Fundamentals of Infrastructure Capital Finance
This section reviews some basic elements of infrastructure finance and common terminology used by practitioners.
Equity-conscious capital investment and equitable development plans can foster workforce development and business mobilization programs, support affordable housing, build community resources such as health clinics and gathering spaces, and create vital transportation links to jobs and schools.
Definition and Examples of Capital Projects
Capital projects are generally defined as tangible assets or physical improvements to assets that are expected to provide a long-term benefit. Most cities also impose a dollar threshold on capital assets (e.g., the City of Pittsburgh requires capital projects to involve at least a $50,000 investment).
A city’s capital asset portfolio can include a variety of projects, such as streets, transit vehicles, tracks, and tunnels, city offices, wastewater treatment plants, drinking water plants, electric utility infrastructure, street lights, bike paths, city vehicle fleets, and fire and police stations.
Because capital projects involve a greater commitment of funds and staff time, most cities have adopted capital planning processes that allow them to prioritize funding for projects and make long-term plans to deliver them. City capital plans usually include planned spending on infrastructure projects for at least five years, and sometimes for longer periods.
Distinction Between “Funding,” “Financing” and “Revenue”
In this guide, the term “financing” refers to debt, or borrowing in anticipation of future revenue. While news reports often conflate the terms funding and financing, financing always involves some form of repayment with interest.
Energy Savings Agreements
While energy efficiency is pretty straightforward to calculate, infrastructure projects generate other cost savings as well that might be monetized in the future.
Funding refers to the mix of borrowed funds (bond or loan proceeds) and any funds that the government has on hand to pay for the construction of the project. Revenue refers to the future source of repayment for any financing on the project, and for future operations and maintenance (O&M). Financing refers to any borrowing that occurs on the project. When these terms are used interchangeably, it can add to the public confusion surrounding financing and project delivery tools, and the need for stable revenue sources to repay them.
Suppose an agency wanted to construct a new courthouse at a cost of $60 million. It would need $60 million in funding, which it might be able to obtain from the proceeds of a bond issuance ($50 million) and $10 million in appropriations from the city council. The bond could be repaid by future property tax revenue. The courthouse would be funded by bond proceeds and appropriations, financed with a bond that could be repaid with future property tax revenue.
Some tools may enable a city to lower its interest rate on a borrowing, or simply increase the amount it could borrow. While financial tools can’t create revenue, they can unlock the ability to tap into new sources of revenue, or mitigate the risk associated with entering into a new type of project delivery model (such as pay-for-success). In order to find the appropriate financial tool(s) for a project, a city has to determine what outcomes the financial tool needs to accomplish.
While it’s important to understand that financing can’t CREATE revenue, in some cases, flexible long-term financing can enable governments to tap into new sources of revenue that might not otherwise be possible to borrow against, or mitigate the risks of entering into a new business model.
Examples of Funding, Financing, and Revenue Sources In Infrastructure Projects.
The Role of Rating Agencies
Credit rating agencies such as Fitch, Moody’s, or Standard & Poor’s provide investors information about the likelihood of repayment on bonds and other government obligations. These ratings have direct impacts on the interest rates that investors will demand from cities attempting to borrow from the capital markets. The agencies analyze on an individual transaction basis, but also provide an overall credit rating to municipalities that reflects the general state of their fiscal health and ability to meet obligations.
Rating implications affect what kinds of financial and delivery transactions a city will consider. Most cities are reluctant to risk a downgrade under any circumstances, since for each step down on the rating scale a city will pay higher interest on every obligation. A city may choose to engage with a particular financial tool or delivery strategy because it may not count against debt limits, or require the same levels of approval to enact. Rating agencies will largely look beyond the legal structure and consider the city’s future payment obligations in rating models, even when a structure is not legally considered city debt.
Advantages of Financing Vs. “Pay as You Go” Approaches
If financing involves interest and issuance costs, why should governments borrow? The first and most basic reason is that most capital projects follow a similar expenditure pattern: there is a large up-front expenditure during construction, then typically much smaller expenditures during the period of operation, until the asset needs to be rehabilitated or rebuilt. Financing can solve the mismatch between current spending needs and revenues that only come in over a longer term. The alternative to financing (termed “pay-as-you-go”) can only work for the limited number of projects for which a city has available funding in a given year.
Spreading Out Costs of an Asset Over its Useful Life
Long-term financing spreads out the cost of an asset over the life of the asset, smoothing out the very “lumpy” expenditures into a more affordable annual cost. In this way, infrastructure finance resembles consumer mortgages, which enable homeowners to purchase houses that would be unaffordable on a single year’s salary. Conversely, a basic financing principle is that the debt service for an asset should not exceed its useful life—it doesn’t make sense to continue paying for an asset that’s no longer in service, or to enter into long-term debt for a short-term asset.
Allocating Costs to Current and Future Users
Infrastructure assets often have very long asset lives (some up to 75 or 100 years). By spreading out the cost over more of this period, financing also spreads out the cost of the asset over all the users that will be using it—current and future. For example, a bridge that is constructed today might last 75 years. Issuing a 30-year bond ensures that some of the taxpayers who will be using that bridge will be paying for it in the future.
Accelerating Project Construction (and Associated Benefits)
Financing can enable critical assets to be constructed earlier. By facilitating quicker construction, financing may preserve the ability to construct an asset, when land or facilities may not always stay available to an agency. While financing does involve interest and issuance cost, if it enables earlier construction it can help agencies avoid cost increases due to inflation. It can also help agencies deliver critical benefits sooner—whether it’s clean water, flood control, congestion relief, or transit service.