This past September, DC Water—Washington DC’s water utility—along with investors Goldman Sachs and Calvert Foundation and intermediary Quantified Ventures, announced the launch of the nation’s first environmental impact bond (EIB). To learn more about the project’s specifics, we sat down with CFO of DC Water Mark Kim for a Q&A session. You can read more about the project at Living Cities.
PFSI: How did DC Water first become acquainted with pay for success and why was it an attractive option for this project?
Kim: Pay for success is an interesting and important phenomenon that has enormous potential. This notion of paying for something, but only if it works, is a very novel concept in the public sector. Paying for outcomes is a powerful framework with which to think about how we deliver public goods and services.
The green infrastructure project financed through our environmental impact bond (EIB) is an important part of our DC Clean Rivers project—a massive $2.6 billion, 25-year long project designed to improve water quality in the District. In 2015, after negotiating with the Department of Justice (DOJ), Environmental Protection Agency (EPA) and the District of Columbia, we modified a legal settlement to incorporate green infrastructure to manage storm water runoff.
While the science behind it is strong, green infrastructure also carries a lot of risk for DC Water. Risk is one of the key inhibitors of innovation in the public sector. First, DC Water has never designed, constructed or maintained green infrastructure before. Second, green infrastructure has never been done on a large scale in DC. And third, the effectiveness of green infrastructure depends on local climactic conditions; the exact same green roof in DC wouldn’t perform the same way, for example, if it was located in Arizona or Seattle.
The inspiration for the environmental impact bond came from the key question: what if green infrastructure doesn’t work? That led to another question: could we structure the financing in such a way that would transfer the core risk of performance to a class of investors whose interests were aligned with ours? The answer was yes, and in response, we developed the EIB.
PFSI: How does this project tie into DC Water’s larger objectives?
Kim: The project is symbolic of DC Water’s culture of trying to drive innovative solutions to public policy problems. Our space is in the environmental sector, but we share the financial pressures and policy constraints around water quality that could be transferrable to other sectors. There are seven additional green infrastructure projects planned as part of DC Water’s Clean Rivers Project – with a cumulative value of at least $100 million. The performance risk is concentrated here in this inaugural project, and if we can successfully demonstrate proof of concept, those other projects can move forward.
The solution of “gray” infrastructure projects (e.g., tunnels) is a proven technology. We know how much it will cost, how long it will take to build, and that it will definitely work. If you have a tried and true solution, like gray infrastructure, what incentive would you have to take the risk of moving to green infrastructure, which may not work? The secondary benefits of green infrastructure can’t drive decisionmaking if your primary objective is cost effective storm water management. The EIB was a way to break through this barrier and enable innovation to happen by “de-risking” the project.
PFSI: How did the investors in this project differ from traditional investors?
Kim: Traditional investors aren’t as concerned about what you do with the money you raise as they are about making sure they will be paid principal and interest on time. Impact investors, on the other hand, not only want a financial return on investment but also care enormously about what you do with their money. As a result, both the Goldman Sachs Urban Investment Group and Calvert Foundation – our two impact investors – have been actively engaged as partners in this project and will be until the term of the investment ends and the performance of green infrastructure in managing storm water runoff has been established. The investors will receive monthly construction reports, conduct quarterly conference calls and/or site visits, and have the right to retain an independent engineering firm to validate construction. In addition, the parties have agreed to a third party validation of the performance results.
Goldman and Calvert were very interested in the program’s co-benefits, including our ambitious green jobs program that will train and certify District residents to build and maintain green infrastructure. Other co-benefits may include improved air quality, reduced heat island effect, higher property values, green recreational space, and more. While DC Water cannot monetize these benefits directly, they were an important part of the thought process in putting together the EIB.
PFSI: When building the contract and designing the project, what were the main challenges you encountered?
