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Innovative Financing of Highways: An Analysis of Proposals January 1998

Around the same time that the Federal Highway Administration was developing innovative financing initiatives under the Innovative Financing--Test and Evaluation Project, it was also studying various organizational structures that might facilitate debt financing. One result of those efforts was a proposal for a program of state infrastructure banks that would provide loans or other credit assistance for transportation projects. FHWA modeled the program in part after state revolving loan funds for wastewater treatment facilities.⁽¹⁾ Although such banks or funds can take many different forms, they are generally established at the state level with capitalization from federal and state funding. They lend money to municipalities or other entities for the purpose of building infrastructure.⁽²⁾

The Department of Transportation (DOT) defines a SIB as "an infrastructure investment fund established to facilitate and encourage investment in eligible transportation infrastructure projects sponsored by public and/or private entities."⁽³⁾ Thus, a SIB is a financial intermediary established by a state or group of states to help finance transportation projects. SIBs can provide financial assistance through loans and credit enhancement. Credit enhancement generally refers to some form of guarantee that strengthens the quality of the debt used to finance transportation projects. It typically includes such measures as bond insurance, loan guarantees, capital reserves, letters of credit, and lines of credit (see Box 3).
 

The State Infrastructure Bank Program

The SIB program has moved quickly from inception to implementation. The President proposed the program in his budget submission for 1996 and as part of several other bills. The Congress subsequently authorized a pilot program for SIBs as part of the National Highway System Designation Act of 1995.⁽⁴⁾ The act authorized the Secretary of Transportation to enter into agreements with up to 10 states for establishing state and multistate infrastructure banks.

The 1997 appropriation act for transportation expanded the SIB pilot program. It authorized the Secretary of Transportation to select additional states (beyond the original 10) to participate in the program. The act also appropriated the first "new money," $150 million, to capitalize the initial pilot SIBs as well as any new ones. States may also choose to contribute to a SIB by using funding authorized by the Intermodal Surface Transportation Efficiency Act of 1991.⁽⁵⁾ The $150 million appropriation is from the general fund, not the Highway Trust Fund.

The Administration has continued its support for this type of organizational structure. The President's budget for 1998 requested an additional $150 million for capitalizing the SIBs. His proposal for reauthorizing the highway program, the National Economic Crossroads Transportation Efficiency Act (NEXTEA), would continue funding for the SIB program at the same levels through 2003. The Congress did not include additional funds for SIBs in the Department of Transportation's 1998 appropriation. Instead, it left the issue for consideration in authorizing legislation.

Ground Rules

Shortly after the NHS Act was passed, the Department of Transportation issued a notice in the Federal Register soliciting proposals by states to participate in the SIB pilot program.⁽⁶⁾ DOT encouraged states to be creative in their applications; it gave them flexibility in determining the structure of the banks, the types of assistance the banks could provide, their sources of funding, and other features. However, the department laid down rules for several aspects of the program. For example, states can capitalize infrastructure banks with up to 10 percent of their federal funding from specified categories under the federal-aid highway and mass transit programs.⁽⁷⁾ But they must contribute enough of their own money to match 25 percent of the federal funding (to yield the customary federal/state arrangement of an 80/20 cost split).

DOT also established certain restrictions on the use of SIB funds. Some restrictions apply only to the initial assistance that the SIB provides. The NHS Act prohibits federal funds that are contributed to the SIB from being used as grants. Instead, at least in the first round, the SIB must use its money only for loans or credit enhancements. As loans are repaid, however, the SIB can use the proceeds to make grants, although the spirit of the program is to keep recycling the funds into more projects through the use of loans. In the initial round of assistance, funding must be used for projects that are eligible under SIB rules. In later rounds, funds that have come to the SIB from the highway account can be used for any project allowed under the overall federal-aid highway program. (The same restrictions and flexibility apply to mass transit funds and projects.)

States' Responses to the Pilot Program

Fifteen states met the March 1996 deadline for submitting applications to participate in the initial phase of the SIB pilot program. Of those, DOT selected eight in the first round: Arizona, Florida, Ohio, Oklahoma, Oregon, South Carolina, Texas, and Virginia. For the other applicants--California, Massachusetts, Michigan, Minnesota, Missouri, Tennessee, and Washington--DOT provided advice on how to revise their submissions to improve their chance of being selected for one of the two remaining slots. All of the states that were rejected in the first round resubmitted their revised applications or asked that their original submissions be reconsidered. DOT subsequently selected California and Missouri as part of the initial group.

