Capital planning provides both short-term and long-term perspective.

Most finance officers have heard about the need for long-term financial planning, a collaborative process that allows for strategic thinking about an organization's future. However, long-term financial planning doesn't just provide perspective over a relatively long period of time--it also provides solutions to many short-term issues. In this era of competing resources, long-term financial planning will help your jurisdiction focus on decisions that will accomplish the goals set forth in the long-term plan. (1)

The biggest component of the long-term financial plan is the capital plan. The most obvious reason to include the capital plan is that capital projects require an enormous amount of capital and operating expenditures, both of which must be included to present a comprehensive picture of expenditure projections. Another reason to include the capital plan in the long-term financial plan is that capital projects, whether they are constructed or purchased, are commonly financed by issuing debt, and a capital plan allows a jurisdiction to see the amount of debt capacity available. (2) It also allows the amount of the debt service to be factored into the financial plan, which may cause increases in projected rates, fees, and other forms of revenue.

Capital planning is crucial for a number of reasons.

1. New capital assets require a substantial outlay of funds over a number of years. For example, a new sewer pipeline project for the Sacramento Regional County Sanitation District (SRCSD) cost $51 million and took seven years to plan, design, and construct.

2. New capital assets require ongoing operations and maintenance costs, which need to be factored into future budgets and long-term financial plans for future years. For instance, a new park will require on-going maintenance, which may require additional labor as well as more equipment.

3. New capital assets are usually debt-funded, requiring ongoing debt service payments. The process of issuing debt also requires that a jurisdiction maintain certain bond coverages (the ratio of pledged net revenue to debt service), and a capital plan will identify the amount of revenue needed for both debt service and coverage requirements.

4. Capital spending is uneven between fiscal years because projects vary from year to year. The rate of spending also changes as projects are delayed or accelerated, depending on a variety of conditions.

A jurisdiction that ignores capital planning and decides to fund new capital projects "when the money is available" is likely to run into problems. Development could be slowed because infrastructure is lacking, and needed services might not be available. There is also a risk of not replacing assets on a cost-effective basis--replacing them too soon, which means spending resources before it is necessary or not replacing them soon enough, which can wind up costing more than necessary because of the amount of wear and tear on the infrastructure.

WHEN TO START PLANNING

The first stage of the capital plan should be the master plan. The Government Finance Officers Association (GFOA) recommended practice, The Role of Master Plans in Capital Improvement Planning, states that master plans are used as a blueprint for the future. They should identify jurisdictional needs ten to 25 years into the future and include economic, land use, and infrastructure development needs. The master plan acts as a framework for the capital improvement plan (CIP), which identifies present and future needs requiring capital infrastructure. The CIP is for three to five years and lists the projects and capital programs planned for the community including the corresponding revenues and financing sources. The CIP should be used to develop the annual capital budget, which lists the projects and programs on which the jurisdiction plans to expend funds in the upcoming fiscal year.

WHAT THE CAPITAL IMPROVEMENT PLAN DOES

The CIP has several specific purposes beyond forming the basis for the long-term financial plan. For a major project, it can take several years to prepare feasibility studies, receive environmental clearance and permits, purchase rights-of-way, and finalize the actual design and blueprints. The CIP allows a jurisdiction to foresee these needs before they must be funded--the SRCSD uses this time to do a business case evaluation to make sure the best project option is selected. The CIP also allows time to arrange financing. Federal and state grants can take a long time to actually award funds, and if the jurisdiction is issuing debt, many months can elapse before the proceeds are available. In addition, there are often several suitable sites for a project within the community and the CIP allows enough time to identify the sites and negotiate the best possible price for the property. In some cases, such as constructing water or sewer lines, the actual route may vary based on requirements from landowners.

Another important function of the CIP is allowing for the orderly replacement and rehabilitation of existing capital assets. Capital assets have different lifecycles and therefore need to be replaced at different times. It might be necessary to replace a sheriff's patrol car every two to three years, while construction equipment might last ten years before it has to be replaced. Infrastructure can last decades, but that lifespan depends on regular maintenance and periodic rehabilitation--failing to plan for replacement and rehabilitation can make the process rushed and costly, and it might shorten the lifespan of the infrastructure might.

The CIP also allows for the coordination of projects. How many times have you had a street repaved, only to find that it needs to be cut within a year or two to accommodate a project underneath it? A CIP allows departments within a jurisdiction to coordinate with each other, resulting in less inconvenience for the public and less expense for the jurisdiction. Similarly, the CIP can help a government coordinate planning with other jurisdictions and organizations.

