2023 Updates to System Development Fee Law

Published for Coates' Canons on October 25, 2023.

As discussed in previous posts, the system development fee (SDF) law, G.S. Ch. 162A, Art. 8, allows a local government utility provider to assess certain costs of developing and maintaining its water and/or wastewater systems on new development that benefits from those systems. (New development is defined to include subdivision of land as well as changes to land or structures that require additional service units (aka additional capacity).) The law was enacted in 2017 with the intent to provide this limited impact fee authority for local government water and wastewater utilities. Unfortunately, the law has left local officials to wrestle with several interpretive grey areas. Almost every year since its adoption, the General Assembly has sought to flesh out and clarify various provisions. Although some ambiguity remains about the scope and application of the law, this year S.L. 2023-55 granted local government utilities some important authority related to interlocal government partnerships to manage regional service provision and growth. Specifically, it exempts reserved capacity fees charged to another local government from the definition of an SDF, and it expressly allows a local government that pays another local government for reserved water and/or wastewater capacity to pass that cost on to new development through an SDF. This post explains these changes and provides some context for understanding them.

Context for New Amendments

Increasingly, local government utilities are providing water and/or wastewater services within other local governments’ territorial boundaries. Most utilities are granted some authority to extend services extraterritorially. A municipality, for example, “may acquire, construct, establish, enlarge, improve, maintain, own, and operate any [water and/or wastewater system] outside its corporate limits, within reasonable limitations . . . .” G.S. 160A-312. Likewise, a county “may acquire, construct, establish, enlarge, improve, maintain, own, and operate outside its borders any public enterprise,” including a water and/or wastewater system. Additionally, counties and regional local government utility providers (including sanitary districts, water and sewer authorities, county water and sewer districts, metropolitan water and/or sewerage districts, joint agencies, and entities created by local act of the General Assembly) often also include one or more municipalities within their territorial boundaries. For example, a water and sewer authority’s territory might encompass all or some part of a city, as well as unincorporated areas. In providing service within another local government’s territory, a utility may partner with that local government in various ways. For example, local government utility A might collect sewage from customers but then send it to local government utility B for treatment. Or local government A could purchase bulk water from local government B that local government A then retails to its citizen/customers. Two local government utilities might share facilities or equipment. Local government utility A might agree to operate and maintain a water and/or wastewater system owned by local government B, or local government A might fund a line expansion that it then deeds to local government utility B. These are just a few ways that local governments work together related to the provision of water and wastewater services on a regional basis.

An increasingly common issue for a local government utility is capacity allocation within its current and/or potential service area, particularly when that service area spans other local governments. Access to community water and/or wastewater often is a key driver of growth in an area. In situations in which a local government does not own or otherwise control that access, it often looks to secure capacity from the water and wastewater utility provider(s). But reserving that capacity often comes at a cost to the utility provider. At a minimum there is an opportunity cost, as capacity reserved for one parcel is not available for another. And at times expected growth exceeds total service capacity of the utility, requiring either rationing of capacity or a substantial capital investment in the system, or both. To illustrate, assume that the county owns and operates a water system. It currently serves the entire county, which includes three cities. Two of the cities are experiencing exponential growth. The third city is not currently growing but is working hard to attract industrial development that will require a substantial water allocation. The county could adopt a “first come-first served” policy, whereby it simply allocates capacity as connections are made. This approach may work if the county has lots of excess capacity. However, as the county’s system approaches capacity limits, it may have to ration service. That presents challenges not just for the county but also the cities who rely on that capacity to sustain their growth or as an economic development incentive tool.

Some local government utilities have addressed this issue by executing interlocal agreements with one or more local governments in their service areas, whereby the utility agrees to reserve a certain amount of water and/or wastewater capacity for planned or expected growth in the other local government in exchange for payment of a fee by that other local government. There are different ways to calculate the fee, but the aim is to compensate the utility for the cost of building and maintaining the reserved capacity to serve the future growth.

