefits. Accordingly, using the expression
for local marginal costs given in equation (2), we can express a
community's abatement response in the presence of cost sharing as
follows :
dCi *i (3)
Thus, the level of local abatement associated with any «6 is found by
solving equation (3) for Q.:
db.
dCi
48
-------
At Q.( = Q- * the denominator of equation (4) can be replaced by equation
(1). Substituting Qj* forQ; in equation (4), the optimal cost-sharing
proportions, 4>- *, can be expressed by
db.(Q.*)
Of course, it then follows from equations (2) and (5) that for <£•
local marginal costs equal local marginal benefits at Q . = Q.*:
dci(Qi*) db.(Q.*)
Thus, by setting . equal to the ratio of local to social marginal
abatement benefits at Q-*, each community will be induced, through cost
sharing, to adopt that level of abatement which is optimal for society as
well as themselves.
We now turn to the case in which there is a constraint on available
Federal cost-sharing funds. (Sufficient local funds are, however,
assumed to be available to pay for the constrained optimal levels of
abatement). The amount of constrained Federal funds, S, is assumed
to be less than S*, the amount needed by the Federal government to pay
for the socially optimal levels of abatement.
We want to determine the appropriate cost-sharing proportions
which will maximize net social benefits across all communities, subject
to the Federal cost-sharing constraint, S. As previously demonstrated,
it is necessary to solve first for the constrained optimal levels of abatement,
Qj s, before the constrained optimal cost-sharing proportions, <£.s , can be
found. '
49
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The expression to be maximized is
(6)
The Federal funding constraint can be expressed by
m
S =
.
i = 1
{7)
To find the Q.s , the Lagrangian function H is formed from equations
(6) and (7):
m
H =
i = 1
m
S-
Ci(QL>
i = 1
where X is the Lagrangian multiplier.
The local abatement response to any cost-sharing proportion is given
in equation (4). Therefore, since <£j can be expressed in terms of
Q., and since we are trying to find the constrained optimal Q. , it is
convenient now to substitute equation (4) into the expression
representing H.
50
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At this point each of the partial derivatives of H with respect to
the Q., as well as the partial derivative of H with respect to A , are set
equal to zero. Solving these m + 1 equations yields the values for the
Q.s . Replacing these abatement levels into m equations given by (4),
we obtain the £js .
In general terms, the first-order condition for the constrained optimal
solution is found by selecting any two of the first m equations generated by
setting the partial derivatives of H with respect to the Q; equal to zero.
Solving these two equations simultaneously, the following first-order
condition is obtained, for communities j and k:
dB
dC.
dQ
dC,
dQ,.
dC,
^
dQ,,
(8)
for j / k, and where
dC.
dC.
dbi
d2c,
dQ/
dCi
107
51
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Condition (8) indicates that attainment of the constrained socially
optimal abatement levels ordinarily does not result in an efficient
allocation of abatement resources. This contention can be proved
easily by showing that an efficient allocation of abatement resources
occurs when the ratio of net marginal social benefits to marginal
social costs is equalized among communities. This requirement is
equivalent to a first-order condition similar to (8), but without the
terms denoted by C. / >'•
J i i
Condition (8) and the first-order condition necessary for an efficient
allocation of abatement resources will only coincide in two instances:
first, when the £• / V. are equal among all communities, that is
essentially when all communities have exactly the same cost and benefit
functions; second, when marginal social benefits equal marginal social
costs for each community, in other words, when the unconstrained socially
optimal abatement level is attainable with the available Federal cost-sharing
funds. In all other instances, an efficient allocation of abatement resources
will not be achieved, despite the fact that net social benefits have been
maximized subject to the Federal cost-sharing constraint.
This inefficient result is due to both the constraint on Federal funds,
as well as to the stipulation that cost-sharing rates apply in total, and not
simply at the margin. Thus, additional abatement must be induced by
higher cost-sharing proportions for total costs, and not simply for
incremental costs. As a consequence, Federal cost-sharing funds cannot
be easily fine-tuned since relatively large changes in Federal funds are
needed to induce relatively small changes in resource expenditures. This
inherent inflexibility, or "lumpiness" in Federal cost shares generally
ensures that abatement resources cannot be rearranged at the margin to
achieve an efficient solution.
Furthermore, because it is not possible to determine the constrained
optimal abatement levels independently among communities, there is no
simple cost-sharing rule that can be separately applied to each project.
Of course, this conclusion is also valid when the ratio of local to social
marginal benefits is constant for each community at all levels of abatement.
Comparison of conditions (5) and (8) yields several interesting obser-
vations. It is clear from (5) that when sufficient Federal funds are avail-
able to pay for the optimal abatement levels, a decrease in the ratio of
local to social marginal benefits for a particular community results in an
increase in the Federal cost-sharing proportion to that community.
52
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Consider the constrained funding case. Suppose there are two
communities, j and k, with identical cost and benefit functions, except
that the social marginal benefit function, at all levels of abatement, is
greater for j than for k. Satisfaction of condition (8) requires that
abatement in j be increased relative to k. To encourage this result, j
must therefore have a higher Federal cost-sharing proportion than k.
However, further meaningful generalizations concerning relative cost-
sharing proportions, as a result of variations in the ratio of local to
social marginal benefits among the two communities, cannot be made.
Numerical Calculations
This section demonstrates the preceding results by presenting some
numerical examples. The initial calculations relate to the case of cost
sharing between two communities. Subsequently, a cost -sharing problem
associated with mutually exclusive abatement project alternatives within
a community is considered.
B/Qj) = 10Q1
20Q2
6Q
The objective is to find those cost -sharing proportions for the two
communities which will maximize net social benefits subject to the
Federal cost -sharing constraint. Substituting the given abatement cost
and benefit functions into condition (8), we find that
Q: = 1.25 (Q2 -1). (9)
The constraint equation is found from (7) to be
S = -2.5Q +Q2 - 8Q+ 20Q2. (10)
53
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The constrained optimal abatement levels for the two communities,
Q($ and Q2S , and the constrained optimal grantor cost-sharing
proportions, 1 - 4>-s ,1 = 1,2, can be calculated for different
values of S 5= S* from equations (9) and (10), The results are
presented in Table IV-1 for several cases.
In the first case the available Federal cost-sharing funds are not
constrained. From equations (1) and (4), the optimal grantor cost-
sharing proportions are found to be 0. 5 and 0. 2 for communities 1 and 2,
respectively. This subsidy policy induces abatement of 5. 00 units from
each community, requiring use of social resources costing $25.00 in the
first community and $50.00 in the second. The grantor cost share is
simply $25. 00 (0. 5) + $50. 00 (0. 2) = $22. 50. The same result is obtained
by employing equation (8) plus the constraint equation (7), with S = $22.50.
In Case 2 less Federal funds are available than are needed to generate
the unconstrained socially optimal solution. The results clearly show
that maximization of net social benefits subject to the cost-sharing
constraint may not result in an efficient allocation of abatement resources.
When S = $7. 68, the constrained optimal levels of abatement are
found to be Q,s = 4.00 and Q2S = 4. 20. These abatement levels require
social resource expenditures amounting to $51.28, and generate social
benefits worth $124. 00. However, if the abatement levels were 4.135 units
in both communities, social benefits would be $124.05, while social
resource costs would remain unchanged at $51. 28. This latter result is
an efficient solution, bu,t it requires a Federal subsidy of $7. 88, which
exceeds the $7. 68 that is available in Case 2.
Obviously, if the cost-sharing constraint were $7.88, a constrained
maximization of net social benefits would not ordinarily be achieved by
maintaining social abatement resource expenditures at $51. 28. A higher
level of resource utilization would be preferable, which would generate
net social benefits in excess of $124. 05. However, once again, this new
allocation of resources would not be efficient.
54
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Table IV-1
Results of Constrained Cost-Sharing Examples
Case
1
2
3
3a
S
$22.50
7.68
3.31
3.31
«i"
5.00
4.00
3.64
3.46
'2'
5.00
4.20
3.90
4.00
i-V
0.500
0.375
0.310
0.277
!-•/
0.200
0.048
-0.026
0.000
2>i«i">
$150.00
124.00
114.40
114.55
SV'i8)
$75.00
51.28
43.67
43.94
Abatement units and dollar amounts are rounded to nearest 0.01.
Cost-sharing proportions are rounded to nearest 0.001.
Oi
-------
Case 3, in which S = $3.31, indicates that a negative subsidy, i.e.,
a tax, is desirable for the second community, and the tax proceeds are
used along with available grantor funds to increase the subsidy for
the first community. In Case 3a, negative subsidies are not allowed:
1 - <#>2 s is therefore set equal to zero, and equation (7) is solved for
Q(s . After ensuring that Q, s ^ Q,*, the Federal cost-sharing
proportion is calculated by first substituting Q,s = 3.46 into equation
(4). We then find that 1 - V = 0.277.
The cost-sharing program studied in this chapter allows for variable
cost-sharing rates among communities. It has been assumed that only
one relevant abatement project exists within each community. Hence, the
appropriate cost-sharing rates have been calculated on the basis of abate-
ment induced for the single community project.
In some cases, however, a community may have to choose among
several projects which are mutually exclusive. The most obvious example
of this occurs when the alternatives differ by project location.
Even if cost-sharing rates are allowed to vary by project alternatives,
there will not exist sufficient degrees of freedom to ensure the satisfaction
of two objectives within a community: namely, attainment of the appropriate
level of abatement for the project which is chosen, as well as selection of the
project which is socially more desirable. For example, in our model the
cost-sharing rates that induce satisfactory levels of abatement for a given
project are determined by considering marginal costs and benefits. However,
local project selection will be made on the basis of total costs and benefits
for each project. Accordingly, there is no reason why the stipulated cost-
rates should necessarily ensuie that the abatement project which is
socially more desirable will in fact generate the highest level of net local
benefits and, hence, be selected by the community.
This problem arises in both the constrained as well as unconstrained
scenarios. An illustration using a numerical example follows, assuming
that Federal cost-sharing funds are unconstrained. Suppose that two
alternative locations are available for a given project within a community.
Also, suppose that the relevant benefit and cost functions for each project
location are given by those expressions used in the previous examples of
this section, with one exception. Let
C2(Q2) = 5Q22.
56
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It is simple to show that in the unconstrained Federal funding case,
Q,* = 5.00, 1 -<*>,* = 0. 500; and Q2* = 2.00, 1- 4>2* = 0.200. Net local benefits
are $12. 50 for the first location, and $16. 00 for the second location. Net
social benefits are $25. 00 for the first location and $20.00 for the second
location. Hence, although the second location is socially more desirable,
the community will select the first location because it generates higher
net local benefits.
Conclusions
This chapter has shown that a cost-sharing program can induce an
optimal allocation of abatement resources only under the most favorable
and idealistic conditions. One of these conditions is that the program
have the flexibility to allow for variable cost-sharing rates. Another important
condition is that sufficient Federal funds will be available to pay for the
government's share of treatment costs. When this condition is not satisfied,
it was demonstrated that those cost-sharing proportions which maximize net
social abatement benefits do not ordinarily induce an efficient allocation
of abatement resources. This means that the resulting level of
social benefits from abatement will not be achieved at minimum social
abatement costs.
It was also shown that when a community has to choose among several
mutually exclusive abatement projects, cost sharing (limited to a constant
rate within each project) cannot simultaneously induce the community to
choose the socially desirable level of abatement, as well as the socially
desirable abatement project. This particular problem arises in both the
constrained and unconstrained Federal cost-sharing cases.
Despite these shortcomings, it is reasonable to suppose that cost
sharing can be used as a means for encouraging the selection of certain
categories of socially desirable pollution control projects. These projects
are those which would not be undertaken by communities to the appropriate
extent (1) in the absence of Federal funding, or (2) if Federal funding was
forthcoming, but only in the form of uniform cost-sharing rates among
projects.
For example, wastewater treatment projects can be expected to
result in a substantial proportion of benefits accruing to residents
living outside the local community. Wastewater collection projects,
such as sewer systems, generate benefits which are captured to a
greater extent by local residents. Thus, in the absence of Federal
funding or in the presence of uniform cost-sharing rates, we would
expect communities to provide too little resources for treatment plants
and too much for sewer systems. In order to offset this tendency, it
appears desirable to provide higher cost-sharing rates and proportionately
larger funding authorizations for wastewater treatment types of projects.
57
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References: Chapter IV
1. Tullock, G. , "Excess Benefit. " Water Resources Reserach, Volume
3, Number 2, Second Quarter, 1967, pp. 643-644.
2. Rose, M, "Market Problems in the Distribution of Emission Rights. "
Water Resources Research, Volume 9, Number 5, October 1973,
pp. 1132-1144.
3. A. V. Kneese, and B. T. Bower, Managing Water Quality: Economics,
Technology, Institutions. Johns Hopkins Press, Baltimore, Maryland,
4. Freeman, A. M., Ill, and R. H. Haveman, "Residual Charges for
Pollution Control: A Policy Evaluation. " Science, Volume 117,
July 28, 1972, pp. 322-329.
5. An Evaluation of Marketable Effluent Permit Systems. U.S. Environmental
Protection Agency, EPA-600/5-74-030, Washington, D.C., September,
1974.
6. Fox, I. K. , and O. C. Herfindahl, "Attainment of Efficiency in
Satisfying Demands for Water Resources. " Am eric an ^Economic
Review, Volume 54, 1964, pp. 198-206.
7. Regan, M. M., "Economically Desirable Institutional Arrangements
and Cost -Sharing Requirements. " Economics of Watershed Planning,
edited by G.S. Tolley and F. E. Riggs, Iowa State University Press,
Ames, 1961, pp. 230-245.
8. Loughlin, J. C., "Cost -sharing for Federal Water Resource Programs
with Emphasis on Flood Protection. " Water Resources Research,
Volume 6, Number 2, 1970, pp. 366-38"2~:
9. Water Policies for the Future. National Water Commission, U. S.
Government Print Office, Washington, D. C., June 1973, pp. 77-80.
10. Marshall, H. E. , "Economic Efficiency Implications of Federal -local
Cost -sharing in Water Resources Development. " Water Resources
Research, Volume 6, Number 3, 1970, pp. 673-682"]
11. Marshall, H. E., "Cost Sharing and Multiobjectives in Water Resource
Development." Water Resources Research, Volume 9, Number 1, 1973
pp. 1-10.
58
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CHAPTER V
DESIGNING COST-EFFECTIVE FEDERAL WASTEWATER
GRANT PROGRAMS FOR MUNICIPALITIES
Chapter IV showed how to determine the economically appropriate
Federal grant rate for community pollution abatement projects. It
was indicated that there are significant differences between the
theoretically optimal cost-sharing system and the present Construction
Grant Program. In fact, data currently do not exist which would even
allow the theoretically optimal solution to be estimated.
The previous chapter concluded that cost sharing should be used by
the Federal government to encourage communities to undertake socially
cost-effective abatement projects. Accordingly, the objective of the
present chapter is to determine the most important obstacles inherent in
the Construction Grant Program to achieving this goal, and then to
design grant programs which will mitigate these obstacles. Grant
programs considered as substitutes for the existing program are project
grants based on both capital and operating costs; and modified construction
grants which involve changes in the existing grant rate and grant eligibility
Programs considered as complements to the existing grant program are
performance subsidies based on the undertaking of designated treatment
activities by the municipalities; and output subsidies based on achieved
levels of abatement.
Existing Cost-Sharing Biases in Project Selection
Under the present Construction Grant Program, certain elements of
treatment costs, such as operation and maintenance (O&M), and land
acquisitions, are not eligible for Federal cost-sharing. In addition,
certain types of abatement techniques, such as in-stream aeration and
low-flow augmentation, are not eligible for a Federal grant.
As a result of these restrictions, communities may be "financially
biased" towards choosing a mode of treatment which achieves Federal
standards at least cost to themselves, but which is not the least costly
alternative to society. The extent to which one project can be more costly,
in real resource terms, than another, and still remain the least costly
local option, depends upon the local cost-sharing proportions relevant
to each of the alternatives.
59
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The local cost-sharing proportion, denoted by *v for project v, is
equal to the ratio of local to total (social) project costs. I/ Suppose that <£v
is constant for any level of a project's total costs. ConsTder two projects,
where $7 > 4>t • The "maximum potential bias" inherent in the first project
is given by the ratio of t = 0.51, which yields a ratio of 1.45. This means
that Technique 1 could be as much as 1. 45 times, or $65, 070 more costly
than Technique 3, yet it would continue to remain the minimum local-cost
option.
There is additional empirical evidence of project selection bias.
