Public/Private Partnerships Change Credit Landscape

By Janet Martin and Janet Rosen

The landscape of solid waste credit analysis has dramatically changed over the past five years. Legal and regulatory factors of the 1990s serve as catalysts for expanding analysis of the sector. The main challenge for solid waste service providers is to ensure cost-efficient operations and continued quality services in an increasingly competitive public/private environment.

The most important legal action affecting solid waste in recent history is the Carbone Supreme Court decision in 1994 deeming legal flow control unconstitutional. Legal flow control, a system's ability to direct waste to designated facilities, was the main credit factor systems relied on to secure revenue streams for operations and debt service. With the loss of this control, resultant challenges for municipal solid waste systems are many.

Responses to these challenges have varied. As a result of pressures described above, the use of waste supply and disposal contracts between the public and private sectors has become most important. These public and private partnerships have changed the credit landscape of solid waste systems, making them resemble those of project finance by blending municipal revenue bond analysis with the credit review of the corporate participants. As systems refund debt, bond security provisions have been restructured to provide operating flexibility in order to respond to an increasingly competitive operating climate.

The MSW sector continues to operate in a volatile climate. While private-sector participants can elect to cease operating in this sector, municipal governments have less flexibility in this regard as the collection and disposal of municipal solid waste is a critical service provided to residents, businesses, and visitors.

To meet these challenges, the municipal sector is expected to continue to select from an array of actions, including closing landfills that do not meet environmental standards, constructing single or regional landfills to satisfy environmental regulations, privatizing municipal systems, and formalizing private- and public-sector partnerships via contracts and agreements.

Approximately $20 billion of outstanding debt has been issued for solid waste facilities nationwide. Solid waste systems have a continuing need to restructure debt and financial operations to ensure competitive system rates, specifically through diversifying revenues, subordinating expenses, and performing distribution tests, among other techniques. Debt issuance for capital improvements remains a priority to meet more stringent environmental regulations for landfill liners, landfill treatment of leachate, methane gas recovery, and installing air-quality retrofits and to meet new standards for waste-to-energy plant emissions.

Rating ranges for all municipal debt and most solid waste credits will fall between BBB- and A+. Newly published rating ranges more closely reflect findings from Fitch IBCA Research titled "Municipal Default Study," dated September 15, 1999. This guideline piece updates the 1996 publication and current analysis focuses on the following:

Impact of and responses to changes in regulatory and legal framework and the following credit factors:

• Revenue sources structure
• Waste supply trends and competition
• Expense structure
• Operations and management fundamentals
• Security provisions

Changes in Regulatory and Legal Framework

The unlined landfills and primitive incinerators previously used for solid waste disposal pose unacceptable environmental hazards. During the past 30 years, laws have been adopted by federal, state, and local governments governing the closure and upgrading of noncompliant existing facilities and the construction of new facilities. Compliance with these regulatory provisions affects the costs of operating solid waste systems and the competitive position of facilities within the systems.

When landfills are closed, the operator, whether a public or private entity, may seek to recover closure and postclosure costs through fees charged at other solid waste facilities of the system. However, those fees may then become noncompetitive. In addition, compliance with environmental regulations regarding siting, construction, and operation of solid waste facilities raises construction and operation costs. While some laws are federal in origin and therefore have uniform consequences nationally, others vary from state to state and by locality. Therefore, ratings take into account the likely impact of state and local laws and regulations on the competitive position of facilities.

In addition to the costs of closing older, noncompliant landfills, operators of all landfills are required by the United States Environmental Protection Agency to demonstrate the financial capability to fund future costs of closure. These future costs must be estimated and accounted for, under Government Accounting Standards Board Statement 18. Underfunding or overfunding of closure costs can adversely affect a solid waste system's financial operations.

Provisions in operating permits also might affect the security of debt issued to finance permitted facilities. For example, permits that must be periodically renewed raise the risk of future nonrenewal, interruption in operations, and disruption in revenues. If the relationship between the facility operator or owner and the host community is contentious, the risk of nonrenewal, as well as the possible imposition of costly fines and penalties, increases. Economic changes might also affect decisions to renew permits.

Enactment of these environmental laws and regulations resulted in the closure of many solid waste disposal facilities and, in many regions of the country, a shortage of solid waste disposal facilities. The remaining disposal facilities often raised tipping fees due to a temporary lack of competition and to compensate for closure costs at other facilities.

