Legislative Analyst's Office: February 2004 Analysis of the 2004-05 Budget Bill

CALFED Bay-Delta Program: At a Funding Crossroads

The CALFED Bay-Delta Program (CALFED), a consortium of 12 state and 13 federal agencies, was created to address a number of interrelated water problems in the state's Bay-Delta region. To date, there has been little direct application of the "beneficiary pays" principle in allocating the costs of this program, even though a funding gap of roughly $6 billion is projected to exist over the program's first seven years. We propose a framework for applying this principle and recommend that the Legislature take the following steps to implement this framework:

• Enact legislation adopting the beneficiary pays principle for funding CALFED and providing guidance on its application.
• Enact a user fee on a broad group of Bay-Delta system water users to partially support CALFED activities that jointly benefit the public-at-large and this group of water users.
• Reevaluate the cost-sharing provisions for water projects under current law.
• Enact legislation directing the California Bay-Delta Authority to submit updated long-term financial plans as part of its annual budget proposal to the Legislature.

CALFED's Funding History

CALFED Created to Address Bay-Delta Water Problems

The CALFED Bay-Delta Program. Pursuant to a federal-state accord signed in 1994, CALFED was administratively created as a consortium of state and federal agencies that have regulatory authority over water and resource management responsibilities in the Bay-Delta region. The CALFED program now encompasses 12 state and 13 federal agencies. The objectives of the program are to:

• Provide good water quality for all uses.
• Improve fish and wildlife habitat.
• Reduce the gap between water supplies and projected demand.
• Reduce the risks from deteriorating levees.

After five years of planning, CALFED began to implement programs and construct projects in 2000. The program's implementation—which is anticipated to last 30 years—is guided by the "Record of Decision" (ROD). The ROD represents the approval of the lead CALFED agencies of the final environmental review documents for the CALFED "plan." Among other things, the ROD lays out the roles and responsibilities of each participating agency, sets goals for the program and types of projects to be pursued, and includes an estimate of the program's costs for its first seven years. In the ROD, these costs are projected to total $8.5 billion for the program's first seven years (2000-01 through 2006-07). This amount has recently been revised upward to $9.2 billion.

CALFED Overseen by the California Bay-Delta Authority. Chapter 812, Statutes of 2002 (SB 1653, Costa), established a governance structure for CALFED. Of the most important elements of this legislation was the creation of a new state agency in the Resources Agency—the California Bay-Delta Authority (CBDA)—to provide oversight and coordination of CALFED. Among the duties of CBDA are the annual review and approval of long-term expenditure plans of the implementing agencies and the preparation of a comprehensive program budget proposal.

Legislative and Other Direction Guiding CALFED Financing

The financing of the CALFED Bay-Delta Program (CALFED) has been guided by funding principles found in the CALFED Record of Decision, various statements of legislative intent, cost-sharing provisions for water projects found in state and federal law, and state bond matching requirements.

There are a number of places in law that provide guidance regarding the financing of CALFED. As discussed below, the ROD contains some guiding principles, including the beneficiary pays principle. The Legislature has also provided direction on a number of occasions regarding how CALFED should be financed, namely in the annual budget act. Finally, state and federal law include cost-sharing arrangements for water projects in general that are relevant to CALFED. In some cases, the cost-sharing pertains to a certain type of project, such as local levees in the Delta region. In other cases, the cost sharing is in the form of a matching requirement for state bond funds.

Record of Decision Envisions a Federal-State-Local-User Funding Partnership. The ROD allocates responsibility for paying the program's projected costs among federal, state, and local/private sources. In most cases, the cost sharing reflects simply a 50-50 split between state and federal sources or a 33-33-33 split among federal, state, and local/private sources. Thus, it was contemplated that each level of government, as well as water users benefiting from the program, would all be major players in financing the program. As will be discussed below, the program's financing to date has turned out rather differently, with the state picking up a majority of the tab and the federal government lagging substantially in its support.

Record of Decision Adopts the Beneficiary Pays Principle. The ROD also states that "a fundamental philosophy of the CALFED Program is that costs should, to the extent possible, be paid by the beneficiaries of the program actions." The ROD, however, provides few details as to how this principle would be implemented. One exception where specific guidance was provided is the ROD's direction that a user fee be developed—to raise $35 million annually—to support ecosystem restoration activities that benefit Bay-Delta water users.

