WATER GLOBAL PRACTICE: DISCUSSION PAPER Achieving Universal Access to Water and Sanitation by 2030 The Role of Blended Finance James Leigland, Sophie Trémolet, and John Ikeda August 2016 01 Achieving Universal Access to Water and Sanitation by 2030 The Role of Blended Finance James Leigland, Sophie Trémolet, and John Ikeda August 2016 Acknowledgments This discussion paper was prepared by the Water Supply and Sanitation (WSS) Global Solutions Group (GSG) of the World Bank Water Global Practice, as part of the Financing Universal Access to Water Supply and Sanitation initiative. This initiative supports countries in their efforts to mobilize commercial finance for water service providers. The paper was authored by James Leigland, Sophie Trémolet, and John Ikeda, with support and input from William Kingdom, Joel Kolker, and Meredith Kummings. 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Cover design: Ryan Clennan, Studio Grafik. www.worldbank.org/water © 2016 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Contents Where is Financing for the Water SDG Going to Come From?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Constraints Limiting Private Financing to the Water Sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Addressing the Financing Gap with Blended Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Tailoring Blended Finance Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Going Forward: Scaling-Up Blended Finance Approaches. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Conclusions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 iv Achieving Universal Access to Water and Sanitation by 2030 The Role of Blended Finance T he Millennium Development Goals helped rally the At present, most water sector actors in developing coun- world around the challenge of providing access to tries rely on government lending and concessional financ- improved water supply and sanitation (WSS). By ing from bilateral and multilateral development banks 2015 hundreds of millions of people had gained (MDBs) to mobilize financing for capital investment. These access to improved water sources and better sanita- financial sources alone will not be sufficient to finance tion. Despite this, with hundreds of millions more still investments on the scale that is called for by the SDGs. lacking access, much remains to be done. Sustainable It is therefore essential to mobilize up-front financing from Development Goal 6 (SDG 6) significantly raises the private, or “commercial” sources as well. In particular, level of ambition for the water sector, calling for universal mobilizing domestic commercial finance (i.e. from domes- access to safe water and sanitation while addressing tic investors in local currency) would eliminate foreign issues of water quality and scarcity to balance the needs exchange risk and help reduce transaction costs. of households, agriculture, industry, energy, and the envi- ronment over the next 15 years. Commercial finance can come in various forms, including: A substantial increase in sector financing will be neces- • Commercial bank loans  When a bank provides a sary to achieve SDG 6. Recent estimates by the World loan at market-based lending terms. These differ from Bank’s Water and Sanitation Program (WSP) indicate “concessional loans,” i.e. loans provided by develop- that the present value of the additional investment in ment banks at conditions that are more advanta- WSS alone needed through 2030 will exceed US$1.7 tril- geous to the borrower than market conditions. lion (Hutton & Varughese 2016). Existing funding falls far short of this amount; countries may have to increase • Bonds  A debt instrument bought by investors. their investment in the water and sanitation sectors by up When buying a bond, an investor lends money to to four times in order to meet the SDGs. the borrowing entity (which can be a government, a municipality or a corporate) for a defined period of time at a variable or a fixed interest rate. Where is Financing for the Water SDG • Equity  An ownership interest in a company. Going to Come From? Buyers of equity shares provide capital in exchange for expected returns in the form of dividends and To cover costs, funding for the water sector ultimately increases in share value, both of which would depend comes from three main sources: from households (via on the company’s financial performance. Equity tariff revenues or direct investments into self-provided shares can be publicly traded on a stock exchange or infrastructure), from domestic taxpayers (in the form of privately held. government subsidies) or from voluntary transfers (from external donors or philanthropic foundations, in the form However, there are good reasons why commercial of grants). The water sector is very capital intensive, finance has been limited for the water sector up to this however, and it is therefore necessary for water sector point. “Blended finance,” defined by the OECD as “the actors to mobilize financing, which they can then repay strategic use of development finance and philanthropic over time, once the infrastructure has been built, delivers funds to mobilize private capital flows to emerging and services, and generates a revenue stream to repay the frontier markets” can help in mobilizing such private financiers. financing. 