Tipping fees at new facilities were also initially driven by high costs of construction and operation. Early resource recovery facilities, which were built in response to changes in the electric utility industry, and lined landfills with methane gas and leachate recovery systems often depended on tipping fees to cover debt service. Consequently, these fees were generally substantially higher than the fees charged at older facilities that were often within transportable distances.

Flow Control

Despite the noncompetitive tipping fees at many solid waste facilities, waste deliveries and, consequently, revenues adequate to service debt were ensured through flow-control ordinances or statutes. Many state and local governments enacted laws requiring that system members deliver all solid waste to system facilities, regardless of alternatives. These flow-control laws were soon challenged, however, because municipal members and/or private waste haulers frequently sought to dispose of waste at lower-cost, out-of-system facilities, which were often also outside the system's state or jurisdiction.

In 1994 the US Supreme Court ruled in Carbone v. Town of Clarkstown, New York that only the US Congress can enact laws directing the flow of solid waste across state borders and that local flow-control laws violate the Commerce Clause of the US Constitution. Subsequent congressional attempts to resolve flow-control issues have failed; no legislation has been enacted to date.

The loss of legal flow-control laws has threatened the financial viability of many solid waste systems and the security of debt, issued prior to the Carbone ruling, that is supported with system revenues. Especially vulnerable are facilities heavily dependent on per-ton tipping fees. When those tipping fees are not competitive, waste may be diverted to less expensive facilities.

Credit Factors

Prior to the Carbone decision, solid waste facilities often relied exclusively on tipping fees to pay debt service and operating expenses. Therefore, analysis of related debt focused on the adequacy of this sole revenue source. The Carbone decision, however, has dramatically altered the finances of many solid waste systems, which can no longer be ensured a steady supply of waste if tipping fees are noncompetitive. Systems have responded by lowering tipping fees and diversifying revenue sources.

Under current regulations and laws governing solid waste facilities, ratings consider diversification of revenues a positive credit factor. Indeed, security of solid waste facility debt supported with a sole revenue source is extremely vulnerable to any future local or regional changes in waste disposal options, nonrenewal of contracts, legal and regulatory changes, and changes in market pricing of waste disposal services.

The competitive climate in which a facility operates is considered, in addition to overall viability of project finances during the entire period that bonds will be outstanding, as outlined below.

Revenue Structure

Most solid waste systems now derive operating revenues from some combination of the following sources: taxes and charges, tipping fees, user fees, revenues from recycled materials, spot waste deliveries, and energy sales from resource recovery facilities.

Each of these revenue sources contributes funds needed to pay operating and debt service expenses. To obtain an investment-grade rating, operating revenues available from all sources must cover at least 100% of debt service and operating expenses. In addition, systems must demonstrate the flexibility to maintain this minimum 1.0 times (x) coverage even if operating expenses increase or one revenue source is diminished. Because rate-setting flexibility is a rating concern, the rate-setting process, including system rules and the role of municipal participants, needs to be studied. Competitive pressures might limit a system's ability to increase rates, however, regardless of its authority to do so.

Solid Waste Taxes and Charges. Some state and local governments have imposed solid waste importation taxes and fees to support solid waste facilities, while other systems benefit from pledges of solid waste charges imposed by municipalities. Other municipalities guarantee the obligations of the solid waste system or employ a deficiency makeup provision. When any form of municipal assistance is pledged directly or indirectly to a solid waste system, the credit of such state or local government becomes a rating factor. Credit of the service area will be evaluated based on residential and commercial growth and income measures (see Fitch IBCA Research titled "Local Government General Obligation Rating Guidelines," dated May 27, 1998, available at www.fitchibca.com).

The service area evaluation will also include an examination of any tax limitations in force at the level of government that is pledging assistance. If taxes are already near their statutory limit, or if voter approval is required for future increases, taxes intended to benefit the solid waste system may be uncollectable or may be collected at a level lower than the one budgeted by the system.

Solid waste systems also may execute service contracts with municipal participants. These contracts, often backed by a limited or general obligation pledge, obligate municipalities to make annual payments for operations, maintenance, or debt service. Some contracts contain put-or-pay provisions, while others are based on the actual amount of waste delivered. Any contractual arrangement, however, contains the inherent risk of nonrenewal or renewal on less favorable terms.

