Challenges to the National Flood Insurance Program (NFIP)

A look at the National Flood Insurance Program, Community Rating System, resilience bonds, and more

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Challenges to the National Flood Insurance Program (NFIP) have been increasing in intensity for years. If the NFIP is not reauthorized by elected federal officials by the September 30 deadline—something still undetermined as we go to press with this article—existing flood insurance policies will remain intact, but new ones cannot be issued, disrupting home sales in high-risk flood-prone areas nationwide where the insurance is mandatory for properties purchased with federally backed mortgages. The National Association of Realtors estimates that past lapses of the NFIP have delayed or canceled as many as 1,400 real estate transactions a day. [Ed. note: On September 8, President Trump signed legislation reauthorizing he NFIP until December 8, 2017. Congress is currently considering reforms to the program.]

Regardless of whether the program is reauthorized, the basic issues remain. This article looks at some of those issues and at alternative ways of coping with storm- and flood-related damages.

According to the Federal Emergency Management Agency (FEMA), of the nearly five million homes and businesses covered by NFIP, 80% are in just 10 states: Florida, Texas, Louisiana, California, New Jersey, South Carolina, New York, North Carolina, Virginia, and Georgia.

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Florida has the highest risk, with 1.8 million of the homes and businesses covered by the NFIP nationwide, followed by Texas’ 605,845 properties in the program. Yet claims in Florida during the past four fiscal years have totaled $183.5 million for 11,182 property owners, in contrast to Louisiana, where property owners filed 35,155 claims totaling nearly $805 million in one year. Florida Republican Senator Marco Rubio has pointed out that Floridians pay four times more into the program than they receive in claim payments. These are among the many challenges inherent in the NFIP.

In its report on flood insurance released in April 2017, the US Government Accountability Office (GAO) pointed out that the NFIP has experienced significant challenges because FEMA is tasked with pursuing competing programmatic goals—keeping flood insurance affordable while keeping the program fiscally solvent.

Emphasis on affordability has led to premium rates that in many cases do not reflect the full risk of loss and produce insufficient premiums to pay for claims, the agency states. That, in turn, has transferred some of the financial burden of flood risk from individual property owners to taxpayers as a whole; resulting in a $24.6 billion debt to the US Treasury, which is on track to worsen without reform, the agency notes.

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On the other hand, shifting the emphasis towards fiscal solvency would reduce the burden on the taxpayer, but requires increasing premium rates, thus creating affordability challenges for many policyholders and discouraging consumers from buying flood insurance.

The increase in private insurers’ interest in selling flood insurance could transfer some risk from the federal government and open the door for Congress to consider potential reforms to address the program’s challenges, according to the GAO report.

The Reinsurance Association of America released a report claiming that more private-sector involvement in the flood insurance market could save billions of taxpayer dollars, based on a comparative analysis of the NFIP and Florida Citizens Property Insurance Corp.—a government-subsidized property insurer that has been following a “depopulation” strategy of having private insurers assume blocks of its business while also increasing rates and investing in reinsurance.

The GAO puts forth six areas in which action could advance programmatic goals, mitigate some tradeoffs resulting from competing goals, and reform the flood insurance program. They include promoting flood risk resilience, minimizing fiscal exposure to the federal government, requiring transparency of the federal fiscal exposure, encouraging consumer participation in the flood insurance market, and minimizing transition and implementation challenges. Those measures must be addressed comprehensively, not piecemeal, and in a sequence that helps to achieve the goals more comprehensively, the report states.

The GAO recommends addressing the outstanding debt through premium rate reform to help reduce the likelihood of a recurrence of another unpayable debt buildup.

Acknowledging that potential reforms could create challenges and resistance from property owners and lawmakers, “taking actions on multiple fronts represents the best opportunity to help address the spectrum of challenges confronting NFIP, advance private-sector participation, reduce federal fiscal exposure, and enhance resilience to flood risk,” the report states.

“As Congress considers reauthorizing NFIP, it should consider comprehensive reform to improve the program’s solvency and enhance the nation’s resilience to flood risk, which could include actions in addressing the current debt, removing existing legislative barriers to FEMA’s revising premium rates to reflect the full risk of loss, addressing affordability, increasing consumer participation, removing barriers to private-sector involvement, and protecting NFIP flood resilience efforts. In implementing these reforms, Congress should consider the sequence of the actions and their interaction with each other.”

