THE SOUTH AFRICAN URBAN AGENDA: Municipal Infrastructure Finance Summary Report

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized JULY R N ZA THE SOUTH AFRICAN URBAN AGENDA: Municipal Infrastructure Finance Summary Report 1) Introduction ) What infrastructure investment is needed? ) Investing in cities: revenues, expenditures and leveraging... 9 a) Municipal revenues and expenditures i) Municipal capital expenditure ii) Development charges b) Borrowing and other leveraging of municipal revenues ) Conclusions and policy options a) Borrowing By Creditworthy Municipalities Benefits All Citizens b) A Regulatory Framework for Development Charges Annex A Supporting Papers and Presentations

2 Introduction In 2007, the Government of South Africa and the World Bank agreed on a Country Partnership Strategy (CPS), under which the World Bank committed to support Government policies and programmes related to urban and rural development through relevant analyses. This analytical report focuses on municipal infrastructure finance in urban areas, and is a summary and update of the Municipal Infrastructure Finance Synthesis Report published in May A list of supporting papers and presentations can be found in Annex A. All papers and presentations listed are available from the World Bank or the National Treasury. The ability of municipalities, and of the nation, to effectively invest in urban infrastructure is likely to be a major determinant of South Africa s economic future. This report focuses on the investment needed to ensure South Africa s cities are vital, sustainable, equitable, and economically productive. Rural needs are no less important, and a similar focused consideration of rural challenges would be appropriate. As the White Paper on Local Government 1 noted over a decade ago, the local government financing framework must recognise and accommodate the differences between municipalities, since urban and rural municipalities, and even those in different metropolitan areas, are in very different financial circumstances, 2 with different prospects for providing adequate services at reasonable costs. A relatively small group of 27 urban municipalities generates 80% of national economic activity, even though these municipalities occupy less than 6% of South Africa s land area. This small group of municipalities is home to more than half of the population, and will account for the overwhelming majority of South Africa s economic growth in the years and decades ahead. Adequate and effective infrastructure investment in these growing municipalities will be a major determinant of South Africa s economic future. This report discusses the types of investment needed in municipalities, and shows that most investment is needed for rehabilitation and growth, rather than for backlogs. The analysis also demonstrates that most urban municipalities are financially healthy and have substantial untapped borrowing potential. If there were more own-borrowing by these urban municipalities, scarce national resources could be freed up for other purposes, including investment in rural municipalities with large populations and few resources. For analytical purposes, we have grouped South Africa s metropolitan and local municipalities 3 as follows (see Figure 1 for a summary of their characteristics): Group 1 (A and B1 municipalities), Group 2 (B2 and B3 municipalities), and Group 3 (B4 municipalities). 1 White Paper on Local Government, 9 March id, Section G 3 Because District municipalities cover the same territory as Local municipalities, the investment needs of both levels of local government have been aggregated for analytical purposes. 2

3 FIGURE 1: MUNICIPAL CLASSIFICATIONS Group Category Description Characteristics No of municipalities GROUP 1: 27 municipalities A Largest cities Metropolitan municipalities 6 B1 Secondary cities Local municipalities with a city in their midst, and with the largest budgets, after the metros 21 GROUP 2: 140 municipalities GROUP 3: 70 municipalities B2 Large towns Local municipalities with a large town as the core urban settlement B3 Small towns Local municipalities with relatively small population, a significant proportion of which is urban, but no large town as a core urban settlement. Typically one or more small towns and rural areas are characterised by commercial farms. B4 Mostly rural Local municipalities which are mainly rural with, at most, one or two small towns. The rural areas are characterised by communal land tenure and villages or scattered groups of dwellings Included with relevant local municipalities C1 District municipalities which are not water services providers. District municipalities with few service delivery obligations and which tend to be aligned with relatively strong local municipalities. Included with relevant local municipalities C2 District municipalities which are water services providers. District municipalities with more service delivery responsibility and which tend to be aligned with weaker and more rural local municipalities. ADAPTED FROM URBAN SECTOR REVIEW: INFRASTRUCTURE INVESTMENT COMPONENT, SUMMARY OF FINDINGS FROM THE MUNICIPAL INFRASTRUCTURE INVESTMENT FRAMEWORK (MIIF), PALMER DEVELOPMENT GROUP, 2009 Investing in rehabilitation and economic growth will cost considerably more than resolving remaining service backlogs, especially in urban areas. The cost of meeting the remaining 3

