April 21, 1998

  To:Strategic Policies and Priorities Committee

 From:City Clerk

 Subject:Proposed Capital Financing Management Plan and Other Capital Funding Issues

 Recommendation:

 The Budget Committee on April 20, 1998, recommended to the Strategic Policies and Priorities Committee, and Council, the adoption of the report (April 16, 1998) from the Chief Financial Officer and Treasurer.

 The Budget Committee reports having requested the Chief Administrative Officer to review the TTC state of good repair budget and report to the Budget Committee on the appropriateness and financing of those assets and providing a comparison with the other infrastructure in the City.

 Background:

 The Budget Committee on April 20, 1998, had before it a report (April 16, 1998) from the Chief Financial Officer and Treasurer forwarding recommendations regarding the proposed Capital financing management plan and other Capital funding issues.

 City Clerk

 Barbara Liddiard/rc/cp

Item No. 1

Attachment

 c.Chief Financial Officer and Treasurer

Chief Administrative Officer

General Secretary, Toronto Transit Commission

Mr. Len Brittain, Finance Department

(Report dated April 16, 1998, addressed to the

Budget Committee from the

Chief Financial Officer and Treasurer)

 Purpose:

 To outline a plan for minimizing fluctuations in future operating budgets caused by the capital budget.

  Financial Implications:

 There are no immediate financial implications from this report. The recommendations contained herein will reduce the impact of the capital program on future operating budgets.

  Recommendations:

 It is recommended that:

 (1)as a guideline, Council adopt future capital programs which would limit average borrowing to a maximum of $110 million for tax supported programs, excluding the impact of TTC downloading and borrowing for the Sheppard Subway;

 (2)a Capital Financing Stabilization Reserve be established to minimize fluctuations in future operating budgets due to changes in debt charges and that seed funding be provided from the consolidation of like reserves of the former municipalities;

 (3)the base level of capital from current be increased by a minimum of $15 million in 1998 (as contained in the operating budget currently being considered) and that Council approve, in principle, further increases of $25 million in each of 1999 and 2000, $35 million in 2001 and $40 million in each of 2002 and 2003 to offset the impact of Provincial Downloading on the capital program of the TTC, estimated at a total of $180 million annually;

 (4)the Chief Financial Officer and Treasurer review, and bring forward for Council=s consideration as appropriate, potential offsets against future capital from current increases contained in recommendation (3); and

 (5)proceeds from major asset sales be applied to reduce borrowing each year, unless Council specifies that a portion of these proceeds be used to fund major rehabilitation and maintenance projects.

 Council Reference:

 Budget Committee, at its meeting on March 12, 1998, directed the Chief Financial Officer to bring forward options for the management of the City=s debt and recommendations regarding the disposal of assets in 1998. At its meeting of February 4, 1998, Council adopted a report from the Chief Financial Officer and Treasurer (January 20, 1998), entitled A1998 Capital Works Program - Preliminary Targets@. Among the recommendations adopted within that report was the establishment of an interim limit of debt charges to 10 percent of the municipal property tax levy and the setting of a minimum amount and general allocation of capital from current.

 Discussion:

 In the absence of financial stabilization policies, operating budgets may be subject to substantial fluctuations from year to year which largely result from prior years= Council decisions. This report addresses the following objectives which would otherwise impact on future operating budgets:

 (1)establish a Capital Financing Stabilization Reserve which would flat-line debt charges in future years at the 1998 level, excluding impacts of Provincial downloading on the TTC; and

(2)identify preliminary options for addressing the TTC downloading issue.

 As well, as requested by the Budget Committee at its meeting of March 9-12, 1998, further options for reducing 1998 borrowing are outlined.

 The proposed plan is predicated on Council approving capital programs which, on average, limit annual borrowing to $110 million for tax supported programs (excluding the impact of TTC downloading which is addressed separately, and the Sheppard Subway which is financed from a dedicated reserve account). While one-time deviations from this plan could be accommodated within the program, approval of capital programs above this level on an ongoing basis would result in debt charge pressure in future operating budgets. Until detailed planning and costing of infrastructure maintenance has been carried out, for example, long term facilities and road maintenance requirements, the adequacy of the $110 million borrowing level cannot be determined. As well, there are potential costs on the horizon that could further add to the City=s capital pressures. For example, capital requirements have not yet been determined for GO Transit, a potential long term landfill site, or for social housing.