The NHS Act authorized the Secretary of Transportation to enter into cooperative agreements with each approved SIB state specifying the terms of the SIB's funding and operation. In recent months, DOT staff have provided technical assistance to states in developing those agreements. Ohio and Oregon were the first states to sign their agreements, and DOT sent Ohio's form to the other states as a guide. By July 1997, DOT had signed cooperative agreements with all 10 pilot states.

In response to the 1997 appropriation act, which opened the SIB program to all states, DOT solicited additional applications. By December 1996, DOT had received 26 additional proposals covering 27 states and Puerto Rico. (There were two multistate proposals, and a 28th state later joined a multistate agreement.) Thus, by May 1997, a total of 38 states plus Puerto Rico had sought approval for SIBs. In June 1997, DOT announced its approval of all the proposals and allocated the $150 million of new money appropriated for 1997 among the 39 participants in the SIB program.⁽⁸⁾

The Initial Set of Applications

The initial set of applications contained proposals for a variety of projects, methods of funding, and sources of repayment. However, the projects that the states proposed in their applications are not necessarily the ones they will eventually carry out. There has already been a great deal of flux--states have dropped some projects and added others. Consequently, the descriptions that follow should be considered illustrations rather than a catalog of SIB projects.

Types of Projects. Twenty-five of the 32 projects proposed for SIB financing through 1998 are highway projects.⁽⁹⁾ Two proposals involve mass transit facilities--a van-pool leasing program in Oregon and rehabilitation of a passenger rail bridge in Cleveland. Several projects are classified as multimodal: two parking facilities, a facility for transferring freight between rail and truck modes, and an at-grade highway/rail crossing.

Most of the highway projects involve new construction, but a few involve major reconstruction. The new construction projects include bypasses, connectors, beltway segments, and interchanges. Several road-widening and realignment projects are also part of the group.

Sources of Repayment. Most of the projects that are being financed by SIBs will use dedicated tax revenues to repay loans.⁽¹⁰⁾ A few will use special assessments. Four plan to use tolls, and four will impose other fees associated with the use of the project, such as fees for parking.

Leveraging. One key matter each state has to decide is whether to leverage SIB funding. One way of doing so is to issue bonds backed by SIB capital. Issuing bonds increases the amount of funding available in the near term and is referred to as leveraging because each initial dollar of SIB funding is used to back several dollars of debt. In the absence of leveraging, only the initial amount of funding (plus any later infusions of additional aid) is available to lend. As initial loans are repaid, the repayments (including interest) become available to be lent again. A second means of leveraging SIB capital is to offer credit enhancements, such as loan guarantees, which enable the sponsors of projects to borrow money at lower interest rates.

As of September 1997, Arizona, Missouri, and Ohio had expressed interest in leveraging SIB funds by issuing bonds. The other states simply intend to make loans from their initial capital and, as the loans are repaid, to make additional loans with the repaid principal and interest. California plans to initiate a loan guarantee program under which its SIB will agree to guarantee up to 25 percent of the debt used to finance a project.
 

Evaluating State Infrastructure Banks

The principal goal of the SIB program is to speed up the availability of funds for transportation projects. SIBs accomplish that objective in part by attracting additional funds from the private sector that otherwise would have been invested elsewhere. Using those funds for transportation purposes affects the allocation and distribution of resources and has implications for the federal budget. Establishing and operating a SIB also place demands on the resources of state governments.

Financing Potential

How much additional money SIBs can make available for highway and transit projects, and how soon, depends in large part on three main factors: the amount and nature of federal aid; the way states respond, including how they structure their SIBs; and the success SIBs have in attracting private capital.

