The Good Side of Debt: Why Borrowing Isn’t Always a Bad Thing

By Hope Thomson, Senior Project Director, UNC Environmental Finance Center

Utilities providing water and wastewater services must find a way to finance infrastructure repair, replacement, or improvement to meet current and future needs. Often, there is a reluctance to fund these improvements through debt—much like how one might prefer to drive a clunker into the ground rather than take on an auto loan for a more reliable vehicle if funds are tight. However, the consequences of neglecting water and wastewater infrastructure challenges are far more significant than the inconvenience of a breakdown on the road. Additionally, debt financing may be the most cost-effective and equitable method of paying for infrastructure improvements for your utility.

Sound hard to believe? Let’s walk through the options for paying for infrastructure improvements.

• Grants
  • Grants are often seen as “free money,” though that’s not entirely accurate. Some grant programs require a financial match, which can be substantial or hard to secure. Additionally, applying for and administering grants can be costly in terms of personnel, time, and resources. Relying on highly competitive grants can delay infrastructure improvements for long periods.
• “Pay as you go”
  • “Pay-go” financing is a conservative approach, where a utility relies only on available funds—typically, the annual budget surplus and any cash reserves. “Pay-go” financing is suited to capital projects that can be completed within one budget cycle, such as purchasing a vehicle. Financially healthy utilities should generate sufficient revenue for emergency repairs and minor upgrades through their system.
    • How do you know if your utility is healthy? Consider looking at KPIs and reflecting on your year-to-year budget surplus. A robust plan for capital improvements alongside a sufficient capital reserve is one component of a health utility fund that should allow you to handle emergency repairs without losing sleep.
  • However, relying on “pay-go” as a long-term strategy can be problematic. Ratepayers who contribute to building reserve accounts may never see the benefit of the saved funds. If it takes multiple years to build a sufficient reserve for capital improvements, those who paid into the reserve may have moved away, passed away, or otherwise left the utility’s service area.
• “Pay as you use”
  • Debt financing is a strategy for capital-intensive projects, where the utility receives upfront funding for infrastructure upgrades and then repays the loan with interest over time. While there can be negative outcomes—such as a loan that far exceeds the useful life of the asset, resulting in a utility paying off defunct assets long after they’ve been retired—when debt financing is aligned with the asset’s life cycle, the “pay as you use” concept ensures that ratepayers benefiting from the infrastructure upgrades are the ones paying off the debt. This makes debt financing a way to address current problems with current resources.
  • Critics often point out that interest rates make projects more expensive. While the cost of interest should indeed be factored in, debt financing can offer long-term savings, particularly when low-interest rates are available, such as through State Revolving Fund programs or other subsidized loan programs.

Let’s walk through the math.

Consider an aging pump station critical to a utility’s water system. Assuming it will cost $200,000 to replace, the utility’s board votes in 2024 to start saving for it by transferring $10,000 annually to a capital reserve account earning 3% interest. The funds should be available in 16 years.

Unfortunately, after 16 years of saving and assuming a 5% annual inflation rate, the project now requires $436,000—far more than the utility has saved. During this time, the utility has also expended energy and resources on patchwork repairs to keep the station running.

By contrast, debt financing locks in the total project cost at the time of the debt agreement, including both principal and interest payments. Using the UNC EFC’s Subsidized Loan Calculator tool, you can compare a subsidized loan with a 2.5% interest rate to a market loan with a 5% interest rate. The market loan would result in annual payments of about $13,010, slightly more than the capital reserves being set aside in the “pay-go” approach. Over 16 years, $208,160 would be paid, with a total of $390,300 paid over 30 years. Though the final cost exceeds $200,000, it is still less than the $436,000 needed after a 16-year delay under the “pay-go” scenario.

For the subsidized loan, the annual payments are estimated to be $9,556 per year—less than the capital reserves set aside in the pay-go example. At the end of the 16 years, the project is not only long in the ground, but the utility has paid $152,896, and the total amount paid at the end of the 30 years is $286,680. This represents a cost savings of $103,620 nominal dollars from the market rate loan.

The savings could be even more significant for larger capital projects. Unless the utility has a substantial head start on its capital improvement fund, it’s unlikely to keep pace with inflation by relying on savings alone.

In these cases, the math matters.

Interest rates, payment schedules, and associated fees should be carefully considered. Debt must be well understood and planned for, as utilities will be obligated to make consistent loan payments, potentially limiting future borrowing. However, not considering debt as a financing tool for capital improvements would be a mistake. Utilities should use a combination of “pay-go” and “pay-use” financing to meet their system’s evolving capital needs. This strategy should be outlined in a capital improvement plan that accounts for infrastructure needs, financial capacity, and available funding sources.

Need free technical assistance? The UNC Environmental Finance Center is here to help!

The UNC EFC can assist communities in evaluating their capital infrastructure options and considering their capacity for loan payments through the state revolving funds in EPA Region 4. If you’d like to discuss the potential benefits of debt financing for your utility, please fill out our Technical Assistance Request Form or contact us at efc@sog.unc.edu.