Legislative Action
While the 2018 White House budget has called for cutting $190 million from NFIP funding for updating US flood maps and instituting targeted premium increases, many proposals to mitigate NFIP concerns have been floated from both the Senate and House of Representatives.

In mid-summer, there were seven different bills on the table from the House Financial Services Committee, each addressing a different NFIP component. The bills were expected to be combined into one package. Three different bi-partisan bills had been created in the Senate.

While there are differences of opinion on how to mitigate the concerns, there is widespread agreement about areas needing to be addressed. They include:

  • Impact on property owners and the extent to which property owners should pay for flood insurance to make NFIP more financially solvent; the percentage at which premiums should be capped; vouchers for families whose insurance costs exceed a percentage of their income; whether older properties that flood repeatedly should continue to receive discounts; and low- or no-cost loans for work such as home elevation to mitigate flooding. Allowing NFIP policyholders to purchase a private flood insurance policy and switch back to NFIP coverage without losing continuous coverage or grandfathering status is also a concern.
  • Creating more private-sector competition while preventing those companies from selecting the least-risky properties, leaving NFIP to cover the rest; caps on commissions paid to insurance companies selling and servicing policies; and addressing wrongdoing by insurance companies and contractors such as that which occurred following Hurricane Sandy and flooding in Louisiana
  • Suspending NFIP’s practice of paying $400 million annually to the US Treasury as interest for loans for past disaster response, and creating NFIP reserve funding
  • Strengthening flood mapping by using high-resolution mapping technology; addressing other mapping issues, including allowing communities to develop their own alternatives to NFIP flood maps that meet minimum FEMA standards; and the use of other risk-assessment tools and a mapping appeal process
  • Strengthening claims-handling with fraud penalties, policyholder appeals, claims deadlines, and governing time frames for determinations on flood claims; modernizing coverage limits to align with actual replacement costs of structures; and assessing surcharges on nonresidential and secondary-home properties.
  • Developing an agreed value insurance pilot option using FEMA’s existing water-depth probability that waters will reach or exceed a given depth of a structure relative to base flood elevation, and pre-determining the amount paid out in claims according to the depth of water damage to a structure
  • Requiring FEMA to provide for an annual independent actuarial study of the NFIP to analyze its financial position based on its long-term estimated losses, with results of the risk profile and changes in policyholder composition reported to Congress
  • Creating a pilot risk-sharing program with Write Your Own (WYO) companies, instructing FEMA to engage in NFIP risk-sharing pilot programs where WYO companies or other qualified insurers assume the first-loss position for claims at or below $50,000 and with the NFIP operating in a secondary-loss position
  • Addressing property issues such as multiple loss, excessive lifetime claims, high risk, all perils, and mandatory purchase requirements
  • Affordability issues, such as authorizing states to voluntarily create a state flood insurance affordability program for eligible owner-occupants of single-family residences unable to pay their chargeable risk premium due to family income; commercial exemptions; differentiations in coastal versus inland properties; and mitigation credits
  • Requiring FEMA to use risk-transfer tools such as catastrophe bonds, resilience bonds, and purchasing reinsurance on the commercial market

FEMA has already taken steps with regard to the last issue. In January 2017, FEMA expanded its September 2016 placement of reinsurance for the NFIP. The agency had used its authority to do so from the private reinsurance and capital markets through the Biggert-Waters Flood Insurance Reform Act of 2012 and the Homeowners Flood Insurance Affordability Act of 2014.

The move is regarded as a measure to put the NFIP in a better position to manage losses incurred from major events like Hurricanes Sandy ($8.3 billion) and Katrina ($16.3 billion) by transferring exposure to reinsurers. It also sets the foundation for a multi-year reinsurance program, according to its website.

Reinsurance is a risk management tool used by insurance companies to protect themselves from large financial losses. Insurance providers pay premiums to reinsurers, who, in exchange, provide coverage for losses incurred by insurance providers up to a specified amount negotiated by both parties.

FEMA transferred $1.042 billion of the NFIP’s financial risk to 25 reinsurers. The reinsurance premium is $150 million and will span from January 1, 2017, through January 1, 2018.

Under the agreement, the reinsurers will cover 26% of losses between $4 billion and $8 billion arising from a single flooding event. NFIP’s recent model suggests a 17.2% chance of losses from an event exceeding $4 billion in 2017.