Tipping Fees. Solid waste systems often continue to set per-ton disposal rates for their facilities. These tipping fees reflect operating and debt service costs based on the amount of waste expected to be processed. Prior to Carbone, tipping fees were often the primary revenue source supporting the payment of debt. As systems diversify revenue streams, tipping fees are now more often one revenue source among many. Tipping fees are analyzed in the face of system dependence and competition. If a system is highly dependent on tipping fees and they are embedded in a secure contract, then whether or not that fee is competitive becomes less important, assuming all contract parties agree to the price. Outside of contracts, competitive pricing of tipping fees is often important if a system is dependent on spot waste or if noncontracted system participants have other regional options. The more competitive the tipping fee, the more likely the system will be able to meet tonnage and revenue goals.

User Fees. Some solid waste systems have successfully imposed fees that are billed and collected similar to water bills for all households and commercial establishments in the service area. Santa Cruz, CA, for example, includes a refuse fee in the water and sewer bill. The penalty for nonpayment of the fee is discontinuation of water service. While in New Jersey these fees may be dedicated solely to debt service to recover costs of discontinued projects or provide for current debt service, this "stranded asset fee" is known as the environmental investment charge.

Revenues From Recycled Materials. In many jurisdictions, recycling is mandatory. Many solid waste systems are responsible for collecting and disposing of recovered waste. Recycled materials can often be generating revenue for the solid waste system. It is necessary to evaluate the demand and market prices for the types of waste recovered by individual systems, both historically and currently, and then analyze whether related revenue estimates are realistic.

Spot Waste Deliveries. Waste from outside the system can provide an alternative source of revenue. Alternatively, revenues from such spot waste delivery may be used to further reduce the tipping fees charged to system participants. Generally revenues from spot waste are based on per-ton tipping fees. An examination must be conducted of whether the fees are competitive and likely to attract expected amounts of waste in addition to whether there is an alternative within transportable distance.

Collection and disposal practices in the region will be analyzed to determine whether waste haulers and municipalities will pursue alternatives to the system's facility. The regularity and number of spot waste deliveries and any offsetting effects (increased operational and maintenance costs posed by additional waste deliveries) will also be considered.

Energy Sales. Sales of energy generated when resource recovery facilities burn solid waste often constitute 20% or more of a system's operating revenues. Energy sales contracts between the resource recovery facility and investor-owned utilities are governed by the Public Utilities Regulator Policies Act. Contract prices for energy are based on the avoided cost of the utility, or the incremental cost that the utility would have incurred to generate the additional energy supplied by the resource recovery facility. Many of these contract prices are above current market rates, and utilities might challenge their enforceability. So far the Federal Energy Regulatory Commission has upheld these contracts, but future enforceability is not ensured.

The likely impact of progressing energy deregulation on existing power contracts and the demand for energy generated by resource recovery facilities is also a credit factor. System contingency plans for reductions in energy sales revenues will also be evaluated.

Waste Supply: Trends and Competition

Following the Carbone decision, solid waste systems sought a mechanism other than flow control for ensuring adequate waste deliveries. Many systems have turned to long-term contracts with waste providers as an alternative. Although neither the US Supreme Court nor the US Congress has settled definitively the types of provider contracts that are constitutional, a patchwork of federal, state, and local laws offers some guidance. Provider contracts that are competitively bid in a manner that does not discriminate between in-state and out-of-state providers have successfully withstood some legal challenges.

As a result of the dynamic state of the law governing them, both provider and energy contracts entail the risk that they will be held unenforceable. In addition, both categories are often executed for terms shorter than the bonds that they secure. In the event that either type of contract is held unenforceable or is not renewed, the demand for the contracted service will determine whether the system will be able to replace the lost revenue. Therefore, the demand for energy generated as well as waste disposal alternatives within transportable distances must be evaluated.

Since the composition and sources of the waste supplied to a facility are also rating considerations, it is necessary to analyze the breakdown of waste by type, the percentages privately and municipally collected, major waste suppliers, and the amount of spot waste to determine the potential nonsupply risk for each part of the wastestream and the impact of such nonsupply on overall system finances.

Because waste production and, therefore, supply for solid waste facilities generally track economic growth, analysis of the continuing financial viability of a solid waste system will be determined in part by growth trends in the region served by the system's facilities. It is important that a system's growth projections be realistic and based not only on historical trends but also on current economic activity.

Expense Structure

Bondholder security has also been strengthened by system initiatives to reduce expenses. Capital costs have been reduced through refunding at lower interest rates and restructuring of outstanding debt. Restrictive rate and additional bond covenants have been relaxed, allowing systems greater financial flexibility. Excessive liberalization of bond covenants, however, might adversely affect bondholder security.