In the 1973 Survey of Needs, Category V (the construction costs of correcting
combined sewer overflows during the period 1973-1990), was estimated
to be $10. 8 billion. Using the same time frame as well as the same
1973 price level, the 1974 Needs Survey estimates this category of
costs to be $26.1 billioru
l_l Because we have previously used the term j to denote the local cost-
sharing proportion for community i, the expression for the local cost-
sharing proportion of project v in community i should be denoted by <£-|v.
However, since we are concerned here with abatement projects within any
one community, we can omit the subscript i in this discussion.
60
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Table V-|
Costs of Wastewater Treatment Alternatives :
Cleveland-Akron Area
Technique
1. Land Treatment
2. Plant (AJv.inccd Biological
Treatment)
3. Plant (Physical Chemical)
Annual Cost to Socie-ty
Construe dor
$120.900
$ 6/1,200
$ 50,500
0 & M
$62,300
$84,300
$94,100
Total
$183,200
$148,500
$144,600
Federal Cost-
Sharing
Proportion
ConHtruccii
75Z
75X
75Z
, 0 & M
02
OX
OZ
Annual Coat To
the Local Community
Construct)
$30,225
$16,050
$12,625
.>n ° * M
$62,300
$84,300
$94,100
Total
$ 92,525
$100,350
$106,725
Local Project Cost-Sharing
Proportion
51 %
6891
U%
cr>
Source: Raymond [1],
-------
The main difference between the two surveys was that unlike the earlier
study, the 1974 Needs Survey did not require that project selection for
Category V needs "be based on evaluation of the most economical and/or
effective alternative" [2]. A substantial portion of the 142 percent cost
increase evident in the later survey can probably be explained by the
inclusion of costs that were not allowed in the earlier survey owing to the
absence of cost-effective analysis. Nevertheless, some portion of the cost
increase may be due to the financial bias existing in the Construction Grant
Program.
Further empircal evidence of financial bias has been recently presented
by the Energy Resources Company [3]. Their analysis indicated that, for
the type and location of municipal treatment plants considered, the marginal
productivity of capital was less than the marginal productivity of O&M
resources, where both measures were expressed in terms of dollars per unit
of treated flow.
It is possible that this result is due, in part, to the capital bias inherent
in past and existing Federal grant programs. If this is so, then some
substitution of O&M for capital dollars would increase treatment efficiency
without increasing resource costs. However, since capital resources may be
subsidized while O&M resources are not, such a substitution could increase
local treatment costs.
Reduction in Project Selection Bias
This section considers ways in which the existing Construction Grant
Program could be modified in order to mitigate the tendency for communities
to select abatement projects that are overcapitalized from a social viewpoint.
Prior to this discussion, two forms of overcapitalization are distinguished.
First, overcapitalization occurs when treatment plants are built larger
than is socially desirable. While the locality generally bears only a small
proportion of the construction costs needed to provide excess capacity, the
resulting level of local benefits that derive from, having excess capacity
may be substantial. The benefits which the community may capture
include (1) the profits that can be generated from servicing industry,
(2) the use of excess capacity as a mechanism for encouraging growth
and for providing a safety margin for unexpected demand, and (3) the
reduced impact on local costs if the Federal grant program is eliminated
in the future,
There are basically three policy variables which induce the construction
of oversized facilities. The first is Federal cost-sharing proportions that
are too high. This issue is discussed briefly in the present chapter. The
two other factors are existing grant-eligible design periods and industrial
cost recovery provisions. These elements of the Construction Grant Program
are studied in subsequent chapters.
62
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The second form of overcapitalization occurs when too much capital
resources and too little operating resources are provided for the given
level of influent to be treated. In these cases, the total costs of achieving
the resulting pollutant removal levels will not be minimized. The main
cause of this form of overcapitalization is unequal cost-sharing proportions
among cost categories and treatment techniques. The primary concern of
this chapter is to consider ways of mitigating this second form of over-
capitalization.
Initially, two categories of programs are considered which would
substitute for the present grant program. Subsequently, two additional
program categories are considered as complements to the existing grant
program.
Abatement Project Grants: One method for encouraging local selection
of the least-costly projects for achieving mandated levels of pollution control
is to provide equivalent cost-sharing proportions. That is, abatement
alternatives that have similar purposes (such as the treatment of wastewater)
would receive a Federal grant that applies to both construction and O&M costs
at the same rate. 2/ By equalizing the Federal grant rate across cost
categories and among abatement projects having similar objectives, the
community would be encouraged through cost sharing to choose the least-
costly project required to achieve a mandated level of pollution control,
independent of the absolute size of the abatement project grant rate.
It is instructive at this point to determine the uniform abatement -
project grant rate which would allow an equivalent number of construction
projects to receive a Federal grant as is possible with the current
75 percent Construction Grant Program. The following assumptions are
made:
1. There exists an annual level of authorized project grant funds,
denoted by A, and equal to the amount authorized for the current
Construction Grant Program.
2. "Authorizations" are synonymous here with Federal funds
available to be allocated to the States for project grants.
2_/ Conceptually, all categories of abatement costs for designated types
of projects should be subject to the same grant rate, in order to induce
the selection of the least costly alternatives.
63
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3. Both capital and O&M project grant funds must be drawn from
authorized grant funds, A.
4. The Federal project grant rate is denoted by !-<#». Annual grant -
eligible O&M costs are denoted by L .
5. Grant -eligible capital costs subject to receiving a Federal grant
are denoted by K. That is, K is the amount of capital costs
generated by Federal authorizations devoted to funding
capital resources.
In the present 75^percent Construction Grant Program, the relation-
ship between A and K is given by
A = 0.75K. (1)
In a project grant program, an amount of grant -eligible O&M costs equal
to L would be subject to a Federal grant at rate 1- <6 . Accordingly, we
can write
A = (1-*)(L+K). (2)
Equalizing the number of construction projects funded in each program is
equivalent to specifying that K is equal in equations (1) and (2). Solving
for K in (1), substituting this expression into (2), and rearranging terms,
we find that
4A + 3L '
The solution of equation (3) for nine feasible combinations of A and
L is presented in Table V-2. The table shows, for example, that if
A = $4 billion and L=$l billion, a Federal project grant rate of 63
percent would allow the same number of annual construction grant
projects to be funded as the present subsidy program.
64
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Table V-2
Project Grant Rates (1-0) Required to Maintain the
Existing Number of Annual Construction Projects Funded
Grant-Eligible
0£M Costs (L)
$1
$2
$4
Dollar amounts
Authorizations (A)
$2
0.55
0.43
0.30
are in billions per year.
$4
0.63
0.55
0.43
$6
0.67
0.60
0.50
As indicated previously, project grants encourage the selection of
the least costly abatement projects. However, unless the grant rates are
allowed to vary at least among categories of projects, the cost-sharing
program will fail to make the most effective use of Federal grant funds.
In order to account for this, broad categories of projects could be
established, such as those defined in the Needs Survey. Within each
category, the same grant rate would apply. However, the grant rate would
differ across categories.
A second approach stipulates a uniform grant rate, but categories are
funded separately with authorizations differing by category. A third approach
could be developed in which the grant rate as well as the size of funding
authorizations differed across project categories. Whichever alternative is
chosen, the cost-sharing program can be designed to provide Federal funds
to supplement rather than to substitute for local funding.
Modified Construction Grants: Political, administrative, and
implementation constraints may substantially limit the options available to
reduce the overcapitalization bias inherent in the existing Construction
Grant Program. In this subsection we consider four alternatives within the
constraint of funding capital costs only. V
3_/ One additional option is discussed in detail in Chapter VII,
This is elimination of industrial cost recoveries collected
against the Federal grant and retained by municipalities.
65
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The first option is simply to reduce the size of the present construction
grant percentage. Note that reduction of the effective Federal cost-sharing
proportion can be achieved by reducing eligible project costs as well as
by reducing the Federal construction grant percentage. In either case, the
distortion between the relative prices of capital and operating resources
is diminished and the potential bias for communities to choose more costly
abatement techniques is decreased. At the same time, the reduced size of
the Federal grant per project allows a greater number of projects to
receive Federal aid in any one year. Finally, the burden of abatement
costs would be shifted somewhat from the Federal government to
municipalities.
The second option is a subsidy to be used for construction costs, with
the size of the subsidy funds provided being independent of the magnitude
of construction costs. Grant rates might depend, for example, upon the
population served bythe project as well as upon the type of project being
constructed. As long as the size of grant funds provided is less than
actual construction costs, communities would not be encouraged to over-
capitalize waste treatment facilities within the designated types of grant -
eligible projects.
A third option has been suggested by the National Bureau of Standards
[4] in their report for EPA. Several construction grant rates could be
specified, depending upon the project size and type. Further, the grant
rates could be set such that the effective Federal cost-sharing proportion
is equalized among alternative abatement projects.
Unfortunately, unless an acceptable limited set of grant rates can
be designed, a case-by-case project evaluation may be necessary, along
with completely variable grant rates by individual projects. To avoid
this problem, the size of the grant rate (or the set of grant rates)
could be defined as the minimum of a given percentage of capital costs,
or a given (lower) percentage of total project costs. This fourth option,
referred to as a project grant-rate limitation, and also suggested in [4],
limits the potential overcapitalization bias, and avoids the administra-
tive problem of determining the appropriate grant rate on a project -
-by-project basis.
A first approximation for an acceptable wastewater treatment plant
grant-rate limitation is now described. Previous research [3, 5, 6]
has indicated that annual operating costs represent 7 to 12 percent
of treatment plant replacement values. Suppose that the plant life is
20 to 50 years, and the discount rate is 7 percent.
66
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Using these figures, it can be demonstrated that, in terms of
present values, a 75 percent construction grant is equivalent to a
project grant rate ranging from 25 to 50 percent.
By stipulating a construction grant rate equal to 75 percent, but
limited to no more than 25 percent of total project costs, the bias
for local communities to choose more costly projects is mitigated.
The bias among those projects which receive a project grant in excess
of a 25 percent rate under the existing grant program is in fact eliminated.
However, the community may still prefer those treatment projects
which receive a project grant equal to 25 percent of total costs to
projects which receive grants of less than 25 percent of total costs,
even though the former projects may be more costly to society than
the latter.
Obviously, imposition of the project grant-rate limitation increases
the average local burden of treatment costs, and more so as this rate is
reduced in size. To minimize the effect on the local burden, while
reducing the tendency for communities to prefer highly capital intensive
wastewater treatment projects, the project grant-rate constraint could
be set at the upper bound for the expected range of values presently
observed for existing treatment plants. In this program, the amount of
grant funds provided would be given by the minimum amount of funds
associated with a 75 percent construction grant rate or a 50 percent
project grant rate.
O&M Performance Incentives: The existing construction grant bias to
undermaintain and overcapitalize wastewater projects could be mitigated
by introducing O&M performance incentives as a complement to a
construction grant program. New York State has a program which
provides a one-third O&M subsidy to those plants satisfying criteria
related to cost-effective operations [7]. The 10-year old program
presently has the participation of 400 of the 500 State municipalities.
Unfortunately, quantitative evidence of the program's cost-effectiveness
is not presently available.
One factor affecting the desirability and acceptability of any Federal
cost-sharing performance subsidy program is the cost required to fund
the program. In the following discussion the potential Federal cost
of a performance subsidy program is calculated.
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The Federal program, cost depends to a large extent on the total
amount of grant-eligible O&M costs incurred each year. We avoid
specifying grant-eligible O&M cost categories and performance require-
ments at this point, and concentrate first on estimating total annual
O&M costs.
Cost and BOD removal data for 106 secondary (or higher level)
treatment plants in New York State were evaluated for the year 1972.
A summary of the data is presented in Table V-3. Note that the table
indicates that the annual per capita waste load generated is approximately
100 pounds of BOD influent.
Next, records for all secondary (or higher level) treatment plants in
the United States were scrutinized, from EPA's Storet File, to determine
the total population served by each of the three plant categories listed in
Table V-3. It was estimated from these records that 125 million people
are presently receiving secondary or higher level wastewater treatment.
Approximately 20 percent of these people are being served by small (0.1 -
0. 99 m. g. d. ) facilities; 30 percent by medium size facilities (1.0 - 10. 0
m. g. d. ); and 50 per cent by large facilities (greater than lO.Om.g.d.).
The sample results from New York State were then applied to all
secondary treatment plants in the United States. The findings are
presented in Table V-4. Current (1975) annual O&M costs throughout the
United States for secondary treatment plants are estimated in Table V-4
to be one billion dollars.
Suppose that a Federal subsidy program is specified in which a 25
percent O&M grant would be provided for plants utilizing approved
secondary or higher level treatment technology. Based on the 80 percent
rate of participation in the New York State subsidy program, grant-eligible
O&M costs are presently estimated to be $800 million annually. If
Federal grant funds merely substituted for local funding, a 25 percent
Federal subsidy would require $200 million annually in grant funds.
Alternatively, if the subsidy program induced additional local spending,
the Federal subsidy cost could be as high as $267 million annually. 4/
4/ In the presence of the subsidy, the maximum amount which could be
spent on grant-eligible costs and still be less expensive locally than
the current level of spending without the subsidy is $800 (106)/0. 75 = $1067
(10). The Federal cost share is then $1067 (106)(0.25) = $267 (106).
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Table V-3
Sample Secondary Treatment Plant Operating
Data: New York State, 1972
Plant Category
Design Flow (m. g. d. )/
Plant Type*
Sample Size
Population Served
per Facility
Annual Ibs . of BOD
Inflow per Facility
(Millions)
BOD Removal Rate
per Plant Category
0.1-0. 99/T.F.
48
2,400
0.263
81 . 0%
1.0-10.0/T.F.
49
16,000
1.584
76.5%
10.0+/A.S.
9
502,000
40.843
76.7%
O&M Cost per Ib. of
BOD Removed per Plant
Category (1975 Dollars)
16.84
11.8*
6.8*
*T.F. = Trickling Filter
A.S. = Activated Sludge
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Table V-4
Estimated Secondary Treatment Plant Operating
Results: United States, 1975
Plant Category
Design Flow/Plant Type 0.1-0. 99/T. F. 1.0-10/T.F. 10+/A.S. Total
Annual BOD Influent
(Billions of Pounds)
2. 50
3.75
6.25 12.50
BOD Influent
Removal Efficiencies
81. 0%
76.5%
76.7% 77.5%
Annual BOD Influent
Removed
(Billions of Pounds)
2. 03
2.87
4.79 9.69
Average O&M Cost Per
Pound of BOD Influent
Removed
16.84
11.8$
10.4$
Annual O&M Cost
($ Billions)
0.341
0.339
0.326 1.006
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A more selective subsidy program could focus upon designated O&M
inputs. If these inputs are currently underutilized by treatment facilities,
the selective subsidy would not necessarily induce excessive employment
of the subsidized resource inputs. At the same time, the selective subsidy
is capable of inducing a given level of abatement for less Federal funds
compared to a program which covers total O&M costs.
For example, discussions with engineers and municipal treatment
plant personnel have indicated that an important shortcoming in many
treatment plant operations is the absence of a properly trained and
highly qualified chief plant manager. A selective subsidy for this
category of O&M costs would substantially reduce the size of needed
Federal funding compared to the amount required for the broader O&M
subsidy program.
In either case, previous findings have indicated that it appears
desirable to reallocate some resources from construction to operating
activities. Accordingly, Federal funding of an O&M subsidy program
could be usefully provided from authorizations originally earmarked for
Federal construction grants.
In this instance, if the Federal construction grant rate is held
constant, it follows that fewer capital projects could be funded in any
one year. However, by rearranging equation (3), it can be shown that
reducing the capital grant rate in proportion to the reduction in
available construction grant funds, the number of fundable construction.
projects could be held constant.
To demonstrate, suppose that authorized annual construction grant funds
during the next few years are equal to $4 billion. Previous calculations
have indicated that a 25 percent O&M performance subsidy program could
require as much as $267 million in Federal funds. Taking these funds
from construction grant funds is equivalent to a 7 percent reduction in
annual authorizations for funding the construction of wastewater treatment
plants. In order to subsidize the same number of annual construction
projects as was originally possible, the construction grant rate would have
to be reduced by 7 percent (equivalent to 5 percentage points), from a
75 to a 70 percent rate.
An alternative to Federal funding of an O&M performance subsidy
program is to have the States undertake such a program. State funding
could conceivably come from funds presently used to supplement Federal
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construction grants. The inducement for States to adopt a performance
subsidy program could be achieved in one of the following ways:
1. Require that States provide funds for O&M performance subsidies
in a matching ratio to Federal construction grant allotments.
2. Provide matching Federal funds for O&M costs to States adopting
their own O&M performance subsidy program.
3. Provide higher construction grant allotments, or higher Federal
construction grant rates, to those States which adopt an acceptable
O&M performance subsidy program.