Historically, flood insurance premiums, available surplus, borrowing capacity from the US Treasury, and in some cases, direct Congressional appropriations, were available to FEMA in order to pay the claims of insured flood survivors.

FEMA conducted a study to understand the financial benefits of reinsurance and then initiated the NFIP Reinsurance Initiative in 2016 to make the first-ever placement of reinsurance for the federal government using it to protect the NFIP against “large and uncertain costs of extreme flooding events,” writes Roy Wright in a FEMA blog. Wright is FEMA’s deputy associate administrator for federal insurance and mitigation. He leads the Federal Insurance and Mitigation Administration, which delivers the agency’s risk management, risk reduction, and flood insurance programs. He directs the NFIP, the mitigation and resilience programs under FEMA’s Stafford Act authorities, the National Earthquake Hazards Reduction Program, and the National Dam Safety Program.

To understand its importance going forward, one must look at NFIP’s history, Wright says. “In 1968, the federal government began offering flood insurance to homeowners who were unable to purchase affordable flood insurance from the private sector,” he writes. “Since then, the federal government has offered flood insurance premiums lower than the true risk in flood-prone areas would dictate.

“While the NFIP appeared to be able to cover the cost of its flood losses from pooled premiums of the insured for many years, that is no longer the case,” he adds. “The NFIP’s exposure to major floods is on the rise, as evidenced by Hurricanes Katrina and Sandy. These events generated claims of approximately $24.6 billion, leaving the NFIP $23 billion in debt to the US Treasury.”

Securing reinsurance does not reduce the size of NFIP’s current Treasury debt, but it is intended to reduce the accumulation of future debt. Wright notes that although the floods “felt like once-in-a-lifetime events, there is actually a 50% chance within a 10-year period the NFIP will once again experience Hurricane Sandy-sized losses.”

Following Hurricanes Katrina and Sandy, FEMA explored new tools to manage potentially major flood risk. In 2013, FEMA began setting aside a portion of premiums in a reserve fund to help cover losses from future major floods. In September 2016, FEMA made its first step toward reinsurance with a placement of $1 million in coverage. The agency later expanded its 2016 placement and re-engaged the private sector in flood risk.

Wright notes that flood insurance policyholders could also help reduce the risk and cost to all Americans when it comes to flood damage by calling upon their local governments to take steps toward reducing the threat of flooding by enforcing stronger building standards, restoring green space, and taking other mitigation measures that lead to reduced premiums through the Community Rating System.

Individual policyholders could further build their resilience to flooding by elevating and otherwise flood-proofing their homes, he notes. FEMA’s Increased Cost of Compliance coverage helps cover the costs of rebuilding flood-damaged homes and businesses to meet communities’ mitigation requirements.

Even so, millions of Americans who are at significant risk of a flood damaging or destroying their homes do not have flood insurance and should, Wright says.

The reinsurance agreement is between FEMA and reinsurers and would not affect the NFIP’s agreement with its policyholders. The placement of reinsurance enables the NFIP to retain its ability to pay out claims to policyholders quickly and fully, and it is less likely to need Congressional action to increase its borrowing authority, FEMA notes on its website.

The January 2017 reinsurance placement did not result in an increase in flood insurance policyholders’ rates. If the program expands in the future, FEMA plans to work with the Administration and Congress to determine how to cover the costs of a larger NFIP reinsurance program.

The agency is preparing for possible future engagements with risk transfer markets in January 2018 by upgrading the reinsurance program’s vision, strategy, and operations based on 2017 lessons learned to optimize a future multi-year program.

Additionally, it plans to expand the NFIP’s flood modeling capabilities and engage industry partners to incorporate best practices from the private sector.

Community Rating System
One of the measures being eyeballed by elected officials is a focus on mitigation efforts, including community-based mitigation plans, credits for communities that have joined the Community Rating System (CRS) program, and a pilot program to provide financial assistance for states and local communities to purchase substantially-damaged properties from low-income property owners.

The CRS program began in 1990 to encourage and acknowledge community floodplain management activities exceeding the minimum NFIP standards.

Under the CRS, flood insurance premium rates are discounted to reward community actions that meet the three goals of the CRS: reduce flood damage to insurable property, strengthen and support the insurance aspects of the NFIP, and encourage a comprehensive approach to floodplain management.

