How to Finance Capital Projects: The Pros and Cons of Each Method
January 27, 2023 – OpenGov
Woven alongside annual budgets and economic development forecasts are capital improvement projects that ensure safe, efficient transportation systems and infrastructure; adequate water and sewer services; facilities and equipment that meet the needs of staff and your residents; and much more.
And, crucial to any CIP is a clear understanding of how capital projects can and should be financed. There are several methods to financing CIPs, and it’s important to choose the one that’s best for your community.
To get started, answer the following questions about the CIP you are looking to fund:
- Is there an immediate need for the asset?
- What is the asset’s expected useful life?
- What is the current availability of funds relative to the project’s size?
- Are there multiple projects that need to be completed simultaneously?
- Is inflation expected to increase?
- Is the borrowing rate expected to increase?
The answers to these questions will lay the groundwork as you begin to plan your project. (After reviewing the financing options below, check out our eBook, Unlocking the Potential of Capital Planning.)
3 Methods to Finance Capital Projects
There are three ways that most governments choose to finance capital projects: pay-as-you-go, debt issuance, or public-private partnerships (P3s). Read on for the benefits and drawbacks of each.
Pay-as-you-go (PAYGO) for Capital Projects
This method of financing uses general fund revenues to pay for capital projects, allowing governments to place funds leftover after operating expenditures into a “capital reserve account” and essentially “save up” for capital projects.
- Future funds are not tied up in servicing debt payments
- Interest savings can be put toward other projects
- Greater budget transparency
- Avoids the risk of default
- Long wait time for new infrastructure
- Large projects may exhaust an agency’s entire budget for capital projects
- Inflation risk
Debt Financing for Capital Projects
For projects financed with debt, neither the bond maturity nor end of the debt repayment period should exceed the asset’s useful life. By issuing long-term debt for costly infrastructure projects with long service lives, governments can increase equity between generations without disrupting the operating budget.
- Infrastructure is delivered when it’s needed
- Spreads cost over the useful life of the asset
- Increases capacity to Invest
- Capital investment’s beneficiaries pay for projects
- Potentially high borrowing rate
- Debt payments limit future budget flexibility, commonly known as “Debt Service,” one of the most costly impacts on a government’s operating budget
- Diminishes the choices of the future
- Generations forced to service debt requirements
Public-Private Partnership (P3) for Capital Projects
P3s can be a good policy for governments seeking to cut costs, improve operational efficiency, fund capital costs, and reduce risk. Non-traditional, private-sector capital financing models, are generally more complex and less transparent. Although the costs and benefits of pursuing capital financing should be thoroughly analyzed in a transparent manner, P3s are a viable mechanism for the public sector to crowd in private capital in the delivery of public goods and services.
- Risk transfer
- Accelerated project delivery
- External funding
- Lower operating costs, and higher revenues • Improved user experience
- Loss of operational control
- Changes in scope or performance standards delay project delivery or impose additional costs
- Certain non-transferable risks (change in laws, approvals by third-party government agencies etc.)
- Potential Loss of Revenue (for example a public-private partnership on a new toll road where the private investor gets all (or a substantial) part of the tolls.
Plan, Procure, Prioritize
Financing is just one piece of the capital improvement project puzzle. For more on a modern capital planning process, download our ebook, Unlocking the Power of Capital Planning.