Additional Federal Aid. As previously mentioned, the Congress did not provide any additional federal aid when it established the SIB pilot program in 1995; it simply permitted states to deposit up to 10 percent of most categories of their existing federal aid into SIBs. In making appropriations for 1997, the Congress gave DOT an additional $150 million to award to SIBs. Although that sum was small in relation to total appropriations for highways (about $20 billion that year), the hope was that it would be enough to induce more states to apply to participate in the SIB program. No additional appropriation was provided for 1998. DOT expects that by the end of 1998, states will have allocated $324 million in federal aid to their SIBs to help fund $1.6 billion worth of projects.⁽¹¹⁾

Opportunities Resulting from Fewer Restrictions on Federal Aid. Using the SIB mechanism, states may be able to make money available for some types of projects sooner than would otherwise be the case because the SIB accords greater flexibility in using federal aid. After a state deposits the categorical federal aid into its SIB and provides a 25-percent match from its own sources, the categorical restrictions on the use of the money within a given mode disappear or are greatly diminished.⁽¹²⁾ As a result, a project that is so large that the state might ordinarily need several years to accumulate enough funding in its category could become affordable more immediately by drawing on SIB funding from multiple categories. In that way, SIBs can serve as intermediaries that pool federal aid from more than one category and thereby broaden the set of eligible projects. States may then be able to deploy their highway funds first on projects that have the greatest total payoffs rather than be constrained to choose the best projects within each category.

SIBs are also more flexible than traditional financing in another way. They can provide assistance for all stages of projects without restrictions on the amounts or percentages of funding that come from specific sources. However, as noted earlier, capitalization grants for the SIB require a nonfederal match of at least 25 percent.

A factor that could affect both the amount of money available for a project and its efficiency and distributional effects is the extent to which rules on federal aid govern the use of funds that are repaid after the first round of SIB lending. For example, the Davis-Bacon Act requires that the prevailing wage be paid to workers on projects built with federal aid, a rule that tends to increase costs. If that requirement was imposed only on the first round of projects financed by a SIB, the costs of later projects built with recycled funds would be lower than if Davis-Bacon had been applied to them as well. Environmental regulations imposed as conditions of federal highway aid are another such example. Whether those requirements apply to later projects has not been resolved, although the Administration's proposal for reauthorizing ISTEA would apply them to recycled funds. Other proposals, however, would loosen federal requirements.

Additional Private Capital. The potential SIBs have for raising money to finance transportation projects depends on whether states leverage SIB funds by attracting additional sources of capital. Leveraging makes more funds available immediately. By providing credit enhancements, SIBs may be able to market bonds at lower interest costs. Using SIB funds to provide backing for projects may also help to draw private equity investment to a venture, including the kind of public/private initiatives described in Chapter 5.

Yet why would a state use the SIB instead of floating a bond issue directly, as many states already do for highways and other capital projects? By using a SIB, a state may bypass its own constitutional or legislative limits on debt, especially if the debt is backed only by toll or other user fee revenues and not by taxes. (As noted earlier, such debt is known as nonrecourse debt.) Of course, a state may still be constrained by its own laws restricting the amount of debt it can carry and by conditions in the financial markets.

Recycling Loan Repayments. Even if SIBs do not leverage funds to magnify the amount of funding available initially, they can still provide additional money for transportation projects during later periods. The reason is that SIBs make loans, not grants, and the loans must be repaid. The funds that are repaid, together with the interest on them, can then be lent again to additional projects. Keeping the funds within the SIB effectively earmarks them for transportation projects and protects future projects from having to compete with other state and local government programs.

Additional Funds from Returns on Investment. If the projects that states choose to finance through SIBs are ones with large payoffs, they will generate additional economic activity and wealth even beyond the amount needed to repay the loans. At least some of that activity is likely to result in additional revenues from fuel taxes and other user taxes and fees that traditionally have been earmarked for transportation. Increased economic activity will also generate additional revenues for states and localities from income, sales, and property taxes. Those revenues may not directly finance additional work on roads, but by helping provide for other public needs, they can reduce pressures on government budgets that restrict the total amount of funds available for transportation.

Keeping the SIB Capitalized. To continue operating, a SIB must maintain its capitalized value. Subsidizing projects by making loans at below-market interest rates can jeopardize a SIB's viability because repayments may be insufficient to maintain that value. Defaults could further reduce the SIB's value, as might inflation, which can erode the purchasing power of SIB funds. If the SIB's capitalized value shrinks, it will need an infusion of additional capital at some point to continue its operations.