4. Subsidize capital costs with periodic Federal grants, rather than
lump-sum payments to the municipalities. Amortization of capital
costs by the Federal government would be subject to satisfaction
of acceptable treatment plant operating performance. 5_/
Output Subsidies: Up to this point, subsidy programs for improving the
allocation of abatement resources have been considered only in terms
of cost sharing. A somewhat different approach consists of an output
subsidy as a complement to a construction grant program, in which
the size of the Federal output subsidy is related to the level of abatement
achieved, rather than to the amount of abatement costs incurred.
In the discussion to follow, we estimate the cost-effectiveness of two
alternative output subsidy programs.
Three parameters define an output subsidy program. They are
the unit of measure for abatement; and the starting point at which
to measure grant-eligible abatement; and the size of the per unit subsidy.
Ideally, "output" should be measured in terms of the variable which
the subsidy is ultimately attempting to influence. Thus, for our purposes,
the appropriate measure would be an index of improvement in water quality.
However, owing to measurement problems and the interdependent relation-
ship of different water pollution sources on water quality, it is neither
practical nor possible to use a water quality index as the unit of measure
for abatement. Accordingly, a proxy is needed.
5/ This option may be unacceptable to municipalities, owing to the
uncertainty associated with periodic Federal funding.
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The proxy chosen for improvement in water quality is pounds of BOD
removed from the waste-water influent. It may also be desirable, in practice,
to include a measure of the pounds of suspended solids removed from the
influent as well. However, removal of suspended solids ordinarily occurs
as a joint product in the removal of BOD. Also, for a given treatment plant,
the distribution of the influent (in terms of pounds) between BOD and
suspended solids , as well as the treatment removal efficiencies for these
two pollutants (in percentage terms), are approximately equivalent. Thus,
it would be an easy matter to modify the output subsidy programs generated
herein to include the removal of suspended solids as an additional measure
of output.
For a given per unit subsidy rate, the starting point for measuring
grant-eligible abatement is an important determinant of the size of the
Federal subsidy program, as well as the number of municipalities and
hence the waste load affected by the subsidy. Obviously, as the abatement
starting point is lowered, the Federal program cost is raised, while the
waste load affected is increased.
Based on the results indicated in Table V-3, it can be expected that
the removal level of BOD in the absence of an output subsidy program
is between 75 to 80 percent. The most effective use of Federal funding
occurs when the subsidy is paid only for incremental abatement.
Accordingly, two alternative starting points are considered: the first
at a 75 percent BOD removal level, and the second at an 80 percent
removal level.
The size of the per unit subsidy depends upon the level of abatement
which is desired. To induce a given level of abatement, it is necessary
that the output subsidy per unit of abatement be set equal to the local
marginal cost of abatement. Of course, the sufficient condition is
that the total subsidy payment exceeds local abatement costs induced
by the subsidy, i.e., local incremental costs. 6/
Qj These conditions apply when local benefits are zero beyond the starting
point for the output subsidy. Otherwise, the per unit subsidy required
would be less than local marginal costs, by an amount equal to local
marginal benefits. At the same time, the corresponding sufficient
condition is that the total subsidy exceeds the difference between local
incremental costs and local incremental benefits.
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Analysis of treatment plant cost data taken from [8] indicates that
marginal costs increase rapidly beyond an 88 percent removal level of
BOD. Consequently, the objective is to find the appropriate subsidy rates
which will encourage abatement up to an 88 percent BOD removal level.
To accomplish this objective, the local marginal cost of abatement at
this removal level has to be found first. Subsequently, the subsidy rates
are then set equal to the marginal cost of abatement.
The local marginal cost of abatement is composed of incremental
construction and operating costs. However, marginal construction costs
can be omitted from the local marginal cost function for the following
reasons:
1. Within the relevant range of abatement, incremental annualized
construction costs are estimated to be less than one-third incremental
annual O&M costs [8J.
2. Of the incremental construction costs required, 75 percent will
presumably be borne by the Federal government; 10 to 15
percent will generally be borne by the State governments; and
the remainder is likely to be borne by industry as a result of
retention by the municipality of one-half of industrial cost
recoveries collected against the Federal construction grant
(see Chapter VIII).
The relationships inferred from [8] between the percent of BOD removed,
denoted by R, and annual O&M costs, denoted by L, indicate that at a given
level of R, the percentage increase in O&M costs owing to a specified increase
in R is equal for different treatment plant design sizes, i.e., for
at R, = R2. The subscripts denote different treatment plant design sizes.
As a result, the cost functions (expressed in terms of R) generated for
each of the treatment plant design size categories should differ only by a
scalar. Reference [8] also indicates that as R increases, operating costs
increase at an increasing rate.
-------
The following functional form for the abatement cost expression satisfies
the above criteria:
Li = a.R. b, i = 1, 2, 3, (4)
where a. > 0 and b > 1. 0 are the parameters to be solved for, and
i = 1 denotes small size plants (Or 1 -0. 99 m. g. d. )
i = 2 denotes medium size plants (1. 0-10. 0 m. g. d. )
i = 3 denotes large size plants (10. 0+m.g. d.)
It was possible to estimate two points on the relevant cost curves,
for each of the three plant categories,using the proportionality relation-
ships inferred from [8] and the absolute values shown in Table V-4.
Substituting these three sets of two points into equation (4), it was
found that, for 73^R^88, 7/
b = 2.833
a, = 0.1409
a2 = 0. 6587
a3 = 9.7742
7/ Local marginal costs increase rapidly beyond R = 88, and are estimated
from [8] to be approximately four times higher at R = 91 compared to R = 88.
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Let M. represent the local marginal cost per pound of BOD removed.
Note that '
100Q.
R = - l-t (5)
Xi
where Q. is the annual pounds of BOD removed, and Xj is the annual pounds
of BOD influent. From Table V-4, X; can be found. Differentiating equation
(4) with respect to Q., the following local marginal cost functions (per pound
of BOD removed) are obtained (for 73^R
M, = . 0001516(R.)''833 (6)
[2 = . 0001178(R2;
M, = . 0001178(R_)''833 (7)
I 833
M3 = .0000678(R3) ' (8)
Substituting R.(= 88 into equations (6), (7), and (8) yields the following
results:
M, = 56
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Analysis of (1) the New York State data discussed previously, (2) sample
data taken from 97 secondary treatment plants throughout the country
[3], and (3) data based on 58 plants chosen in a sample from Connecticut
[3] indicate that approximately 75 percent of the total BOD influent load
is presently being treated at or greater than a 73 percent removal level;
approximately 65 percent of the total BOD influent load is presently
being treated at or greater than a 78 percent removal level. These are the
relevant influent waste loads which will be affected by the output subsidy
programs under consideration.
To determine the incremental BOD treatment induced by the output
subsidies, we assume that for BOD influent currently being treated at
R = 73, the average removal efficiency is 80.5, i.e., (73 + 88)/2.
Similarly, we assume that for BOD influent presently being treated
at R = 78, the average removal efficiency is 83. 0.
Given these removal efficiencies, the waste load influent distributed
by plant sizes (Table V-4), and the local marginal control cost functions
(equations (6) -(8)), the measures of cost-effectiveness induced by
the two output subsidy programs under consideration have been calculated.
The results are presented in Table V-5. Incremental capital costs
(assumed not to be borne locally) are estimated from the relation-
ships given in [8], in order to calculate the increase in the cost of
Federal construction grants induced by the output subsidy programs.
Table V-5 shows that a Federal output subsidy program having
a starting point at R = 75 is expected to reduce the existing secondary
treatment plant BOD effluent by over 22 percent. The average (local)
O&M cost per incremental pound of BOD removed is 36 cents, while
the average social cost (including annualized construction costs) per
incremental pound of BOD removed is approximately 47 cents. The
current Federal cost of funding this first output subsidy program,
for secondary treatment plants, is estimated to be less than one-half
billion dollars annually.
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Table V-5
Results of Output Subsidy Programs
(1975 Prices)
Cost-Effectiveness Measures
Option 1; R = 75
Option 2: R = 80
Incremental BOD Removed
(Millions of Pounds Per Year)
Change in BOD Effluent
Incremental Municipal
O&M Cost
($ Millions Per Year)
Average Municipal O&M
Cost Per Incremental Pound
of BOD Removed
Federal Output Subsidy
Cost ($ Million Per Year)
Incremental Federal
Construction Grant Cost
($ M illions)
700
- 22.4%
254
36
459
629
410
- 12.8%
153
37
246
415
78
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An output subsidy program having a starting point of R = 80 is expected
to reduce the existing secondary treatment plant BOD effluent by almost
13 percent, and incur average O&M costs of 37 cents per incremental
pound of BOD removed. The average social cost per incremental pound
of BOD removed is 48 cents, while the current Federal cost of funding
this second output subsidy program is estimated to be one-quarter of
a billion dollars annually.
Conclusions
The present Construction Grant Program encourages substantial in-
efficiencies in the allocation of abatement resources. Four alternative
categories of Federal subsidy programs tend to increase the incentive
for local communities to choose more socially cost-effective abatement
projects: project grants, modified construction grants, O&M performance
subsidies, and output subsidies.
Project grants provide a uniform cost-sharing proportion for both
capital and operating expenses within designated categories of pollution
control projects. One measure of comparison between a project grant
program and the Construction Grant Program is the project grant rate
which allows the same number of construction projects to be funded
annually as is possible under the existing grant program, for a given
level of available Federal grant funds. The project grant rates associated
with annual authorizations of $2, $4, and $6 billions are estimated to
be 55%, 63%, and 67%, respectively.
Several modified construction grant programs were discussed which
essentially reduce the grant rate compared to the present program.
They included programs in which (1) the nominal construction grant rate
is reduced below 75 percent; (2) the number of grant-eligible items
is reduced; and (3) construction grant funds are limited to a specified
percentage of total project costs.
Performance subsidies provide an O&M cost-sharing subsidy for the
adoption of designated treatment activities. A 25 percent O&M performance
subsidy for grant-eligible secondary treatment plants is estimated to
currently cost less than $300 million annually.
Output subsidies, where Federal payments would be made to municipalities
only if demonstrable abatement results are achieved, provide an abatement
incentive for existing plants, which are subject to less Federal control
than new plants. At the same time, this category of programs encourages
communities to undertake abatement beyond mandated treatment levels,
79,
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if it is inexpensive to do so relative to the amount of the subsidy forthcoming.
Output subsidies also tend to mitigate the overcapitalization Lias inherent
in the Construction Grant Program.
For a starting point of 75 percent BOD removal, the output subsidy
program is projected to induce more than a 22 percent reduction in
the existing BOD (and suspended solids) effluent for secondary treatment
plants. The Federal cost of this output subsidy program for existing
secondary treatment plants is estimated to be less than $500 million
annually. An output subsidy program having a starting point of 80
percent BOD removal is estimated to be approximately 50 to 60 percent
as effective and costly compared to the option which has a 75 percent
starting point.
Owing to the incommensurability of the criteria (effectiveness, efficiency,
equity, Federal funding requirements, local funding constraints, political
considerations, etc. ) for evaluating each of the four categories of grant
programs, and the absence of important data elements (measures
of benefits, community abatement response to each grant program, etc. ),
it is not possible to choose objectively among the grant programs analyzed.
However, project grants or the modified construction grant programs
appear worthwhile as substitutes for the existing grant program, while
performance or output subsidies could complement a construction grant
program in a cost-effective manner. Any of these options can be designed
to improve upon the existing allocation of abatement resources without
affecting (1) the size of the Federal commitment, (2) the annual number
of construction projects funded, and (3) the distribution of the existing
pollution control cost burden between Federal and local interests.
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References: Chapter V
1. Raymond, R. , "The Impact of Federal Financing Provisions in the
Federal Water Pollution Control Act Amendments of 1972. "
Public Policy, Winter, 1973, pp. 109-119.
2. 1974 "Needs" Survey. Office of Water Program Operations, U.S.
Environmental Protection Agency, Washington, B.C., September
3, 1974.
3. Alternative Municipal Wastewater Management Systems, Standards,
and Financing! Draft report prepared by Energy Resources Company
for U.S. Environmental Protection Agency, Washington, D.C.,
December, 1974.
4. Analysis of Cost-Sharing Programs for Pollution Abatement of
Municipal Wastewater. U.S. Environmental Protection Agency,
EPA-600/5-74-031, Washington, D.C., November, 1974.
5. The Economics of Clean Water - 1972, Volume 1. U.S. Environmental
Protection Agency, Washington, B.C., April 27, 1972.
6. Evaluation of Alternative Methods for Financing Municipal Waste
Treatment Works. U.S. Environmental Protection Agency, EPA
600/5-75-001, Washington, B.C., March, 1975.
7. Requirements and Procedures - State Aid for Operation and Maintenance
of Sewage Treatment Planish State Department of Health, Albany,
New York, January, 1969".
8. An Evaluation of Marketable Effluent Permit Systems. U. S. Environ -
mental Protection Agency, EPA-600/ 5-74-030, Washington, B.C.,
September, 1974.
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CHAPTER VI
EVALUATION OF ALTERNATIVE ALLOTMENT PROGRAMS
The preceding two chapters were concerned with the distribution of
grant funds from the Federal government to municipalities. In practice,
there has traditionally been an intermediate step: the allotment
of grant funds to the States for distribution to those projects having the
highest priority within each State.
From the perspective of economic efficiency, the allotment process
is undesirable, since it ensures that a global, optimal allocation of
abatement resources cannot be achieved. An optimal allocation cannot
be achieved, because allotments are made without reference to project
benefits and without comparison of the merits of projects among States.
Allotments were not included in Chapter IV, because only
optimal allocations were considered therein.
The objective of the study to this point has been to develop grant
programs which will encourage a more efficient allocation of abatement
resources than is presently generated by the Construction Grant Program,
This objective will continue to be relevant in our study of allotments.
However, there are other criteria for evaluating the success of a Federal
grant program besides economic efficiency. The most important of these
other criteria is that of equity, or in a general sense, fairness of the
program.
The analysis to follow suggests that both efficiency and equity can be
served and the allotment process improved by splitting the construction
grant appropriation into two parts: one part to be dispersed on the basis
of an efficiency criterion and the other part according to an equity
criterion. Based on the efficiency criterion, projects are funded
according to their cost-effectiveness. Based on the equity criterion, a
portion of the Federal appropriation is disbursed in proportion to the
relative fiscal burden which States will incur in complying with the law.
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The Current Allotment Formula and Funding Process
Historical Bases for Allotments: Throughout the history of Federal
cost sharing of wastewater treatment facilities, determining a satis-
factory approach for allocating appropriated funds to the States has
proven a continuing dilemma. The basis for distributing the funds has .
changed frequently and radically over the years.
As described in Chapter II, between 1956 and 1966 allotments were
based half on relative State population and half on relative State per
capita income. The 1966 Amendments provided that the first $100 million
of appropriated funds be allocated according to the rule that was in effect
during the previous ten years, but any appropriations beyond that were
to be determined entirely on the basis of population. Appropriations in
fiscal year 1967 were only $150 million, so State per capita income
continued to play an important role in determining allotments. By 1971,
however, appropriations had grown to $1 billion, and hence per capita
income of the States was no longer a significant factor in determining the
distribution of the funds.
In 1972 the allotment formula was altered significantly. Dropping
all consideration of population and income, P.L. 92-500 called for funds
to be distributed "in the ratio that the estimated cost of constructing all
needed publicly owned treatment works in each State bears to the estimated
cost of construction of all needed publicly owned treatment works in all
of the States. " !_/ The cost estimates were to be based on a survey taken
in 1971, with the~results appearing in Table III of House Public Works
Committee Print Number 92-50.
Subsequently, P.L. 93-243 directed that half of the money appropriated
for fiscal year 1975 be distributed on the basis of all the needs
and half on the basis of needs reported in Categories I, II, and IVA
(treatment plants, interceptors, forced mains, and pumping stations).
Cost estimates are to be taken from the 1973 Needs Survey. Also, no
State is to receive less allotments than it received in fiscal year 1972.
I/ P.L. 92-500, section 205(a).
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Despite all these changes, disenchantment with the allotment procedure
remains.
Program Objectives: A reading of the legislative history suggests that
although the relative emphasis on efficiency or equity may have changed
over the years, the primary objective of the cost-sharing program, the
allotment formula, and the State priority systems has been to improve
water quality in an efficient and equitable manner. In the ten-year period
1956-66 when State allotments were a function of relative State per capita
income and relative State population, equity and efficiency seem to have
been equally important. That is, per capita income is a crude but
conventional measure of ability to pay. Hence allotments based on per
capita income can be considered to focus upon the objective of achieving
an equitable distribution of grant funds. Population is often used to
reflect the relative extent of the problem, in this case, the amount of
resources needed to control pollution and the amount of benefits that will
result from such an undertaking. Accordingly, allotments based on
population can be considered to focus upon the objective of inducing an
efficient allocation of abatement resources.