The CALFED Implementation Plan (a companion document to the ROD) also references the development of a "user fee" to partially support CALFED program costs and provides a policy rationale for the beneficiary pays principle. In addition to CALFED agencies considering this policy to be equitable and fair, the plan states that having beneficiaries pay for programs encourages more careful review by beneficiaries of their water needs and of program costs in relation to the benefits they receive. In addition, public funds are spent more cost-effectively to the extent that the implementation of the beneficiary pays principle encourages the examination of a broader range of alternatives to meet program goals.

Legislature Has Provided Direction Regarding CALFED Financing. While neither the CALFED governance legislation (Chapter 812) nor other legislation lays out a comprehensive framework for how CALFED should be financed over the long term, the Legislature on a number of occasions stated its intent regarding CALFED financing. These include budget control language in the 1999-00 and 2000-01 Budget Acts stating that beneficiaries of surface water storage projects that proceed to construction should reimburse all prior planning expenditures made from the General Fund. Similarly, in the Supplemental Report of the 2002-03 Budget Act, the Legislature directed CALFED to draft a financing plan for potential surface storage facilities consistent with the beneficiary pays principle. Finally, the 2003-04 Budget Act includes a statement of legislative intent that CBDA submit a broad-based user fee proposal for inclusion in the 2004-05 Governor's Budget, consistent with the beneficiary pays principle specified in the ROD. (We discuss the status of CBDA's user fee proposal later in this write-up.)

Federal and State Cost-Sharing Provisions for Water Projects. There are various provisions under state and federal law that provide for a sharing of costs among federal, state, and local/user sources for the construction and operation of certain types of water projects. Some of these provisions reflect cost-sharing arrangements that were established several decades ago. As will be discussed later, the Legislature may wish to reevaluate the appropriateness of some of these provisions, including their application to financing CALFED-related projects. This is because if applied to the financing of CALFED projects, some of these cost-sharing provisions might deviate significantly from the application of the beneficiary pays principle. Figure 1 highlights a number of the cost-sharing provisions under current law.

State Bond Matching Requirements. In addition to the cost-sharing provisions discussed above, a number of state bond measures, or their implementing legislation, providing funding for CALFED projects either require, authorize, or encourage matching funds. For example, Chapter 240, Statutes of 2003 (AB 1747, Committee on Budget), provides that the Proposition 50 grant and loan project solicitation and evaluation guidelines may include a requirement for matching funds. As a result, matching funds are currently "considered" in the selection of CALFED's Proposition 50 ecosystem restoration and watershed grants and are a requirement of the Proposition 50 water use efficiency grants.

As regards Proposition 13 bond funding, the bond measure in general encourages, but does not require, matching funds for grants in CALFED's ecosystem restoration, groundwater storage, conveyance, and water supply reliability program elements. In many cases, the CALFED implementing agencies have chosen only to consider the availability of matching funds in their Proposition 13 grant selection rather than require the matching funds. However, Proposition 13 grants under CALFED for conveyance, water use efficiency, and capital projects to control nonpoint source pollution are subject to matching requirements. Finally, CALFED agencies consider without requiring matching funds in their selection of Proposition 204 ecosystem restoration grants.

State Funds Have Contributed Most to CALFED

The CALFED Bay-Delta Program (CALFED) has largely been funded by state bond and general funds, with substantially lagging federal and other nonstate support. Our review finds that there has been little direct application of the beneficiary pays principle in developing CALFED's budget proposals up to now.

State Has Been the Major Contributor to CALFED, by Far. Although the ROD envisioned CALFED being financed over time by roughly equal contributions of federal, state, and local/user funding, the state has been by far the major funding source for the program's first four years, providing over $1.5 billion, or almost 60 percent, of funding. Figure 2 shows the imbalance of the contributions of these three funding sources.

Almost all of the state funds supporting CALFED have been taxpayer-supported "general-purpose" funds, namely monies from the General Fund and bond funds. Apart from a relatively small contribution from State Water Project and Central Valley Project contractor revenues, no user fees have supported the program. The local funding support for the program, while significant, largely reflects a match for state bond funds mainly for water use efficiency projects.

Consequences of Lagging Nonstate Support. We find that the lagging nonstate support for CALFED has affected the amount of funds available for the program's various elements very differently. As shown in Figure 3, the biggest gap between funding anticipated in the ROD and actual funding during CALFED's first four years is found in the drinking water quality (funding shortfall of 73 percent), levees (68 percent), science (52 percent), and water transfers (57 percent) program elements. (The funding gap for levees and science in future years will be partially addressed by Proposition 50 that provides funds explicitly for these two program elements.) Other program elements—water use efficiency and ecosystem restoration in particular—have had access to substantial state bond funds in order to make up most of a funding deficiency due to lagging nonstate support.