A community accrues points to improve its CRS class rating and can receive increasingly higher discounts. Points are awarded for engaging in any of the 19 creditable activities, organized under four categories: public information, mapping and regulations, flood damage reduction, and flood preparedness.

Public information credits can be attained through elevation certificates for new construction, flood map information service, flood-related outreach projects, property hazard disclosure, flood protection information, flood insurance promotion, and flood protection assistance.

Credits for mapping and regulations can be attained through floodplain mapping, open space preservation, higher regulatory standards, flood data maintenance, and stormwater management.

Flood damage reduction credits can be attained through floodplain management planning, acquisition and relocation, flood protection, and drainage system maintenance.

Flood preparedness credits are attained through flood warning and response, levee safety, and dam safety.

According to FEMA, nearly 3.8 million policyholders in 1,391 communities participate in the CRS by implementing local mitigation, floodplain management, and outreach activities that exceed the minimum NFIP requirements. Although CRS communities represent only 5% of the more than 22,000 communities participating in the NFIP, more than 69% of all flood insurance policies are written in CRS communities.

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The CRS class rating system is similar to a fire insurance rating, but is used to determine flood insurance premium reductions for residents. CRS classes are rated from 9 to 1. Most communities enter the program at a CRS Class 9 or Class 8 rating, entitling residents in Special Flood Hazard Areas (SFHAs) to a 5% discount on their flood insurance premiums.

As communities engage in additional mitigation activities, residents become eligible for increased NFIP policy premium discounts. Each CRS class improvement produces a 5% greater discount on flood insurance premiums for SFHA properties. For example, a Class 1 community would receive a 45% premium discount, while a Class 9 community would receive a 5% discount. Class 10 communities are not participating in the CRS and receive no discount. CRS class changes occur on May 1 and October 1 of each year.

Five US communities have attained the highest CRS class level with each having developed a floodplain management program tailored to its own particular hazards, character, and goals.

Roseville, CA, was the first to reach Class 1, the highest CRS rating. The city strengthened its floodplain management program following flood damage in 1995 and currently earns points for nearly all CRS creditable activities. Its average SFHA policy premium discount: $850.

In Tulsa, OK, comprehensive planning for floodplain management helped to reduce flood damage from the dozens of creeks within its jurisdiction. The Class 2 city has cleared more than 900 buildings from its floodplains. Its average SFHA policy premium discount: $630.

At Class 2, King County, WA, has preserved more than 100,000 acres of floodplain open space and receives additional CRS credit for maintaining it in a natural state. Its average SFHA policy premium discount: $664.

Pierce County, WA, a Class 2 entity, maintains more than 80 miles of river levees. Each year, county officials mail informational brochures to all floodplain residents. The county’s average premium SFHA discount: $687.

Fort Collins, CO, a Class 2 city, has experienced extreme flash flooding in its past and has developed one of the nation’s most exemplary comprehensive programs, according to FEMA. Its average SFHA policy premium discount: $589.

Top-ranking cities and counties in other classes include Sacramento County, CA; Ocala, FL; and Louisville-Jefferson County, KY in Class 3, and Charleston County, SC; Maricopa County, AZ; and Thurston County, WA, in Class 4.

In addition to earning lower-cost flood insurance rates, other CRS benefits include the increased opportunities property owners in CRS communities have to learn about risk, evaluate individual vulnerabilities, and take action to protect themselves as well as their homes and businesses.

FEMA also points out that CRS floodplain management activities provide enhanced public safety and reduced damage to property, no-charge technical assistance to community officials in designing and implementing some activities, incentives to maintain and improve flood programs over time, and the ability to evaluate the effectiveness of flood programs against a nationally recognized benchmark.

A community applies to CRS by initially informing the regional FEMA office of its interest, followed with application and documentation showing it is implementing the activities for which credit is requested. The application is submitted to the Insurance Services Office (ISO) CRS specialist. ISO works on behalf of FEMA and insurance companies to review CRS applications, verify communities’ credit points, and perform program improvement tasks.

FEMA establishes the credit to be granted and notifies the community, State, insurance companies, and other appropriate parties. The community must annually verify that it is continuing to perform the activities for which it is given CRS credit for annual recertification. The community also can continue to improve its class rating and earn additional points by undertaking new mitigation and floodplain management activities that earn even more points.

CRS specialists are available to assist community officials with applying to the program and with designing, implementing, and documenting the activities that earn even greater premium discounts.