The desire to achieve a more equitable distribution of pollution
control costs appears to have been an important factor influencing the
revision of the allotment formula in 1972. Since the 1972 Act made
secondary treatment mandatory and imposed a considerable financial
burden on municipalities, Congress apparently felt obliged to make the
costs (i.e. , "needs") that would be incurred in meeting the provisions
of the Act the basis for allotments.
On the other hand, the introduction of categorical needs as a variable
in the allotment formula in 1974 may have been prompted, in part, by a
desire to improve the allocation of abatement resources. Concern over
efficiency considerations is also implied in the Federal guidelines to
the States relating to the establishment of priorities. In formulating
their priority lists the States are directed to take account of the severity
of pollution, the size of the population affected, and the cost-effectiveness
of the project.
Achieving effluent and water quality standards in an efficient and
equitable manner is an eminently sensible objective. The justification for
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efficiency is self-evident; with a limited amount of Federal grant funds,
it is economically desirable to induce as many net social benefits as
possible.
The supporting arguments for equity are twofold: First, the 1972
Amendments were an abrupt change in legal requirements, and imposed
a marked increase in financial burden on many municipalities. Although
almost all emissions into navigable waters were prohibited in 1899, the
law was never enforced, and de facto pollution rights evolved. It
seems reasonable to provide differential assistance during the period of
adjustment to the new statute. Second, the distribution of benefits from
wastewater treatment and water quality improvement between communities
is highly uneven. In some communities the benefits are captured locally;
in others they accrue to down-stream communities. Hence, in many cases
benefits are not closely related to the taxes paid and the costs borne. In
these situations, equity considerations acquire additional significance,
It is desirable that the Construction Grant Program generate an
efficient and equitable allocation of abatement reasources. However, the
present allotment formula, in conjunction with the State priority systems,
is a seriously deficient mechanism for achieving these objectives. The
next two sections examine the inadequacies of the current Federal allotment
formula and the State priority systems.
The Current Allotment Formula: Currently, allotments are based solely
on the concept of need, i.e. , the capital costs required to comply with the
law. Need is conceptually inappropriate for achieving either efficiency or
equity.
Need is an input into the abatement process, not a measure of the
output. There is no reason why needs should be correlated with the
benefits of wastewater treatment. Since need is undependable as a proxy
for benefits, its use for allocating grant funds is not necessarily consistent
with efficiency.
State priority lists rank projects according to their importance within
each State, and presumably reflect abatement benefits. However, Federal
allotments occur without any consideration of these lists, and hence without
any consideration of benefits. No project-by-project comparison occurs on
a nation-wide basis. In the absence of comparisons across State borders,
investment errors are inevitable. In some places relatively inefficient
projects will be undertaken at the expense of socially preferable projects
elsewhere.
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The cost of waste-water treatment reflects the absolute burden on a
community, but not the burden relative to fiscal capacity. Consequently,
needs alone are a very crude measure of equity. A wealthy State with
extensive needs may be under no greater fiscal burden than a poor State
with limited needs.
A simple allotment formula based on only one variable is attractive
from an administrative point of view, but simplicity should not take
precedence over the primary program objectives. There is unlikely to
be one variable which can simultaneously promote two such different
objectives as equity and efficiency.
Later in this chapter a procedure is considered for improving the
allotment formula as well as the entire decision-making process for
determining investments in wastewater treatment facilities (referred to
hereafter as the "funding process").
In this procedure, appropriated funds are divided into two parts: a
portion to be distributed on efficiency grounds and a portion on grounds
of equity. A variety of variables are considered for inclusion in the
allotment formula, with different variables being used to promote the
two different objectives.
Implementing Allotments Through the Needs Survey: In its present
form the allotment formula is deceptively simple. It is based on the
single and seemingly easily understandable concept of the cost of
complying with the law. In practice there have been numerous
misunderstandings of what constitutes eligible needs, and the estimates
of these needs have proven unreliable. Although the problems with the
Needs Survey have been well publicized, a brief discussion of the most
salient difficulties is useful here.
The allotment formula allocates the largest share of appropriations
to those States with the largest estimates of costs which will be incurred
in meeting the standards. The States are aware of this, and there is
some evidence that they protect their share of budgeted funds by biasing
the cost estimates upwards wherever possible. 2/ Although cost curves
2/ The National Commission on Water Quality conducted a survey of States
fb determine (in part) the accuracy of the estimating procedures for the
Needs Survey. One State wrote an unsolicited letter indicating that the
costs were largely concocted to comply with the legislative requirement,
but more especially to protect the State's share of Federal funds.
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were provided as guidance for estimating some categories on the survey,
only limited direction was given for the others, and the survey was too
massive to permit EPA to thoroughly review the statistical techniques
employed throughout.
States were directed to report treatment needs up through 1990 based
on projected residential population, 3_/ non-residential population, and
industrial flows. Needs were not reported by year; only the total needs
up through 1990 were provided. Even if one were committed to a program
of allotments proportional to costs, total needs up through 1990 does
not seem to be the relevant statistic. These needs are not an estimate
of current capital requirements, and it is difficult to understand how
they are germane to the problem of distributing current appropriations.
An example may help to illustrate this point. Consider two States
with identical total needs and identical distributions of needs among
categories. The existing treatment facilities in State A are old and
require replacement now, while the bulk of State B's investments won't
be needed until 1985. Despite this important difference between the two
States the present allotment formula would result in each State receiving
the same share of current appropriations. This is clearly not a cost-
effective method for allocating wastewater treatment capital. The same
anomalous result can occur due to differences in any of the variables
affecting the waste stream, e.g. , population growth or expected
industrial concentration. It occurs because all future needs (up to
1990) are weighted equally and counted as current needs no matter when
the waste stream problem is expected to arise.
In spite of these observations, the vast majority of actual needs occur
during the next few years. Thus, in practice, the inclusion of future
capital requirements in the allotment formula has only a minor impact
on the current allotment of funds. However, retension of the existing
formule may adversely affect the allotment of funds after the existing
backlog is satisfied.
3/ This was not to exceed the Department of Commerce Series E
projection.
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The Priority Systems: Thus far we have examined the difficulties
with the first stage of the funding process: the inappropriate design of
the allotment formula and the practical problems associated with using
the Needs Survey data to apportion Federal grant funds. The second
stage of the funding process, namely the formulation, review, and
approval of State priority lists, has equally disturbing features.
The priority lists are of critical importance. They are supposed to
rank individual projects according to their merits, taking into account
such things as the severity of pollution, the cost of the required facilities,
and the number of people who will benefit. Although not formally design-
ated as such, the priority lists are supposed to serve the function of a
benefit-cost algorithm. However, there is little confidence in their
validity.
A State's priority list is formed by evaluating each prospective
project within the State according to a set of criteria. Some of the
criteria are required by Federal Rules and Regulations, but some are
established by the State. The State assigns a maximum value or weight
to each criterion. A project is awarded points for each criterion, and
the total points determine its ranking on the priority list.
In order to illustrate the arbitrary nature of the priority systems,
the approach taken by Connecticut for ranking projects is indicated below.
Priority System Criteria
Maximum
Points
20 1. Severity of pollution problem
15 2. Population affected by the project
10 3. Need for preservation of high quality waters
5 4. National priorities (priority basins)
15 5. Projects needed to meet enforceable
provisions. 4_/
10 6. Projects desirable in terms of water quality
improvement. 4/
4/ Mutually exclusive criteria.
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Priority System Criteria (continued)
5 7. Projects which are not discharges. 5_/
10 8. Benefits to downstream users of receiving
streams: public health and health of aquatic
ecosystems, recreation, industry, agriculture.
IQ_ 9. General water quality improvement expected
due to project.
85 Possible Points
Although the first four items are mandated by the Federal government,
no weights are specified. The States choose the weights, and there seems
to be no objective justification for the relative values assigned to each
criterion. Futhermore, the method of scoring individual wastewater
treatment projects within a State is likely to lack uniformity.
Because of these problems the project lists can be structured in almost
any desired way. In addition to having complete freedom in assigning
weights for each criterion, the States have considerable discretion in
defining those which are Federally imposed and in choosing additional
criteria.
Flexibility of this kind provides the States and localities with an
opportunity to express their individual preferences, but it also makes
it very difficult for the EPA regional offices to evaluate the priority
systems and resulting project lists. In point of fact, the systems are
so fraught with subjectivity that there is no objective way to evaluate
chem, and the regional offices have virtually no option except to approve
them.
Summary of Problems with the Current Funding Process: We have
identified three principal features of the present funding process which
conflict with objectives of the Construction Grant Program:
1. The two stage design results in allotments being made without
explicit reference to project benefits.
2. Needs, the basis for allotments, reflect neither benefits nor the
burden of the program relative to fiscal capacity.
5/ Mutually exclusive criteria.
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3. The priority systems, which are responsible for ranking
individual projects according to their merits, are so
unstructured that even within the States there is little
assurance that appropriate investments are being undertaken.
It is apparent from these observations that the objectives of equity and
efficiency cannot be served simultaneously through the existing allotment
formula.
Alternative Formulas
The Inappropriateness of Conventional Allotment Formulas: Although
allotment formulas based on relative per capita income and relative
population have been used in this and other programs, 6/ reverting to a
formula based solely on these variables would not serve~~T:he objectives
of the program, and would perpetuate the problems inherent in the
current formula and funding process. Per capita income and population
are variables which provide useful information which can be utilized to
promote policy objectives. However, they have to be used with care,
and the objectives which they are supposed to promote have to be
precisely defined.
Simply because population is likely to bear some correlation to the
extent of pollution, the cost of abatement, and the demand for and
potential benefits from improved water quality does not guarantee that
its casual inclusion in an elementary algebraic function will promote
efficient resource allocation. It is unrealistic to expect this one
variable to reflect both costs and benefits and to account for the proper
relationship between them.
Population is not the sole determinant of costs and benefits.
Although the load on a treatment plant is highly correlated with
population, the amount of treatment necessary, and hence the cost of
6/ Allotment formulas based on these two variables are quite popular.
They are currently used to determine allotments for Adult Basic
Education, The National Teachers Corps, Vocational Rehabilitation,
construction of hospital facilities under the Hill-Burton Act, and
services and construction under the Library Services and Construction
Act.
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abatement, is also related to the environmental characteristics of the
region. The value of benefits derived from an improved water segment
are related to the type of use that is to be sustained and the availability
of substitutes. If a serious attempt is to be made to achieve efficiency
these additional relationships have to be taken into account.
Furthermore, the mere addition of variables to the allotment
formula will not transform the two-stage funding process into a decision-
making procedure which allocates resources efficiently. A proiect-bv-
project comparison across State lines is necessary if efficiency is to be
improved.
There are a number of reasons why relative per capita income is a
poor variable to use to achieve equity. These are discussed in detail ^
later. (See the section entitled "Equity Considerations. ") Principal
among these are:
a) For our purpose relative per capita income is not the best
variable to use to reflect fiscal capacity, and
(2) Fiscal capacity alone is not the relevant variable to use to
promote equity.
The appropriate concept is the cost of abatement relative to fiscal
capacity.
In the next section an alternative allotment formula and funding
process is discussed which mitigates the above problems inherent" in
the current system. In this approach the two-stage funding process
is eliminated; a uniform system for evaluating individual projects and
ranking them nationally on their merits is developed; and because the
approach is based on variables which reflect benefits, costs, and fiscal
capacity, it improves the tendency of the funding process to promote
efficiency and equity compared to the present program.
A Two-Part Allotment Formula: The dual objective of efficiency
and equity can be served by splitting the wastewater treatment
appropriation into two parts: one part to be disbursed on the basis of
an efficiency criterion and the other part distributed according to an
equity criterion. There is ample precedent for such a dichotomous
structure; allotments were made in an analogous manner from 1956
to 1971.
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There is no logical procedure for determining the relative
proportions between equity and efficiency. Congress will have to
make this decision according to its preferences. The only assistance
which can be provided on this issue is that there is no reason to retain
the same proportions year after year. Because the 1972 Amendments
imposed large burdens on many municipalities, one might want to give
greater consideration to equity during the years when communities are
adjusting to this abrupt change in requirements. Once the adjustment
process is complete and secondary treatment has been universally
achieved, less emphasis might be placed on equity.
The remainder of this paper is devoted to developing an approach
for alloting grant funds on the basis of an efficiency criterion and an
equity criterion, and to discussing the feasibility and problems
encountered in implementing and refining this approach. The efficiency
criterion is treated first.
Efficiency Considerations
A National Benefit-Cost Ranking: This section presents an
economically optimal criterion for allocating the efficiency portion of
allotments, assuming that the basic form of the wastewater treatment
program is retained, i.e. , that the program continues to be one in
which only capital is subsidized and the legislated cost-sharing pro-
portions are uniform. The criterion is optimal in the sense that net
social benefits will be maximized subject to a Federal grant (a fixed
appropriation). 7_/ If the subsidy program takes a different form and
any of the options discussed in Chapter V are adopted, then an alternate
allotment formula may have to be developed.
7/ Chapter IV also presented an economically optimal criterion for
cTetermining which projects to fund. That criterion was based on the
assumptions that all treatment costs (not just capital costs) were
subsidized, and that cost sharing proportions could be variable. We
assume here that the grant program will not meet either of these
conditions, and hence the appropriate criterion in this case not only
differs from that found in Chapter IV, but in addition, is much simpler
to generate.
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For the specified program design, net social benefits will be
maximized subject to the Federal funding constraint by rankin°- all
proposed projects according to their benefit-cost ratios, and funding
them sequentially until the efficiency portion of appropriations is
exhausted. 8/ The relevant benefit-cost ratio is given by the expression
B - C
(1)
K
where B = the discounted value of total abatement benefits,
C = the discounted value of total abatement costs, and
K = the discounted value of grant-eligible capital costs. 9/
The problem with implementing this ranking scheme is that it
requires the estimation of benefits from water quality improvement.
Although fairly reliable cost information can be obtained, beneiit
estimation is still in a primitive stage of development.
Estimating Benefits: A project generally results in/a water segment
being improved, and this improvement in the water segment will in
turn generate and encourage new activities (recreational, aesthetic,
life support, etc. ). In order to estimate benefits the type of activities
generated as a result of the improvement have to be identified, the
annual amount of each activity estimated, and a value estimated for
a unit of each activity.
8/ Implicit here is the assumption that municipalities will not undertake
projects without Federal funding. If there were a way to predict which
projects would be undertaken in the absence of Federal subsidies, then
net social benefits could be increased by devoting the Federal budget to
projects other than these.
9/ For a discussion of criteria in the selection of water-resource
projects seeMcKean [1].
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Intially, this involves determining the post-installation quality of the
water, the types of use that the improved water segment will sustain,
and the size of the water segment that will be improved as a result of
the project. This information can be obtained. Indeed, it is currently
required as part of the grant application process.
Next, the amount and value of the activities have to be estimated.
A water body normally has multiple uses: contact and non-contact recreation,
aesthetic enjoyment, health benefits, drinking water supplies, life support
for plants and animals, irrigation, industrial cooling, etc. Only some
of these activities have market prices, and even for these an estimate
would have to be made of the quantity that would be consumed at these
prices. For others the usual approach is to attempt to approximate
the number and value of the user days generated during the year. For
some activities benefit estimation is simply not fruitful.
Even if all of this can be accomplished, only the gross value of the
activities is estimated, while it is the net contribution which is important.
Some of the activities generated by the improved water segment will
replace activities formerly engaged in elsewhere, e.g., a day of fishing
may be substituted for a day of golfing, or a day of canoeing on this
segment substituted for a day of canoeing on another segment.
The value of the supplanted activities has to be subtracted out in order
to estimate the improvement in social welfare attributable to the
project undertaken.
Finally, the benefits from improved water quality do not all accrue
in one year. A stream of benefits accrues over time, and the annual
amount may vary. Annual benefits have to be estimated for the effective
life of the treatment project and their value discounted to the present.
Cost-Effectiveness Analysis: Clearly, the dimensions of the task
preclude any attempt at precise estimation of the value of wastewater
treatment benefits. An alternative approach is cost-effectiveness analysis.
Cost-effectiveness analysis uses non-monetary output variables to form
an index of benefit surrogates. The output variables chosen depend
upon the objectives of the program. For example, we might decide to
measure the effectiveness of wastewater treatment projects by the number
of stream miles improved to a certain water quality.