4 service delivery backlogs is the smallest of municipalities investment needs. Much larger investments in rehabilitation of core infrastructure are needed to avoid further deterioration and interruption of essential services. The electric power crisis that began in 2007, with its unpopular and disruptive load-shedding, has helped focus attention on the need for ongoing reinvestment. In addition, strategic infrastructure capacity is necessary for continued economic growth. As of July 2009, the global financial and economic situation continues to pose serious challenges. From the start of the democratic era until quite recently, South Africa had seen sustained growth, which enabled generous government spending on local infrastructure. Indeed, the principal constraint was capacity to spend, rather than the resources themselves. For the future, things will be different for an unknown period. Export demand from places like the U.S., Europe and Japan, has plummeted, affecting both commodities and manufacturing. It is now clear that South Africa s economy is in its first recession in 17 years. The World Bank s 2009 Global Development Finance Report projects 1.5% decline in South Africa s GDP in The silver lining is that the economic contraction has given Government a little breathing room in terms of infrastructure investment. Many municipal water and sanitation systems, electric supply systems, and municipal roads were operating at or above their design capacity as a result of many years of sustained growth. For the near term, Government will run deficits and attempt to maintain spending levels on established priorities, but such deficit spending would not be sustainable indefinitely. The win-win scenario will be strategic investment in local infrastructure which both stimulates the economy in the near term and increases urban productivity in the long term. It is hoped that appropriate urban infrastructure investments will lay the foundation for rapid and robust growth when the global economy recovers. The report suggests options for financing the infrastructure investment needs of urban municipalities. These include expanded borrowing by creditworthy municipal borrowers which, as a group, are significantly underleveraged. This can be accomplished through strategies to extend maturities of municipal borrowing, and to develop and deepen the secondary market for municipal securities. The DBSA could play a significant role in these two strategies. Other ideas include further restructuring of the Municipal Infrastructure Grant and other capital transfers to allow pledging and to incentivise appropriate leveraging; special funds to support feasibility and pre-procurement studies; a legal and regulatory framework to provide the basis for better use of development charges; and support for long-term capital planning by urban municipalities. What infrastructure investment is needed? This report focuses on investment needs in the territory of Group 1 municipalities. 4 Focusing on the territory covered by this group of 27 municipalities is appropriate first, because with their overwhelming weight in the national economy, they hold the key to long term sustainability for the rest of the nation; second, because they represent the future as South Africa continues to urbanise, still more people and more jobs will be located in these 27 municipalities; and third, because they hold the promise of financial sustainability, if they are provided with the right tools and incentives. Our analysis focuses on municipal investment 4 A supporting paper has data for all categories. See Urban Sector Review: Infrastructure Investment Component, Summary of Findings from the Municipal Infrastructure Investment Framework (MIIF), Palmer Development Group

5 needs in the territory covered by these municipalities, whether the actual investment would be made by local (Category B) or district (Category C) municipalities. 5 Across sectors, urban infrastructure investments can be divided into three types: 1) Service delivery backlogs: this refers to investments needed to serve households which do not have access to the basic services that municipalities are meant to provide, such as water and sanitation, electricity, solid waste disposal, roads, and other public services 2) Rehabilitation: this refers to investments needed to upgrade, repair or replace infrastructure that has deteriorated beyond the point that routine maintenance is adequate. 3) Growth: this refers to investments in infrastructure needed to support a growing population and a growing economy. Service delivery backlogs remain a challenge. The term service backlogs refers to households without a service to which they are legally entitled. Backlogs are a function of the definition of minimum service levels. For example, if pit latrines are deemed acceptable, then there are relatively fewer sanitation backlogs, whereas if water-borne sanitation is considered the basic standard, there are more backlogs. Such backlogs are also a function of the number of households without resources to acquire services for themselves. Unfortunately, the number of households living in poverty has increased over time. Because many people remain without services (see Figure 2 below), resolving these backlogs will continue to be a priority. FIGURE 2: BACKLOGS FOR KEY SERVICES SOURCE: MUNICIPAL INFRASTRUCTURE INVESTMENT REQUIREMENTS, B.C. GILDENHUYS, JANUARY 2009 Rehabilitation has been overlooked. Unfortunately, strategic planning in many municipalities has been limited to addressing service backlogs, without adequate understanding of the need to protect the capacity of existing infrastructure networks or of the infrastructure requirements associated with economic growth. The condition of any asset starts deteriorating from the day it is commissioned at some point it becomes necessary to rebuild or replace parts of the asset to restore it to a required functional condition or to extend its useful life. Rehabilitation generally 5 Most of the districts covering B1 municipalities do not provide significant infrastructure and services, and raise little ownsource revenue. An emerging debate in South Africa is whether there is a real need for the district tier in the case e.g. of B1 municipalities. The relatively strong B1 municipalities are different e.g. from many B4 municipalities, where the district tier often does provide substantial services. 5