Little Direct Application of the Beneficiary Pays Principle. Our review finds that during the course of the program's first four years, few funding decisions appear to have been made by the CALFED administration that involve an intentional, direct application of the beneficiary pays principle. (There are a few exceptions to this. For example, CALFED's water conservation grant program has developed a new process in which each grant application is reviewed to determine the local and state share of the benefits and costs.)

While CBDA indicates that the program has followed cost-sharing or matching requirements in current law or state bond implementation guidelines, it is unable to say if existing practices are consistent or inconsistent with the beneficiary pays principle. Rather, the CBDA anticipates making this determination when it completes its analysis of the program's benefits and beneficiaries later in the spring.

As a consequence of the above, almost all of the state funds supporting the program have been taxpayer-supported funds, without there being an explicit accounting of the extent to which the program's benefits were received by individuals or groups of beneficiaries, as opposed to the public-at-large.

CALFED's Funding Future: An Enormous Gap to Be Filled

Actual and expected funding sources have been identified for only about one-third of CALFED's funding requirements for the program's first seven years.

Funding Is Uncertain for About Two-thirds of Estimated $9.2 Billion Program Costs. The CALFED program is clearly at a funding crossroads. As shown in Figure 4, CBDA has identified actual and expected funding to support about $3.1 billion, or roughly 33 percent, of the program's funding requirements for the program's first seven years beginning in 2000. (Expected future-year funding includes remaining state bond funds and continuation of base-level state funding from sources other than bonds, such as the General Fund. No future-year federal funding has been assumed by CBDA. However, while it is likely that some federal funds will materialize in future years, history would suggest that this funding is unlikely to be substantial.) Accordingly, this leaves about $6.1 billion, or 67 percent, of the program's estimated costs without an identified funding source to pay for them.

The Budget Proposal

The budget proposes $68.6 million in state funds for the CALFED Bay-Delta Program in 2004-05, of which $12 million is from the General Fund and the balance mainly from State Water Project funds and bond funds. This is a decrease of $454 million, or 87 percent, from estimated state expenditures in the current year. This decrease largely reflects the administration's decision to defer to later in the spring the submittal of most of the Governor's 2004-05 resources bond proposals. Contrary to legislative direction, the budget does not propose funding from a new user fee. Rather, the administration indicates that it intends to submit a framework for long-term finance "options," including a user fee, later in the spring.

Figure 5 shows the breakdown of CALFED expenditures in the current year and as proposed for 2004-05, among the program's 12 elements.

Current-Year Expenditures. As shown in Figure 5, the budget estimates CALFED-related expenditures from state funds of $522.6 million in 2003-04. Of this amount, $14.7 million is from the General Fund, with the balance mainly from Proposition 50 ($349.9 million), Proposition 13 ($71.6 million), and Proposition 204 ($50.1 million) bond funds.

For the current year, the largest state expenditures are in the ecosystem restoration ($136.3 million) and water use efficiency ($112.7 million) programs.

Budget Proposes $68.6 Million of State Funds for 2004-05. As shown in Figure 5, the budget proposes $68.6 million of state funds for various departments to carry out CALFED in 2004-05, a decrease of $454 million, or 87 percent, from the current year. Of this amount, $12 million is proposed from the General Fund, with the balance mainly from State Water Project funds ($33.4 million) and various bond funds ($20.3 million). This substantial expenditure reduction largely reflects the administration's decision to defer to later in the spring the submittal of most of the Governor's proposals to spend resources bonds in 2004-05.

As Figure 5 indicates, CALFED expenditures are spread among seven agencies. The largest expenditures are found in the Department of Water Resources ($53.7 million) and CBDA ($9.4 million). The largest state expenditures are proposed for water conveyance ($21.5 million) and ecosystem restoration ($11.9 million).

Budget Does Not Include a User Fee Proposal. The 2003-04 Budget Act stated legislative intent that the Governor's 2004-05 budget proposal for CALFED include a broad-based user fee consistent with the beneficiary pays principle. However, the budget as submitted to the Legislature does not include a user fee proposal. Rather, CBDA is currently developing a framework for financing CALFED over the long term that will include a number of finance options. The CBDA anticipates such a framework being ready for legislative review later this spring.