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The preceding section indicated that the improvement in net social
benefits was the relevant measure for evaluating a project's desirability
Because an effectiveness index is not measured in monetary terms, it
is not possible to net out costs, to account for supplanted activities', or
to discount the value of future outputs to the present. It is only possible
to measure project effectiveness during a particular time period per
dollar of expenditure. Thus, an effectiveness index is an inherently less
accurate measure of the value of a project than net benefits. However,
as a surrogate for benefits it is preferable to the existing, amorphous
priority systems.
Desirable Elements of an Effectiveness Index for the Wastewater
Treatment Program: It is desirable to have an effectiveness index which closely
reflects the value of benefits, that is, the product of the price of the
output and the quantity of output. It would also be desirable to have an index
that distinguishes beween types of uses, because not all uses are
equally valuable. For example, the price of the output varies
depending upon the type of activities generated as a result of improving
a water segment. The price of the output is also sensitive to the
availability of substitutes. If there is a large amount of high quality
water in an area, additional improved segments would be less valuable
compared to a situation in which only a few substitutes are available.
Finally, the index should incorporate variables which reflect the amount
of use, i. e., the quantity of output. Amount of use is a function of the
size of the improved segment, the availability of substitutes, and the
location of the segment relative to population centers. If an improved
water segment will not receive much use, either because the area is
remote, or the segment is small and won't support much use, or because
there are numerous alternatives, then it is not nearly as valuable as it
would be if it were used extensively.
Thus, the value of the benefits derived from water quality improve-
ment depends largely on the type of use that the water body will receive,
the amount of use (the number of user days), and the availability of
substitutes. Variables that might be used to reflect these characteristics
in an allotment formula are discussed below:
1. Type of Use: Although an effectiveness index which manifests
all three of these characteristics would be desirable, estimating
differential values for uses does not appear feasible. It is
possible to identify the different uses that a water body will
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support, but in the absence of market prices for all activities
it is not possible with confidence to place relative values on
different uses. Some simplifying assumptions regarding use are
necessary.
There are five commonly accepted use categories: recreation
(including aesthetic enjoyment), drinking water supplies, aquatic
life support, agriculture, and industry. For several reasons
it appears that we will not violate optimality seriously if the
effectiveness index accounts only for recreational benefits.
Preliminary study shows that the dollar value of existing
recreational damages from water pollution exceeds the aggregate
amount of damages from the remaining use categories [2]. It is
reasonable to suppose that within each use category, total damages
are indicative of the relative amount of marginal damages. It
follows that useful estimates of relative project benefits for
incorporation in a grant-allotment formula can be obtained by
focussing mainly upon recreational uses.
Moreover, in order to meet the 1977 water quality standards,
receiving waters must be capable of supporting indigenous aquatic
life and secondary recreation. For the most part grant-eligible
projects will be required to take receiving waters from an industrial
or agricultural quality to a quality suitable for fish and recreation
other than swimming. Thus, it is likely that the majority of the
actual benefits forthcoming from wastewater treatment projects
will be recreational and aquatic life support.
Finally, the capacity to sustain aquatic life is highly correlated
with water of recreational quality. If we assume that aquatic
benefits are proportional to recreational benefits, it is not necessary
to explicitly account for aquatic benefits in the effectiveness
index. 10/
10/ Even with recreational quality water, the types of species and their
relative abundance will differ, and so will the aquatic value of the improved
water segment. Evaluating the aquatic benefits in any units, let alone in
the same units of measurement as the recreational benefits, is extremely
difficult. Hence, devising an additive index which accounts for recreational
as well as aquatic benefits appears to be a remote possibility. As a practical
matter, one is forced to adopt the assumption of proportionality.
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There will undoubtedly be projects which generate drinking water,
agricultural, and industrial benefits in addition to recreational and
aquatic life support benefits. An index which accounts only for
recreational benefits will undervalue such projects. Unfortunately, in
the absence of market prices it is very difficult to devise an index which
evaluates all types of benefits in common units, and allows them to be
aggregated. If there is a low incidence of projects with multiple types of
benefits (or if the inference that recreational benefits dominate is
valid), then an index which accounts only for recreational benefits should
prove acceptable.
With few exceptions, projects whose benefits are exclusively or
primarily agricultural, industrial or drinking water should not be
eligible for Federal funding, and should not be included in the index.
These benefits are usually saleable, and their values can be captured
locally through the market. If the benefits are sufficiently valuable,
the municipality should be willing to pay to generate them without
Federal subsidies. 11 / In contrast, the recreational and aquatic
benefits from water quality improvement have public goods aspects,
and it is much more difficult to market these.
Adopting an index which concentrates on recreational values
solvesonly partially the additivity problem associated with diverse
uses. There are numerous types of recreational activities, and
they are unlikely to be of equal value. Despite this problem, it
appears that the only practical method of dealing with these
remaining uses is to assume that no matter what the specific
form of activity (fishing, boating, aesthetic enjoyment), all man
days of water recreation are equally valuable. Thus, none of
the alternative indices developed below attempts to distinguish
among uses.
2. Amount of Use: Direct estimation of the number of man days
of use that each improved water segment will generate is complex,
costly, and unlikely to provide satisfactorily accurate results. A
practical surrogate variable for the amount of use is the population
that lies within some specified radius of the water segment. Other
things equal, larger populations should generate greater use, and
persons living close to the improved segment should benefit more
from it than those living farther away.
11 / The exceptions to this principle occur when transactions costs are so
large as to prevent markets from forming or properly functioning. Under
these circumstances government action which would result in welfare gains
being realized is justified.
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Resident population data is easily obtained, of course, but
resident population may not be the best proxy for the population
benefiting from the improved water segment. Preferences differ,
and not all persons within a region are likely to make use of the
improved segment. Similarly, the proportion of the resident
population using the water is not likely to be constant throughout
the country. Furthermore, some areas are predominantly tourist
areas, and using only resident population in the effectiveness index
creates a bias against projects in these locations.
It is possible to refine the population estimates, but the
cost of doing so may be prohibitive. Refinements and their
feasibility are discussed later. Initially we are concerned with
developing an effectiveness index with a relatively simple structure
and examining its implications for resource allocation. For
purposes of convenience and exposition we assume that the population
measure employed in the index is the resident population within a
100 mile radius of the improved water segment.
3. Availability of Substitutes: The stock of comparable quality
water segments within a specified radius of the improved water
body can be used to reflect available substitutes. Theoretically,
non-water activities are substitutes for water activities, but it
does not seem practical to attempt to incorporate these in the
proxy for available substitues.
Some arbitrariness is involved in specifying the geographic
limits to the region of relevant substitutes. For purposes of
and consistency with the measure of the preceding variable
we use a 100 mile radius from the project site.
Water bodies are not homogeneous, and have a variety of
characteristics: length, depth, width, circumference, surface
area, volume, etc. Which characteristic(s) is relevant depends
in part upon the type of use that the water will receive. This
topic is explored later and a possible resolution suggested.
Assume for the moment that streams are the only water
bodies improved by the program and that length (stream miles)
is the accepted unit of measurement.
A Possible Form for the Index: Although an infinity of possible functional
forms exist for the effectiveness index (E), there is no convenient way to
determine which form will generate the best approximation of net social
benefits. Initially an uncomplicated form is chosen which ranks projects
in a desirable manner, and is based on variables whose values are
easily estimated.
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Other options which use more refined variables are discussed subsequently.
Let E = P a (P/W)b (dW/W)c ,
where P = the resident population within a 100 mile radius of the
improved water segment,
W = the stock of water (measured in stream miles) within a
100 mile radius of and comparable in quality to the
improved segment,
dW =the length of the improved segment. I2j
The symbols denoted by a, b, and c represent positive scalar parameters,
The expression dW/W represents the percentage change in the area's stock
of water which is generated by the investment in the treatment project.
For a given dW, this expression will have a smaller value in relatively
water-rich regions, and will produce an effectiveness index having
a smaller value than it would in more arid regions.
The population per stream mile, denoted by P/W, is a density variable.
It provides an indication of how crowded the area's recreational water
facilities are likely to be. If the region is rich in water relative to the
population, E will tend to be lower than if the region has a meager stock
of water.
12 / It should be noted that this effectiveness index is not appropriate for
ranking wastewater treatment projects which must be installed in order
to comply with effluent standards, but which do not improve the water
quality sufficiently to upgrade the use of the water segment. Such
projects do not increase the stock of water available for any particular
use, and hence no new activities are generated. Thus, dW = 0, and
E = 0. This does not appear to be a serious problem. It is
estimated that less than 5 percent of the construction funds required to
comply with the law will be devoted to such projects.
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Consider two areas with identical values for P/W and dW/W, but one
area is more populated. More benefits are likely to be generated in the
area with the larger population, because more people will be using the
water. The above functional form for the effectiveness index reflects
this, since E increases with increases in P.
The parameters a, b, and c are discretionary; there is no objective
way to determine values for them. By altering the size of these para-
meters, one can alter the relative effect of the statistics P, P/W, and
dW /W on E.
Of course, E is only the numerator of the cost-effectiveness index.
Eligible capital cost constitutes the denominator. For a given level of
effectiveness, a higher capital cost reduces a project's cost-effectivenss
ratio (E/K) and the likelihood that it will receive funding. This is as
it should be, because for the limited appropriation we wish to undertake
those projects which will maximize J]Ej, the aggregate magnitude of
effectiveness, where E. = B. - C. in equation (1).
This option for a cost-effectiveness index has some appealing character-
istics: it ranks projects in a manner consistent with improved resource
allocation, and is based on variables that are easily estimated. However,
a cost-effectiveness ranking scheme represents a major structural change
from the existing funding process. Before discussing more complicated
cost-effectiveness indices, the administrative feasibility of this option
relative to the present system of allotments and priority systems is
examined.
Feasibility of a Cost-Effectiveness Ranking: The initial reservations
about an allotment system which requires a cost-effectiveness analysis
for all proposed projects and distributes funds based on the relative
ranking of projects are that it appears to be a radical, complicated
departure from the present program design, and that it might increase
administrative expenses markedly. Neither concern seems well founded.
The present Construction Grant Program requires analogous project
evaluations. Currently, States have to make cost estimates for proposed
projects when completing the Needs Survey. States and municipalities
also have to engage in a form of benefit analysis during the preparation
of the priority lists. Among other requirements, each State has to submit
an annual assessment of water pollution problems; a ranking of State
water segments, taking into account severity of pollution, population
affected, need for preservation of high-quality waters, and other national
priorities; and an explanation of its criteria for project selection. Thus,
substituting a cost-effectiveness ranking procedure for the current program
requirements would not involve a radical change in design. States have to
conduct these kinds of activities now.
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Since the cost-estimating procedures would be virtually unchanged,
cost-estimation would not be a source of increased administrative expense.
However, an increase in the accuracy of the estimates could be expected.
The present incentive for States to bias their cost estimates upward in
order to protect their share of allotments would be eliminated. If they
continued to overestimate their costs in an effort to obtain greater funding,
the States would jeopardize the ranking of their projects. If they under-
estimated their costs in order to improve the project rankings, they would
jeopardize the size of their grant.
Thus, whether substituting a cost-effectiveness ranking scheme for the
present system would add substantially to administrative costs depends
entirely on the degree of refinement desired for the variables in the
effectiveness index. If the effectiveness index employed the variables
defined in equation (1), there would be virtually no additional administrative
costs associated with determining the value of E for a project. Population
data are readily available from the census, and EPA maintains an updated
inventory of waterways and their quality. Administrative costs are likely
to rise rapidly, however, if more precision is required. Below we discuss
the problems associated with developing more precise effectiveness indices
by (1) improving the estimate of the user population, (2) altering the units
of measurement for the water, and (3) divising a substitute for discounted
future values.
Alternative Population Measures
Three possible refinements of the user population estimate are discussed
in this section: (1) including nonresident users in the estimate; (2) refining
the estimate for a given municipality based on expected differential rates of
participation in recreational water activities; and (3) refining the estimate
for a municipality based on the distance that the municipality lies from, the
improved segment.
1. Nonresident Users: An effectiveness index which includes only
resident population creates a bias against projects that would
be heavily used by tourists. Any solution to this problem would
probably require careful sampling, and the expense might make
it impractical. In some areas data on motel and campground
registrations are available, and could be used to approximate
the population of nonresident users. It would be surprising,
however, if record-keeping practices were uniform in all areas
and constituted an acceptable sampling design. Reliance on
available information simply because it is accessible is likely to
introduce biases, and the cure may be worse than the problem.
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The availability of recreational water facilities may not be the
specific feature of an area responsible for attracting vistors. In
such locations inclusion of the tourist population in the effectiveness
index would inflate a project's rank.
One possible approach to this problem might be to develop an
initial screen for distinguishing between those areas that attract
tourists because of their water recreational aspects and those that
do not. An appropriate procedure for sampling the nonresident
population would still have to be devised for the former group,
however.
Differential Participation Rates: Because preferences differ, not
all persons (residents or nonresidents) within an area benefit
equally from recreational water facilities. Activity participation
rates have been estimated based on demographic characteristics
(income, sex, age, race, place of residence, etc.). 13/ If the
information necessary to utilize these participation factors were
readily available through the census, it would not be difficult to
modify the population weights in the effectiveness index.
However, it is unlikely that information in sufficient detail exists
for all municipalities and their environs. In that case, sampling
would be necessary, and sampling of this kind is very expensive.
Differential Distance Weights: Persons who live closer to
recreational water facilities probably use them more and benefit
from them more than those who live farther away. One way to
account for this in the effectiveness index is to assign differential
weights to persons living within the 100 mile radius of the improved
water segment. The weights would be a function of the inverse of
the distance which a person lived from the segment, and persons
living farther away would acquire less significance in the index.
13/ See Mueller and Gurin [3].
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For example, let
x = the distance from municipality i to the improved
water segment, where x. g 100 miles, and
P. = the population of municipality i.
A possible substitute for P = £?. in the effectiveness index is
P' = T^d/x.r P-, where d g 1.' '
Although this option may sound involved, it is a simple and
inexpensive task to incorporate a variable like P1 in the
effectiveness index. A modest amount of clerical work is
required. If a procedure is adopted for including non-
resident population in the effectiveness index, distance weights
can be applied to it, as well.
Measuring the Amount of Water Resources: The appropriate units
in which to measure the size of a water segment improved by a wastewater
treatment project as well as the inventory of available substitutes depend
upon the use for which the water is designed. If the relevant uses are
drinking, irrigation, or industrial processing, a measure of volume per
unit time is appropriate. For swimming, boating, and fishing, length
or surface area and a minimum depth seems relevant. For purposes
of environmental values and aesthetics, it is difficult to decide what
measure to use. The fact that different uses require different units
creates a potential problem, because if cost-effectiveness analysis
is to be applied, projects have to be comparable, and a common unit
of measure has to be stipulated.
Two considerations tend to simplify the problem. First, since
recreational benefits are a primary concern, volume is not a relevant
measure. Second, the receiving waters for effluent are primarily
rivers, streams, and oceans. For many of the recreational activities on
these water bodies, length (stream miles or shoreline) would be a relevant
feature. However, use of length alone to measure the recreational
resources might create some distortions. For instance, a mile of a wide
river or a mile of ocean beach can certainly support a greater variety
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and amcamt of activity than a mile of a narrow creek. Thus, although
length might serve as a rough approximation of the amount of resources,
one might feel more comfortable if some of the other distinguishing
characteristics of the water bodies could be captured, as well.
One option is to establish a classification of waterways based on
depth as well as width or surface area. An arbitrary numerical weight
could be assigned to each class, with larger water bodies receiving higher
weights. Then, instead of W and dW in the effectiveness index being
measured in length alone, they would be measured in length times the
relevant weight. The weights serve to distinguish the carrying capacity
of the water bodies or the number of user days that they will support.
Some preliminary research on relative carrying capacity could reduce the
degree of arbitrariness associated with choosing the weights.
Discounting Future Benefits: One of the problems with the current
allotment formula is that it utilizes all needs up to 1990 in determining
State allotments, and counts a dollar of needs in any one year as equivalent
to a dollar of needs in any other year. This is an improper procedure,
because the value of a dollar ten years from now is less than
the value of a dollar today. Future dollars have to be discounted
over time using an appropriate interest rate in order to make them
comparable to current dollars.
In its present form the cost-effectiveness index suffers from a
similar problem. Wastewater treatment projects generate outputs and
benefits over a time span. The annual outputs and their values need not
be uniform throughout the life of a project. Productive life spans differ
among projects and originate in different years. For purposes of
comparison we would like to be able to monetize the annual outputs,
discount them, and determine the present value of each project.
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However, the monetary values of the outputs are unavailable or difficult
to estimate. In the absence of monetary values, discounting is impossible,
and no alternative approach is suggested in the cost-effectiveness literature.
