UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
ENVIRONMENTAL FINANCIAL ADVISORY BOARD
SEP 28m
Honorable Christine Todd Whitman
Administrator
U. S. Environmental Protection Agency
Washington, D.C. 20460-0001
Dear Administrator Whitman:
We are pleased to provide you the latest report of the Environmental Financial Advisory
Board (EFAB), "Arbitrage Relief Would Increase Funds Available to Meet Critical Water and
Sewer Funding Needs." Its principal author is Sonia Toledo, Managing Director, Public Finance
Department, Lehman Brothers. Ms. Toledo is chair of EFAB's Public Finance Workgroup.
Recent environmental financing studies have found that the nation faces significant and
growing water and wastewater infrastructure costs. State and local governments shoulder by far
the largest portion of this infrastructure burden. EFAB believes the federal government should
explore ways to help these governments address this funding challenge. One way would be to
remove federal restrictions to the efficient management, investment and operations of federally-
funded drinking water and wastewater infrastructure programs.
In that regard, the enclosed report examines the idea of removing Internal Revenue Code
arbitrage restrictions on the federal and state dollars used to fund the Clean Water and Drinking
Water State Revolving Funds. Arbitrage is the difference between the interest rates at which bond
proceeds are borrowed and the interest rates at which they are invested. Generally, the Internal
Revenue Code requires that arbitrage earned on the investment of tax-exempt bond proceeds be
rebated to the federal government.
Freedom from arbitrage restrictions would have a significant, positive impact on funding
for these public-purpose State Revolving Funds. Further, since federal statute controls the use of
monies held in the Funds, any arbitrage earnings could only be used for authorized environmental
purposes. From a federal budget perspective, the change would make additional funding available
immediately without a corresponding immediate budgetary impact. Of course, federal receipts of
arbitrage rebate payments from the State Revolving Funds would fall over time.
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In a broader sense, we believe that the consideration of tax and financial issues such as the
Internal Revenue Code's arbitrage rebate restrictions have long been, and continue to be, of
considerable importance to EPA and its programs. In this regard, we suggest that you consider
naming a senior Agency headquarters official with financial expertise as a permanent liaison with
the Department of the Treasury. Such an individual could meet regularly with Treasury and
Internal Revenue Service officials to communicate and represent EPA's interests across all of its
environmental programs.
We hope that you will find the report and our suggestions constructive and useful. The
Board is prepared to discuss its findings and recommendations, and to take any follow-up actions
that are consistent with its charter. If you or your staff have questions regarding the report, or
would like to arrange a meeting, please let us know. We greatly appreciate the continuing
opportunity to serve the Agency.
Sincerely,
Robert O. Lenna A. Stanley Meiburg
Chair Executive Director
Enclosure
cc: Linda Fisher, Deputy Administrator
Tracy Mehan, Assistant Administrator for Water
Michael W. S. Ryan, Deputy Chief Financial Officer
Joseph L. Dillon, Comptroller
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Environmental
Board
EFAB
Robert Lenna
Chair
A. Stanley Meiburg
Executive Director
Members
Hon. Pete Domenici
Terry Agriss
George Brewster
George Butcher
Pete Butkus
Michael Curley
Michael Deane
Michael Finnegan
Evan Henry
Anne Pendergrass Hill
Martin Kamarck
Stephen Mahfood
Langdon Marsh
John McCarthy
George Raftelis
Arthur Ray
Andrew Sawyers
James Smith
Sonia Toledo
Jim Tozzi
Billy Turner
Mary Ellen Whitworth
Joseph Young
Arbitrage Relief Would Increase Funds
Available to Meet Critical Water
and Sewer Funding Needs
FINAL REPORT
This report has not been reviewed for approval by the U.S. Environmental
Protection Agency; and hence, the views and opinions expressed in the report do not
necessarily represent those of the Agency or any other agencies in the Federal
Government.
September 2001
Printed on Recycled Paper
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UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
ENVIRONMENTAL FINANCIAL ADVISORY BOARD
Arbitrage Relief Would Increase Funds Available to Meet Critical Water
and Sewer Funding Needs
Scope of Needs
A number of recent environmental financing studies have placed water and wastewater
infrastructure costs at staggering levels B outlining the critical importance of additional
funding sources to meet these basic environmental needs. Both the Environmental
Protection Agency (EPA) and the non-profit Water Infrastructure Network studies have
identified the looming water and drinking water infrastructure funding gap at around
$23 billion annually over the next 20 years.