1 Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance Given existing structural issues in the water sector, BOX 1  Exploring the potential to improve utility blended finance approaches need to be applied strategi- efficiency and create opportunities for commercial cally as part of a package of reforms to improve sector borrowing in the WSS sector efficiency and governance and to increase sector funding sources on a sustainable basis, so that sufficient rev- Based on data from 605 developing country utilities in the enues can be mobilized to repay commercial financing IBNET database (2013), just 17 percent of these utilities over time. When these conditions are in place, different cover their Operation and Maintenance costs and create blended finance strategies can be used to help mobilize a surplus (assumed as having cash revenues exceeding commercial financing depending on local financial market costs by at least 20 percent) that could potentially be used conditions, as discussed in this paper. to mobilize commercial borrowing to help them move towards achieving the SDGs. This means that 83 percent of utilities would have difficulties mobilizing such financ- ing, unless they implement significant reforms to improve Constraints Limiting Private Financing cost recovery. to the Water Sector Using this same dataset, the average level of reported Serious structural constraints have so far limited private Non-Revenue Water (NRW) was 35 percent. However, financing flows to the water sector in low-income coun- there are significant variations in performance: the top tries and many middle-income countries. While many quartile performers achieve NRW levels of 15 percent, of these constraints are not unique to the water sector, while the levels in the lowest quartile was 67 percent. commercial financing to the sector has historically been In terms of collection efficiency, the average from the very modest, for reasons set out below. dataset was 92 percent, whereas the average in the top quartile was 100 percent and the lowest quartile collected WSS service providers can only access commercial only about 50 percent of the amount billed. finance if they have a reliable cash surplus that can be used to repay commercial financing—in other words, Assuming that: (i) utilities could achieve the performance if they are deemed “creditworthy.” The normal modus of utilities in the top quartile in terms of NRW and col- operandi in the sector is to make investments with public lection efficiency; (ii) that water saved from leaks can be funds and to simply stop investing once those funds sold at the prevailing average tariff, and (iii) that modest have been used, thus locking the sector into the current energy efficiency gains of 15 percent can be made, then low levels of service. Fortunately, however, the sector 66 percent of utilities in the IBNET sample could create has many opportunities for generating efficiency gains, sufficient surplus to mobilize commercial borrowing. This which could help generate financial surpluses, access means that such efficiency improvements could almost new sources of investment, and break out of its low-level quadruple the number of utilities that could access these equilibrium. Most utilities in developing countries are sources of investment funds. At the same time, such technically and commercially inefficient. Addressing those performance improvements would result in 83 percent inefficiencies can move many utilities to a cash positive of the utilities fully covering their operating costs. In this situation—thus opening up the possibility of borrowing simplified model, the financial improvements are achieved funds. Given their monopoly in the provision of a prod- without mobilising additional revenues from tariffs uct which is essential for life, water utilities could, and adjustments. should, provide a sound, reliable long-term source of cash surplus that attracts private financing. The simple Mobilizing funds up front to deliver such efficiency gains calculation in Box 1 illustrates the amount of funding that would be needed, as would capacity building. But, if these could be released for the sector if utilities in developing cash surpluses can be maintained or increased over the countries could match the service performance of best long term through good policies, governance, and incen- performers. tives then the ability to mobilize additional sources of investment towards meeting the SDGs starts to look like a Generating such efficiency gains, with the crea- possibility. tion of improved incentive regimes and better sector 2 Water Global Practice Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance governance, would require a change in mindset at the accessing commercial debt finance. Their individual level of policy makers and utility operators. investment needs are often not large enough to attract private banks, except at high interest rates, and are too Private investors tend to view the water sector in emerg- small for borrowing on capital markets to be cost-effec- ing markets as not creditworthy. Banks or bond investors tive. In OECD countries, governments have developed who lend money for infrastructure investment assess programs to assist small-scale borrowers, like small the credit strength of the intended borrower, including water service providers, with accessing private finance the willingness and ability of the borrower to pay back through instruments like pooled bond funds. In develop- the money. In developed economies, such investors are ing countries where responsibilities for water and