Rebuilding California’s Infrastructure (Introduction)

Part 1 of 6 Part Series

Ed Ring, Jill Eicher, Kevin Dayton and Marc Joffe

This is Part One of “Rebuilding California’s Infrastructure,” to access the other five sections, click on the links below. To access the entire six-part study in a single, printable PDF document, DOWNLOAD HERE.

Part One: Introduction
Part Two: Water Reuse
Part Three: Water Storage
Part Four: Desalination
Part Five: Energy and Transportation
Part Six: Financing Models and Policy Recommendations

EXECUTIVE SUMMARY

California’s water, energy and transportation infrastructure has not been adequately maintained. The state’s water infrastructure has not been expanded since the 1970’s and is designed to accommodate 20 million residents when California now has nearly 40 million residents. Its transportation infrastructure is considered one of the worst maintained in the U.S. Its energy infrastructure is increasingly oriented towards renewables, without a clear plan to realize the distribution and storage upgrades necessary to realize this dramatic shift.

Current policies in California embrace water and energy conservation and mass transit to balance demand with supply. While we don’t oppose conservation per se, we believe that current and future Californians deserve abundant and affordable water, power and mobility. Current state policies that enforce scarcity are ultimately inconsistent with a prosperous and growing California.

This study investigates California’s infrastructure challenges, focusing on projects to increase the supply of water, but also surveying opportunities in energy and transportation. We find that many infrastructure projects can yield viable returns to investors. With respect to water supply, the study finds cost effective solutions in the areas of storm runoff storage in aquifers and reservoirs, as well as in sewage treatment and reuse. The study finds desalination to also be a financially viable alternative, particularly as a way to ensure diverse and resilient sources of water to California’s large coastal urban centers.

As an alternative to funding new infrastructure through municipal bonds, we suggest the possibility of securing investments from California’s state and local public employee pension funds. Over 90 independent pension systems, led by CalPERS and CalSTRS, in aggregate have nearly $800 billion in assets under management. Deploying a significant percentage of these assets to fund revenue producing civil infrastructure could deliver to these pension funds safe and reasonable returns. These returns are comparable to the target earnings of the pension systems, while offering reliability during an era of uncertain stock market performance.

Encouraging pension investment in civil infrastructure not only serves the twin goals of rebuilding California’s water, energy and transportation assets and providing safe and lucrative investment opportunities for pension funds. It will create hundreds of thousands of good construction jobs along with tens of thousands of jobs operating these new facilities, enriching California’s economy. And having these new assets will greatly improve California’s quality of life, attracting new residents and businesses.

With respect to infrastructure, the conventional wisdom in California politics today is austerity – resource conservation and minimal financial wherewithal. Our study proposes an exciting alternative that embraces prosperity and abundance.

CONTENTS

Section One: Introduction – Why Now?, Objectives of this Study

Section Two: Water Reuse – Current Capacity, Costs to Build Water Reuse Capacity, Revenue Potential, Return on Investment

Section Three: Water Storage – Current Capacity, Proposed projects to expand surface water storage capacity, Developing groundwater storage capacity, Costs to Acquire Water Storage Capacity, Revenue Potential, Return On Investment

Section Four: Desalination – Introduction, The Carlsbad Desalination Plant, What’s Innovative about the Carlsbad Desalination Plant?, Cost for Customers of Water Produced by Carlsbad Desalination Plant, Financing and Plant Economics, Obstacles – Cost and Financial Risk, Other Seawater Desalination Plants in California, Controversy over the Huntington Beach Plant, Responding to the Cost-Based Arguments against Desalination, Brackish Groundwater and Surface Water Desalination, Desalination Elsewhere in the United States, International Cases, Desalination in Israel and its Relevance to California, Other Countries, Conclusion

Section Five: Energy and Transportation – Energy, Natural Gas Pipelines, Freight Rail, Oil Trains vs. Pipelines, Passenger Rail, High Speed Rail, High Occupancy Toll Lanes, Conclusion

Section Six: Financing Models and Policy Recommendations – Policy Recommendations: California, Policy Recommendations: Federal, Conclusion

INTRODUCTION

California’s civil infrastructure was once the envy of the nation. During the 1950’s and 1960’s the state wisely invested in transportation, water and power infrastructure, delivering capacity well in excess of the needs of the state’s population at the time. Even today, the scale of California’s network of aqueducts and pumping stations to transfer water from north to south, east to west, is one of the largest in the world, and California’s vast network of freeways has few rivals.