Legislative Evaluation of Budget Proposal. In the sections that follow, we present a funding framework—based on the beneficiary pays principle—to guide the Legislature's evaluation of the Governor's budget proposal for CALFED and its consideration of how CALFED should be financed over the long term. We think that the Legislature's policy direction to, and oversight of, CALFED is enhanced by having the relevant policy and budget committees, in each house, jointly consider CALFED budget proposals at oversight hearings as was done in past years. Among other issues, these joint hearings should be a forum for the Legislature to be informed of the programmatic implications if federal support for CALFED continues at its laggard pace and of CBDA's plans to address this problem. To the extent possible, we think that the Legislature should articulate its expenditure priorities for CALFED. This would help guide a redistribution of funds among program elements that might become necessary should funding assumed by the budget not materialize.

The Future: A Recommended Funding Framework for CALFED

In the sections that follow, we recommend a funding framework for the CALFED Bay-Delta Program (CALFED), involving the beneficiary pays principle. This framework should assist the Legislature in evaluating the California Bay-Delta Authority's forthcoming report on CALFED financing options. In addition, we think that the implementation of the beneficiary pays principle can assist in addressing CALFED's substantial projected funding gap.

Statutory Adoption of the Beneficiary Pays Principle

We recommend the enactment of legislation that adopts the beneficiary pays principle as a policy for funding the CALFED Bay-Delta Program (CALFED) and provides guidance on its application. In particular, we recommend that the legislation require that the General Fund be reimbursed for planning costs of surface storage projects that proceed to construction. We also recommend that the legislation provide parameters for using state general-purpose funds to support CALFED activities.

Adoption of Beneficiary Pays Principle in Statute. Although the Legislature has made statements of intent (such as in budget act language) consistent with the application of the beneficiary pays principle in funding CALFED, it has not adopted this funding principle as a statutory policy to guide CALFED's funding on an ongoing basis. We think that there are major benefits from applying this principle to CALFED funding-related decision making. Not only will this result in a more appropriate allocation of the program's costs to those who benefit from the program, but it will also serve as a foundation to begin addressing the substantial projected funding gap facing the program. The application of the beneficiary pays principle serves to refine the rough 33-33-33 cost allocation (to federal, state, and local/user sources) found in the ROD. The 33-33-33 allocation was more of an indication that the program's costs would be shared, with the intent that costs would be allocated more specifically to program beneficiaries on an activity-by-activity basis.

We therefore recommend the enactment of legislation that adopts the beneficiary pays principle for funding CALFED and provides guidance regarding its application. We think that providing this guidance will be important for a couple of reasons. First, if this funding principle is not defined, there is a substantial risk that stakeholder gridlock would result when CALFED attempts to apply it on its own, due to inevitable disagreements among program beneficiaries about the extent to which costs should be allocated to them. Second, as noted by the California Business Roundtable in a report on financing water infrastructure, there is a tendency to over-allocate the costs of water projects to the broad public benefit, perhaps because it is easier to do and it avoids difficult decisions about allocating costs to specific beneficiaries. However, this tendency should be avoided, particularly in light of the significant drawing down in recent years of bond funds available for water projects.

Fairness and Administrative Simplicity Should Guide Application of Beneficiary Pays Principle. We recommend that the legislation provide a framework for the application of the beneficiary pays principle that is guided by principles of fairness and administrative simplicity. By fairness, we mean that costs imposed on beneficiaries should be reasonably proportional to the benefit received by them. In the sections that follow, we discuss a framework that we think would be fair and administratively cost-effective to implement.

Categorizing Activities by Directness of the Cost-Benefit Connection. The legislation should recognize that there is great variability among CALFED activities in the directness of the connection between an activity's costs and the benefits received by clearly identified, well-defined beneficiaries. We think that the administrative workability of implementing the beneficiary pays principle would be improved if the legislation required CALFED's activities to be broadly categorized on a spectrum according to the directness of this cost-benefit connection. We recommend that there be three broad categories on this spectrum as follows.

When Private Parties Should Pay. At one end of the spectrum would be activities where there is a very direct link between a cost and a well-defined, discrete group of private beneficiaries. A case in point would be the construction of a surface storage project that benefits an easily identified, discrete group of water users. It would be consistent with how the state currently funds the SWP to require full cost recovery for such projects from these direct project beneficiaries.

It is important to note that of the projected funding gap for CALFED programs discussed earlier, the largest portions by far relate to the storage and water use efficiency programs (over $3 billion of the gap). Projects under these programs typically have a well-defined, discrete group of private beneficiaries. Therefore, as these projects are finalized over the coming years and the beneficiaries are identified, the implementation of the beneficiary pays principle would result in the costs being allocated to these private beneficiaries.

As part of implementing the beneficiary pays principle in the storage program, we recommend that the legislation require that the General Fund be reimbursed for any planning costs that it has already funded for s