 While the ultimate goal of the City should be to establish the capital program on a basis which would reduce future debt charges and move to more of a pay as you go basis, this would be possible only through one or more of the following actions:

 (1)reducing future capital expenditures - to the extent that the program is oriented toward maintenance and rehabilitation requirements, it would be inadvisable over the longer term to defer maintenance - longer terms costs would be higher as a result of this strategy whereby rehabilitation could give way to replacement of assets.

 (2)identifying alternative sources of revenue. A process is now underway to evaluate and bring forward recommendations on a City-wide development charges program. As well, other potential revenue sources will continue to be evaluated, for example, asset sales.

 It must be recognized, though, that the combined impacts of the above actions will be unlikely to offset a significant portion of the Provincial TTC downloading. As well, the Operating Budget will continue to be stretched to accommodate the operating impact of downloading and the City=s own pressures, and cannot be expected to also absorb the capital downloading. The inescapable conclusion is that successive operating budgets should accommodate the TTC downloading. Options for phasing in these operating increases are discussed later in this report.

  Fluctuations in Debt Charges:

 One component of the operating budget which can fluctuate from year to year and which is largely beyond the control of Council in each year is the reduction in debt charges from maturing debt. Decisions made with respect to capital borrowing up to 10 years prior have a direct bearing on the level of debt charges each year, regardless of the capital program being considered. This will occur, even if, for example, Council adopted a capital program over the next five years which approximated a stable borrowing level of $110 million, exclusive of the impact of Provincial TTC downloading, and the Rapid Transit Expansion Program which is discussed later in this report.

 To offset these fluctuations in debt charges, it is recommended that a Capital Financing Stabilization Reserve be established. Currently, reserves exist in the former municipalities for capital financing purposes, with an aggregate 1998 opening balance of approximately $30 million. On the basis that Council approves successive capital programs which maintain tax supported borrowing requirements of an average of $110 million, exclusive of the impact of TTC downloading, then the reserve could be used to stabilize debt charges in future years at the 1998 level. In those years where debt retirements were low, or, because of market conditions, borrowing occurred earlier in the year, withdrawals could be made from the reserve. Alternatively, when retirements were high or borrowing occurred later in the year, provisions could be made to the reserve. Over time, the reserve could be expected to maintain a constant balance.

 Following illustrates how the reserve could work with annual borrowing of $110 million. The actual provisions and withdrawals to and from the reserve will vary from these, based on actual market conditions, timing of borrowing, levels of capital expenditures, capital from current changes based on the recommendations above, etc.

 Capital Financing Stabilization ($Million)

19981999200020012002

 Change in Tax Supported Debt Charges

($110 million annual borrowing excl.

Impact of Provincial TTC

Downloading and RTEP):08(12)4(8)

Offset To/(From) Stabilization Reserve0(8)12(4)8

Net Change in Debt Charges00000

 Capital Financing Stabilization Reserve

Opening Balance3030223430

Provisions/(Withdrawals)0(8)12(4)8

Closing Balance3022343038

   TTC Downloading:

 The above recommendations are designed to manage fluctuations in future operating budgets. They exclude the impact of Provincial downloading on the TTC on basis of the fact that the balance of the capital program, which is mainly dedicated to infrastructure rehabilitation and maintenance, cannot absorb the downloading. In fact, the impact of approximately $180 million is more than one and a half times the stable borrowing level. Were the balance of the capital program to be maintained, i.e. requiring annual borrowing of $110 million, and no offsets found against the downloading, the total annual borrowing requirements would rise to $290 million by the year 2001. Debt charges would rise over the next 20 years from the current level of $200 million to $470 million, requiring average increases in the operating budget of $14 million, or 0.5 per cent. every year for 20 years. At the same time, debt charges as a per cent. of property taxes would rise from the current level of 7.5 per cent. to 18 per cent. At some point, the inevitable downward implications on the Corporation=s credit rating could also affect the City=s borrowing rate, which would further push future capital financing costs higher.