Policymakers of that era had planned to continue to expand these infrastructure assets to accommodate a growing population, but that all came to a halt in the 1970’s.[1] During the 1970’s not only were the plans for additional water storage and distribution assets abandoned, but state-owned rights-of-way and land acquisitions both for water and transportation were sold to private interests. As a result, California now has a population of 40 million people living in a state with civil infrastructure designed to accommodate 20 million people.[2]

California’s political leadership has avoided new investment in civil infrastructure by zoning ultra-high density infill in urban areas, transit villages, and light rail, by mandating energy efficiency and incentivizing decentralized renewable energy sources such as rooftop photovoltaics, and by mandating water conservation and incentivizing retrofits such as low-flow faucets and toilets. In effect, the new political alternative to infrastructure development is conservation.

The deliberate imposition of scarcity on Californians has artificially elevated the cost-of-living. Restrictions on land development, elevated prices for water and electricity, and monstrous commutes on congested freeways[3] take an inordinate toll on wallets and productivity. What’s more, it is not clear that these restrictions have been beneficial.

For example, restrictions on urban water reuse don’t have a significant impact on water availability – at a macro level. In a dry year, around 150 million acre feet (MAF) fall onto California’s watersheds in the form of rain or snow; in a wet year, we get almost twice that much.[4] Most of that precipitation either evaporates, percolates, or eventually runs into the ocean. In terms of net water withdrawals, each year around 31 MAF are diverted for the environment, such as to guarantee fresh water inflow into the delta, 27 MAF are diverted for agriculture, and 6.6 MAF are diverted for urban use. [5] Of the 6.6 MAF that is diverted for urban use, 3.7 MAF is used by residential customers, and the rest is used by industrial, commercial and government customers.[6] Put another way, 65 million acre feet of water is diverted each year in California for environmental, agricultural and urban uses, and a 25% reduction in water usage by residential customers will save exactly 0.9 million acre feet – 1.4% of our total statewide water diversions.

Figure 1: California Water Budget in a Dry Year (amounts in AF)
20161123-cpc-infrastructure-f1

Consumption of electricity is an area where considerable progress has been made towards conservation over the past few decades. But this progress, while impressive, puts an economic burden on low income families, small businesses, and energy-intensive large businesses. And the ambitious goals set forth in the Scoping Plan issued pursuant to the Global Warming Solutions Act of 2006 (Assembly Bill 32, commonly referred to as AB 32) cannot be achieved without imposing even greater economic burdens on Californians.

Conservation has been a convenient policy initiative in the face of shrinking budgets and reduced funding. It has given license to defer maintenance on existing infrastructure assets which has both eroded service delivery and shortened assets’ useful lives.  Neglected bridges on major freeways suddenly collapse in flash floods, roads plagued with potholes cause accidents and make commutes longer, aging water mains burst. To reverse this course will require over $700 billion.[7]

Conservation in lieu of investment has also resulted in decades of under-investment in new infrastructure assets to improve services and provide resiliency to weather droughts, to ride out market-price spikes, and to accommodate a growing population.  This approach has prevented California from benefitting from supply-producing infrastructure innovations in water reuse and energy generation, as well as service improvements via transportation modernization.

The premise of this study is that massive new investment in California’s infrastructure in the areas of water, energy, and transportation will lay the foundation for a prosperous 21st century in the Golden State. It goes beyond the scope of this study to offer a detailed critique of the many policies aimed at promoting conservation. Rather the purpose of this study is to offer balance to the discussion by surveying an assortment of civil infrastructure projects that would increase supply and improve services. While this challenges the conventional political wisdom, it is nonetheless consistent with the spirit of innovation that has made California great and continues to define its culture. We believe that designing policies to create abundance instead of scarcity is an idea whose time has come.

