By James W. Scarrow

Municipalities thinking of contracting out operation of their sewage treatment plants to private companies quickly run up against two barriers.

One is a US Environmental Protection Agency, or EPA, rule that sewage treatment plants that were financed with help from federal grants cannot later be sold, leased or otherwise encumbered. The other is a set of restrictions the US tax laws impose on plants that benefited from tax-exempt bonds. Many treatment plants benefited from both forms of subsidy.

EPA Grants

EPA disbursed more than $67 billion in federal grants to local governments for the construction of wastewater treatment plants between 1972 and 1987. Starting in 1987, Congress replaced the grants program with a clean water state revolving fund program that makes low-interest loans to communities for water pollution control projects.

Each grant between 1972 and 1987 was conditioned on the local government’s agreement that it would not sell, lease, or otherwise encumber the federally-funded facility.

EPA takes the position that this means, for example, that a local government cannot hire a private operator under a contract that requires the operator to make an up-front payment to the local government, even if the arrangement purports not to encumber the facility. Thus, the operator cannot even be required to pay the local government at the start of the contract an amount equal to the estimated present value of the local government’s share of cost savings to be achieved over the life of the contract.

Any contract with a private operator that involves a payment of money by the operator to the municipality — even over time — must first receive a grant deviation from EPA. The only exception is where the private operator will reimburse the municipality for the documented costs of the transaction or will pay an amount no more than 1% of the present value of the contract to the municipality. Because of a general perception that the grant deviation process is unduly time consuming, the great majority of operator contracts for publicly-owned sewage treatment plants to date have been structured to avoid that process.

Somewhat ironically, the grant deviation process has limited the structure and, perhaps, number of private operator contracts at the same time that the federal government is seek-ing to encourage infrastructure privatization transactions.

Tax-Exempt Financing

Municipalities have traditionally been able to borrow in the tax-exempt bond market to finance public facilities. However, the municipality must be careful not to allow more than 10% “private business use” of the facilities or else the tax exemption on the bonds will be lost. Unless the municipality is careful how it writes the operator contract, hiring a private company to operate will be considered a “private business use” of the facility.

Revenue Procedure 97-13, issued by the Internal Revenue Service, describes the “safe harbor” conditions under which an operator contract for a bond-financed wastewater treatment plant will not be considered “use” of the plant by the private operator. The availability of the safe harbor depends on both the contract’s compensation structure and duration. For example, operator contracts for wastewater treatment plants can be for up to 20 years and fall within the safe harbor if at least 80% of the annual compensation is based on a fixed, periodic fee. If the operator contract is for less than five years, then at least 50% of the annual compensation must arise from fixed, periodic fees.

To qualify as a periodic, fixed fee, the compensation cannot be based on the facility’s net profit, nor can payment be directly linked to the amount of wastewater treated. However, up to 20% of the private operator’s compensation for each annual period can arise from variable payments such as performance-based incentives. These non-fixed fee incentive payments can be linked either to increases in revenues or decreases in expenses, but not both. For example, the private operator might receive a portion of any savings in electricity or chemical costs (both typically pass-through items that do not qualify as “compensation”) that are realized beyond a specified performance benchmark. Because the caps on incentive-based compensation are annual caps, an interesting open question is whether an operator contract can be structured so that any incentive payments that would otherwise exceed the cap are carried forward to the following year.

The requirement that at least 80% of compensation be based on fixed periodic payments would appear to be violated if the private operator receives additional compensation for overseeing capital expansion of the plant during the contract’s life. However, in a private letter ruling, the IRS said the safe harbor protections of Revenue Procedure 97-13 are not lost where compensation for the private operator’s construction management services are provided pursuant to a separate contract the terms of which are similar to those that would have been reached through an arms-length negotiation.

In summary, although care must be taken when structuring operator contracts for publicly-owned sewage treatment plants, a variety of structures are available to accomplish the respective objectives of the local government and private operator.

by James W. Scarrow, in Washington