A week-long CRS course for local officials is offered for free at FEMA’s Emergency Management Institute on the National Emergency Training Center campus in Emmitsburg, MD, and can be field-deployed in interested states. A series of webinars is also offered throughout the year.

Bryan Koon, director of the Florida Division of Emergency Management, says his primary focus is on flood insurance coverage in the state. Florida has lost nearly 15% of its flood insurance policies in the last four years, he notes, adding that price has been a driving factor.

Koon cites increases in flood insurance premiums that resulted from the Biggert-Waters Flood Insurance Reform Act of 2012 “as they started going to actuarially sound rates,” he says. “Prices have gone up and people have dropped their policies.” He says that in Florida, “we’ve gone from more than two million policies in the state to 1.7 million, so when we have the next hurricane and the next flood, there will be people who will be uninsured and will not have any way to make themselves whole without that flood insurance. It’s important that people understand how important flood insurance is and have every opportunity to purchase it.”

That’s where municipalities come in to help reduce flood insurance rates by participating in CRS for floodplain management, says Koon.

“We’re working on the state level and encouraging locals to do everything they can to make their communities more flood-resilient and apply those points toward the CRS,” he says. “If you can get a 45% discount, what is now a $1,000 a year policy goes to a $550 policy, and you’re going to get a lot more people buying flood insurance.”

Koon says that his staff has made “good progress” with some communities, such as Ocala—which went from a Class 8 to a Class 3 community, moving it from a 10% discount to a 35% discount on flood insurance.

“That money adds up. That is hundreds of millions of dollars a year for Floridians,” he says. “Currently, Florida spends about $1.2 billion a year for flood insurance premiums, but we can save hundreds of millions through the CRS program.”

The CRS manual has more than 12,000 potential points with every 500 moving a municipality up one class, Koon points out.

“We encourage communities to dive in there to see how they can improve the flood resilience of their community and also reduce the cost of flood insurance for the people in their community because that’s going to benefit the entire community,” says Koon.

“Those people are going to have insurance, they’ll be able to rebuild, and the community will be able to recover more quickly. The tax base stays up, the jobs stay in town, the quality of life stays better. If you don’t have insurance, people don’t rebuild their homes, property values go down, the tax base goes down, and everything goes downhill very quickly. Having a good base of flood insurance is vitally important.”

Koon points out that while ­Florida building codes have improved ­significantly and the ability to withstand hurricane-force winds is “far greater than it was during Hurricane Andrew or even Wilma,” the risk remains for water.

“Water not only kills people if they don’t evacuate; it also causes the longer-term problems associated with salt, and it causes it farther inland where communities may not be thinking about it as much,” he says.

“Every town in Florida needs to be aware that there’s going to be a storm out there that’s going to dump enough rain for them to flood. It may not have happened recently, but there are storms that are going to dump 10 to 30 inches of rain in a short timeframe that’s going to overwhelm the system and cause flooding, so anything they can do now to prepare for that is going to pay off in the long run.”

Communities need to consider their land use, planning, zoning, drainage systems, and the maintenance of the drainage systems now, “because it’s going to pay off when you get that 30-inch rainfall that gives flooding everywhere,” Koon says.

Resilience Bonds
One option for communities is a relatively new financial tool called a resilience bond, which offers communities the dual benefits of managing financial risk from catastrophes while also promoting investment in infrastructure to mitigate risk.

The details of the financial tool are outlined in a report, “Leveraging Catastrophe Bonds as a Mechanism for Resilient Infrastructure Project Finance,” released in late 2015. Funded by the Rockefeller Foundation, the report is a collaborative effort of RMS, a catastrophe risk-management and modeling firm, design firm Re:Focus partners, reinsurance company Swiss Re, and the Rockefeller Foundation.

Shalini Vajjhala is founder and CEO at Re:Focus partners, a team of former White House and EPA employees whose work focused on stormwater issues around the time that Philadelphia was going through a consent decree before the city developed its first green infrastructure plan.

“One of the things that became incredibly important from a federal regulatory perspective was realizing that you couldn’t enforce your way into whole system stormwater retrofits,” she points out.

“There’s very little way when a city wants to go to green infrastructure to guarantee performance,” adds Vajjhala. “The analogy we always use is you’re trying to turn your city from a funnel into a sponge. You’re trying to replace pipes and water treatment plants, which are known entities in the utility world, with tens of thousands of street trees and porous pavement.”