Regardless of whether loans from SIBs are funded only by capital provided by the federal and state governments or also by borrowed capital, they must be repaid. Typically, funds for repayment will come from tolls or other user fees or taxes. Using those sources of revenue to repay loans has implications both for efficiency and for the way the costs of this kind of mechanism are distributed among taxpayers and users. In addition, the choice of repayment source could affect the federal budget.

Efficiency

To the extent that the SIB mechanism allows states to blend funds from several categories of federal aid, it lessens some constraints on states' choice of projects. Moreover, it enables them to choose projects with the highest economic returns overall and not just the highest returns within each category of federal aid. The ability to move beyond categories to focus on the "big picture" can increase efficiency in investment.

Whether resources are allocated efficiently depends largely on how loans from the SIBs will be repaid. Several SIB projects that states have proposed will repay loans with tolls and other user fees, a strategy with two beneficial economic effects. First, using tolls and fees for repayment reinforces the need to select projects for which benefits--and user-fee revenues--exceed costs.⁽¹³⁾ It also provides incentives to make those investments the "right size" and to keep costs in check. Under such a repayment plan, gold-plated investments and investments that are too large for the expected demand (features that have characterized some public works in the past) would be discouraged.

Second, repaying loans with tolls and other user fees can provide incentives for efficiency in the use of a road project if tolls and fees are set in a way that reflects the cost of use. For example, tolls that are higher at peak periods encourage those motorists who can to shift their use to less congested roads or times, reducing traffic at rush hour on congested tollways. In addition, the revenues raised from relatively high tolls at peak hours can help fund projects that increase highway capacity. Alternatively, they can support projects to improve mass transit facilities and equipment.

As Chapter 2 notes, user-fee financing may or may not produce an efficient allocation of resources. To achieve allocative efficiency, the price paid by the user must reflect the marginal social cost of the resources associated with that use. User fees that are set with recovering costs or maximizing revenues as their primary objective may not provide incentives for the most efficient use of the resources.

In the early responses to DOT's call for applications for the SIB program, 14 proposals listed tolls as a source of loan repayment (although some proposals combined revenues from tolls and from dedicated taxes). By February 1997, only four projects cited tolls as a principal means of repayment. Many more were relying on state and local taxes on transportation and on fees that were not directly related to the use of the specific project that they were helping to fund. Using repayment sources that are not directly related to the project's use diminishes the prospects for increased efficiency resulting from user charges. But the goal of efficiency may have to give way in order to get the project built. Dedicated tax revenues may be needed to attract private investment in facilities that are desirable to build because they pass a benefit-cost test. SIBs can help reduce the cost of debt if they signal to private investors that a project is especially creditworthy or if they provide enough backing to enhance the quality of the debt.

Some of the projects mentioned in SIB proposals submitted by the states are projects to be done at the state level; most, however, are projects sponsored by municipalities, authorities, or other agencies created by state governments. Those substate entities may find it difficult to borrow money for projects even if the work has a reasonable prospect of yielding competitive returns. In contrast, states generally have experience with bond issues, together with the necessary apparatus (staff, legal and financial advisors, legal authority, and so forth). Furthermore, states are known entities to credit-rating agencies and bond buyers.

Municipalities and other substate government bodies may be less experienced and little known in the bond world, especially if they are relatively small and have not engaged in much debt financing. Such entities may have difficulty floating a bond issue, even if their finances are strong, because potential bond buyers may know little about them and consider them too much of a risk.⁽¹⁴⁾ By making loans or offering credit enhancement to lesser-known entities, SIBs may overcome those obstacles.⁽¹⁵⁾ A state infrastructure bank with expertise in transportation projects might be willing to overlook such problems to lend to a project with a strong potential for return. In that way, a SIB could promote efficiency in investment.

In addition, by aggregating the financing of several projects into one bond issue, SIBs can reduce costs associated with issuing bonds, such as hiring legal and financial counsel and obtaining a credit rating.

For municipalities (or authorities or states) that have excellent credit ratings, using the SIB to float a bond issue may not be the wisest approach. Those entities might do better to borrow on their own instead of through an institution in which they are pooled with higher-risk borrowers. Depending on the structure of the debt (in particular, whether debt repayments can be used to cover obligations of other members of the pool), stronger borrowers might get lower interest rates by "going it alone" than by pooling with "weaker links."