WHY NOW?

There is a convergence today of several trends that justify massive investment in new and upgraded civil infrastructure. California’s infrastructure assets have increasingly become liabilities to cash-strapped municipalities, with a significant percentage of them unable to supply goods and services to satisfy demand due to deferred maintenance and obsolescence. At the state level, the cost of repairing and replacing these assets is a long-term liability that could ultimately impact the California’s credit rating.[8]  At the same time, an ever-growing pool of institutional investment capital is seeking to invest in infrastructure assets that can generate returns and income no longer reliably available from stocks and bonds.[9] This presents an opportunity for California to capitalize on investor interest by creating policies and programs to encourage the creation of infrastructure that will provide more goods and services and that, collectively, will strengthen and sustain the state’s economy.

The scope of California’s deferred maintenance problem is quantified in the Governor’s 2016 Five-Year Infrastructure Plan for California. The report attributes 90% of the state government’s $77 billion in deferred maintenance costs to transportation and water infrastructure assets.[10] The Governor’s plan to address the $57 billion in deferred maintenance on roads, for example, calls for spending a one-time $1.7 billion on road fixes and improvements and an additional $36 billion over ten years. This approach, however, continues to fall far short of what’s needed to protect and improve the operation of Californian infrastructure assets and to meet the demands of its citizens.

While public finance officials grapple with the consequences of deferred maintenance and underinvestment, institutional investors struggle to adapt to lower return expectations for both the equity and fixed income markets.

A recent McKinsey report suggests that annual returns on US equities will fall from 7.9% to somewhere in the range of 4.0% to 6.5%, while US bond returns will fall from 5.0% to between 0.0% and 2.0%.[11] These less generous return expectations, borne of today’s low interest rates and limited GFP growth, is causing investment managers to consider alternatives to traditional equity and fixed income holdings. One such alternative investment is the universe of core infrastructure assets, particularly those assets with strong operating histories and contracted, inflation-linked cash flows, which could replace income traditionally generated by fixed income investments.

Long-term institutional investors are eager to deploy capital into US infrastructure yet struggle to do so because investment opportunities are limited and highly competitive. The recent auction of the Indiana Toll Road demonstrates the value of high-quality infrastructure assets to institutional investors. In 2015, a consortium of pension funds purchased the remaining 66 years of a lease on the Indiana Toll Road for $5.725 billion; this price was well above the $3.85 billion paid by the original investment group in 2006, and came despite the fact that this original concessionaire declared bankruptcy.[12]

The lack of infrastructure opportunities for US institutional investors is attributable to the fact that most infrastructure assets and systems are owned by government and operated as monopolies. It is very difficult for private-sector businesses to compete with government monopolies delivering subsidized goods, especially those protected by legislation from market forces that promote efficiency and competition. This restricts the investable universe for institutional investors.

By and large, California has ready and abundant access to tax-exempt financing through the municipal bond market. It does not make sense then for public agencies to pay institutional investors more for their capital than they pay in the municipal bond market—currently about 4 percent.

But while capital at 4 percent appears cheap, borrowing costs are only the starting point in public infrastructure projects. Other costs, such as operations and maintenance, ought to be considered—and too frequently are not—when undertaking projects that might stretch out over 30 years. Governments and taxpayers would potentially get far more value from institutional investors willing and able to finance total lifecycle costs than they do from a simple bond issuance.

In competing for opportunities to invest, institutional investors will need to differentiate themselves and demonstrate that they can add value beyond what is available in the municipal market. This may include providing: 1) the ability to provide a ready source of patient equity capital that is more interested in long-term dividends than up-front fees for advisory and/or construction services, 2) expedited contracting procurement for projects with time-sensitive and/or complex delivery requirements, 3) domain expertise and management resources, and, 4) a way to monetize non-essential assets without ceding public ownership.