6 involves returning an asset to its original level of service requirements. Examples include rebuilding of roads and slip-lining of sewer mains. Existing municipal assets are estimated to be, on the average, % deteriorated. Unfortunately there has been little real information on the extent of rehabilitation needs. It is however possible to provide order-of-magnitude estimates. The results of more than 40 municipal infrastructure network condition assessments funded by the DPLG, European Union, the Limpopo Provincial Government and individual municipalities, suggest that roughly 45% of the economic potential of the nation s municipal infrastructure has been consumed. We can apply these estimates to the current replacement cost of municipal infrastructure portfolios, using data in the Municipal Infrastructure Investment Framework (MIIF), and assuming the average lives of infrastructure networks to be in the order of 60 years based on published guidelines and engineering assessments. Rehabilitation is important for new users as well as existing customers. Reliable infrastructure networks are needed to support service extensions as well as current users. Extensions typically link in with existing infrastructure. So rehabilitation is a pre-condition for growth. In addition to the actual investment, there is a need to work on institutional capacity to quantify rehabilitation needs, optimise rehabilitation costs where possible by integrating these requirements in asset upgrading projects, prioritise rehabilitation allocations, and ultimately specify and procure the rehabilitation work. Because most municipalities have limited data on the extent of their assets and their condition and capacity, it can be difficult to scope realistic rehabilitation projects. Sustained economic growth requires sustained infrastructure investment: Modern cities can be thought of as a complex of overlapping infrastructure networks: streets that carry commuters to work and goods from factories; water pipes that deliver reliable water supplies on demand for homes, hospitals, manufacturers; sewage pipes that carry human and industrial wastes out of the city; electricity and telephone lines that power and link all of us together. As the economy grows, and as urban population grows, these networks must be constantly and continuously expanded. A healthy economy requires a certain amount of reserve capacity in all of these networks, so that there is always room for growth. When networks do not keep up, and services cannot be delivered, growth is constrained. Economic growth in South Africa averaged about 3% during the first decade after the end of apartheid, from At that point growth increased, reaching a high of about 5% before the current economic crisis. This sustained period of high growth, unprecedented in South Africa s history, put severe strains on infrastructure systems across the country. By 2006, it was clear that there was an energy crisis which, it is now believed, could last until 2013, as a direct result of that growth. The nation allowed its reserve energy capacity to be steadily consumed, without adequate investment, until there was no reserve. Many municipal systems in urban areas are in an analogous condition. Hours-long traffic jams in major urban centers have become the norm, sewage plants are working at capacity, and some development projects have been unable to proceed because of lack of municipal services. There is little or no reserve capacity in municipal services in many urban areas. Urban areas are the engines of productivity and growth and bottlenecks in urban areas seriously constrain economic growth. While there is currently a contraction in the economy that may give some breathing room, one hopes for a return to sustained growth at or above the rates that were being experienced before the recent contraction. For that to happen, investment to remove urban infrastructure bottlenecks is critical. If infrastructure capacity is not on hand to support new private investment, then the urban economy cannot grow, and the nation will lose 6

7 opportunities for growth and employment. And, if rehabilitation investment is not made as and when needed, existing business activity is threatened - with unreliable water or electric services, businesses may cut back operations or investments plans, or even fail completely, with adverse effects on the economy. Infrastructure is critical to attract job-creating private sector investment. Emphasizing the importance of an adequate infrastructure foundation for economic growth, a recent report entitled Bridging the Global Infrastructure Gap, was compiled by the Economist Intelligence Unit for KPMG, and drew on interviews with 328 senior executives from 21 countries, including South Africa. Ninety per cent of those canvassed indicated that the availability and quality of infrastructure will affect where they locate and expand their business operations. 6 FIGURE 3: 10 YEAR AGGREGATED ESTIMATE OF MUNICIPAL INFRASTRUCTURE INVESTMENT REQUIRMENTS. SOURCE: MUNICIPAL INFRASTRUCTURE INVESTMENT REQUIREMENTS, B.C. GILDENHUYS, JANUARY 2009 The estimates shown in Figure 3 reflect the investment needed within the territory of the three groups of municipalities over a 10 year period, assuming a 15 year target for rehabilitating deteriorated infrastructure, and a 15 year target for eliminating service backlogs. The calculation of investment needs over a given period is naturally dependent on the assumptions one makes about economic growth and the timetable for eliminating service backlogs and rehabilitation backlogs. The quantum and type of investment needed is very different in the three groups of municipalities. As can be seen from a glance at Figure 3, the total investment needed is very different in the three groups, and the composition of the investment estimates is also significantly different. 7 The territory covered by the 27 Group 1 municipalities 6 Infrastructure quality will drive investment decisions, survey finds, Engineering News Online, 18 February For the purpose of these estimates, investment needs are territorial, not related to which level of municipality would actually make the investment. Thus, the investment needs of district municipalities are aggregated with the investment needs of local municipalities covering the same territory. 7