Part of her company’s genesis is dealing with the challenges inherent in doing a citywide infrastructure retrofit and ensuring its financing, she says.

After leaving the EPA and starting her company, Vajjhala worked with eight cities throughout the nation with the support of the Rockefeller Foundation to test the model that one could do designs of $100 million systems and build the financing into the design process. Some of that early work led the company into resilience bonds.

“We realized we were designing infrastructure that was creating benefits for the insurance industry, and it’s very difficult to capture those benefits at a retail level,” she says. “If you build a seawall, there is almost no incentive for an insurer to reduce their rates unless it is mandated.”

Instead of looking at the retail insurance level when designing green infrastructure, “we should be able to think about this more like life insurance for cities where if you quit smoking, your rates go down,” she says.

Her team started applying catastrophe models to some of the infrastructure projects they designed to understand how much the new infrastructure changed the risk profile of properties by protecting them from floods, storm surge, wind, earthquakes, and other catastrophes.

“It depends on the type of infrastructure and the type of peril, and that was how we came to resilience bonds,” she says. “We realized that well-designed infrastructure can actually change what causes a trigger of a catastrophe bond. If you think about it like the switch on a life insurance policy, you’re changing the likelihood that an event will happen in a given year or you’re changing the amount of damage it could cause by putting in something protective.

“It was a very practical path to a very unusual insurance mechanism. We kept asking the question of who loses money when this doesn’t work well, and we finally got to the point where we realized the insurance industry loses money if San Francisco’s seawall fails.”

She says, “If you look at a world with a resilience project in place to protect an area and one without, when that project goes into effect, you re-price your bond at the new level of risk. That reset mechanism is captured as a resilience rebate to fund projects upfront.”

A resilience bond is akin to an energy efficiency project where savings are forecast and brought forward to pay for the retrofit with payback over time, notes Vajjhala.

“That’s what you would be able to do now for anything from making homes sturdier in the face of stronger winds or building a seawall for surge protection or even doing a quick retrofit,” she says.

Resilience bonds are an “instrument in process,” notes Vajjhala, comparing them to where social impact bonds were a year before their first issuance.

“It’s validated by the industry, but not yet in practice because it takes some time to structure the transaction,” she adds.

Noting that there is no pilot for this scale of investment, she says her company is going full swing into the concept with a set of interested cities and utilities.

“What’s going to determine who goes first is the speed at which the projects move, because you want to time the insurance issuance with the timing of when a project is put into place,” she says.

“If you think about a five-year bond term, you want to lock in your insurance rates before your project takes effect, but it doesn’t just become a public good once it’s in place. You then would have the project finish construction during the term of the bond.”

Her company expects to release a report this fall that will include steps for interested sponsors.

The company is currently involved in an initiative called Build It Green, working with three New Jersey cities on combined sewer overflow mitigation. CSOs are a problem plaguing more than 800 US communities, and mitigating them is estimated to require billions of dollars.

“Jersey City was really well matched to a resilience bond for integrating storm surge protection with CSO mitigation,” says Vajjhala.

Jersey City is an example of a city that not only has basic stormwater issues and environmental compliance problems, but also is “dealing with massive real estate development in a really vulnerable area and looking potentially at hundreds of millions of dollars in additional exposure over what they have now or what they had during Sandy,” she says.

In considering any project for a resilience bond, the question is if it will meaningfully change the community’s risk, she says. If it won’t, “you should consider redesigning the project, and if you get through that initial catastrophe modeling screen, then we can work with a utility or city directly to structure a bond.”

In addition to climate change challenges, the aging infrastructure, and political policy shifts, Vajjhala notes that one of the factors she and her company’s partners see most often is “a loss of confidence at the municipal level after the recession.

“I believe they’re underrepresented in a lot of conversations about ‘Money is cheap. We should be doing lots of infrastructure investment.’ Money isn’t cheap, and municipalities are going to be the ones left holding the bag,” she says.

“In trying to help cities through these very transparent investment options like resilience bonds, we want them to know how much they can get and how much value they’re creating and make that part of the public discourse so it’s not an all-or-nothing conversation about every infrastructure project or an indefinite design negotiation so nothing ever gets built.”

Vajjhala credits DC Water in Washington DC and stormwater officials in Milwaukee and Philadelphia for paving the way and changing cultures in utilities regarding the use of green infrastructure.