For these reasons, encouraging institutional investment in California’s infrastructure now—when public agencies and institutional investors needs and interests are advantageously aligned—potentially provides a way to rebuild the backbone of the state’s economy.

OBJECTIVES OF THIS STUDY

This study aspires to identify opportunities for investment in civil infrastructure that have the potential to increase supply and improve services to Californians. We survey infrastructure with revenue-generating capacity that can repay taxpayers and investors in key project areas that we believe urgently require investment.

We begin with in-depth examinations of three opportunities for water infrastructure investment:

Water Supply Reuse:  Upgrade sewage treatment plants to produce potable water. California’s sewage treatment plants currently produce approximately 5 million acre feet of waste water per year. Less than 20% of this water is currently treated sufficiently to be reinjected into aquifers for reuse as potable water. Reusing sewage could replace up to 50% of California’s total urban water consumption.

Reservoirs:  Build reservoirs for runoff capture. The Sites reservoir proposal is a good example of a project with excellent return on investment potential that cannot get built primarily due to objections from environmentalists. As a project that diverts runoff, however, it is not nearly as objectionable as high dams. This section will survey what both of these types of water storage options cost, taking into account current best practices to minimize environmental impact.  This section will include an analysis of the parallel value of reservoirs as a means to store and distribute intermittent renewable energy.

Desalination:  Build desalination plants along the California coast. California currently has one major desalination plant operating, in Carlsbad, producing (by world standards) a relatively meagre 50,000 acre feet per year. Meanwhile, desalination technology and economies of scale elsewhere in the world prove that desalination is cost effective. Taking into account the cost to pump water through California’s extensive system of inter-basin aqueducts, desalination in Southern California is even an energy-neutral proposition.

For each of the above cases we will survey the most likely possible projects, many of them already proposed. We will discuss the costs to build them, their capacity, and the impact they will have in the context of total existing capacity. We will report on their estimated potential revenues, operating costs, and potential return on investment. Where possible, for comparison, we will also report on the cost, capacity, and returns for similar projects elsewhere in the developed world.

We also provide a survey of successful financing models and policy initiatives used in other countries to increase private investment in civil infrastructure. We will analyze these models and incentives to understand the benefits of their approach in contrast to the American method of investing on a transactional basis in a bond offering.

After addressing water infrastructure in depth, we survey energy and transportation investment opportunities at a higher level. We find evidence that new investments in solar/natural gas hybrid power generation, commuter rail and High Occupancy Toll (HOT) lanes would provide benefits in excess of cost.

We acknowledge that there are significant political challenges to investing in California’s infrastructure on a major scale including uncertainty about the state’s expiring public-private partnership legislation, balance in environmental reviews, debt capacity, and the utility of cost-for-services legislation. We have tried to factor these challenges into both our investment and policy recommendations.

The study will conclude with proposed policy recommendations aimed at improving the quality of life in California and strengthening its economy.

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FOOTNOTES

[1] Carson Bruno (April 13, 2016). California’s Crumbling Condition – The Past, Present, and Future of Infrastructure in California. Hoover Institution.

[2] The state’s population was 20 million in 1970. For more on the stoppage of infrastructure development at that time, see Victor Davis Hanson (Winter 2015). The Scorching of California, City Journal.

[3] According to 2015 Census data, 24% of Los Angeles County commuters took 45 minutes or more to get to work.

[4] Elizabeth A. Stanton and Ellen Fitzgerald (February 2011). California Water Supply and Demand: Technical Report. Stockholm Environment Institute.

[5] Ellen Hanak, et. al. (2011). Managing California’s Water: From Conflict to Reconciliation. Public Policy Institute of California. Table 2.2, Page 86.

[6] Author’s analysis of California Department of Water Resources (April 23, 2014). 2010 Urban Water Management Plan Data: DOST Tables 3, 4, 5, 6, 7a, 7b, & 7c: Water Deliveries – Actual and Projected, 2005-2035.