State and local governments shoulder by far the most significant portion of public sector
environmental infrastructure needs. For example, these governments have financed 87
per cent of water supply and wastewater capital investments since 1956. The ability of
state and local governments to continue to shoulder this burden in the face of large and
growing infrastructure funding needs will become increasingly difficult, particularly if
consideration is given to water and sewer rate affordability.
The Board believes that the federal government should explore ways to help states and
local governments bridge this funding gap. Recognizing the impediments that exist to
establishing a trust fund structure with dedicated taxes or to increasing appropriations
for environmental infrastructure, alternative approaches merit consideration. One such
alternative would be to remove restrictions attached by the Internal Revenue Code to
the management, investment and treatment of monies in existing, federally-funded state
drinking water and wastewater infrastructure programs.
Arbitrage and Arbitrage Rebate Defined
The most important Internal Revenue Code restriction in question relating to municipal
bonds involves a financial concept known as arbitrage. Arbitrage is the difference
between the interest rates at which bond proceeds are borrowed and the interest rates at
which the proceeds are invested. Positive arbitrage earnings occur when governments
borrow funds at tax-exempt rates by issuing municipal bonds and then invest the funds
received from the issues in higher earning taxable securities. Generally, the Internal
Revenue Code requires that arbitrage earned on the investment of tax-exempt bond
proceeds must be rebated or remitted to the federal government. The rebate is basically
a 100 per cent tax on investment earnings that exceed an issue=s bond yield.
Arbitrage and the State Revolving Fund Programs
The Internal Revenue Code currently imposes the arbitrage earnings restrictions on the
federal and state match dollars used to fund the Clean Water and Drinking Water State
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Revolving Funds. Freedom from the restrictions would have a meaningful and
immediate positive impact on funding for environmental projects. Since the federal
government restricts the use of monies held in these public-purpose State Revolving
Funds to the environmental uses authorized by federal statute, arbitrage earnings
derived from the Funds could only be used for federally-authorized purposes. The result
would be additional funding for environmental projects without any increase in
dedicated federal funds or appropriations.
In particular, current Internal revenue Code restrictions affect three important areas of
State Revolving Fund financial operations:
Treatment of Reserve Funds. Under current regulations, a State Revolving
Fund which provides a 33 per cent subsidy to municipalities for undertaking
environmental projects authorized under the Act would need to dedicate a $33 million
debt service reserve fund to provide $100 million in project funds to municipal entities.
The $33 million provides interest earnings which in effect serve to subsidize the loan to
67 per cent of the bond yield. Most, if not all, of these reserves are funded with federal
grants and state matching funds, not bond proceeds. If the State Revolving Fund=s
reserves were not subject to rebate, the same $33 million capital investment would yield
$103 million in project funds while keeping the same level of subsidy in place.
Advance Refundings. Because of the treatment of federal capitalization
grants and state matching funds under the Code, a State Revolving Fund may not be
able to take advantage of advance refundings like other governmental purpose issuers.
In a reserve fund model such as the one described above, a refunding would trigger a
transfer of debt service reserves to the lower-yielding refunding issue. This transfer either
eliminates or substantially reduces savings from the refinancing to the Fund and its
borrowers by forcing a reduction in reserve fund earnings to the lower yield on the
refunding bonds.
The foregone savings to State Revolving Funds and municipalities financing water and
sewer improvements across the nation are significant and affect states as varied as New
York, Connecticut, Massachusetts, Missouri, Michigan and Colorado. In this regard,
New York=s Environmental Finance Corporation which manages the state=s Clean
Water and Drinking Water Revolving Fund programs, has provided a case study report
to EPA=s Office of Water outlining in detail the extent of the limitations imposed on
advance refundings by the arbitrage provisions.
Project Funds. Similarly, under current regulations a State Revolving Fund
that leverages its capitalization grants has to limit the amount of earnings its bond-
funded loan accounts can earn to the yield on the bonds. If the Fund was able to earn as
much as it could outside of the Code=s spenddown restrictions, less bonds would need to
be issued to finance a like amount of project costs since interest earnings on project funds
would be able to meet a greater share of loan demand.