sanita- usually willing to lend to water service providers as these tion service provision have been decentralized, water are viewed as low risk with reliable, reasonable returns. service providers are typically small and not used to bor- In developing economies, because water sector actors rowing from private sources. Many of the smallest provid- have been constrained in their ability to increase tar- ers do not have audited financial statements and are iffs to cost-covering levels and are supported by a mix unable to deal with the complexities of loan applications, of domestic subsidies and international concessional much less meet basic borrowing requirements. Where financing, they are typically not deemed to be creditwor- regional, national, or a pool of service providers are in thy. Service providers are often unable to provide accu- place, size may be less of an issue but lack of familiarity rate, detailed information about their operations. Audit or with borrowing procedures remains a key concern. disclosure rules may not be strictly enforced and credit rating agencies may not exist or be familiar with the There might be restrictions in place limiting commercial operations of the water sector. Also the water providers investment in the water sector. Many markets place themselves may not have sufficient strength of leader- restrictions on the actions of both lenders and borrow- ship, management skills or corporate structure to enable ers. For example, pension funds may be prohibited from them to prepare properly to access commercial finance. purchasing securities that have not been listed on public exchanges for certain minimum periods of time and are Returns on water sector investments tend to be relatively thus prohibited from investing in initial sales of bonds. low, and can only be attractive to commercial inves- Banks may be allowed to invest only up to a certain tors if such investments are also deemed to be low-risk. percentage of their capital in securities sold by utilities. Returns on water sector loans must compete with those Utilities may be prohibited from issuing corporate bonds earned from other kinds of investments. The returns on and limited to borrowing from government sources like loans or bonds in developed markets are relatively low, intergovernmental loan funds or development banks, but risks are also low and returns are stable over long rather than from the private sector. In some countries, periods of time, so the risk-adjusted profitability of the banks are required to lend a certain percentage of their sector could be attractive. The water sector could offer overall portfolio to local infrastructure projects in tar- very good investment opportunities for long-term inves- geted sectors or regions. This makes credit analysis tors, such as pension funds or insurance companies, less necessary and keeps these lenders from develop- who need to match the profile of their long-term liabilities. ing knowledge of their customers’ business models and Water sector actors in developing countries, however, are creditworthiness. unable to generate adequate revenues, especially due to the policy uncertainties they face and the other kinds Private financiers and service providers have differ- of risks involved, such as tariffs that are frequently not ent objectives. Investors want to be able to adjust their set at or near cost-reflective levels or poor management investment strategies over time and look for the ability to practices. This creates a high-risk environment that either adjust these strategies. In contrast water sector actors’ demands higher returns for investors (meaning higher need long-term investment stability. Banks want to main- interest rates, which the sector cannot afford) or simply tain their ability to shift quickly into different investments kills the market. by keeping maturities on bank loans short, particularly if they are uncertain about the creditworthiness of their Relatively small transactions are less attractive to com- borrowers. They may also insist on strong security mercial investors. Many small-scale water service measures to ensure timely repayment and dedicated providers, even in developed markets, have difficulties revenue streams to enhance collateral requirements. www.worldbank.org/water 3 Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance Such short-term lending gives banks the opportunity Box 1) and through revisions of tariff levels and/or struc- to adjust interest rates to respond to changing market tures when this is politically feasible. This will generate conditions or increased familiarity with their borrowers. the financial surplus that provides the opportunity to bor- By contrast, water utility borrowers have the opposite row funds through commercial channels, thus comple- priority. Borrowers look to mitigate the initial costs of menting the limited public funds currently available. borrowing by obtaining long maturities on their debt, so as to spread out payments to match the useful life of the Blended finance can help leverage additional funds into infrastructure and reduce the size of annual debt service the sector and reduce borrowing costs compared to a costs. fully commercial arrangement—thus accommodating affordability and/or political constraints that set a ceiling on tariff levels. The use of blended finance can initiate Addressing the Financing Gap with steps towards the long-term goal of increased com- mercial financing, which