Kim: I wouldn’t say that we encountered skepticism or resistance to what we were trying to do, but rather strong governance and oversight from our board to make sure that the financial terms of the EIB were in the best interests of our customers and that we were managing risk appropriately. We required strong due diligence from our engineers – I applaud them because they were willing to go further than they were typically required to. Finally, because the investors cared so much about the project itself, we needed to make sure financing structure was in alignment with the underlying science and hydrology of green infrastructure.
As a result, this project took a little longer than traditional financing—18 months from idea conception to launch as compared to six to ten weeks for a traditional bond.
It was definitely more work, and more challenging at times, than I expected. In addition to wanting to prove the efficacy of green infrastructure, we also believed in the value of this financing mechanism. We structured this EIB to be scalable and replicable for other issuers.
The agreement we had with Goldman and Calvert was that once the deal was done, everything was going to be made public. We have disclosed all of the terms of our private placement agreement—interest rates, methodology, performance tiers—which is usually kept under lock and key. We did this with the express hope that issuers might find value in what we did, and by leveraging the work we did, they’d be able to build an even better financing structure in the future.
PFSI: How did you determine the outcome targets and payment amounts?
Kim: This was the coolest part of this whole deal. The science of green infrastructure and the modeling behind it is very sound. That is something that is quantifiable, objective, and verifiable. Those were key reasons why we were able to get this deal done.
It was a three step program evaluation. Step one was to establish baseline conditions. The green infrastructure project we’ve designed is the perfect test case. Every drop of storm water runoff that happens at the project site will flow through a single sewershed. That wasn’t an accident; we picked that site because we were able to measure, monitor, and evaluate performance.
Step two was to predict performance using the information we collected in step one. We ran a simulation with thousands of runs to establish the probability distribution of outcomes, and then to construct confidence intervals, which are reflected in the thresholds for the three performance tiers.
Step three is the post-construction monitoring to measure actual storm water runoff and calculate the performance of green infrastructure.
PFSI: Can you explain the two-way contingent payment?
Kim: The core defining characteristic of the EIB was a two-way contingent payment tied to managing storm water runoff. If the green infrastructure performs as we expect it to, DC Water will pay investors the stated interest rate on the bond of 3.43%, which is comparable to DC Water’s long term cost of funds. If the green infrastructure underperforms, investors will still receive the stated interest rate on the bond, but they will make a “risk share” payment back to DC Water. If green infrastructure outperforms our expectations, then DC Water, in addition to the interest on the bond, will make an “outcome payment” to the investors.
The way we structured the contingent payment was to make it roughly equivalent to the total amount of interest to be paid on the bond. The investors wouldn’t take a loss on principal, but a loss on their interest payments. If investors have to make a risk share payment back to DC Water, they would essentially have given us an interest free loan. If the green infrastructure outperforms, DC Water pays investors a bonus payment of $3.3 million.
Now the question is why we would include a two-way contingent payment. If you have a car, you have to pay for car insurance whether or not you get into an accident. The benefit of the EIB is that DC Water gets “free” insurance on its down-side risk if the green infrastructure underperforms. And the only time that we have to pay for that insurance is if the project outperforms. Let’s assume that green infrastructure is twice as effective as it was supposed to be, then we only need to construct half as much to get the same results. We are willing to share that potential (financial) benefit with our investors if it happens in exchange for the downside risk protection if the project fails.
We’re all incentivized in this scenario, which is one of the defining characteristics of PFS and why it has the potential to be such a powerful model. It better aligns the interest of payors and investors.
PFSI: Are there any reflections or key takeaways you’d like to share?
Kim: There are so many types of risk associated with this project—design risk, construction risk, maintenance risk, and performance risk. We found that DC Water was in the best position to manage all of those risks except for the performance risk. What if we do everything right, and it just doesn’t work? That’s the risk we wanted to transfer with the EIB.
My key takeaway from this deal is that it’s all about risk. First, you have to understand what risks you have and also what your risk tolerance is for them. Second, once you understand project risk, you need to quantify it. Third, once you can quantify risk, then you can price it and sell it, like we did with our EIB. That is the way to leverage PFS to drive more private capital to help solve public problems!
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