Cost-effectiveness analysis normally assumes that benefit streams are
of equal length and begin in the same year, and the annual outputs and
benefits are uniform. When these assumptions hold, the effectiveness
index has a constant, annual value. These assumptions are invalid in the
case of wastewater treatment projects, and it is not apparent which year's
statistics to use in evaluating two important variables in the effectiveness
index: the user population and the stock of water.
Since the essence of discounting is to create comparability between
benefits in different time periods so as to avoid committing too much
capital to projects whose benefits are not realized for some time, a_
procedure which utilizes time-oriented eligibility criteria might be a
suitable substitute. The criteria could be used as a screening device
to reduce the number of projects eligible for inclusion in the cost-
effectiveness ranking. For example, preference might be given to
projects necessary to meet the 1977 water quality standards. A second
criterion might be that projects that are not expected to be operating
and producing benefits within, say, the next 6 years are ineligible for
current funding. As a result, projects that previously could only be
justified on the basis of benefits expected well in the future would no
longer qualify for support.
There is no theoretically satisfying way to determine which year's
statistics to use in estimating the user population and the stock of water.
Since it seems inappropriate to base the investment decision on one
year's data, an averaging procedure might be developed, e.g. , the
arithmetic average of the effectiveness index for the first five years
of operation occurring within a decade of the year when funds were
appropriated.
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Equity Considerations
In the preceding sections we have discussed how to revise the
allotment formula in order to improve the efficiency of the investment
funding process. Efficiency is only one criterion of the cost-sharing
program. In this section we examine alternatives for implementing the
second criterion: equity. An index is developed which can be used to
determine the distribution of equity funds among the States, and
alternatives to this index are briefly discussed. In addition, problems
associated with determining how the funds are to be spent within the
States are examined.
The purpose of distributing a portion of the funds on the basis of
equity is to provide some fiscal relief in those communities where the
1972 Amendments imposed a disproportionate financial burden.
The data requirements for an equity index make it very difficult to
develop an index at the community level. Consequently, an index to
distribute funds among the States is proposed. The implications of
this for achieving equity among communities is discussed later.
The Relevant Cost Concept: As previously mentioned, program cost
relative to fiscal capacity is generally a better indicator of burden than
either cost or fiscal capacity alone. Cost and fiscal capacity can be
measured in a variety of ways, however, and the implications for equity
can be quite different.
It has already been pointed out that the Needs Survey estimated costs
by aggregating all (undiscounted) capital requirements up through 1990.
This is not an appropriate statistic to use in determining either the
current burden on a State or the distribution of the current appropriation.
Current capital requirements is the relevant statistic. 14/
14/ Operation and maintenance expenses are also a burden imposed on
communities by the 1972 Amendments. However, research has shown that
these expenses are approximately proportional to the capital costs of a
project. See [4, 5, 6]. Consequently, the equity index need not explicitly
account for them, because they will not alter the relative financial burdens
incurred by communities.
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These capital requirements differ depending upon what assumption is
made regarding compliance with the law. Assume initially that
communities will comply with the law whether or not they receive Federal
funding, i.e. , funding from the efficiency portion of the appropriation.
Define
k. = Sic.- = the total, current, grant-eligible capital costs of all i
1 i projects in State j necessary to comply with the 1977
water quality and effluent standards plus the capital
costs of all those projects which must be undertaken
now, if they are to be completed in time to comply with
subsequent standards.
f-, = the proportion of k-; funded under the efficiency portion
of the appropriation.
In this case the relevant current capital costs borne by State j is given by
a- vv
If it is assumed that communities will not have to comply with the law
and that they will be required to undertake only those projects funded
under the efficiency portion of the appropriation, then define
k. = the total, grant-eligible capital costs of all i projects
J in State j funded under the efficiency portion of the
appropriation, and
V'o = tne legally mandated uniform cost-sharing proportion.
The relevant current capital costs borne by State j is now given by 15/
15/ Note that ^. = f k ./k., where k. g TE . . In the current legislation,
J J J J J
^ = 0.75.
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Measuring Fiscal Capacity: Having identified the appropriate cost
concept, it remains to determine a measure of fiscal capacity with which
to compare it. Fiscal capacity of a State does not mean the statutory
tax base, but rather the potential tax base. The fact that a State
has revenue sources which it chooses not to tax should be irrelevant
to the Federal government's determination of how to distribute equity
funds.
Neither per capita income nor total personal income are by themselves
completely satisfactory measures of a State's fiscal capacity. Both are
relevant in determining a State's ability to bear program costs. A State
with a relatively high per capita income, but a small population could be
seriously burdened by abatement costs, because it may have a small tax
base. Thus, a total rather than a per capita concept is appropriate.
However, in a State with a large tax base the burden on individual tax-
payers could be substantial, simply because the base is comprised of a
large population with a low per capita income.
A concept which avoids the disadvantages of both per capita income
and total personal income, but retains the fiscal capacity information
inherent in both of them is the sum of personal income in excess of some
specified low income level, e.g. , the poverty level. States with a large
low-income population would be assigned a relatively low fiscal capacity
under this definition, as would States with a high per capita income but
a small population.
Income information of this kind is readily available from the census,
and is updated annually by the Current Population Survey. This type
of information is not easily obtained for municipalities, which is why
we have chosen to develop a State equity index rather than a municipality
equity index.
Of course, there are tax bases other than personal income which might
be included in the fiscal capacity measure: personal wealth, personal and
corporate property, and corporate income. 16/ Personal and corporate
property information are available by State, But estimating personal wealth
and corporate income would pose considerable statistical problems.
16/ Retail sales have not been included in this list, because the regressive
nature of the sales tax together with the fact that in some States non-
residents may account for a sizable portion of the revenues makes it an
inappropriate revenue source for purposes of wastewater treatment.
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The Equity Index: There are numerous functional forms for the
equity index. One option appears below. Under the assumption that States
would comply with the law whether or not they received funding, State j's
percentge of appropriated equity funds is given by
,..
J J J
y n -^ ^ k /Y
^(l WYJ
where Y. - £ (y.. - yp.)
= the sum of all personal income in State j in excess of
poverty level,
y.. = the personal income of individual i in State j,
J
y . = the poverty level in State j, and
t"^ J
y.. - y . =0 for y.. < y . .
J J J ^ J
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If States will only be required to undertake those projects funded under
the efficiency portion of the appropriation, then
In both cases flj gives a measure of the fiscal burden of wastewater
treatment in State j relative to the burden in all States. States with
a relatively high burden will receive more equity funds than those
with a low burden.
The Distribution of Equity Funds to Communities: The purpose of the
equity fund is to provide some fiscal relief to those communities experiencing
a disproportionate wastewater treatment burden. However, because
financial data at the community level is more difficult to acquire than at
the State level, the equity index was devised to determine an allocation
of funds to the States. Without some additional restrictions there is no
guarantee that the States will dispense their allocations to the neediest
communities.
States could be required to develop a systematic procedure for
distributing these funds in a manner consistent with the equity goal. Un-
fortunately, a system as nebulous as the current priority system is the
likely result of such a requirement. Considerable Federal administrative
problems could be avoided if no such requirement were imposed. Even
without Federal involvement in local distribution, equity is likely to be
served at least in part, because the funds are allocated to the States
based on the relative burdens which they are experiencing. If State
authorities choose not to dispense the funds to the neediest communities
within their borders, they risk a political problem with their constituencies.
As a contingency the Administrator could request authority to oversee the
local distribution of the funds in the event that the equity goal is flagrantly
disregarded.
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Even if States were granted complete discretion in choosing the
communities that would receive the equity funds, in the interests of pre-
serving some incentive for efficiency the Federal government might want
to place a limit on the amount of Federal financing that any one project
could receive. For example, the maximum Federal share of eligible
capital cost might be restricted to 85 percent. In this way local
communities would still bear part of the burden of abatement, and would
have an interest in cost minimization.
Rewarding Additional Abatement
A possible program objective not yet addressed is that of
encouraging States to engage in pollution control which has not been
Federally funded. One way of doing this would be to create a third part
to the allotment formula: a separate appropriation could be established to
reward States which had either undertaken projects not funded with equity
or efficiency money or had incurred abatement expenditures in excess of
those necessary to match these Federal funds. Whatever criterion were
used to determine a State's eligibility for such reimbursement, it is not
clear that this would be a desirable use of Federal funds.
The effect of such a fund would be to extend additional discretion
to the States regarding which projects to undertake. There are only two
grounds on which the granting of this discretion can be justified: first,
if there are reservations about the accuracy of the cost-effectiveness
index, and second, if political considerations require that States be given
more control over the program. Only the first of these requires
discussion.
If the index is considered reliable, then it is a waste of Federal funds
to reward States for undertaking projects which are not cost-effective.
There are more urgent projects which need funding. However, if there
are reservations about the index, then a discretionary fund could be
justified. It would allow States the opportunity to undertake projects
which they deem important despite the relatively low rankings indicated
by the index. The fund could serve as a substitute for an appeals mechanism,
thereby reducing administrative expenses. Although it might not entirely
obviate the need for an appeals process, it would defuse a number of
potential disputes, and reduce the amount of administrative review.
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If a discretionary fund were established, one would probably not want
to permit States to have complete freedom of choice in the use of Federal
equity funds. Furthermore, the Federal cost share for rewarding
additional abatement would have to be less than that for cost-effective
projects, or the advantages of the cost-effectiveness ranking could be
vitiated. States would be able to undertake projects that were not
cost-effective with the assurance that they would be reimbursed next
year by the full amount of the capital subsidy, just as if the project
had been cost-effective.
Summary and Conclusions
Since the annual appropriation of funds for wastewater treatment
facilities is insufficient to undertake all eligible projects simultaneously,
decisions have to be made regarding how best to utilize the limited budget.
The appropriate decision rule for allocating the funds depends upon the
objective of the program. In this chapter we examined (1) the objective
of the program, (2) the existing project funding process, and (3) several
alternatives for improving the process.
The legislative history together with the Federal rules and regulations
suggest that the primary objective of the program is to improve water
quality in an efficient and equitable manner. The present program design
is ill-suited to achieving this objective.
Funding is currently a two-stage process. The initial step is the
determination of allotments or the proportion of the appropriation granted
to each State. The second stage consists of: the development of State
priority lists; their review, revision, and approval by EPA; and the ultimate
granting of project funds, generally in accordance with the approved lists.
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There are three principal features of this process which conflict with
the program objective:
1. The two-stage design results in allotments being made without
reference to project benefits; no comparison of the merits of
projects is made between States.
2. State needs, i.e. , the estimated capital cost of required projects,
which are the basis for allotments, reflect neither benefits nor the
burden of the program relative to fiscal capacity.
3. The priority systems, which are responsible for ranking individual
projects according to their merits, are so unstructured that even
within the States there is little assurance that appropriate invest-
ments are being undertaken.
Allotment formulas used in other programs were examined. It was
found that they had features which would perpetuate the problems inherent
in the current formula and funding process.
The funding process can be improved, however, by splitting the waste -
water treatment appropriation into two parts: one part to be disbursed on
the basis of an equity criterion and the other part according to an efficiency
criterion. Assuming that the program continues to be one in which only
capital is subsidized and cost shares are uniform, the efficiency criterion
which maximizes net economic benefits is: rank all proposed projects
according to their benefit-cost ratios (i.e., net economic benefits relative
to capital cost) and fund them sequentially until the efficiency portion of the
appropriation is exhausted.
Because it is difficult to estimate and monetize the benefits from water
quality improvement, it is not feasiible to implement this optimal allocation
procedure. As an alternative to cost-benefit analysis, a cost-effectiveness
approach was developed: variables, chosen to reflect the benefits from
water quality improvement, are combined into an effectiveness index, and
projects are ranked and funded according to their cost-effectiveness ratios.
The value of the benefits derived from water quality improvement
depends largely on the type of use that the water body will receive, the
amount of use, and the availability of substitutes. Variables which reflect
amount of use and the availability of substitutes were developed, but it is
not presently possible to develop variables which distinguish among types
of uses. It was shown that this is probably not a serious inadequacy, and that
an improvement in efficiency is likely even in the absence of variables
which distinquish among uses.
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It was shown that substituting a cost-effectiveness ranking procedure
for the current program requirements does not involve a radical change in
program design, and need not be expensive to implement. In the course of
complying with current program requirements, States now conduct many of
the activities necessary to implement a cost-effectiveness procedure. A
specific cost-effectiveness index was presented which ranks projects in a
manner consistent with improved resource allocation, and is based on
variables that are easily estimated. However, administrative costs are
likely, to rise rapidly if more precise and sophisticated variables are
introduced into the index.
An equity index was devised based on program cost relative to fiscal
capacity. The proportion of the equity appropriation which a State receives
depends upon the fiscal burden of wastewater treatment in that State relative
to the burden in all States.
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References: Chapter VI
1. McKean, Roland, Efficiency in Government Through Systems Analysis .
John Wiley and Sons, Inc., New York, 1967, pp. 103-133, and especially
p. 122.
2. Abel, Fred, Dennis Tihansky and Richard Walsh, National Benefits
of Water Pollution Control. Washington Environmental Research
Center, U. S. Environmental Protection Agency, Washington, D.C. ,
1975. ,
3. Mueller, Eva and Gerald Gurin, Participation in Outdoor Recreation
Factors Affecting Demand Among American Adults . Outdoor Recreation
Resources Review Commission Report No. 20, Washington, D.C. 1962.
4. Alternative Municipal Wastewater Management Systems, Standards,
and Financing. Draft report prepared by Energy Resources Company
for U.S. Environmental Protection Agency, Washington, D.C.,
December, 1974.
5. The Economics of Clean Water - 1972, Volume 1. U.S. Environmental
Protection Agency, Washington, B.C., April 27, 1972.
6. Evaluation of Alternative Methods for Financing Municipal Waste
Treatment Works. U. S. Environmental Protection Agency, EPA
600/5-75-001, Washington, D.C., March, 1975.
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CHAPTER VII
ANALYSIS OF THE INDUSTRIAL COST RECOVERY PROGRAM
P.L. 92-500 stipulates that all recipients of waste treatment services
pay for their share of operation and maintenance costs through user charges.
Also, industrial recipients of treatment services are required to pay for
that portion of the Federal construction grant allocable to the treatment of
industrial wastes. Industrial repayment of the Federal share of construction
costs is known as cost recovery. Of course, the municipality is free to
negotiate with industry to recover the local share of construction costs
allocable to industry as well.
The recovery of O&M and construction costs from users of wastewater
treatment facilities serves two important economic functions. First,
revenues generated can be used to pay for operating and replacement costs,
and also provide funds for amortizing the debt incurred to finance initial
construction costs.
Second, user charges and cost recovery serve as price signals to both
recipients and suppliers of treatment services. As such, the charges, if
set appropriately, can act to distribute demand and allocate pollution abate-
ment resources in an economically efficient manner. This chapter is
primarily concerned with investigating the efficacy of the existing cost
recovery program as a mechanism for satisfying the second of these
economic functions.
Of primary concern in this regard are cost-recovery regulations which
(1) allow municipalities to retain one-half of industrial cost recoveries,
and (2) do not require that an interest charge be included in cost recoveries.
The analysis indicates that as a result of these regulations, both the
municipality and industry may be in a position to benefit at the expense
of society as-a-whole.
The municipality may be able to lower the amount of construction
costs which its residents have to bear by building facilities of sufficient
size to service industrial users. Industry can negotiate with the municipality
to obtain some share of the grantee's profits from industrial participation.
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At the same time, industry receives a substantial subsidy from not having
to pay an interest charge on its portion of the Federal grant I/
As a consequence, both industry and the municipality may find it
advantageous to ensure that public facilities are provided to service
industry, even when private treatment would require less real resources.
The extent to which industry can benefit from the use of public facilities
depends upon the relative cost of private treatment, including the
avail-ability of tax-exempt financing, as well as its bargaining strength
vis-a-vis the municipality. The extent to which the municipality can
benefit from the use of joint facilities is directly related to both the
industrial proportion of the work load, and to the degree of economies-of -
scale which can be captured. Accordingly, the local cost burden of
satisfying pollution control requirements will generally fall most
heavily on small communities that do not service industry.
The analysis shows that the most effective and administratively
simple way to mitigate the inefficiencies and inequities induced by the
cost recovery program is to require that all industrial cost recoveries
be returned to the U. S. Treasury, or to the Construction Grant Program.
If this change is not forthcoming, it is desirable to make two other
modifications in the existing cost recovery program.
First, 100 percent (rather than the presently required 80 percent)
of retained cost recoveries should be held in reserve, to be used solely
for funding approved wastewater treatment projects. (A project can
receive EPA approval without receiving a grant, e.g., budget limitations
may prevent Federal funding of a socially as well as locally desirable
project.) This would prevent municipalities from using 20 percent
of retained cost recoveries for funding activities unrelated to wastewater
pollution abatement.