will begin to create new under- Blended Finance standings, relationships, and potential new opportunities between the water and the financial sectors. In OECD countries and some middle-income countries, commercial lenders are providing substantial amounts of Apart from the mobilization of additional investment liquidity to the water sector for investments and work- funds, the use of commercial borrowing in blended ing capital. In those countries, private financiers see the financing has three additional and powerful benefits: water sector as a low-risk and low-return investment resulting from transparent regulation, ring-fenced rev- • Commercial finance brings requirements for greater enues, independent management, and cost reflective investment discipline and transparency, which in turn tariffs. These factors contribute to the perception that supports improved efficiency in the sector, an objec- water is a good opportunity for long-term safe invest- tive for most water sector reform efforts around the ments. In other middle-income countries and most world. low-income countries, financiers are much less at ease • Private sector financing for creditworthy or close to with the water sector, which they may regard as politi- creditworthy investments would allow reallocating cally influenced and non-transparent. They are not willing public funds to other areas where public subsidies to provide long-term financing to the sector and would are likely to be needed. usually charge a price to reflect their perception of high risks. In all developing countries, private sector financing • Commercial financing can change sector dynamics accounts for a meager 7 percent of total spending on by introducing increased accountability towards lend- water and sanitation (WHO and UN Water 2012) and in ers, which in turn can act as a stabilizing force for the Sub-Saharan Africa, the figure is less than half of 1 per- sector. cent (Foster & Briceno-Garmendia 2010). This is in sharp contrast to countries like the U.S., France, or the United To date, blended finance in developing economies Kingdom, where commercial finance, along with effective has not been widely used at scale in the water sec- regulation, has been instrumental in achieving high levels tor. A few isolated experiences have been supported of water service coverage and quality. by international donors, but these have mostly been in middle-income countries and they have so far failed In middle-income and low-income countries, increasing to be replicated at scale. Repayable financing remains the level of commercial financing for the sector will allow at very low levels in the water sector, particularly when service providers to borrow and invest in service expan- compared to other infrastructure sectors such as energy sion and quality improvement, without having to wait for or telecommunications, which have been much more scarce public resources to be made available. However, successful in mobilizing such financing. given that the starting point, today, is limited or no com- mercial financing, there needs to be a gradual move The limited role of blended finance in the water sector is towards mobilizing such funds. This means improving due to the way that this tool has typically been used in the financial performance of utilities through a mix of development, in addition to the constraints identified pre- improved technical/commercial efficiency (as illustrated in viously. Earlier subsidy programs distorted local markets 4 Water Global Practice Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance and failed to address the genuine “market failures” that • Assist borrowers in generating efficiency gains, occurred when resources were not allocated efficiently. reduce costs, and boost revenues so as to develop a For example, a classic market failure occurs when banks better credit profile. deny credit to an early market entrant simply because • Assist borrowers in establishing credit track records, the business area is new and unfamiliar to them as thereby helping them become more familiar with lenders. Blended finance can help correct this failure by lender requirements and expectations. giving an initial impetus to a new business candidate that becomes commercially successful, thereby demonstrat- • Help lenders to better understand the water sector in ing the viability of the general business endeavor to later the target country. entrants and financiers. • Help borrowers and lenders understand the mechan- Some cases do exist in the water sector where blended ics of project finance, in which loans are secured by finance could be used in this conventional manner to revenue flows. correct genuine market failures. Blended finance tools • Demonstrate to governments (and development part- can be used in these countries as one-off support to initi- ners) that partial commercial finance can and should ate self-sustaining, cost recovering projects and utilities, become a normal complementary component when with the potential for significant demonstration effects. financing the water sector. But for most cases in the water sector in least-developed countries, fully commercial enterprises or projects will • Introduce a measure of financial discipline and reduce not result from the application of subsidies, because of already-existing market distortions created by the the severe constraints in the sector. In these countries, dominance of indiscriminate, highly subsidized