8 has the greatest growth and rehabilitation needs, while the area covered by the 70 Group 3 local municipalities remains with the greatest service delivery backlogs. The territory covered by the 140 Group 2 local municipalities has the smallest investment needs, notwithstanding that these account for the majority of local municipalities. Figure 4 below is based on the same estimates as Figure 3 above, but shows the investment needs for Group 1 municipalities over a nominal 10 year period, rather than as a single lump. FIGURE 4: AN ESTIMATE OF ANNUAL INFRASTRUCTURE INVESTMENT REQUIREMENTS IN GROUP 1 MUNICIPALITIES. SOURCE: MUNICIPAL INFRASTRUCTURE INVESTMENT REQUIREMENTS, B.C. GILDENHUYS, JANUARY 2009 The investment needs, especially in Group 1 municipalities, are dominated by rehabilitation and growth. As Figures 3 and 4 illustrate, the amount needed for elimination of service delivery backlogs in Group 1 is a small fraction of the total municipal investment requirement. Over the 10 year period, the service extension investment needed for Group 1 municipalities is projected at about R 26 billion, less than 10% of the total investment required by these municipalities. By contrast, the growth and rehabilitation investment needs are each over R 120 billion for the same period, depending on the assumptions one makes about economic growth. 8 There is increasing recognition of the need for rehabilitation of core infrastructure, and strategic investment to support growth. The National Treasury recently noted that the limited provision of strategic infrastructure and a declining quality of service are growing constraints to economic growth and poverty reduction. If this trend is not arrested it might undermine the future sustainability of everything. 9 In other words, if the balance of local infrastructure investment is tilted primarily toward service delivery extension, in municipalities where that is no longer the biggest challenge, there is a risk of ending up with marginally increased access to low-functioning services, and limited ability to grow the economy. In urban 8 These 2009 estimates reflect National Treasury s early 2009 prediction of 1.9% economic growth for the year. Since the preparation of this model, expectations for 2009 are for economic contraction. The model used to generate these estimates is available to any interested party, and the assumptions can be easily altered to reflect changing expectations Local Government Budgets and Expenditure Review, 2003/ /10, National Treasury, Republic of South Africa 8

9 areas, the need for rehabilitation is a constant and growing priority, and the need for investments to support growth has become a priority because the inherited capacity surpluses in core infrastructure have largely been consumed. Without new investment, economic growth faces critical bottlenecks. Investing in cities: revenues, expenditures and leveraging Cities require constant investment over time. South Africa s urban infrastructure asset base represents a significant amount of historical investment. Inevitably, this infrastructure is constantly aging and deteriorating. Even with sound maintenance practices (which are not always followed), cities must continually rehabilitate and replace aging infrastructure. And because the urban population and urban economic activity are growing, there are always new residents and businesses demanding services. Infrastructure investment needs are thus not onetime needs the need for new investment is always there, and the needs grow if they are unmet. Cities therefore need sustainable and long-term strategies for the routine funding of new infrastructure investment. Most funding for urban investment (and rural investment) must ultimately come from within the cities. As in most countries today, South Africa s cities 10 are home to the greatest share of national wealth, income and productivity. And they hold the key to the greatest future gains in productivity and national economic growth. Since cities are where most economic activity and growth do and will take place, it is where the greatest share of the tax base is. Revenues generated within these cities will therefore ultimately need to pay for the investment that is needed to make them grow and prosper. One way or another, residents and firms in cities will bear the burden of financing urban infrastructure. Even if national grants and transfers are expanded, it must be remembered that the national revenues which fund these transfers are largely derived from cities. So, taxes from urban areas can flow to national government and thence back to cities, as with the current Municipal Infrastructure Grant system, or taxes can stay in urban jurisdictions and be used locally, as with property rates and the former RSC levies. Either way, it is the economic activity and wealth of people in the cities that will pay for urban infrastructure. In this way, urban municipalities are very different from rural municipalities with little tax base and revenue potential of their own. To provide any reasonable level of services, such rural municipalities must rely on transfers from national government. Since the revenue used to fund these equalisation transfers largely originates from taxpayers in the cities, the rural municipalities also have a stake in the health of South Africa s cities, and their ability to produce a healthy climate for growth, income, wealth, and productive taxation. Naturally, the revenue potential of South Africa s cities varies, and the revenue potential as between urban and rural economies varies even more. The own-source revenue potential of any municipality depends primarily on the wealth and economic activity of people and firms within its borders. Similarly, the national revenue generated from any geographic space depends on the revenue potential of that space, with urban areas contributing the lion s share of national revenues. Because the economic base varies widely from place to place, equalising transfers such as the equitable share play a key role in ensuring that all municipalities have sustainable financing for delivering on their constitutional responsibilities. Conceptually, the purpose of the 10 As noted, we are using the term cities to refer to the Group 1 municipalities, acknowledging that these municipalities contain substantial rural areas as well as urban cores. 9