Over time, if SIBs prove successful in helping finance projects at the substate level, they might encourage more such projects. The same reasoning that underlies the federal-aid highway program--that states know their specific highway needs better than the federal government--may apply at a lower level as well. That is, local communities may know their needs better than the state government. Consequently, a mechanism such as the SIB, which would provide a form of state assistance to local projects and shift more decision-making to lower levels of government, might yield more efficient investments in infrastructure than financing mechanisms at higher levels of government.

Distributional Effects

Debt financing by SIBs has two types of distributional effects that differ from the effects of traditional financing based on user taxes and fees. First, it shifts the burden of financing from current payers of user taxes to future users and other beneficiaries of the projects it funds. Depending on the source of revenues dedicated to repayment, the debt financing that SIBs provide may also shift the burden to future taxpayers in general. Second, tax-exempt debt shifts some of the burden from taxpayers at the state and local levels to those at the federal level.

SIB financing may have other distributional effects as well. For example, as mentioned earlier, federal requirements may not govern projects that states or other entities build with recycled SIB funds. Thus, if the rules of the Davis-Bacon Act regarding prevailing wages were deemed not to apply, workers might receive lower wages (unless labor markets were tight). But taxpayers and users of roads would gain from lower project costs.

Administrative Feasibility

Participation in the SIB program is voluntary. States that want to form SIBs and capitalize them with federal aid may apply to the Department of Transportation for permission. Some states found SIBs attractive even before the Congress appropriated additional funds for them in 1997. Others waited until the Congress had provided that money to submit their applications. Whether the added funds were the primary motivation or whether states just came to the conclusion that the SIB mechanism could be useful to them is not clear, although some state officials have suggested that the $150 million was an influential factor.

The 15 states that initially applied for the pilot program indicated that they thought SIBs were a feasible approach to highway financing. The second group of 26 applications by 28 states and Puerto Rico provided further evidence. DOT permitted flexibility in the organizational structure: a state could form a SIB within its highway or transportation department, in a budget or finance department, or in whatever organizational format it chose. The NHS Act allowed states to use up to 2 percent of federal capitalization grants to cover the costs of administering SIBs. All of those factors probably encouraged more states to participate.

Some states may need legislation to be able to put a SIB in place, especially if the bank is given authority to issue bonds or make loans for private ventures.⁽¹⁶⁾ However, most states have experience to draw on in authorizing and establishing such an entity because most states have state revolving funds (SRFs) for wastewater treatment, after which SIBs are partially patterned. The NHS Act prohibits commingling of highway and mass transit funds with other funds. As a result, SIBs probably could not be combined with SRFs unless mechanisms were established to keep separate accounts for each program.

Implications for the Federal Budget

The only direct effect of the SIB program on the federal budget thus far is the $150 million in appropriations for 1997. The 1998 appropriation legislation did not include additional funds for SIBs.

In authorizing the SIB program, the Congress directed that disbursements to capitalize the banks be at a rate consistent with historical levels for the federal-aid highway program. Funding the SIBs in that manner assumes disbursements of 15 percent in the first year, 53 percent in the second, 16 percent in the third, and the remaining 16 percent spread out over the fourth through ninth years. The Federal Highway Administration has advised the states that they must delay actual cash deposits to their SIBs to conform to those disbursement rates. The Administration's proposal for reauthorization of ISTEA would alter the disbursement rate so that SIBs would receive 20 percent of the funds each year for five years.
 

The Outlook for State Infrastructure Banks

SIBs are a relatively new mechanism for funding transportation projects, and it remains to be seen whether they will fulfill their intended purpose. The next few years will determine how well the SIB structure works or whether alternative mechanisms might be of greater value.

Highway projects dominate the set of initial proposals for SIB funding. That circumstance could reflect one or more factors: a bias toward highways on the part of state transportation officials, a judgment that highways are a more pressing need than transit ventures, an absence of suitable mass transit projects, or an inability to identify sources of repayment of loans for transit projects. Identifying and reprogramming funds with which to capitalize transit accounts are another problem. The requirement contained in the NHS Act that states keep separate accounts for highways and mass transit may present an institutional obstacle in that regard.