donor supply/demand mismatches do not result from market or MDB financing. failures. The market is in fact functioning correctly by denying credit and investment to local water and sanita- • Incentivize governments to improve regulation. tion projects because the projects are not creditworthy • Commence the process of moving away from the or are incapable of generating competitive investment dominance of development assistance and public returns. finance in the sector. To address the critical need for increased commercial • Introduce the discipline of governance, reporting, and investment in water and sanitation infrastructure across transparency required by commercial lenders. a broad range of developing countries, donors need a • Begin the process of increasing the transparency of flexible and pragmatic approach to the use of blended subsidies, which are often hidden and almost never finance—one that adapts to the state of financial mar- quantified. ket development and sector investment needs in target countries. A conventional approach to blending could be used in more advanced countries with nascent capital markets and utilities with the potential to be commer- Tailoring Blended Finance Options cially sustainable. However, in countries facing severe constraints to commercial investment in the water sector, Approaches to using development finance to mobilize the gradual introduction of private finance with blend- private capital flows in a strategic manner will need to be ing would be a legitimate objective. This would involve tailored depending on the level of capital market devel- improvements to commercial viability, using instruments opment and on the way in which water sector actors such as grants, grant-funded technical assistance, and currently access repayable financing. guarantees. In most cases, however, these projects would not be expected to initially achieve full financial Before defining a blended finance strategy it is essen- viability through tariff revenues alone. tial to identify the origin of current financing and know what is preventing water sector actors from scaling up Partial private financing of water projects would realize these investments in line with their investment needs. several objectives: The nature and extent of private commercial market development in a particular country would determine www.worldbank.org/water 5 Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance TABLE 1  Current access to finance for water sector actors and the role of blended finance Potential and current How blended finance could help? lenders to the water sector Commonly observed shortcomings Developmental Objectives Examples of what can be done Commercial Banks • Short-term debt only • Educate banks on opportunities in • Help national officials deal with • Poor understanding of water sector the water sector contingent liabilities from borrowing • High interest rates • Reduce perceived risks at sub-national level • Heavy collateral requirements • Leverage finance • Facilitate pilot loans • Lack of understanding of the water • Improve service providers technical • Concessional finance linked to sector and financial performance commercial interest rates • Regulatory constraints-Asset Liability • Lines of credit to commercial banks Management • Guarantees to mitigate bank risks Intergovernmental Loan • No credit analysis • Encourage inter-governmental loan • Incentivize graduation of best Funds • Subsidized interest rates funds to act more like a bank borrowers to commercial market • Poor collection rates • Release strongest borrowers to • Move from subsidy offsets to project • No penalties for defaults private sector revenues for repayment • Potential interference and competing objectives • Repayment via inter-governmental aid offsets National Development • Minimal credit analysis • Use DFI strengths to help build • Provide lines of credit for Finance Institutions • Below market interest rates private market commercial-type loans (DFIs) • Lending is part of bundled service • Help DFIs benefit from market • Help DFIs add market-building packages development services to their product lines (e.g. guarantees) Nascent Bond Markets • Only corporate bonds sold • Facilitate pilot water bond issues • Finance shadow ratings and • Limited government securities • Build issuer/investor confidence in management improvements • No secondary market market • Facilitate initial water bond issuance • Weak disclosure rules • Expand investors into the water costs • High initial issuance and debt service sector • Use guarantees to mitigate risks and costs • Familiarize financial regulators with extend tenors the water sector Deepening Bond Market • Limited secondary market activity • Help investors become more familiar • Facilitate credit ratings • Lengthening tenors with water bonds • Tighten disclosure rules • Limited institutional investors • Facilitate credit ratings and • Liberalize investment rules for • Some rating agency activity secondary trading institutional investors Maturing Financial • Bonds & bank loans available for • Diversify the pool of financing • Subsidize structuring advice Markets water sector, but not yet extensively options to the water sector • Facilitate pooled bond issues used • Foster more engagement by • Support ratings and guarantees, as • Rating agencies trusted institutional investors necessary • Disclosure rules in place • Institutionalize commercial finance in • Facilitate