10 equitable share transfer is to allow a municipality with less of an economic base to meet its constitutional responsibilities. 11 Borrowing, like other capital finance techniques, can leverage available revenues. Borrowing allows financially healthy municipalities the option of tapping into future revenues now. Borrowing is appropriate for municipalities which have revenues in excess of expenditures, and is generally inappropriate for those which do not have reasonable operating surpluses. Borrowing potential depends on the size of the actual or projected operating surplus, 12 and our analysis shows that the urban municipalities that have the greatest operating surpluses and the greatest borrowing potential. The discussion which follows is broken into two parts: first, we discuss the current state of finances in urban municipalities; second, we will discuss ways in which these revenue sources can be leveraged through borrowing, PPPs and other long term arrangements. MUNICIPAL REVENUES AND EXPENDITURES The National Treasury has published comprehensive municipal financial data in the 2008 Local Government Budgets and Expenditure Review. 13 The Treasury finds growing evidence that municipal services are under-priced relative to the cost of production and that municipalities have also been wary of actively leveraging private sector finance, through debt, PPPs, and development charges... The Review also notes an increasing reliance of municipalities on transfers from national government to fund their activities...limited own revenue effort and a lack of commitment to leverage private finance. A revenue summary is shown in Figure 5 below. FIGURE 5: MUNICIPAL OPERATING REVENUE 2003/ /10 R A E P R S C RSC I G P O T R SOURCE: 2008 LOCAL GOVERNMENT BUDGETS AND EXPENDITURE REVIEW 2003/ /10, NATIONAL TREASURY, REPUBLIC OF SOUTH AFRICA The current economic contraction may impact South African local government less than would be the case in most countries. Over 40% of local revenues are service charges while 11 Many South Africans have come to see the equitable share as a way of funding free basic services. However, the free basic services policy is a more recent innovation (circa 2000) that post-dates the constitutional requirement for the equitable share. There is no legal restriction barring municipalities from using their equitable share allocations, which are a constitutional entitlement, for any purpose they choose. 12 The operating surplus in question can be for the municipality as a whole, if the issue is general obligation debt, or for a particular project. It is possible, though not common, to have viable borrowing or PPP projects in poor municipalities with little revenue potential Local Government Budgets and Expenditure Review 2003/ /10, National Treasury, Republic of South Africa 10

11 the recession may limit the ability of municipalities to increase their service charges, demand is likely to be somewhat inelastic. Another 18-19% of local revenues come from property rates, which will not be affected in the first year or two of a contraction a longer recession which seriously depressed property values or affordability would be required before a substantial impact on property rates becomes an issue. An increasing percentage of local revenues is already coming from government grants more than 25% in FY06/07 and Government s counter-cyclical spending stance means that this would be sustained for at least some years. The diversity of revenue sources is likely to provide substantial robustness in South African local finances. FIGURE 6: MUNICIPAL OPERATING EXPENDITURE 2003/ /10 R A E E C R R D F C M G O T R SOURCE: 2008 LOCAL GOVERNMENT BUDGETS AND EXPENDITURE REVIEW 2003/ /10, NATIONAL TREASURY, REPUBLIC OF SOUTH AFRICA Employee costs, materials and bulk purchases, and other expenditure dominate the municipal expenditure picture, while finance charges are quite small. As shown in Figure 6, finance charges are quite small and falling, at under 4% of operating expenditure per the most recent actual data. This indicates that in the aggregate, there is significant upward potential for increased long term borrowing to fund strategic infrastructure. Interestingly, and perhaps unrealistically, the Treasury projections anticipate sharp increases in finance charges, more than doubling from 2006/07 to the following year, and nearly tripling by the end of the MTEF period in 2009/10. Because revenue growth has outpaced expenditure growth, municipalities aggregate operating surpluses have been growing. Figure 7 below sets out the operating revenue, expenditure and surplus for the financial years 2003/4 to 2006/7. Revenue growth has been higher than expenditure growth by between 2-3% per annum. Part of this increase is due to changes in accounting (municipalities have moved to new accounting standards referred to as Generally Recognised Accounting Practice - GRAP). Another reason for the revenue growth has been the increase in government grants and the economic development in the major cities. 11

12 FIGURE 7: OPERATING SURPLUSES GENERATED ON A NATIONAL BASIS SOURCE: CALCULATED FROM BUDGET INFORMATION ON THE NATIONAL TREASURY WEBSITE MUNICIPAL CAPITAL EXPENDITURE Budgeted capital expenditure is high relative to operating expenditure, and has increased significantly in recent years. Figure 8 below shows the ratio for the fiscal years indicated. FIGURE 8: SUMMARY OF BUDGETED OPERATING AND CAPITAL EXPENDITURE 2003/4 2004/5 2005/6 2006/7 2007/8 R000 R000 R000 R000 R000 Operating 69,300, ,140, ,042,025 98,843, ,558,3 71 Capital 16,762, ,291, ,638,071 28,462, ,735,96 6 Ratio (%) Nominal increase yearon-year (%) SOURCE: A REVIEW OF THE FINANCIAL CAPACITY OF MUNICIPALITIES IN SOUTH AFRICA, ALAN YORKE, MARCH 2009 Capital expenditure budgets for the 2007/08 financial year are more than double the 2003/04 level. This is due in part to the investment in infrastructure that relates to the 2010 Soccer World Cup. For 2008/9 and 2009/10 (not shown in Figure 8), National Treasury projects a decline in the ratio of capital expenditure, after the 2010 World Cup spending is largely complete. Actual capital expenditure lags behind budgeted expenditure, but is also growing, and has nearly doubled from the 2003/04 to the 2006/07 financial years. In addition to this dramatic increase in actual spending, there is improved ability to spend what has been budgeted. Group 1 municipalities show a large and steady increase in actual expenditure, and significantly improved performance against budgets. The municipalities sampled in this group show both absolute gains in spending, and greatly increased spending performance as compared to budgeted amounts. In FY 2006/07, Group 1 municipalities spent 93% of what they had budgeted. Actual expenditures 12