If all states deposited 10 percent of their eligible funding for highways into SIBs, the total would be about $2 billion a year. In a survey of 15 states, the General Accounting Office found that SIBs would probably be funding less than 10 percent of the transportation projects in those states over the next five years.⁽¹⁷⁾ Apparently, states are being cautious about SIBs, but if initial experiences are successful, they will be receptive to greater use of the mechanism.

Without restructuring of the entire federal-aid program, SIBs are unlikely to become a major source of highway financing in the next few years. Indeed, the General Accounting Office cited an FHWA official who said that only a small number of projects could generate enough revenue to repay loans made by SIBs.⁽¹⁸⁾ Nevertheless, SIBs may enable certain types of projects--especially those for which tolls and other user fees are the source of debt repayment--to go forward sooner than they could under traditional financing.

1. The program of federal assistance to states for construction of wastewater treatment plants was authorized in the Clean Water Act. The Water Quality Act of 1987 established the program in which the federal government provides grants to capitalize state revolving funds. The funds are designed to lend money to communities to build facilities to treat wastewater according to the requirements of the act.

2. This study uses the terms "bank" and "revolving fund" interchangeably, although some academics prefer to use "revolving fund" when the repayments of debt are lent out again and "bank" when the proceeds are used simply to retire debt. The "revolving fund" terminology is more common for entities that finance wastewater treatment facilities, following the terminology in the Clean Water Act that provided for them. "State infrastructure bank" is the term more commonly employed for transportation, following its use in the National Highway System Designation Act of 1995.

3. Department of Transportation, "Participation in the State Infrastructure Bank Pilot Program," Federal Register, vol. 60, no. 249 (December 28, 1995), p. 67159.

4. Section 350, 109 Stat. 618-622.

5. States may contribute up to 10 percent of funds they receive for most categories of federal aid.

6. Department of Transportation, "Participation in the State Infrastructure Bank Pilot Program," pp. 67159-67160.

7. Under the SIB pilot program, states may deposit up to 10 percent of their 1996 and 1997 apportionments and allocations for most program categories of federal highway funds. The categories of highway funds eligible for use in SIB capitalization are National Highway System, surface transportation program, Interstate maintenance, bridge replacement and rehabilitation, minimum allocation, Interstate reimbursement, hold harmless, 90 percent payment adjustments, and donor state bonus (see Table 2 in Chapter 2).

8. Department of Transportation, "29 Additional States Are Approved to Participate in State Infrastructure Bank (SIB) Pilot Program" (press release, DOT 93-97, June 19, 1997). Four of the 38 states received only conditional approval from DOT until they had passed legislation allowing them to establish a SIB. The 1997 appropriation act directed DOT to refrain from distributing the $150 million before April 1997, 180 days after the legislation was enacted. The Congress gave the Secretary of Transportation the authority to decide how to distribute the funds among the SIBs.

9. Department of Transportation, Evaluation of the U.S. Department of Transportation State Infrastructure Bank Pilot Program: Status as of February 28, 1997 (June 1997). As of June 1997, two states were still evaluating candidate projects.

10. Ibid.

11. Ibid., p. 13. DOT estimates that by the end of 1997, states will have allocated $260 million in federal aid to their SIBs to help fund $940 million worth of projects.

12. According to DOT, highway and mass transit funds must be kept separate for their initial use, but repaid funds can be blended subject to state laws. See Federal Highway Administration, "SIB Update," October 1996 (available at http://www.fhwa.dot.gov/innovativefinance/).

13. In general, a government should not undertake a project unless benefits exceed costs. But in the case of highways, recouping all the benefits in the form of user fees may be difficult. The existence of external benefits is one reason roads in the United States have been publicly provided and have not been required to cover costs with user fees.

14. Municipalities with poor underlying economic conditions or with a history of default may find borrowing virtually impossible. Their inability to find lenders is not a failure of the market but rather a market signal that lending under those conditions is a high-risk proposition.

15. Some states already make use of credit pooling. See Congressional Budget Office, An Analysis of the Report of the Commission to Promote Investment in America's Infrastructure, CBO Paper (February 1994), pp. 28-29.

16. General Accounting Office, State Infrastructure Banks: A Mechanism to Expand Federal Transportation Financing, GAO/RCED-97-9 (October 1996), p. 18.

17. Ibid., p. 2.

18. Ibid., p. 16.

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