She also cites a project for which her company did pre-design for the city of Hoboken, NJ, working with the Hudson Sewer Authority before going into the construction RFP stage.

“What was most encouraging to us is we were doing stormwater mitigation in an area that was under 12 feet of water during Superstorm Sandy. The city and the utility, after a lot of back and forth, managed to pursue a more aggressive strategy than we originally designed, which was looking more at sewer separation plus green infrastructure.

“Part of what we did in Hoboken was combine parking fees with water fees to help cross-subsidize stormwater investment,” she adds. “I think we’re going to see a lot more of that once you make the financial case for change. It opens up a lot more opportunity to be even more proactive because it’s less of a zero-sum game.”

Her company has put out a document called “A Field Guide to CSO Plus,” she says, “which is rather than thinking about your CSO project as a standalone, think about the plus that can make both investments cheaper.”

Rockefeller Foundation Funding Options
Public-private partnerships and other private financing options are being increasingly explored as public coffers are challenged by such factors as aging infrastructure, manifestations of climate change, and shifts in political policies impacting funding availability.

One organization exploring these options is the Rockefeller Foundation. Its Zero Gap Portfolio was launched in 2015 to support research and development and piloting of new financing mechanisms to mobilize private-sector capital toward the United Nations Sustainable Development Goals. The portfolio uses philanthropic risk capital to focus on developing the next generation of financing solutions to meet the financing needs. The UN estimates a $2.5 trillion annual funding gap over the next 15 years to achieve sustainable development goals in developing countries alone.

Two of the projects in the portfolio relate to surface water.

DC Water, which serves the nation’s capital, is one of the hundreds of communities with a combined sewer system. Raw sewage and stormwater flow through the same pipes into its treatment facility where the water is treated and discharged into the Potomac River.

During periods of heavy precipitation, the volume of water and sewage exceeds the pipes’ capacity, and by design, bypasses the treatment facility and is discharged directly into local rivers. That has resulted in two billion gallons of annual sewage overflows directly into the Chesapeake Bay watershed.

In 2005, EPA, the Department of Justice, the District of Columbia, and DC Water entered into a consent decree to address the problem. DC Water’s solution was a $2.6 billion tunnel system designed to capture the CSO before it enters the rivers.

Halfway through the 20-year project, the practice of green infrastructure managing urban stormwater emerged as a viable alternative to augment gray infrastructure tunnels, soak up precipitation, and slowly release it into the sewer system over time to prevent system overload.

Because green infrastructure had not been deployed at this scale before, DC Water officials contemplated whether it would be worth the risk to attain successful results. They chose Quantified Ventures to model and advance the first-of-a-kind transaction in an effort to better offset and manage the proposed project’s risks.

The funding option: the nation’s first environmental impact bond (EIB), a pay-for-success (PFS) transaction emanating from a partnership between Quantified Ventures and DC Water in September 2016.

The financing mechanism allowed DC Water to shift the performance risk of its green infrastructure project to investors interested in such projects. DC Water will pay for the desired outcomes, in contrast to paying for a project.

The Washington DC-based Quantified Ventures works with governments, nonprofit organizations, and entrepreneurs in tapping into financial resources needed to sufficiently scale operations for projects demonstrating positive impact on social good.

PFS—also known as social or environmental impact bonds—was first conceived and launched in the United Kingdom in 2010 to provide an innovative way for governments, healthcare entities, and foundations to pay for outcomes versus projects. It also enables service providers to scale approaches that work and taps investors to shoulder the financial risk of generating measurable outcomes. While standard municipal bondholders invest in the issuer’s ability to repay on schedule, EIB investor returns are tied to project outcomes.

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Investors provide the upfront capital to a service provider to scale an evidence-based intervention that delivers measurable outcomes and sometimes savings. Outcomes are measured by independent evaluators. Investors are paid if the intervention is “successful” in attaining its goals.

DC Water and Quantified Ventures applied the PFS model to green infrastructure, structuring the financing to transfer core project risk to investors. The iterative process of outcomes research, analysis, and collaboration across disciplines such as finance, engineering, and legal culminated in the nation’s first EIB, a $25 million tax-exempt bond sold in a private placement to Calvert Foundation and Goldman Sachs Urban Investment Group.