13 in FY 2006/07 were roughly double those three years earlier. The conclusion is that Group 1 municipalities have been relatively successful in ramping up their spending capacity. Human resource capacity constraints are a concern, but outcomes in Group 1 municipalities suggest that capacity is growing. There are many programmes aimed at identifying and addressing the capacity gaps. The Synthesis report lists examples of analytical efforts and of capacity building and support programmes. While there are no quick fixes, investment outcomes suggest that capacity to spend is improving rapidly. As noted above, spending on local government infrastructure has roughly doubled from FY 2003/04 to 2006/07. Given the plethora of analytical and training programmes aimed at building capacity, and the increased spending over this recent period, there is reason for optimism that this trend will continue, and that capacity in Group 1 municipalities need not be a binding constraint. DEVELOPMENT CHARGES There are two types of development charges to consider: 1) capital cost recovery fees and 2) impact fees. Both are intended to recover the externalities associated with development from the development activity that creates the cost. Capital cost recovery fees are imposed by a municipality to recover historic costs that it has incurred to provide services. Such a fee is imposed when a new user connects to municipal networks. After a municipality has invested in plant and equipment in order to deliver electricity or water to new users, it can recover a proportionate share of that investment each time a new user connects. If the new user is a high end residential development, or a commercial or industrial user, it would pay the full cost. That cost can then be rolled into the developer s overall cost structure, and financed through the purchaser s mortgage bond. This shifts both the cost itself and the financing costs associated with it onto the actual user in an affordable way, freeing up municipal capital for more investment. 14 Without effective capital cost recovery, the municipality recovers its capital costs over time in the tariffs it charges meaning increased tariffs for all users. In practice, tariffs can be difficult to raise, so the full costs may never be recovered, in which case new investment will be discouraged, and the system will generally face financial challenges as it tries to balance its capital and operating requirements. An impact fee is a development charge for off-site impacts. For example, when a developer builds a new shopping mall, it ordinarily is required to upgrade the streets adjacent to the shopping mall, and to accommodate on-site impacts. But the new mall will also attract additional motor vehicle traffic over a wide area, potentially congesting streets and intersections some distance away. As more facilities are built in the area, new traffic lanes, traffic lights, and even highway interchanges may be required. In addition to the traffic impacts, the paving over of former farm land increases storm drainage loads downstream of the property, and ditches and culverts, even new water detention facilities may be required. These sorts of impacts are incremental and cumulative. It would not make sense for each new developer to expand downstream storm drainage facilities or build parts of highways. But in the aggregate, the lack of effective impact fees eventually imposes serious off-site financial and economic consequences. If off-site traffic improvements are not made, congestion increases, and everyone sits in long traffic jams whether they are headed for the shopping centre or not. If they are made, 14 If the end user is a low income user entitled to free basic services, then Government would pay some or all of the cost recovery. 13

14 the public often has to bear the cost of the improvements, and the developer has successfully moved part of his development cost onto the public. The burden of paying for infrastructure shifts, depending on the source of funds. When investments are funded from a municipality s general revenues and accumulated surpluses, the capital is provided by local taxpayers and consumers. When investments are funded from national grants, such as the Municipal Infrastructure Grant, the capital is provided by all South African taxpayers. When investments are funded from specific user charges or impact fees, the capital is generated from those who use the infrastructure, or create the need for it. Each of these approaches carries its own social and political dynamic, and has its own economic and financial implications. As a general principle, infrastructure which benefits the nation as a whole, such as that connected with health and education is mostly financed from general, national revenues. This means that the burden is borne by all taxpayers in proportion to their tax payments, with urban residents as a group therefore paying more than rural residents, and the rich paying more than the poor. Infrastructure that benefits residents within a particular municipality, such as the city streets and street lighting, storm drainage, parks, and similar public places are generally financed from general, local revenues. Infrastructure that benefits particular users, or is needed because of development by identifiable parties, can be financed in whole or in part from user fees and development charges. 15 Development charges have the potential to allocate costs more equitably: If we accept that affluent households, industrial and commercial users, and others that can afford to, should pay at least in proportion to what they use, or to the impacts they cause, then we would want to consider the role of development charges. These charges are typically imposed when a property is rezoned or subdivided, or when a new building permit is issued. They can be one way of ensuring appropriate contribution to the cost of additional municipal infrastructure arising out of development and densification. Money which is collected at the time of development is cheaper money for the public it isn t borrowed, and it doesn t carry financing charges. By contrast, if the capital cost of new water or sewer outfall lines is recovered through tariffs, then everyone s cost of water and sewage service goes up. Even low income users must pay more, because they have to cover the capital cost and carrying charges for someone else s development. Development charges have a long history in South Africa. One of the earliest recorded forms of development charge was a betterment fee levied in the former Cape Province beginning at least as early as Beginning from at least the 1970s, the former provincial administrations had land use planning ordinances that authorised the imposition of development charges as a condition of approval of development applications. A typical mechanism involved the developer s execution of an Acknowledgement of Debt (or Notarial Deed in the Natal Province) for anticipated or historical public expenditure related to the development proposal. The charges, or in-kind contribution, were established as part of the planning framework, rather than as part of the financial framework, a practice which continues today in municipalities. The current legal status of development charges is unclear. Some courts have considered development charges to be essentially a tax. 16 This may be sloppy use of language, but it 15 South Africa has determined that minimum levels of basic services to households should be a matter of right and provided as free services. There is less clarity about whether the full cost of free basic services should come from national subsidies, or whether some should come from local cross-subsidies. 16 Johannesburg City Council v Victteren Towers (Pty) Ltd (1975(4)SA334(W)); City Council of Johannesburg v Norven Investments (Pty) Ltd. (386/91) [1992] ZASCA 192 (12 November 1992) 14