Second, the amount of funds accumulated in reserve should not be
deducted from grant-eligible costs for the purpose of determining the
size of the Federal grant. This would improve resource allocation by
eliminating the financial bias which exists in the present program
for communities to expend the reserve fund on projects that do not
receive a Federal grant.
I/ Industry can also benefit from economies-of-scale in public treatment.
"Although this effect will encourage the construction of larger municipal
facilities, and hence result in an increase in the size of the Federal
construction grant commitment or a reduction in the number of fundable
projects, it will not, by itself, induce an inefficient allocation of abatement
resources.
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The analysis of the interest subsidy issue indicates that, suprisingly,
it does not appear desirable to require that interest be recovered from
industry on its share of the Federal grant. The reason for this is that
in the presence of income-tax advantages and higher monitoring costs
in private treatment, and economies-of-scale and average cost pricing
in public treatment, recovery of an interest charge would induce a
financial bias in favor of private treatment. This outcome is not consistent
with the apparent intent of Congress to encourage public treatment
of industrial wastes, nor is it desirable on economic efficiency grounds.
Cost Recovery Model
In the current Construction Grant Program, the nominal local cost-
sharing proportion of grant-eligible construction costs is 25 percent.
However, communities are allowed to retain one-half of industrial cost
recoveries collected against the Federal grant. Thus, the effective
local cost-sharing proportion of grant-eligible costs is actually equal to
or less than 25 percent, depending essentially upon the industrial-residential
waste-load ratio. The objective of this section is to quantify the relationship
between the effective local cost-sharing proportion and the fraction of the
waste-load representing industrial users. 2_/
Legislative provisions in the 1972 Act relevant to cost recovery effectively
stipulate that:
(1) Cost recovery will be collected from industrial users of municipal
facilities to repay that portion of the Federal grant allocable to
the treatment of industrial wastewater. 3_/
(2) The grant recipient will retain 50 percent of industrial cost recoveries
collected against the Federal grant. 4_/
21 The original research on the development of this relationship was
conducted for EPA by the National Bureau of Standards [1].
3_/ P.L. 92-500, Section 204 (b)(l)(B).
4/ Ibid., Section 204 (b)(3).
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Federal Regulations pursuant to the 1972 Act further govern existing
cost recovery policy through the following requirements: 5_/
(a) Industrial cost recovery will not include an interest charge.
(b) Cost recovery will be collected from industry in equal annual payments
over the life of the treatment works or over 30 years, whichever
is less.
(c) No more than 20 percent of retained cost recoveries will be
used by the municipality for projects unrelated to wastewater
treatment or collection.
(d) At least 80 percent of retained cost recoveries will be placed
in a. reserve fund (held in government-issued or government-
guaranteed securities or accounts), the principal and interest
earned to be used solely for funding grant-eligible construction
projects "associated" with the project necessary to meet the
requirements of P.L. 92-500.
(e) If a subsequent Federal grant is forthcoming, the unexpended
balance in the reserve fund will be deducted from grant-eligible
project costs for the purpose of determining the size of the
grant. However, the fund need not be held until a grant is
forthcoming; i.e. , the fund may be used for eligible and approved
costs apart from any grant.
In order to evaluate the effect of the industrial cost recovery program
on municipal cost-sharing proportions, the following assumptions are made:
1. Industrial users of public treatment facilities are not considered
part of the municipal segment. Thus, the grantee is defined as
being equivalent to residential users only.
2. The first industrial cost recovery payment is to be made one
year after local obligation of construction costs.
3. The municipality will keep precisely 80 percent of retained
cost recoveries in the reserve fund.
5/ "Final Construction Grant Regulations, Construction Grants for Waste
Treatment Works, " Federal Register, Title 40, Part 35, February 11,
1974.
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4. The municipality will expend the entire reserve fund on projects
which do not receive a Federal grant.
5. The municipality will not recover from industry any portion of the
nominal 25 percent share of construction costs initially borne
locally.
The first assumption is made in order to distinguish the costs borne
by local residents from those borne by industry. The second assumption
is made for mathematical convenience. The third assumption is a
realistic projection of how a municipality will choose to distribute retained
cost recoveries. That is, a municipality will generally choose to define
the legal minimum portion of retained amounts as being non-discretionary,
(i.e. , 80%), since these funds are restricted in use while discretionary
funds are not restricted.
The fourth assumption also derives from the course of action which
appears to be clearly in each community's best interests. 6_/ If the
reserve fund were retained for Federally funded projects, grant-eligible
construction costs would have to be reduced by the size of the reserve
fund, before the Federal construction grant rate was applied. With a
75 percent construction grant rate, this means that the Federal grant
is reduced by 75 percent of the amount in the reserve fund. Thus, when
the reserve fund is used to pay for projects receiving a Federal grant,
the local cost share is reduced by only 25 percent of the size of the
reserve fund, and not by the full amount in the fund. On the other hand,
if the reserve fund is used to pay for projects which do not receive a
Federal grant, the local cost share is reduced by the full amount held
in reserve. Therefore, a reserve fund is four times as valuable to
a municipality if it is used to pay for projects which do not receive a
Federal grant, compared to the case in which the fund is used to pay
for projects which do receive a Federal grant. 7/
6/ An approach developed in [2] quantifies the local cost-sharing
proportion when the reserve fund is used in part or in total for funding
grant-related projects.
7/ If the reserve fund is used to pay for projects receiving a Federal
grant, the municipality would also incur a reduction in the amount of
future retained cost recoveries, since this amount is based upon the
size of the original Federal grant. This aspect of cost recovery would
tend to reduce further the value of the reserve fund held for funding
projects which receive a Federal grant.
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The four assumptions just described are retained through-
out the analysis. The fifth assumption, made initially to simplify the
argument, is subsequently relaxed.
The following symbols are defined:
K = grant-eligible construction costs. 8/
9 = municipality's effective cost-sharing proportion of K.
Y = fraction of the total waste-load allocable to
the treatment of industrial wastes.
F= amount (dollars) of cost recovery required to be collected from
industrial users of the municipality's facility, and subsequently
retained by the grantee.
F(n,i) = present value of an annual cash flow equal to F/n, generated at
the end of each year for n years.
i= municipality's opportunity cost of capital.
With a 75 percent Federal construction grant rate, in conjunction with
local retension of one-half of industrial cost recoveries, the expression for
9 can be written
e = 0.25- F(n'i}
r±
The symbol denoted by F(n,i) can be expressed in terms of F as follows:
F(n,i) = ZF, (2)
8/ To simplify the exposition, all construction costs are considered eligible
for a Federal grant.
-------
where
7 i-g +i) "n
L - in
Further, based on legislative provisions (1) and (2) and Federal regulation
(a) described previously, we interpret F to be given by
F = 0. 5 (0.75) YK. (3)
Substituting equation (2) and (3) into (1), we find that
9 = 0.25 - 0.375YZ. (4)
Equation (4) represents the (effective) local cost-sharing proportion of
construction costs, when the amount of funds recovered from industry
is limited to the industrial portion of the Federal grant. This scenario
is consistent with assumption 5.
Now suppose that the municipality also recovers from industry the
nominal 25 percent share of construction costs initially borne by the
locality (including interest), but allocable to industrial use of public
facilities. In this case, 0 in equation (4) is reduced by 0.25Y. 9_/
We assume that recovery of both the Federal share (without interest)
and the local share (with interest) of the allocable construction costs
from industry results in the lower bound for & . We also assume
that recovery of only the allocable Federal share (without interest) of
construction costs results in the upper bound for 6 . Therefore, we
can write
0.25(1-Y) - 0.375YZ ^ B ^ 0. 25 - 0. 375YZ. (5)
9/ If only the principal amount of the local share of construction costs
allocable to industry is recovered, hence no interest on the local share
is charged to industry, 9 in equation (4) would be reduced by 0.25YK(n,i),
where K(n,i) is defined in a similar manner to F(n,i).
122
-------
TABLE VII-1
Municipal Cost-Sharing Proportions
Y
0.
0.
0.
0.
0.
1.
0
2
4
6
8
0
e
0
0
0
0
-0
-0
Total Cost-Sharing Proportions ()
.25
.18
.10
.03
.04
.12
P= 0.1
0.
0.
0.
0.
0.
-0.
P = 0.5
93
74
55
36
18
01
0.
0.
0.
0.
0.
0.
63
49
35
22
08
06
p = 0. 9
0.33
0. 24
0.15
0.07
-0. 02
-0.11
List of symbols:
Y = industrial proportion of the waste load.
9 - effective municipal cost-sharing proportion of
construction costs.
4> = effective municipal cost-sharing proportion of
total costs.
P = ratio of construction to total costs.
123
-------
Quantitative results for 9 are shown in Table VII-1. It is assumed therein
that n = 30, and i = 0.10. Also, we assume in the table that the industrial
share of all local costs is recovered from industry. Accordingly, 9 is given by
the term on the left-hand side.of equation (5).
The second column in Table VII-1 represents the municipal cost-
sharing proportion of construction costs 9 , for the different levels
of industrial participation shown in the first column, and designated
by Y. The remaining columns represent , the municipal cost-sharing
proportion of total costs, (construction as well as operating and maintenance)
as a function of both Y and the ratio of grant-eligible to total costs, denoted by
p •
Table VIII-1 indicates that d declines as Y increases. 10/ In other
words, for any given treatment plant size, the local cost burcfen will
decline as the industrial proportion of the waste load increases. Further,
communities of equal residential size but having unequal levels of
industrial participation will presumably build different size plants, with
larger facilities being provided in the more industrialized communities.
Of course, in these cases, the communities building the larger facilities
will bear a lower proportion of construction costs.
Each of these results is desirable on both economic efficiency and equity
grounds. Unfortunately, however, the cost recovery program tends to
overcompensate municipalities for providing industrial capacity. As a
consequence, biases are created for municipalities to overbuild and to
overcapitalize treatment facilities. Also, per capita residential treatment
costs will tend to be higher in smaller, non-industrialized communities.
The overcompensation factor inherent in the cost recovery program is
now demonstrated. Grant-eligible construction costs are denoted here by
K0+ AK, where
KQ = construction costs required to service only residential
users.
AK = additional construction costs required to service industry.
10/ Note that the extent to which economies-of-scale can be captured
cToes not directly affect 6 . However, the magnitude of construction
costs required to service a given waste load is, of course, affected
by this factor. Presumably then, economies-of-scale will be taken
into account in determining the appropriate plant size to build, and
hence will affect the resulting level of industrial participation. Never-
theless, for any given plant size, 9 only depends upon the distribution
of the waste load between residential and industrial users, and the values
assumed by n and i which determine Z.
124
-------
In the absence of industrial participation, the municipality's share
of grant-eligible costs is equal to 0. 25 KQ. In the presence of industrial
participation, the municipality initially bears costs equal to 0.25(K0+ AK).
Therefore, 0.25AK represents the added grant-eligible costs initially
borne by the municipality in the presence of industrial participation.
The municipality will subsequently recover and retain from industry
an amount equal to 0. 375YZ(K0+ AK), which represents one-half of the
Federal share of construction costs allocable to industry, and an amount
equal to* 0.25Y(K0+ AK), which represents the industrial share of
construction costs that are initially borne locally. Let A k be the
additional construction costs ultimately borne by the municipality in
servicing industry. From the preceding argument, we can write
Ak = 0.25 AK - 0.375YZ (KQ + A K) - 0. 25Y (KQ + AK). (6)
In the presence of constant returns to scale, the following relationship
applies:
Y (K0+ AK) = AK
Substituting (7) into (6) and dividing through by AK yields
Since Z is positive, the community can reduce the local share of
construction costs by inducing industrial participation 11 /. For example,
given that n = 30 years and i = 0.10, the municipality could make a profit
of almost 12 cents on each dollar of incremental capacity provided to
service industry, if the municipality recovers the industrial share
of construction costs initially borne locally 12/.
11 / This result can also be inferred from Table VII-1, where it is seen
fKat for a given increase in Y, the proportional decline in 9 exceeds the
proportional decline in 1-Y .
12/ It can be easily demonstrated that this rate of profit is even higher
uTthe presence of economies-of-scale, because in this case
Y(Krt+ AK) > AK.
125
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As a consequence of this finding, we conclude that the existing cost
recovery program has the following adverse affect on the allocation of
abatement resources and on the distribution of Federal grant funds:
1. Communities have an economic incentive to encourage industrial
use of public facilities, since the absolute amount of costs borne
by the communities can be reduced by servicing industry. As a
result, an additional capital bias is introduced into the treatment
plant design and maintenance decision-making process. Further,
required Federal construction grant funds will increase (or the
number of fundable projects will decline) owing to the incentive
for municipalities to build joint wastewater treatment facilities
to service industry.
2. Communities have an economic incentive to undercharge industry
relative to the incremental costs required to service them. In
this way, both the municipality and industry can benefit (a) at the
expense of the Federal government, by sharing the proceeds of the
Federal subsidy, and (b) at the expense of society as-a-whole, if
industry is induced to treat publicly even though private treat-
ment requires less real resources.
Accordingly, the retention of one-half of industrial cost recoveries by
municipalities has an adverse effect upon economic efficiency, equity, and
upon the size of the Federal cost share needed to induce mandated levels
of pollution abatement. It would appear that the most effective and
administratively simple solution to this problem is to require that all
industrial cost recoveries be returned to the U.^S. Treasury, or to the
Construction Grant Program for redistribution to the highest priority
water pollution control projects.
Adoption of this recommendation would, in mathematical terms, be
equivalent to eliminating the second term on the right-hand side of
equation (6). As such, the additional construction costs ultimately
borne by the municipality as a result of servicing industry would then
be simply equal to initial local construction costs not paid for by the
Federal government, less the amount of capital user charges collected
from industry.
For example, suppose that the municipality is not allowed to retain
any part of industrial cost recoveries. Also, suppose that we have a
situation defined by the presence of either average cost pricing and constant
returns to scale, or marginal cost pricing and economies-of-scale.
(In both of these cases, industry pays the full resource cost associated
with treating its wastewater.) It follows from equation (6) that Ak = 0
if user charges are collected from industry to pay for their share of
local construction costs. Thus, the abolishment of local retension
126
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of industrial cost recoveries results in the elimination of (1) the financial
bias (induced by cost recovery provisions) for municipalities to overbuild
public treatment facilities, and (2) the tendency for municipalities to
undercharge industry (apart from the Federal interest subsidy) for using
public treatment facilities.
Suppose that the regulation which allows communities to keep one-
half of industrial cost recoveries is retained. In this case, there is
no easy way to modify the cost recovery program to account for the
previously noted deficiencies with respect to the (1) overcapitalization
bias, and (2) undercharging of industry. However, if the legal provision
relating to retension of cost recoveries is not abolished, then the
following issues become relevant:
1. Communities can use up to one-fifth of retained cost recoveries
for projects and activities unrelated to the collection or treat-
ment of wastewater.
2. It is generally advantageous for a community not to accumulate
its reserve fund, but rather to expend the fund on pollution
control projects which will not receive a Federal grant. In this
way, the community can reduce its share of abatement
project costs by the full amount of the reserve fund, denoted
by Fr. Otherwise, if the fund is held for projects receiving a
Federal grant, the size of the grant will be given by 0. 75(K - Fr),
and the reserve fund will then reduce the local cost share by
only 0. 25Fr .
In regard to the first of these two issues, it is difficult to see the
logic in allowing communities to use part of what amounts to Federal
construction grant funds for purposes totally unrelated to the abatement
of wastewater pollution. Patently, the 20 percent discretionary fund
allowance should be eliminated, and all retained cost recoveries should
be held in the reserve fund.
Consider the second issue. We have shown that a significant financial
bias exists for communities to use the reserve fund to pay for projects
that will not receive a Federal grant. Owing to this financial bias,
the projects chosen to be so funded may well have a low priority, in real
resource terms, both locally and nationally. Moreover, any intent to
encourage some additional degree of community self-sufficiency in the
funding of future facility construction projects, through accumulation of
127
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cost recoveries, is hampered by this local incentive to periodically
deplete the reserve fund. Accordingly, it appears desirable that the
amount of funds held in reserve not be deducted from grant-eligible
construction costs for the purpose of determining the size of the
Federal grant. This would eliminate the financial bias in favor of
using reserve funds for non-grant related projects. Communities would
then have a significantly greater incentive than presently exists to accumulate
their reserve funds, and to subsequently use their reserve funds on •
projects which are locally cost-effective (in terms of local abatement
benefits and social resource costs), thereby resulting in improved allocation
of abatement resources.
Resource Allocation Effects of Cost Recovery on Industry
The previous section analyzed the effect of various elements of the
cost recovery program on the allocation of abatement resources by
municipalities. In this section we evaluate one important element of
cost recovery which indirectly affects the size of the industrial waste
load generated, and directly affects industry's choice of public versus
private treatment.