Local government utilities have relied on two sources as legal authority for these agreements. The first is the utility’s general ratemaking statute. The general ratemaking statutes for most local government utility providers was amended in 2017 to allow fees and charges “for services furnished or to be furnished” by a local government utility. See, e.g., G.S. 160A-314 (municipalities); G.S. 153A-277 (counties); G.S. 162A-9 (water and sewer authorities); G.S. 162A-49 (metropolitan water districts); G.S. 162A-72 (metropolitan sewerage districts); G.S. 162A-85.13 (metropolitan water and sewerage districts); 162A-88 (county water districts). The second is the interlocal government agreement statute, G.S. 160A-461, which provides broad authority for local government entities to partner and perform authorized activities on behalf of each other. Together these statutes appear to authorize these types of reserved capacity agreements between local government entities. Unfortunately, though, the SDF law posed a potential legal impediment to these agreements. The definition of SDF in G.S. 162A-201(9) includes “any amortized charges, lump-sum charges, and any other fee that functions as described by this definition regardless of terminology” assessed “with respect to” new development. And G.S. 162A-203(a) specifies that any such capacity fees, except those expressly exempted, must be imposed pursuant to the SDF law itself. There was no explicit exemption for reserved capacity agreements between local governments. The SDF law, thus, likely preempted the broader authority in the general ratemaking statutes as it applied to reserved capacity charges for new development. But the SDF law did not lend itself to these types of reserved capacity agreements between local governments for future growth. That left local government utilities with no clear authority to charge other local governments for reserved capacity in this manner.

A second problem was that even if the SDF law did not preempt these reserved capacity agreements, the local government paying for the reserved capacity had no way to recoup this cost from its new development. Except for bulk water and wastewater capacity purchases pursuant to a wholesale arrangement between a water and sewer authority and anther local government, the SDF law did not allow a local government to charge an SDF if it did not own or operate a water or wastewater facility, as defined by the statute. And, as detailed above, there was no authority to charge a similar impact/capacity fee outside the SDF law.

New Amendments

The new amendments to the SDF law in S.L. 2023-55 address both these issues, granting local governments clear authority to enter into reserved capacity agreements and to pass on the costs of these agreements to new development.

First, G.S. 162A-201(9)f now exempts fees charged by a local government utility to another government entity for reserved capacity in its water and/or wastewater system from the definition of SDF. That means that a local government utility does not have to proceed under the SDF statute for this type of charge. Instead, a local government utility may rely on the combination of its general ratemaking authority and the interlocal government agreement statute cited above. And it may define this agreement and the payment structure however works best for the local governments involved.

Second, G.S. 162A-201 now expressly allows a local government that incurs costs “to purchase capacity in, or reserve capacity supplied by, capital improvements or facilities owned by another local government” to assess an SDF fee on new development (in accordance with the SDF law’s requirements) to recoup those costs. That means that even if a local government does not own, operate, or lease a water or wastewater system, it may assess an SDF on new development to recover amounts it paid to reserve capacity in another local government utility’s system(s) to serve that new development.

A local government that wishes to adopt an SDF fee to recoup these costs will follow the process mandated by the SDF law, including contracting for a professional analysis pursuant to G.S. 162A-205. Significantly, the analysis must use the combined cost methodology (to allow it to capture reserved capacity costs already incurred by the local government) and calculate a service unit rate on a gallons per day basis. (Note that because of restrictions on use of the revenue, a local government may not use the buy-in method to recoup these costs.) The local government must post this analysis for public comment for at least 45 days. Any comments must be considered for potential revisions to the analysis. The local government must then notice and hold a public hearing on the final SDF fee schedule before it is adopted. As the SDFs are collected, a local government must account for them in a capital reserve fund.

A local government may use the SDF revenue generated from the combined cost method to pay for “contractual obligations to another local government unit for capacity in such facilities owned by another local government unit.” G.S. 162A-211(a)(4). Does this mean that SDF revenues may only be used for future such contractual obligations, or may they be used to reimburse the local government for reserved capacity costs already incurred? The answer is not entirely clear based on the statutory language. (And the interpretation is complicated by the requirement that SDF proceeds be placed in a capital reserve fund associated with a specific future capital project.) But given the nature of reserved capacity agreements, which require a local government to incur the costs before new development happens, it appears the intent of the new amendments was to allow a local government to recoup these costs from the SDF payments. That interpretation is consistent with G.S. 162A-211(a1), which allows SDF revenue from the combined cost method to be expended for previously completed capital improvements for which capacity exists. Because there is some ambiguity in the statutory language, though, a local government should consult its attorney for his/her interpretation before proceeding.

Effective Date of Amendments 

The new amendments became effective June 23, 2023, and apply to reserved capacity agreements entered into before, on, or after that date. So the law effectively ratifies prior interlocal agreements requiring payment by a local government for reserved capacity in another local government’s water and/or wastewater system(s).

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Topics - Local and State Government