If green infrastructure performs as expected during the initial pilot project, then DC Water can build the remaining green infrastructure needed to meet the consent decree with an evidence-based understanding of expected outcomes, costs, and risks. If outcomes are better than expected, DC Water can modify the design of its green infrastructure plan, presumably saving money. In that case, both DC Water and investors would share in these savings.

If green infrastructure underperforms, then investors make a “risk share” payment back, providing DC Water with “free” insurance. DC Water is then armed with the information it needs to decide whether to continue with a green infrastructure approach or go back to its gray infrastructure tunnel solution.

By identifying, quantifying, and transferring project risk, DC Water’s EIB created the incentives into deploy an innovative solution to a historical public policy problem by “de-risking” the project. The project also is believed to promote economic development through sustainable green jobs as well as fostering healthier communities.

The EIB can serve as a replicable and scalable model not only for stormwater management issues, but also across a broad range of clean energy, agriculture, forestry, fishery, and infrastructure projects. Quantified Ventures officials say they look forward to seeing this financing strategy customized and improved upon over time by public officials considering innovative solutions to policy problems but faced with the inevitable question of whether those solutions will work.

Andrea Barrios, innovative finance analyst for the Rockefeller Foundation, says the EIB is starting with green infrastructure as a priority, “but we’re also expanding the opportunity for cities to offer up other potential resilience projects.”

Another financing tool is the forest resilience bond, expected to launch in fall 2017 after completion of its R&D and pilot phase, notes Adam Connaker, program associate with the Rockefeller Foundation.

This type of bond was created around the idea that the US Forest Service policy of total fire suppression has disrupted the cycle of small natural fires that traditionally maintain the healthy state of forests in the western United States. The policy has led to substantial overgrowth resulting in increased risk of small, naturally-occurring fires growing into mega-fires, which lower water yields and lower the quality of water reaching reservoirs, as well as compromising air quality, increasing carbon emissions, and destroying habitats.

The Forest Service has spent billions of dollars fighting the mega-fires. The growing number and intensity of the fires have stressed the agency’s budget, leaving insufficient resources for prevention activities like forest restoration.

The forest resilience bond allows investors to pay for critical forest restoration activities at scale, such as forest thinning and controlled burns, which are proven preventative methods for reducing mega-fire risk, augmenting water resources available to local communities, and which are 40 times less costly than fighting active mega-fires.

By accelerating the flow of capital to scale forest preservation work, private investors can contribute to the goal of making forests healthier and more resilient while receiving market-rate returns on their investments.

The bond also addresses the belief that healthier forests are less of a threat to communities and contribute to solving other key challenges like water shortages in the face of drought.

The grantee for the forest resilience bond is Blue Forest Conservation (through the US Endowment for Forestry and Communities) in partnership with the Forest Service, state governments and agencies, and local utilities. It was piloted in California and is believed to have global replicability.

The forest resilience bond uses both cost share and pay-for-performance contracts to provide diversified cash flows to institutional and high net worth investors while meeting the restoration needs of the forest. Investors receive returns from the Forest Service and the State—which saves resources and achieves agency goals from a reduced number of mega-fires, and from water and electric utilities benefiting from increased water supply and reservoir protection from avoided ash and polluting gases.

The process is as follows: investors’ capital flows into the forest resilience bond, which provides funding for forest restoration. An evaluation is conducted by a third party, and Forest Service and state governments make contractual payments to the bond while utilities make outcomes payments to the bond. Capital flows back to investors from the forest resilience bond.

Connaker says the Rockefeller Foundation launched the portfolio about two and a half years ago in response to massive funding gaps in some of the climate goals that became part of the Paris Climate Agreement. The gaps transcend “well beyond the budget that philanthropy and in many cases even public sector is going to provide, so we were thinking about where else can we look,” he says. “It’s fairly obvious we need to get to the capital markets in a broader and more in-depth way.”

The portfolio also ties into the foundation’s mission to benefit humanity: “and there was a deep recognition that finance is a tremendously powerful tool and that there are a lot of opportunities to unleash that tool for good,” he says.

The early days of social impact investing were focused on high net worth individuals and family offices and foundations, “but realistically the pots of money we’re talking about are retail and institutional investors,” says Connaker. “We need to start trending the early work into more mainstream distribution channels and structures. That’s where we could play a catalyst role and use the foundation’s history and knowledge on several of these issues to drive new structures and build things that make sense.”  SW_bug_web

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