Benefits of Arbitrage Relief
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If one believes that the federal government should continue to assist states and local
governments in addressing the funding challenges associated with essential water and
sewer infrastructure investments so that water and sewer rates will remain affordable
throughout the nation, the discussed amendments to the Internal Revenue Code make
sense. From a federal budget perspective, the changes would make additional funding
available immediately, accelerating infrastructure investment. Furthermore, this new
leverage would be made available without a corresponding immediate impact on the
federal budget. Of course, the federal government=s receipt of arbitrage rebate payments
from the Clean Water and Drinking Water State Revolving Funds would fall over time.
Rebate Numbers. Some interested parties have examined the potential
impact of lifting existing federal arbitrage restrictions on the Clean Water and Drinking
Water State Revolving Fund programs. For example, the Council of Infrastructure
Financing Authorities, the national trade association that represents most of the State
Revolving Fund organizations (44 states, the District of Columbia, and the
Commonwealth of Puerto Rico), has estimated that if arbitrage restrictions were lifted
for the State Revolving Funds programs the states could earn an additional $100 - $200
million annually on their capitalization funds. The Council further estimates that these
earnings, if leveraged, would permit an additional $200 - $400 million annual
investment in badly needed water and sewer infrastructure projects.
EPA=s Office of Water (OW) has examined the impact of federal arbitrage restrictions on
its Clean Water State Revolving Fund Program. OW has used its planning model to
compare project disbursement figures by this Program under current arbitrage
restrictions to possible disbursements in the absence of arbitrage restrictions. Using
conservative assumptions, the comparison indicates that the states could generate
significant additional dollars in project disbursements over time if the Internal Revenue
Code=s arbitrage restrictions were lifted for the Clean Water State Revolving Fund
Program.
EFAB Recommendation
The Board believes that states and local governments should continue to shoulder the
principal burden of financing essential water and sewer infrastructure investments.
However, the Board also believes that some federal support will be necessary if these
governments are to continue in this role and assure that water and sewer rates remain
affordable across the nation. To help achieve these goals, the Board strongly urges that
EPA support amending the Internal Revenue Code to provide that monies contributed
to the federally-created Clean Water and Drinking Water State Revolving Funds be
freed from the arbitrage earnings restrictions. As noted earlier, any arbitrage earnings
derived from the Funds could only be used for purposes authorized by the Clean Water
and Safe Drinking Water Acts.
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UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
WASHINGTON, D.C. 20460
NOV 1 6 :T<
OFFICE OF
WATER
Mr. A. Stanley Meiburg
Executive Director
Environmental Financial Advisory Board
U.S. Environmental Protection Agency
Region IV
61 Forsyth Street, S.W.
Atlanta, Georgia 30303-3104
Dear Mr. Meiburg:
Thank you for your letter of October 5, 2001, transmitting the Environmental Financial
Advisory Board's (EFAB) latest advisory report, "Arbitrage Relief Would Increase Funds
Available to Meet Critical Water and Sewer Funding Needs " (report number EPA-EFAB-PF-01-
03). Administrator Whitman asked me to reply to your letter and provide you with comments on
the report.
As you know, the Agency has undertaken a review of future water and wastewater needs
and current infrastructure investment. The Administrator has identified infrastructure as one of
her priorities and is committed to fostering a dialogue with stakeholders over the best approaches
to maintaining critical infrastructure services.
The Board's recommendations concerning arbitrage restrictions are a timely addition to
the discussion the Agency would like to have with its stakeholders and Congress about the
appropriate roles for Federal, State, and local governments, and the private sector in addressing
the Nation's infrastructure needs. In reviewing the Board's recommendations, we agree that the
Drinking Water and Clean Water State Revolving Fund programs potentially could accrue
substantial benefits by lifting the arbitrage restrictions for drinking water and wastewater
infrastructure investment.
As you are aware, statutory and regulatory authority for the application and interpretation
of arbitrage requirements falls under the jurisdiction of the Department of Treasury. As such, we
encourage you to advise Treasury of your concerns and recommendations for changes in the
requirements applicable to water infrastructure investment. We would also like to offer to
participate with you in any of these discussions.
Recycled/Recyclable .Printed with Vegetable Oil Based Inks on 100% Recycled Paper (20% Postconsumer)
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Again, thank you for your suggestions and your commitment to working with the Agency
to find innovative financing solutions. We look forward to working with you on this matter. If
you have further questions, please feel free to contact me or call Michael B. Cook, Director,
Office of Wastewater Management, at (202) 564-0748.
}. Tractf Mehan, III
AssistantsAdministrator
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