[7] John Chiang (February 9, 2016). Building California’s Future Begins Today. Page 2 quotes estimates from CA Forward of the state’s infrastructure needs and available funding. Water infrastructure is expected to require $200 billion of investment of which $24 billion is not yet available; transportation requires $535 billion of which $294 billion is not yet available.

[8] To the extent that the state relies on newly issued debt to fund infrastructure maintenance.

[9] Ed Ring (May 16, 2016). The Coming Pension Apocalypse, and What to Do About It? California Policy Center.

[10] Edmund G. Brown (2016). California’s Five Year Infrastructure Plan.

[11] McKinsey Global Institute (May 2016). Diminishing Returns: Why Investors May Need to Lower Their Expectations.

[12] Caitlin Devitt (March 11, 2015). Huge Indiana Toll Road Bid Seen Boosting P3 Sector. The Bond Buyer.

Bill Dolan (March 11, 2015). Down-under consortium claims victory in Toll Road bidding. Northwest Indiana Times.

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ABOUT THE AUTHORS

Marc Joffe is the Director of Policy Research at the California Policy Center. In 2011, Joffe founded Public Sector Credit Solutions to educate policymakers, investors and citizens about government credit risk. His research has been published by the California State Treasurer’s Office, the Mercatus Center at George Mason University, the Reason Foundation, the Haas Institute for a Fair and Inclusive Society at UC Berkeley and the Macdonald-Laurier Institute among others. He is also a regular contributor to The Fiscal Times. Prior to starting PSCS, Marc was a Senior Director at Moody’s Analytics. He has an MBA from New York University and an MPA from San Francisco State University.

Jill Eicher Jill Eicher is a researcher focusing on innovative financing models for public-sector agencies. Most recently, she was a Visiting Scholar at Stanford University’s Global Projects Center, working on the development of a cooperative investment model for public pension funds to deploy capital into U.S. infrastructure. She co-founded the Fiduciary Infrastructure Initiative, a research-driven venture focused on the applicability of international pension cooperatives making direct infrastructure investments as models for the U.S. A graduate of Wellesley College, Eicher did post-graduate work in mathematics and was issued a patent for her method for assessing investment risk.

Ed Ring is the Vice President of Policy Research at the California Policy Center. His work has been cited in the Los Angeles Times, Sacramento Bee, Wall Street Journal, Forbes, and other national and regional publications. Previously, as a CFO primarily for start-up companies in the Silicon Valley, he has done financial accounting for over 20 years, and brings this experience to his analysis and commentary on issues of public sector finance. From 1995 to 2009 he was the editor of EcoWorld, a website covering environmental issues from a free-market perspective. Between 2007 and 2010 he launched in partnership with AlwaysOn Media the highly successful “GoingGreen” clean technology investor conferences, held annually in San Francisco and Boston. He has an MBA in Finance from the University of Southern California, and a BA in Political Science from UC Davis.

Kevin Dayton is a policy analyst for the California Policy Center, a prolific writer, and the author of frequent postings about generally unreported California state and local policy issues on the California Policy Center’s Prosperity Forum and Union Watch. Major policy reports written by Kevin Dayton include For the Kids: California Voters Must Become Wary of Borrowing Billions More from Wealthy Investors for Educational Construction. Dayton spent more than 17 years in various federal, state, and local policy positions for Associated Builders and Contractors (ABC), including ABC of California State Government Affairs Director from 2005 to 2012. He was also a legislative assistant in the U.S. House of Representatives for Congressman Gary A. Franks (R-Connecticut) from 1992 through 1994. Dayton is a 1992 graduate of Yale University, where he majored in History.

ABOUT THE CALIFORNIA POLICY CENTER

The California Policy Center is a non-partisan public policy think tank providing information that elevates the public dialogue on vital issues facing Californians, with the goal of helping to foster constructive progress towards more equitable and sustainable management of California’s public institutions. Learn more at CaliforniaPolicyCenter.org.

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