Operating costs have been stabilized or reduced through partnerships with private companies that operate facilities, haul waste, and/or market recycled products. These private companies are often experienced in waste management. They are usually divisions or departments of very large national companies involved in all aspects of solid waste collection and disposal. Consequently, experience and national networks may increase system efficiency and reduce operating costs.

Operating and Management Fundamentals

As stated previously, solid waste collection and disposal is now often a public/private collaboration. Solid waste systems are generally under the direct management of public authorities and composed of one or more municipal members. The authorities contract with private companies to provide some or all of the collection and disposal services. Management and operational practices and the experience of both the public authorities and the private contractors are rating factors.

Authority Management

Efficient and cost-effective waste collection and disposal depends on the authority's working relationship with its municipal members and its private contractors. Authority budgets and capital plans generally must be approved by municipal members, which may also participate in their development. Communication between the municipal members and the authority should remain open and frequent so that the needs of both parties are met.

Authorities must also manage relationships with any private facility operators and waste haulers. Some authorities employ consultants to evaluate operators. Contracts with operators and haulers must be negotiated and, often, renegotiated over the life of rated debt. Therefore, the authority's negotiation strategies and goals will be subject to scrutiny.

Some authorities operate their own facilities or have contingency plans to operate facilities if attempts to renegotiate operating contracts fail. In either case, the ability to perform these functions on a current or contingent basis is of concern.

Private Contractors and Contracts

The integration of private companies into the critical municipal functions of solid waste collection and disposal is intended to increase system operating efficiencies. These efficiencies will only be achieved, however, as long as the private partner fulfills its obligations.

To determine whether private facility operators have the technical and financial ability to meet construction and operating challenges, their operating history and the credit position, including historical and projected income statements and cash-flow position, are relevant to the rating analysis.

When a parent company guarantees an operator's obligations, the terms of the guarantee and the finances of the guarantor must be examined. The terms of the guarantee should ensure payment prior to the time when funds are needed for debt service. The financial analysis focuses on the parent's income and liabilities, including direct debt, leases, and other guarantees, as well as borrowing patterns and planned future borrowing. Private haulers will also be evaluated based on their historical reliability and, when they are responsible for billing and collecting for services performed, their finances.

System revenues must be insulated from any risks related to the bankruptcy of every private partner or its parent/guarantor. This is accomplished when the private partner is limited to performing an operational function for a predetermined fee, the private partner serves as an agent of the system, and revenues are deposited daily into an account controlled by the system, not the corporate operator.

Terms of contracts between private partners and systems will also be examined. An important consideration will be the duration of the contracts and, if shorter than the term of the related bonds, the renewal provisions. Risk of nonrenewal is mitigated by market-based pricing structures for private partner services, which create incentives for renewal by the private partner. Collection, disposal, and billing methods are also evaluated. The responsibility for each function needs to be established in order to determine what may prevent the responsible parties from delivering services and then billing for them. Systems should establish the billing cycle and the timing and source of payments. A frequent billing cycle with high collection rates and a requirement for partial payments when frill payment is not possible enhances credit.

Pricing of the services provided by the private partner is often based on a complex formula embedded in the contract. Formula variables may include actual operating costs and renewal and replacement costs. Rate stabilization and/or renewal and replacement reserve funds may mitigate such risks.

The allocation between the system and the operator of unforeseen and uncontrollable costs will also be analyzed. For example, disposal costs for ash byproducts of resource recovery facilities have fluctuated significantly. If the system is solely responsible for such increased costs, revenues must be increased to cover additional payments. Municipal participants might have difficulty raising rates or taxes. Tax limitations may also block increases in revenues. Therefore, operating contracts should provide for some form of equitable division of increased costs among a system and its facilities operator.

Feasibility studies are an important element of any analysis. Objective and independent analysis intrinsic to a feasibility study assists in evaluating whether a system's projections are realistic. Feasibility studies generally contain the breakdown of waste by type, method of collecting and measuring waste, basis for charges, assumptions on nonoperating revenue, growth projections, and estimates of closure costs for system facilities. Feasibility studies are often obtained even for existing facilities because the studies performed in connection with construction of the facility are often based on pre-Carbone revenue assumptions. Evaluation of the technology to be utilized in new facilities should either be part of the feasibility study or covered in a separate engineering report.

Security Provisions

In addition to analyzing the sources and amounts of revenues pledged, how the revenues are pledged and whether the liens purported to be created through the pledges are valid and binding must be established. The value of a first lien on net or gross revenues will be diluted if those revenues have been previously pledged to other obligors of the system. In addition, if the documents containing the revenue pledges are unenforceable, the pledges provide no security for bondholders. Consequently, a legal opinion stating that all documents containing revenue pledges are the legal, valid, and binding obligations of, and enforceable against, the parties to the agreements is mandatory, along with evidence that the liens have been perfected.