THE COSTS INCLUDED IN A CAPITAL IMPROVEMENT PLAN

A common mistake made in developing the CIP is to include only the actual construction or acquisition costs. Each project within the CIP should include all costs that are necessary to get the project or acquisition into operating condition, including:

* construction labor and materials

* planning and design

* legal services

* acquisition of land or other property

* land preparation

* easement

* equipment and furnishings

* financing charges

* construction management

Not every project or program should be included in the CIP. Some governments have specific dollar limits on which projects should be included; for example, SRCSD includes only projects that cost more than $100,000. Other governments may choose to put reoccurring capital costs such as deferred maintenance in the operating budget. Equipment and vehicles may be included in the CIP or the operating budget, depending on the cost. Information technology can become very costly, especially when a major system is being replaced or upgraded, so some jurisdictions will choose to put these costs in the capital budget.

PRIORITIZING CAPITAL PROJECTS

Almost all jurisdictions have more capital needs than available resources. This situation requires prioritization of capital projects. The GFOA recommended practice, Multi-Year Capital Planning, outlines several steps to take when prioritizing capital requests:

* Reflect the relationship of projects submitted to financial and governing policies, plans and studies.

* Allow submitting agencies to provide the initial prioritization, especially when more than one project is submitted.

* Incorporate input and participation from major stakeholders and the public. This is valuable when dealing with projects that have a direct impact on a neighborhood.

* Adhere to legal requirements and mandates.

* Anticipate the impact capital projects will have on the operating budget. Lifecycle cost analysis can be helpful in determining what these impacts might be.

* Apply analytical techniques as appropriate for evaluating potential projects. These techniques can include net present value, payback period, cost-benefit analysis, lifecycle costing, and cash flow modeling.

* Reevaluate capital projects that were approved in previous multiyear capital plans. A project that has a top prioritization one year may have a lower prioritization when compared with current projects.

* Use a formalized rating system to help with decision making.

Rating systems for prioritizing capital projects can range from subjective to very objective. In his book, Capital Budgeting and Finance: A Guide for Local Governments. (3) A. John Vogt discusses six primary approaches: experience-based judgment; department or functional priorities; broad categories of needs; urgency of need criteria; weighted rating of urgency of need and related criteria; and program priorities, goals, and service needs.

Experience-based judgment. This approach prioritizes projects based on the judgment of experienced managers and others involved in the decision-making process. This fundamentally intuitive technique appears to be the method used most commonly in small and medium-sized governments. If the decision makers are aware of the community's most pressing infrastructure needs, they can provide an efficient way of selecting the projects.

Department or functional priorities. Departments are asked to prioritize the capital requests for their program areas. The departments might establish priorities as they see fit, or they might be asked to consider certain criteria such as health and safety concerns when ranking their projects. This approach can be useful when there are pressing needs in a departmental area or when it is necessary to include a number of capital requests from each department.

Broad categories of needs. Decision makers can rank capital requests into several broad categories to prioritize the requests for the entire jurisdiction. Projects can be categorized into priorities as simple as high, medium, and low. When these general rankings are used, each capital request is assessed on its own merits and placed in one of the priority categories accordingly without being directly compared with other requests.

Urgency-of-need criteria. Small and medium-sized governments can use a variety of urgency-of-need ranking criteria. These include: meeting legal mandates, removing or reducing hazards, advancing the governing board's goals or objectives, improving efficiency, maintaining standards of service, supporting economic development, improving services, facilitating new services, improving quality of life, and offering convenience. Jurisdictions will assign these criteria different priorities, and they tend to be used as general guidelines rather than the means for determining actual priorities.

Weighted rating of urgency-of-need and related criteria. The above approach ranks each criterion equally. However, a jurisdiction can assign a greater weighting or priority to some criteria over others, and then assign each criterion a numeric value based on that weighting. Each capital request is evaluated and given a score, which then determines the ranking.

Program priorities, goals, and service needs. Program goals are usually included as one of the criteria in the weighted rating system. However, a capital project can be ranked solely on the basis of whether it meets program priorities, program goals, and service needs. The rationale is that with good priorities and goals, no other rating systems are needed.

THE BIOGAS ENHANCEMENT PROGRAM

SRCSD frequently uses lifecycle costing to determine what type of capital project should be constructed, along with its total lifecycle cost. The project can then be prioritized against other capital requests. If the project is approved, the capital and operating costs identified in this analysis are used in the budget. The Biogas Enhancement Program provides an example of the analysis that is currently being used.

