Inflation has grown 7.5% between January 2021 and January 2022, while the federal funds rate remains at 0.25%. This disparity between interest rates and inflation means that the Fed will be forced to allow inflation to continue its rise or increase interest rates. We’ve explored inflation’s impact on municipalities in a previous blog, but high interest rates have their own hazards and solutions. Bonds allow municipalities to fund obligations without raising taxes or utility bills, but an increase in real or nominal interest rates relative to the current high inflation will make the issuance of debt expensive for all municipalities and prohibitive for small ones. For example, interest rates hit 20% in 1980 to combat 13.5% inflation.
Property taxes and utility bills are often a municipality’s only regular sources of revenue, and in a high interest rate environment, bonds may not be an affordable means of securing debt. High interest rates, meaning rates equal to or greater than the inflation rate, will make the servicing of existing debt a significant budget draw. In these circumstances, local leaders will need to get creative to leverage the current value of their assets to bolster revenue when planned or unplanned large expenditures are needed. In this article, we’ll focus on water and wastewater utility assets and how they can be used and managed to improve a municipality’s financial situation.
For small and medium sized municipalities, utility expansions and upgrades are typically funded by a combination of grants and debt. Public-private partnerships (PPPs) offer a more cost-effective alternative to bonds when interest rates are high. Such partnerships can be structured as a loan from a private firm or as equity in the utility’s revenue to be paid in exchange for a private firm’s funding of an expansion or upgrade. These arrangements require a bit more due diligence on the part of a municipality, but offer more flexibility in negotiating the most beneficial structure for funding. PPPs can allow a city or town to sell a portion of its utility or simply fund small projects. Additional benefits of PPPs also allow a municipality to bring outside expertise to the management of its water and wastewater utilities.
A municipality may see it fit to sell off an entire water or wastewater utility to a private firm. This measure may sound extreme to some, but depending on a municipality’s goals, may be a smart financial decision. For example, if a water or wastewater utility is not operating profitably and needs an expansion, liquidation will provide a hefty budget boost for spending that will draw more property taxpayers while allowing a private firm manage upgrades and expansions. Further, these expansions could draw larger housing developments or businesses whose taxes could offset the lost utility revenue.
Even if you as a local leader don’t see a situation where the sale of utilities or PPPs would benefit your community, it’s still important to consider how your operations will change in the absence of cheap debt. If you have any questions or wish to consult with municipal management experts, don’t hesitate to give us a call at 260-224-5936.