involvement by institutional the water sector investors how blended finance could be used most productively to repayable financing. They are not necessarily sequential, catalyze more commercial finance for water and sanita- mutually exclusive, or exhaustive but they provide a way tion infrastructure. to think about what blended finance can achieve in these different circumstances and how solutions need to be Table 1 sets out six main types of situations to character- tailored to conditions in the local financial markets. ize different ways in which financial markets and com- mercial sector finance opportunities might be structured The text that follows provides additional discussion on in different countries. These situations are defined based how providers of concessional finance, which include on how water sector actors can expect to mobilize MDBs, donors, or philanthropic organizations, can best 6 Water Global Practice Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance use their grant funding (either as pure grants, or as part and develop systems to manage contingent liabilities of a concessional loan) to catalyze commercial sector arising from borrowing by subnational utilities. financing through blending. • Parallel capital grants can help reduce the effective interest rates on commercial bank loans in order to Situation 1—Commercial banks are the main reduce capital repayments and ease debt service potential providers of repayable finance outside burdens, extend tenors, or support repayment grace MDBs. Some water sector actors can borrow from com- periods. mercial banks. While banks may be willing to consider such loans, they tend to treat utilities and other water • Guarantees can back long-term repayment com- service providers as a subset of normal commercial mitments and can be structured on an individual or lending, and to offer only expensive, short-term loans portfolio basis. Technical assistance and road shows (1–3 years) with requirements that loans be secured can help local banks better understand water sector with real property or other forms of collateral. Because projects, their risks, and their opportunities. the borrowing period does not match the useful life of the assets being constructed, efficient service pricing is • Concessional finance can be provided as lines of difficult, and borrowers must constantly refinance short- credit to commercial banks, so as to provide them term debt borrowed for long-term assets. A longer-term with liquidity to extend loans to the water sector. debt capital market does not exist (or water sector actors are unable or not allowed to access it). This is a situation Situation 2—An Intergovernmental Loan Fund is that is very common in most low-income and middle- in place, which can be accessed by water sec- income countries, where commercial banks exist but, on tor actors. In this scenario, a debt capital market does the whole, do not tend to be actively lending to the water not exist, but local governments can borrow from a sector, and where few other alternatives exist in terms of donor-capitalized fund. Such a fund may be a dedicated government-supported development finance. water fund or a municipal development fund (MDF). This kind of fund exists in a number of countries, such as How blended finance can work. Blended finance can Bangladesh, Sri Lanka, Indonesia, Kenya, Colombia and help unlock private financing from commercial banks India. These are usually set up as financial accounts, for water investments. The ultimate objective is to help rather than banks, and they are managed by adminis- banks understand how a project finance approach can trators rather than professional bankers. They can be work in this sector, meaning that lending will be done on hosted by the Ministry of Finance or lodged in a water the basis that revenues generated by the assets built or sector institution if they are specialized. Long-term rehabilitated with the loan proceeds will play a significant money may be available from the fund, but all borrow- role in repaying the debt. Some kinds of water infrastruc- ers tend to be charged the same price for debt and the ture Investments have relatively short payback periods money is often repaid via offsets against intergovern- and are better able to take advantage of the short-term mental aid flows, so a credit analysis is rarely carried out. loans offered by such banks. These investments could Borrowing rates are often subsidized; defaulting borrow- include non-revenue water reduction, leak detection, ers may be allowed to continue borrowing from the fund improvements to billing and collection systems, energy without penalties. efficiency improvements, etc. Although such funds can provide useful investment Grants and grant elements in MDB loans can be blended opportunities for water sector investments, they may in various ways: actually delay the development of private finance markets because these markets typically try to lend to borrowers • Support for institutional strengthening of the water who are best able to repay their debts. The latter tend to utility and associated institutions. be precisely those who would be best able to graduate to normal commercial finance relatively quickly. These • Expert input in order to assist with diagnostic and funds also often resist efforts to end their monopoly information management. Technical assistance at the position as the only active lenders to sub-national service