 To maintain the Corporation=s infrastructure, limit future operating budget impacts, and maintain the City on a sound financial footing, it is critical that the TTC downloading issue be addressed decisively. As such, it is recommended that the base level of capital from current be increased by a minimum of $15 million in 1998, as contained in the preliminary budget being considered by the Budget Committee. From a financial standpoint, the ideal solution would be to fully offset the impact of downloading in each year through corresponding increases to capital from current, i.e. $45 million in 1998, and a further $15 million in 1999, $5 million in 2000 and $115 million in 2001. However, from a practical standpoint, this may place undue burdens on the operating budget in certain years. Instead, it may be preferable to phase in the increases to capital from current and borrow the remaining shortfall in each year.

 It is therefore recommended that Council approve, in principle, additional increases to the base operating budget of $25 million in each of 1999 and 2000, $35 million in 2001 and $40 million over the succeeding two years to offset the impact of Provincial Downloading on the capital program of the TTC.

 Following is a summary of the impacts of the TTC downloading and recommended approach:

  Impacts $Million

1998199920002001

Annual Provincial Downloading Impact456065180

Cumulative Capital From Current Increase154065100

Borrowing for Remaining Shortfall 3020080

Accumulated Debt Charges on Shortfall15710

 Although these recommendations will cause very significant operating pressures over the next few years, these increases are critical to the ongoing financial condition of the Corporation. To the extent that there may be other options to the recommended capital from current increases, it is recommended that potential offsets be reviewed and brought forward for Council=s consideration as appropriate.

  Funding of the Rapid Transit Expansion Program (Sheppard Subway):

 A further factor which will affect future debt charges is the Sheppard Subway. When Metro Council approved construction of the line in 1996, it dedicated $12 million annually to a reserve to fund future debt charges, which translated at that time into a one per cent. dedicated tax. This increase was predicated on the fact that the balance of Metro=s capital program or operating budget could not absorb the impact of RTEP. At that time, Metro Council was apprised that further increases in the annual provision to the reserve of approximately $24 million would be required to fully offset the debt charges and the approval of the RTEP program was made on that basis.

 Based on the total expenditures to date and projected cash flows and a continuation in the operating budget of the $12 million annual provision, the existing reserve will be insufficient to offset the debt charges by the year 2000. In that year, the shortfall will be $7.6 million and will grow to approximately $24 million following completion of borrowing for the line in 2002. Council will be given the opportunity at that time to increase the annual contribution to the reserve, increase the operating budget by the amount required each year to fund the debt charges, or incorporate other potential financing options. The impacts of RTEP debt charges have not been factored into the capital financing options identified in this report, above. In other words, the recommended capital financing stabilization reserve is not intended to fund debt charges related to RTEP.

   Summary of Operating Impacts From Above Recommendations:

 In total, the following operating impacts would result from the above recommendations:

  Annual Operating Impacts $Million

19981999200020012002

 Base Program (After Stabilization Reserve)00000

TTC Provincial Downloading:

Capital From Current Increase1525253540

Accumulated Debt Charges From

Remaining Shortfall142311

RTEP Additional Requirements008105

Total Projected Annual Impacts1629354856

   Potential Offsets Against 1998 Borrowing:

 Following is a breakdown of the net borrowing requirements for tax supported programs (excluding Sheppard Subway) based on the 1998 Capital Budget recommended by the Budget Committee at its meeting of March 31 and April 2 and 3, 1998:

  $Million

Base ProgramTTC DownloadingTotal

 Net Requirements27045315

Potential Underspending/

Cash Flow Deferrals(46)0(46)

Capital From Current/Other

Internal Funding(131)(15)(146)

Borrowing9330123

 Incorporated within the above financing is one time revenues of $20 million. In a communication dated March 11, 1998, the Chairman of the Toronto Parking Authority indicated that, on a one time basis in 1998, surplus capital reserve funds in the amount of $20 million could be made available to the City. Given that a sizeable portion of the 1998 Capital program is committed to past funding decisions and that the new City has not had the time to fully review its long term capital priorities, it is appropriate to use funding of this type on a one time basis to reduce 1998 borrowing requirements. Of the $20 million proposed by the Authority, $10 million was included as a potential funding source within the Capital from Current and Other Internal Funding previously tabled with the Budget Committee. The balance of $10 million has been applied in the above table and reduces the borrowing for the recommended base program to $93 million, below the long term stable borrowing level of $110 million.