The amount of outstanding debt for any solid waste system will also be a rating consideration, as the debt burden will impact the ability of that system to meet its obligations. Similarly, rate covenants and additional-bonds tests will determine the amount of debt that a system will be able to issue in the future. Such covenants are especially important to bondholder security when operating revenues cover debt service and operating and maintenance expenses only by a sum-sufficient 1.0x. This coverage, common to many solid waste facilities because of the competitive operating environment, must be protected through bond covenants. Structural considerations will include the following.

Flow of Funds. All revenues pledged to debt service should be deposited into accounts held by the trustee in the order determined by the bond indenture. Debt service pledges can be funded prior to operations, yielding a gross pledge of revenues to bondholders, or after operating expenses, yielding a net pledge to bondholders. The impact of subordinating operating expenses to debt service will enhance revenues available to maintain and operate the facility. In addition, the items included in the definition of operating expenses will be considered. Sometimes debt service on bonds issued to finance other facilities of a system is included in the definition of operating expense, resulting in a subordinate lien for holders of bonds secured by a net-revenue pledge.

Reserve Funds. The debt service reserve requirement is typically either 10% of the par amount of bonds outstanding or 125% of the maximum or average annual debt service. Typical structures also include reserves for operations in the form of two to three months of expenses. Maintenance and repair reserve requirements are usually determined by technical consultants.

Rate Stabilization Funds. Rate stabilization funds are crucial to systems that continue to rely on per-ton tipping fees for a large percentage of revenues. Rate stabilization funds allow such systems to ensure a steady stream of waste through a consistently competitive fee structure. It is important to determine the priority of funding, conditions for drawing upon, and period of time for replenishment following a draw applicable to all reserve funds.

Distributions of Revenues. Some publicly owned systems authorize transfers of revenues to other units of government after payment of all expenses (including debt service) and funding of all reserves. Such open systems generally weaken security for bondholders, while closed systems, which retain surplus revenues while bonds are outstanding, enhance bondholder security.

Privately owned systems often authorize the distribution of surplus revenues in the form of equity to shareholders and owners or for the purpose of constructing capital improvements. Distribution tests, which govern such releases of funds, should be incorporated into governing legal documents. Releases for equity or capital purposes should not be authorized unless the remaining funds will be sufficient to meet the highest debt service obligations and to fund all reserves.

Rate Covenants. Inclusion of operating and nonoperating revenue in coverage calculations weakens bondholder security. Rate covenants for solid waste facilities have ranged from 1.0x to l.5x. Although a higher coverage ratio implies adequate funds to meet debt service, system finances and flexibility may be compromised by overly restrictive covenants.

Additional-Bonds Tests. These tests determine whether system revenues will remain sufficient to support outstanding and new debt. Standard tests vary from 12 of the prior 18 months to 24 months or the last fiscal year. More importantly, the test period must be reviewed in light of historical and pro forma experience and the extent to which competitive factors are considered when establishing future rates and utilization. This analysis is important because systems dependent on high tipping fees for future revenues included in the additional-bonds test may not be able to raise rates appropriately in the face of competition.

Events of Default and Remedies. The events triggering events of default under the bond documents, and the time allotted to cure events of default, must be carefully examined. Payment provisions of municipal or vendor guarantees will be evaluated to determine whether they will be available to avoid acceleration of bonds.

Conclusion

The rating approach for solid waste facilities incorporates elements of project finance analysis, corporate analysis, and general obligation—bond analysis. Credit characteristics of the region served by the system and the system's private partners are important elements. In addition, the source, pledge, and amounts of revenues available to service debt are reviewed.

Characteristics of a system receiving a minimum investment-grade rating of ‘BBB' or ‘A' include sufficient waste supply, an economically viable and stable service area, realistic revenue projections and/or history, economic and financial flexibility, and sufficient reserves and debt service coverage. Conversely, credit concerns would be raised by limited financial flexibility, an uneconomic rate structure, competition from other facilities within transportable distance, an uncommitted waste supply, and dependence solely on tipping fees.

While these guidelines have been prepared by Fitch IBCA to assist issuers and their financing teams in structuring future transactions, it is important to bear in mind that additional rating considerations may be applied on a case-by-case basis.

Janet H. Martin is program manager for and Janet Rosen is a consultant to Fitch IBCA Solid Waste System Responses.