The cost recovery element of concern provides that industry need not
pay an interest charge on its portion of the Federal construction
grant. If, as a result of this implicit subsidy, the costs borne by
industry are disproportionately low compared to the real resource costs
required to service industry in public treatment, a financial bias is
said to be created.
This financial bias encourages an inefficient allocation of resources in
two ways. First, industry may be induced to use public facilities in cases
where private treatment would require less real resources. Second, even
when public treatment is the least social-cost treatment option, the
appropriate incremental costs of servicing industry will not be internalized.
As a result, higher levels of water pollution than are socially desirable will
be generated, because final products that are pollution related will tend
to be underpriced and overproduced.
In order to mitigate the distortions in resource allocation caused
by the first of these effects, it is desirable that the ratio of costs borne
by industry in public and private treatment be equal to the ratio of
real resource costs needed to service industry in each activity. This
relationship would encourage the appropriate allocation of abatement
128
-------
resources, between public and private facilities, for whatever the level
of wastewater generated. In the absence of this relationship, a financial
bias in favor of public or private treatment is created, because relative
prices would not reflect relative abatement resource requirements. 13/
In the Legislative Hearing held prior to the enactment of P.L. 92-500,
the Committee on Public Works, House of Representatives, stated that
"each industrial user of a public system would pay a charge that would
include not only that share of operating and maintenance costs allocable
to such user but which would also be sufficient to recover that portion
of the Federal share of the capital cost of the facility allocable to
such user subsidy of private industry through the waste treatment
works grant program would be haphazard and inappropriate. " [3]
A few sentences later, the "committee affirmatively concluded that
capital costs recovered from industry should not include an interest
component. " [3]
The impact of this interest subsidy on the relative abatement construction
costs borne by industry in public and private treatment is determined below.
Taken in conjunction with Federal income-tax considerations,
these calculations will reveal the conditions under which the interest
subsidy creates a financial bias in favor of public treatment. 14/
The following assumptions are made.-
1. All cost recoveries are returned to the Federal government.
Equivalently, for calculation purposes, we could assume that
industry does not share in any local profit on cost recovery.
2. Industry's share of Federal and local construction costs incurred
in public treatment is recovered over 30 years.
13/ Note that the creation of a financial bias does not guarantee that
a misallocation of abatement resources will, in fact, occur, for the given
level of effluent generated. For example, suppose that the socially
optimal solution is for each firm to treat its wastewater effluent entirely
in one activity (i.e. , publicly or privately). As long as the activity
requiring less real resources imposes lower costs on each particular
firm, the appropriate allocation of resources between public and private
treatment will be encouraged.
14/ Owing to differences in State tax codes, and also to the minor effect
6TState corporate income taxes on the relative costs of public and private
treatment, only Federal income taxes are quantified in the model.
129
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3. The municipal cost of capital is 6 percent.
4. The Federal cost of capital is 7 percent.
5. Marginal cost pricing is employed in public treatment.
6. Real resource (construction) costs required to service industry
in both public and private treatment are equal to $100. 00.
From assumption 5, we can infer that the prices charged industry in
public treatment are equal to the incremental costs required to service
industry. Further, it follows from assumption 6 that if we find that
the (construction) costs borne by industry in public and private treatment
are unequal, a financial bias in favor of one of these activities will have
been shown to exist. 15/
The construction costs borne by industry in public treatment are
found by determining the present values of specific public treatment cost
elements, taking into account Federal income-tax considerations. These
present values, representing discounted cash flows, are equivalent to the
cost that industry would be willing to pay now (as a non-tax deductible
expense) in order to forego the periodic payments implied by each of the
cost elements.
The present values are calculated using two alternative figures for
the firm's opportunity cost of capital, i.e., the after-tax discount rate-.
4.5% and 9.0%. 16/ For example, Table VII-2 shows that if a
firm's (after-tax)~3iscount rate is 9 percent, payment of the allocable
Federal share without interest, plus the allocable local share with interest
15/ The equality assumption between the real costs of public and private
tFeatment (at $100.00) is made for expositions! purposes only. In fact,
any combination of real resource costs would suffice. In this more
general case, as indicated previously, a financial bias is shown to exist
if the ratio of costs borne in each activity is not equal to the ratio of real
resource costs incurred in each activity. In the presence of numerous
corner solutions (each firm treating entirely publicly or privately), the
primary concern should be that the activity requiring a higher level of
real resource costs also imposes a higher cost burden on industry. The
equality of the ratio of real resource costs incurred in each activity to
the ratio of costs borne would then be of secondary concern.
16/ Calculation of these present values was initially done by Charles
Marshall of the JACA Corporation.
130
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TABLE VII-2
Present Value of Industrial Construction Costs Incurred
in Public Treatment: Allocable Costs = $100.00
After -tax Discount Rates
Construction Cost Element *
75% Federal Share
25% Local Share
6% Interest on Local Share
Existing Construction Costs
Paid by Industry
7% Interest on Federal Share
4.5%
$21.18
7. 06
7. 57
$35.81
$26. 73
9.0%
$13.35
4.45
5.70
$23.50
$18.15
Potential Construction Costs
Paid by Industry
$62.54
$41.65
* For example, the 75% Federal Share cost element is calculated as follows:
$21.18 = $16.29 ($3.33)(0.75)(1-0.48),
Where $16.29 is the present value of a 30-year annuity, at 4.5%, paying
$1 per year.
$3.33 is the annual payment of the original $100 cost.
0.75 is the Federal share.
0.48 is the Federal tax rate.
131
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at 6 percent, imposes costs (in present value terms) of $23.50 on industry.
Payment of interest at 7 percent on the Federal share increases the amount
of costs borne by industry in public treatment to $41. 65. In both cases, the
present value of the potential construction costs borne by industry is less
than $100.00 (the social marginal cost of servicing industry), because the
interest charges are less than the market rate confronting industry and
the expenses incurred by industry are tax deductible.
For comparison purposes, we now calculate the construction costs borne
by industry in private treatment. 111 The following assumptions are made:
1. Funds used to finance the construction of the private abatement
projects are borrowed in the money market.
2. The cost of borrowing is 10 percent in the corporate bond market,
and 6 percent in the tax-exempt market. Tax-exempt financing
refers to Industrial Revenue Bonds, issued by a municipal authority
for private industry. Responsibility for repayment of principal and
interest rests with industry, and bondholders are not required to
pay Federal income taxes on the interest earned by the bonds.
3. Asset lives and the payback period for principal and interest lie
within the range of 20 to 30 years.
4. The choice between the 7 percent investment tax credit and rapid
amortization 18/ was determined by finding that option which
incurred lowe~F~private costs for a given combination of parameter
values, i.e. asset life, payback period, interest rate, discount rate.
17/ This analysis is further complicated by three factors: (1) Continuing
modifications in the income-tax code; (2) obscure tax regulations; and
(3) allowable tax deductions specified in dollar, rather than percentage
terms. Although it is believed that the net effect of these factors on our
findings is small, it would be prudent to consider the results presented
here as first-order approximations.
18/ Rapid amortization rules allow an asset having a useful life of
IF years or less to be depreciated over a five-year period, using
the straight-line method. Assets having useful lives in excess of 15
years may be depreciated under rapid amortization for only that portion
of the asset cost allocable to the 15-year period. The remainder is
subject to normal depreciation rules.
132
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As before, we specify two alternative discount rates: 4.5%, and
9. 0%. Also, the real construction costs of private and public treatment
are equalized at $100.00.
Table VII-3 shows, for example, that with a 9% discount rate and
a 10% interest rate on corporate borrowing, the costs borne by industry,
which result from a $100.00 investment in"pollution abatement, range
from $34.43 to $49, 78, in terms of present values. The lower-bound
figure occurs when the asset life is 20 years, and the payback period
is 30 years. The upper-bound figure occurs when the asset life is 30
years, and the payback period is 20 years. Note again that the costs
borne by industry are less than the social costs ($100.00) due to tax
deductibility of expenses and interest charges which are below market
rates.
Comparison of Tables VII-2 and VII-3 indicates that under the existing
cost recovery program (for a given discount rate), the abatement
construction costs borne by industry in public treatment are less than the
costs borne in private treatment. For example, given a 4.5% discount
rate, public treatment costs are estimated to be $35.81, while private
treatment costs range from $45.25 to $69.57. Similarly, with a 9.0%
discount rate, public treatment costs are found to be $23, 50, while
private treatment costs range from $24. 23 to $49. 78. Since it was
orginally postulated that the real construction costs incurred in each
activity are equal, it follows that in our example a financial bias is
seen to exist in favor of public treatment.
Suppose that the cost recovery program were modified such that industry
is required to pay a 7 percent interest charge on its share of the Federal
grant. The tables show that, for firms that can take advantage of
tax-exempt financing, a financial bias is then generated in favor of
private treatment 19/. In this case, public treatment costs borne
by industry are $52754 for a 4. 5% discount rate, and $41. 65 for a 9. 0%
discount rate, while comparable private treatment costs range from
$45. 25 to $53. 41 for a 4. 5% discount rate, and from $24. 23 to $37. 25
for a 9. 0% discount rate.
19/ It is well known that tax-exempt financing is inefficient, in the sense that
STe government tax-revenue losses exceed industry's gains from the interest
subsidy. Also, the interest subsidy inherent in tax-exempt financing is of
dubious effectiveness as an incentive to control pollution, because the subsidy
only reduces the cost of an already unprofitable investment. At the same time,
private tax-exempt financing raises the cost of borrowing for competing debt
instruments, mostly municipal bonds. Finally, tax-exempt financing is
usually available only to the larger private firms. Because of these reasons,
it would appear desirable to eliminate the use of tax-exempt financing for
pollution control investments, apart from any changes in the cost recovery
program.
135
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TABLE VII-3
Present Value of Industrial Construction Costs Incurred
in Private Treatment: Allocable Costs = $100.00
After-Tax Discount Rate
Interest Rate Paid on
Private Borrowing
4.5%
9.0%
6% Tax-Exempt Rate
$45.25 - $53.41 $24.23-$37. 25
10% Regular Corporate Rate
$66.25 - $69.57 $34.43-$49. 78
134
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It has been estimated that one-half of industry's construction costs
for controlling pollution will be financed in the tax-exempt bond market
during the next five years [4], Accordingly, based on the example presented,
it does not appear desirable to recover an interest charge from industry
on its share of the Federal grant, owing to the financial bias which
would be created in favor of private treatment for those firms that
can take advantage of tax-exempt financing.
In fact, the example actually understates the bias created in favor of
private treatment when interest is recovered from industry on its share of
the Federal grant. This is the case because several factors were not
considered which tend to favor private treatment.
First, ambient monitoring costs are lower when industry uses public
facilities, since the number of outfalls to monitor is reduced. Ambient
monitoring costs are generally borne by the Federal (and local) government,
hence in the absence of a monitoring fee, industry will not take these
costs into account in deciding whether to use public or private facilities.
Second, State income taxes generally favor private treatment, because
the depreciation period of a private abatement investment'is usually
shorter than the payback period used by a public facility. However,
this bias is offset to some extent in States that require that property
taxes be paid on pollution control investment projects.
Third, in practice, industries using public facilities usually will be
charged on the basis of average, not marginal costs. In the presence
of economies-of-scale, average costs will exceed marginal costs at any
treatment plant design size 20/. Hence, industry will tend to be overcharged
relative to incremental resources required in public treatment, excluding
the effect of the interest subsidy.
20/ At a given treatment plant design size, the ratio of average costs to
marginal costs increases as the degree of economies-of-scale increases.
Thus, in the presence of average cost pricing, the higher the degree of
economies-of-scale, the greater will industry be "overcharged" relative
to incremental resources required. At the same time, even in the presence
of average cost pricing, the absolute amount of costs charged to industry
declines as economies-of-scale increases.
135
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Thus, the failure to include an interest charge in the price of public
treatment services is offset by (1) a similar failure in the price mechanism
to reflect lower monitoring costs in public treatment, (2) State income-tax
regulations favoring investment over expense items, and (3) the use of
average cost pricing, by municipalities, in the presence of economies -of-
scale. Accordingly, if an interest charge based on the Federal grant were
recovered from, industry without accounting for these three factors, the
financial bias in favor of private treatment would then be higher than was
estimated previously in our example. Thus, it is concluded that in the continued
presence of tax-exempt financing, it would be inappropriate to require that
interest be recovered from industry on its share of the Federal grant.
In fact, even if tax-exempt financing were eliminated, Tables VII-2
and VIII-3 imply that taking into account monitoring costs, State
income-tax considerations, and average cost pricing, a financial bias would
still be created in favor of private treatment if interest on industry's share of
the Federal grant were recovered.
Owing to economies-of-scale, it can be expected , a priori, that the
real resource cost of industrial treatment is lower in public facilities.
As a consequence, it does not appear desirable to generate a financial
bias in favor of private treatment. Therefore it is concluded that given a
choice between no interest recovery, and full interest recovery on the
portion of the Federal grant allocable to industry, the former option is
preferable.
Nevertheless, the analysis suggests that the optimal solution
probably would be to recover from industry some part of the Federal
interest allocable to industry. Unfortunately, determination of
"appropriate" proportion of the interest component to be recovered
from industry is an extremely complicated theoretical and empirical
problem, and lies beyond the scope of the present study.
136
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References: Chapter VII
1. ' Analysis of Cost Sharing Programs for Pollution Abatement of Municipal
Wastewater. U. S. Environmental Protection Agency, EPA-6QO/5-74-0031.
Washington, D.C., November, 1974.
2. Marshall, H.E., and Ruegg, R.T., "Impact of User Fees on Cost
Sharing for Abatement of Municipal Wastewater Pollution. " National
Bureau of Standards, Washington, D.C., 1974.
3. A Legislative History of the Water Pollution Control Act Amendments of
1972. Volume II. Prepared by the Library of Congress, U.S. Government
Printing Office, Washington, D.C., January, 1973, p. 1447.
4. Peterson, G. E., and Galper, H. , "Tax-exempt Financing of Private
Industry's Pollution Control Investment. " Public Policy, 1975,
forthcoming.
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TECHNICAL REPORT DATA
read Instructions on the reverse before completing)
1 . Rt PORT NO.
EPA-600/5-77-01lb
4. 1 I r L L A IN U S U U 1 I T L E
Economic Analysis of Selected Features of Municipal
Wastewater Construction Grant Legislation
7. AUTHOR(S)
Marshall Rose,
Jon Goldstein,
9. PERFORMING ORGANIZATION NAME AND ADDRESS
8. PERFORMING ORGANIZATION REPORT NO.
Ph.D.
Ph.D.
Environmental Protection Agency
Washington Environmental Research Center
Office of Research and Development
Washington, D.C. 20460
12. SPONSORING AGENCY NAME AND ADDRESS
Air, Land, and Water Use
Office of Research and Development
U.S. Environmental Protection Agency
Washington, D.C. 20460
3. RECIPIENT'S ACCESSIOONO.
5. REPORT DATE
September 1977 issuing date
6. PERFORMING ORGANIZATION CODE
10. PROGRAM ELEMENT NO.
1BAG30
11. CONTRACT/GRANT NO.
In-House
13. TYPE OF REPORT AND PERIOD COVERED
Final
14. SPONSORING AGENCY CODE
EPA/600/16
15. SUPPLEMENTARY NOTES
16. ABSTRACT
This report analyzes the current Federal Construction Grant Program for
funding the treatment of municipal wastewater. Four main elements of this
Federal program are evaluated: the grant formula, the allotment funding
process, grant-eligible reserve capacity, and industrial cost recovery.
Existing legal provisions with respect to each of these program elements are
shown to be deficient in terms of their ability to encourage an efficient
allocation of abatement resources and to promote an equitable distribution
of Federal grant funds. The report presents several options within each
program element for improving the principles of Construction Grant Legislation.
17.
KEY WORDS AND DOCUMENT ANALYSIS
DESCRIPTORS
Grant rate, Allotments, Design period,
User fees, Cost recovery, Cost sharing,
Matching grant, Economic incentives,
Subsidies, Water pollution
b.IDENTIFIERS/OPEN ENDED TERMS
Benefit cost analysis,
Design costs, Municipal
engineering, Economic
evaluations, Cost plus
incentives
c. COSATI Field/Group
05/A
Behavioral and
Social Sciences
Administration
and Management
V>. DISTRIBUTION STATEMENT
UNLIMITED
19. SECURITY CLASS {This Report)
UNCLASSIFIED
21. NO. OF PAGES
138
20. SECURITY CLASS (This page)
UNCLASSIFIED
22. PRICE
EPA Form 2220-1 (9-73)
138
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