15 points to the need to make a clear distinction, by legislative enactment if necessary. Taxes imposed for the purpose of raising revenue, should be distinguished from fees which seek to recover actual costs. There has also been confusion over when development charges are to be paid, e.g. at the time of the development application or when the owner receives a tangible advantage from selling the land at its increased value or of putting up a building in accordance with the new right accorded to the property. 17 This confusion is exacerbated by the fact that many of the ordinances predate the current Constitution and legislative framework for municipal finances. 18 In addition to the local planning legislation, the 1995 Development Facilitation Act authorises the Minister of Land Affairs to nationally regulate the payment by any person of compensation or a development contribution in respect of any such amendment or substitution and the basis for the calculation thereof, 19 though it does not appear that such regulations have been issued. Processes and amounts vary considerably. Planning departments, individual service departments, and engineering departments play various roles in different cities, and appear to have considerable discretion in establishing what should be paid, and the degree to which in-kind contributions will be made instead of cash payments. Methods and cost averages that were developed before the December 2000 amalgamation of municipal boundaries remain in use in some places. A paper prepared in support of this research is available, which documents the procedures in some detail. 20 Particularly striking is the wide variation in effective rates at which reported development charges are imposed, based on revenue received as a function of the value of buildings completed. The Synthesis Report contains a table showing some municipalities collect nothing at all, while others have collected as much as 50% of the value of buildings completed. Charges are often calculated conservatively, resulting in under-charging of developers and implicit public subsidies for new developments. Municipalities usually charge only for very specific impacts directly and narrowly related to new development. No attempt is made to charge developers for the capacity they use in shared facilities, nor for other external impacts. Although municipalities are required by Generally Recognised Municipal Accounting Practices to capture revenues from development charges, there is no consistency in this regard. It seems that development charges are actually falling as a percentage of the value of buildings completed and building plans approved. Because of data limitations, it is difficult to be precise about the amount of under-recovery, but we estimate the range for all municipalities at between R500 million and R4,7 billion per year. The result is that this financing burden is transferred to taxpayers in general, i.e. there are implicit subsidies to new developments, including those for affluent residents, commercial, and industrial users. This limits the pace at which municipalities can finance rehabilitation of existing facilities and extension of services to poor residents. Many off-site impacts of development are simply not addressed, resulted in congested infrastructure systems, which impose economic costs on society and act as a disincentive to job-creating 17 Johannesburg v Norven Investments, supra 18 The Municipal Fiscal Powers and Functions Act, No. 12 0f 2007 requires that municipal taxes or surcharges be approved by the Minister of Finance, so that if development charges are held to be such, they may be vulnerable to legal challenge where they have not received such approval. 19 Development Facilitation Act, No. 17 of 1995, section 46(1)(p) 20 Evaluating the Performance of Development Charges in Financing Municipal Infrastructure Investment, David Savage,

16 investment. By failing to adequately charge for and collect development charges, municipalities are implicitly: Transferring benefits to private developers through permitting them to maximise their profits at the cost of ratepayers and consumers Failing to tap into a ready source of infrastructure finance, which relies on the property finance industry and home-owner creditworthiness, rather than municipal balance sheets. Implicitly reallocating resources away from other priorities, such as pro-poor expenditures Imposing economic costs associated with network congestion Increasing the user charges that must be borne by all users BORROWING AND OTHER LEVERAGING OF MUNICIPAL REVENUES Leveraging resources through borrowing: Capital investment can be funded using future revenues, by promising to repay principal over time, with interest. This allows a municipality to leverage its resources and build more infrastructure more quickly than could be done on a payas-you go basis. The legal agreements that evidence borrowing can take many forms, including loan agreements and municipal bonds. The lenders can be one or more private investors, financial institutions, or public entities and development finance institutions. Other leveraging arrangements: There are many ways for a municipality to arrange infrastructure investments which are not thought of as borrowing, but which embody the same essential arrangement. For example, a municipality can promise to pay for electricity or treated water over time, in exchange for which a private investor builds a plant that can produce the desired commodity. Or a municipality can promise to lease equipment for a period, in exchange for which a private investor acquires the equipment and leases it to the municipality. These arrangements have many of the same financial characteristics and fiscal implications as borrowing. They can carry most of the same risks, and should be analysed in comparison to debt financing. All promises to pay from future revenues limit a municipality s future flexibility, because the funds committed to meet these obligations will not be available for other priorities that may emerge. Binding long-term financial commitments, in whatever form, inevitably reduce municipalities future flexibility to finance other investments, or to deal with unanticipated conditions. This is often a wise trade-off, because the capital investment being made will generate growth, or provide services, at a level that could never be afforded on a pay-as-you go basis. But it can be unwise if the capital from such arrangements is poorly invested. Leveraging is powerful - it can increase the benefits accruing from wise decisions, and they impose severe consequences for poor decisions. South Africa s policies are designed to allow leveraging of municipal resources through debt and other long-term commitments. South Africa has taken a clear policy decision that, in order to leverage in private sector investment, well-run municipalities must be able to make long term financial commitments, and meet them either from existing revenue streams (such as intergovernmental transfers, municipal taxes, or user tariffs) or from charges imposed on new users. The progressive development of policy in this area has been clear and consistent: In 1998, the White Paper on Local Government stressed the importance of gearing in private investment, and of using capital markets to do so. 16