central government level can help officials understand providers (including water service providers), while they www.worldbank.org/water 7 Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance tend to be heavily dependent for their continued exist- How blended finance can work. Blended finance could ence on support from donors and MDBs. be focused on helping DFIs work more strategically with private commercial lenders so as to diversify the sources How blended finance can work. MDBs can use their of finance for the sector: funding and convening powers to begin forcing some • Technical assistance grants could be used to build degree of commercialization into the operations of the DFI capacity to structure guarantees for borrowers inter-governmental loan fund in the following ways: who are willing to sell bonds or access commercial • Funding can be provided to an inter-governmental bank loans. loan fund on the condition that a certain percentage • Concessional funding could also be used to capitalize of borrowers are “graduated” every year and borrow guarantee programs, thus reducing risks associated from commercial lenders. with lending to water service providers and encour- • A percentage of donor funding may be required to be aging DFIs to move towards lending on commercial lent at market rates. terms. • Technical assistance (TA) grants can be used to build • Technical assistance grants could be used to help the capacity of the Intergovernmental Loan Fund access DFI skills in bond underwriting or credit to assess creditworthiness, grade borrower perfor- ratings. mance, and penalize non-performance. • Tranches of donor or MDB funds could be channeled • Donors or MDBs can use their convening power to through DFIs on condition that they are on-lent on encourage governments to loosen rules requiring utili- commercial terms, or the money could be on-lent ties to borrow only from intergovernmental loan funds through selected commercial banks. of this kind. • Donor grants could be used as equity to facilitate • Access to this funding for utilities comes with the commercial lending. requirement to develop governance, transparency, • Technical assistance grants could be used to build and reporting requirements. the capacity of utilities to access commercial loans from private banks. Situation 3—Government-owned development finance institutions (DFIs) are dominant on the Situation 4—Bond markets are nascent but have market and water sector actors tend to be obliged yet to be tapped by water sector actors. In this situ- to borrow from them. In this case local governments ation, water service providers can borrow from com- or water service providers can borrow from government- mercial banks and a nascent bond market also exists, owned development finance institutions (DFIs) that may primarily for corporate issuers. A secondary trading also engage in relationship banking by bundling lending market typically does not exist, which means that bond services with support for local government budgeting, maturities tend to be short, much like maturities on com- planning, cash management, etc. Minimal credit analysis mercial bank loans. Commercial banks are the princi- is carried out and borrowing rates vary depending on the pal bond investors because few institutional investors analysis, but are generally below market rates. Long-term (pension funds, insurance companies, or mutual funds) money is available. To some extent the development are active in the market and virtually no individual retail banks depend on the access they have to local govern- investors participate. Disclosure rules are often weak, ment financial information, as a result of bundled service credit rating agencies exist, but their sector expertise, provision, to identify potential repayment problems and independence, and objectivity are either underutilized or implement remedial support. Debt capital markets are not appreciated. either very limited or local governments are unable or not allowed to access it. Such conditions prevail in countries How blended finance can work. The opportunity here such as Mozambique, Angola, Tanzania, South Africa, or would be to help bond market development achieve the Philippines. some momentum in terms of becoming more famil- iar to and trusted by investors, particularly institutional 8 Water Global Practice Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance investors like pension funds and insurance companies • Technical assistance grants can help with institution that need long-term investment assets. This can be done strengthening and addressing credit weaknesses (by in the following ways: improving planning and budgeting, billing and collec- tions, reducing non-revenue water, etc.). • Technical assistance grants can help with listing bonds on stock exchanges to facilitate trading. • Technical assistance grants can help design and establish bond banks or pool facilities to assist • Deal structures can allow investors sell securities smaller borrowers. back to issuers prior to maturity, thus facilitating lengthened maturities. • Grants can be utilized to reduce the size of borrowing needs and effectively reduce debt service. • Grant-funded road shows can help potential bond investors (especially institutional investors) understand • Technical assistance and capacity building grants water service provider operations. can be used to build the skills of pension regulators and securities commissions, so