 A second potential capital financing tool is the sale of surplus City owned properties and other major assets. From a financial perspective, an appropriate use of these funds is against capital borrowing requirements. One option would be to apply proceeds from asset sales to reduce debt each year and make corresponding increases to the capital from current allocation equal to the debt charges avoided from this action.

 As an illustration, were the City to secure surplus revenues annually of $35 million over ten years from sale of assets or other sources and applied these amounts to reduce annual borrowing, the City could increase its capital from current by $80 million and reduce its annual debt charges by $90 million, while maintaining a base capital program at the 1998 level (again, excluding the impact of TTC downloading and RTEP). At that rate, one half of the annual reductions in debt charges from the retirement of old debt would be converted to additional capital from current each year. There is no indication at this time that such surplus revenues would be available, but the same concept could apply to lesser amounts which would help to reduce the reliance on debt. The change in mix of capital financing from capital from current and debt charges from this scenario is illustrated in the following graph:

 Given that surplus asset sales provide a temporary source of funding, it may also be appropriate during the transition to the new City to use such funds to offset borrowing required for transition related projects. The funding of such projects will be the subject of a separate report.

 The Case for Debt Financing:

 Several major trends continue to influence domestic and international financial markets. The effects of global access to markets, deregulation, competition as well as new financing alternatives have created new opportunities for innovation and being able to achieve lower borrowing costs.

 Although the City is committed to reducing its reliance on debt issuance to finance capital expenditures over the next five years, it is important to realize that the cost of issuing municipal debt has never been lower over the last thirty years. The financial markets have emerged from a period of extreme volatility, high rates of inflation and federal and provincial deficits to an era of low inflation accompanied by low interest rates not seen since 1968 and the virtual elimination of current budgeted operating deficits. Even with a declining need for debt being established as an objective to be achieved over the next five years, it is important to have the ability to participate in the financial markets with an appropriate degree of flexibility to ensure that the City=s transactions are successful and result in the lowest cost of funds available. Therefore, although a target of $110 million in average debt issuance is being recommended, there must be the ability to vary this amount as well as the term-to-maturity on occasion, depending upon market conditions. Debt financing occurs in a highly specialized environment and requires the ability to be able to respond to economic and financial indications as judged to be appropriate.

 Debt, when managed properly, is one of several efficient and effective methods of financing capital projects. It can be used to equate the costs and benefits of capital expenditures over the useful economic life of the asset in order to transfer the cost of infrastructure between current and future generations who will also benefit from the project. This argument is suited to growth-related projects with an extended useful life such as a subway and not for regular maintenance and required renovation which should either be financed from current funds or through debt with a relatively short maturity.

 In order to handle an emergency, such as the ice storm which affected parts of eastern Ontario and Quebec earlier this year, debt financing may be the only reasonable course of action available to cover these types of expenditures.

 Although it may be difficult to measure at the municipal level, responsible and well-managed debt financing can have a positive impact on the local economy by providing jobs, income and a demand for construction materials whereby the alternative would be a deferral of various projects until funding could be provided from current funds. By avoiding these delays, the City may be able to take advantage of favourable economic conditions whereby a skilled labour force, combined with lower material costs can actually create cost-savings and allow a project to be completed under-budget and on time.

 In order for a capital financing management plan to be effective, it must be responsive to external economic and financial conditions and not artificially constrain the ability to participate in domestic and global capital markets in order to achieve the lowest cost of funds available through a successful transaction.

 Conclusions:

 The recommendations contained in this report would serve to minimize the fluctuations in future operating budgets due to annual changes in debt charges. Further, specific recommendations with respect to capital from current funding to offset the impacts of Provincial downloading on the TTC are identified. Although these will dramatically impact on the operating budget over the next few years, the actions are necessary to maintain the City=s long term financial stability and infrastructure. Finally, recommended application of one-time offsets against borrowing would reduce the impact of future debt charges on the operating budget.

 Contact Name:

 Len Brittain, 392-5380; Fax: 392-3649; Internet: len_s._brittain@metrodesk.metrotor.on.ca