The program injects fats, oils, grease, and food waste directly into the anaerobic digesters at the sewage treatment plant to produce biogas. Biogas, which is another name for methane gas, is then used to produce electricity at a cogeneration facility located at the treatment plant. The options for this project were:

1. Do not proceed with the program.

2. Use existing capacity to implement the program.

3. Initially use existing capacity, and eventually build new assets to continue the program.

The project options were further refined by adding two revenue options to each of the three project options. One revenue option was to make no change to the "tip fee" (the amount of money paid by septage haulers to drop waste at the treatment plant), which is currently $0.0504 per gallon. The second revenue option increased the tip fee to $0.10 per gallon, since the current fee is below what nearby jurisdictions are charging. Exhibit 1 shows the key assumptions and a summary of the lifecycle costs for each of the six options.

Based on the above analysis, the project manager was given approval to proceed with a pilot study for Alternative 3, which uses existing fats, oils, and grease already delivered to the treatment plant. This alternative allows SRCSD to use a "staged" approach to confirm the process will work as planned. The lowest net present value was not selected because it required substantial outlay of funds for new assets. The pilot study also includes further research into whether or not tipping fees could be increased based on market comparison with other tipping fees in the area.

CONCLUSION

Capital planning is vital to the success of a long-term financial plan, which shows the impact of future operating and capital decisions, and what resources will be required to pay for those decisions. Capital planning is necessary because capital projects require substantial amounts of funding over a long period of time, including ongoing operations and maintenance costs, all of which have to be factored into budgets for future years. And funding new capital assets often means issuing debt, which means future budgets must include debt service payments and coverage requirements. An organization that does not adequately plan for these costs runs the risk of not being able to meet the needs of the community.

Notes

(1.) Shayne C. Kavanagh, Financing the Future: Long-Term Planning for Local Government (Chicago: Government Finance Officers Association, 2007).

(2.) Ibid.

(3.) A. John Vogt, Capital Budgeting and Finance: A Guide for Local Governments (Washington, D.C.: ICMA Press, 2004).

MARCIA MAURER is chief financial officer of the Sacramento Regional County Sanitation District. She can be reached at [e-mail].

Exhibit 1 : Analysis of Options

                         Alternative 1   Alternative 2   Alternative 3

Description               No Project      No Project       Existing
                                                           Capacity
                                                             Only

                            No Tip         With Tip         No Tip
                         Fee Increase    Fee Increase    Fee Increase

Key Assumptions

Grease Tip Fee              $0.0504          $0.10          $0.0504
($/ballon)

Operation & Management      $0.0504         $0.0504         $0.0172
Processing Cost
($/gallon)

Required Improvements        2046            2046            2038
to Digester (to allow
for processing of
more waste)--year

Required New Lined           2049            2049            2046
Dedicated Land
Disposal (so increased
amount of solids can
be disposed of)--year

Financial Summary

Revenue Net Present          $6.43          $11.28          $23.73
Value ($ million)

Operation & Management      -$4.92          -$4.92          -$5.98
Net Present Value
($ million)

Biogas Enhancement             0               0            -$14.74
Capital + Operation &
Management Net Present
Value ($ million)

Digester Improvements       -$1.47          -$1.47          -$1.71
Capital Net Present
Value ($ million)

New Lined Dedicated         -$6.14          -$6.14          -$6.51
Land Disposal Capital
Net Present Value
($ million)

Total Net Present           -$6.10          -$1.26          -$5.21
Value ($ million)

Ranking                        6               3               5

                         Alternative 4   Alternative 5   Alternative 6

Description                Existing        Existing        Existing
                           Capacity        Capacity        Capacity
                             Only        + New Assets    + New Assets

                           With Tip         No Tip         With Tip
                         Fee Increase    Fee Increase    Fee Increase

Key Assumptions

Grease Tip Fee               $0.10          $0.0504          $0.10
($/ballon)

Operation & Management      $0.0172         $0.0172         $0.0172
Processing Cost
($/gallon)

Required Improvements        2038            2025            2025
to Digester (to allow
for processing of
more waste)--year

Required New Lined           2046            2038            2038
Dedicated Land
Disposal (so increased
amount of solids can
be disposed of)--year

Financial Summary

Revenue Net Present         $40.98          $40.00          $57.25
Value ($ million)

Operation & Management      -$5.98          -$8.28          -$8.28
Net Present Value
($ million)

Biogas Enhancement          -$14.74         -$23.74         -$23.74
Capital + Operation &
Management Net Present
Value ($ million)

Digester Improvements       -$1.71          -$2.20          -$2.20
Capital Net Present
Value ($ million)

New Lined Dedicated         -$6.51          -$7.59)         -$7.59)
Land Disposal Capital
Net Present Value
($ million)

Total Net Present           $12.04          -$1.80          $15.45
Value ($ million)

Ranking                        2               4               1