17 In 2000, the Cabinet adopted a "Policy Framework for Municipal Borrowing and Financial Emergencies" which spelled out the details of government policy In 2001, Parliament added a new Section 230A to the Constitution, 21 which authorised a municipal council to legally bind the municipality over the long term, in order to secure loans and investments. 22 In 2003, Parliament revised Section 139 of the Constitution, 23 to lay the foundation for effective legislation governing resolution of financial problems in municipalities. Also in 2003, Parliament enacted the Municipal Finance Management Act (MFMA), 24 which laid out clear rules on municipal debt, in Chapter 6, and resolution of financial problems, in Chapter 13. In 2007, the Minister of Finance gazetted disclosure regulations, prescribing how transparency in borrowing is to be ensured. The policy framework for municipal borrowing is aimed at promoting market-based borrowing by creditworthy municipalities. The policy framework does not seek to make soft or subsidised credit available to municipalities. Rather, it seeks the discipline of at-risk lenders, who reward good municipal management with access to credit at reasonable prices, and who withhold credit from poorly managed municipalities. Lenders in South Africa are appropriately at financial risk if they irresponsibly lend beyond a municipality s ability to repay. Since the enactment of the MFMA, the Johannesburg and Cape Town municipalities have authorised general obligation bonds totalling about R8.1 billion. See Figure 9 below. The first Johannesburg issue was significant, being the first municipal bond issue since the end of apartheid. The subsequent issues and Cape Town s entry into the market are causes for optimism. Cape Town is now working on a second issue, valued at R1.2 billion. FIGURE 9: MUNICIPAL BOND ISSUES SINCE 1994 Issued amount (Z AR) Issued Date Coupon rate % Term of years Johannesburg 1,000,000, Apr Johannesburg 1,000,000, Jun Johannesburg 700,000, Apr Johannesburg 1,200,000,000 5-Jun Johannesburg 2,268,000,000 5-Jun Johannesburg 900,000,000 9-Dec Cape Town 1,000,000, Jun ,068,000,000 SOURCE: BOND EXCHANGE OF SOUTH AFRICA WEBSITE Notwithstanding these notable municipal bond issues, there has been less borrowing than was hoped for. As of 31 December 2007, National Treasury reports that the total outstanding 21 Section 17 of the Constitution of the Republic of South Africa Amendment Act, No. 34 of Prior to this amendment, the weight of legal opinion was that a municipal council could not make commitment that would bind future municipal councils. This was a clear barrier to long-term investment in municipal debt. 23 Section 4 of the Constitution of the Republic of South Africa Second Amendment Act, No. 3 of Act No. 56 of

18 long-term municipal borrowing stood at approximately R22.7 billion. 25 In nominal terms, this represents a slight upward trend over time, but adjusted for inflation, long term debt has actually declined, as can be seen in Figure 10 below. It should be noted that new borrowing from both public and private sources has been occurring, and at the same time old debt has reached maturity and been retired. The net effect of new borrowings undertaken, less old borrowings repaid, accounts for the outstanding debt stock levels illustrated in the figure. FIGURE 10: MUNICIPAL DEBT OUTSTANDING, ADJUSTED FOR INFLATION USING CPI FOR ALL ITEMS, METROPOLITAN AREAS PRIVATE SECTOR DEBT ADJUSTED FOR INFLATION PUBLIC SECTOR DEBT ADJUSTED FOR INFLATION SOURCE: AUTHORS CALCULATIONS BASED ON NATIONAL TREASURY DATA Prior to the most recent Johannesburg and Cape Town issues, the form of municipal borrowing has been trending in favour of more loans, and fewer bonds. The long term trends shown in Figure 11 below may now be reversing, but through the end of 2007 there had been a trend away from the issuance of securities and toward the placement of loans with specific investors. This has consequences for the secondary market and thus for the liquidity of municipal debt holdings. A more liquid market, which allows holders to dispose of holdings prior to maturity, is desirable both because it limits liquidity risk and encourages more investors to become involved, and because securities can be traded readily among institutional investors and even individuals. 25 Unfortunately, National Treasury does not have complete data since the end of 2007, reportedly because the data which previously came from the South African Reserve Bank is no longer available. As a result, National Treasury has not been able to use the same methodology track municipal borrowing data from the beginning of