that they will better • Guarantees can back loan terms and payback understand investments in the water sector to match commitments. their long-term liabilities. • Grants can reduce the size of borrowing needs. Situation 6—Financial markets, including for com- • Technical assistance grants can help with setting up mercial lending and bond issuance, are maturing appropriate disclosure rules to enhance transparency but need to be further supported. In this case primary and increase market confidence. and secondary bond markets are liquid and functioning. Rating agencies are trusted and adequate disclosure Situation 5—Bond markets are deepening but are rules are in place. Market players are engaged in devel- yet to be fully accessible for water sector invest- oping and using sophisticated financial instruments. ments. In this situation, basic elements of both a primary The bond market competes effectively with private bank and secondary bond market may exist alongside com- lending, providing longer maturities, larger transactions, mercial banking activities. But the secondary market and lower interest rates. Commercial bank loans and still needs improved liquidity. Some government entities bonds can also be combined to finance long-term infra- as well as private corporations issue bonds. Maturities structure. The flexibility of bank lending can see projects are beginning to extend to medium to long terms (7–10 through the more risky construction phases, whereas the years). Debt instruments are increasingly standardized advantages of bonds can be realized when they are used and institutional investors are beginning to enter the to refinance bank loans once construction is complete market, sometimes because of reforms to public pension and project operations begin to generate revenues. administration. Disclosure rules are tightening and rating agencies are developing reputations for discipline and How blended finance can work. Concessional funding expertise. can be used to help with structuring pioneering transac- tions for the water sector, in which bank loans and bonds How blended finance can work. Most of the effort can are used for the same project so as to complement focus on helping water service providers understand their respective characteristics and help attract institu- when and how bonds make more sense than bank tional investors. Such pioneering transactions could, for loans, as well as how to structure and sell bonds, with a example, include pooled bond issues (whereby a pooled view to support a bond issuance by a water operator to structure is established to facilitate access to finance fund an investment program or to fund a specific project for small or medium-sized borrowers who agree to join with clearly identified returns. Concessional finance can forces) or large, complex projects with a particular social be used in the following ways: agenda. Technical assistance grants can help structure the transaction, support credit ratings and guarantees, • Grants can support shadow credit ratings (to identify and particularly facilitate the involvement of institutional potential credit weaknesses and provide the basis for investors. addressing such weaknesses) or normal published ratings. www.worldbank.org/water 9 Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance • Service providers must work towards commercial Going Forward: Scaling-Up Blended and technical efficiency and need cost-reflective Finance Approaches tariffs. In most emerging markets, tariffs are indeed set well below affordability levels. Blended finance in The use of blended finance is unlikely to distort market the water sector will have minimal viability unless local development, particularly in situations where develop- governments and utilities are able to secure revenues ment assistance pays for nearly all of the current invest- to back borrowings from private sources, and to ment in the water sector in most emerging markets. This maintain the systems being financed, so that debt does not mean that subsidies will not sometimes result service obligations can be met. in wasted or misapplied resources, or will never generate • Water and finance ministries must work together excess profits for private lenders or operators. However, to develop financing and sector policies that these risks are secondary to the problems of insufficient support the development of well-run utilities. One water sector investment in developing countries (Carter aspect of such policies would be based on the rec- 2015). The benefits of crowding in commercial finance far ognition that different types of water investments may outweigh the risks of solely relying on grants and public be more or less attractive to private financiers. This resources in the sector. means that public funds should be allocated to those areas that are least attractive from an investment per- Scaling up blended finance will require collaboration spective, such as sanitation or rural water supply; and between governments, service providers, and donors on subsidies should be decreased for sub-sectors that several key points: are relatively more attractive for private sector financ- • All parties must raise awareness of the poten- ing, primarily urban water supply. Donors should tial benefits of commercial finance. Catalyzing a also start to abide by such policies. Poorly designed market for commercial financing would reduce the grant funding can actually be counterproductive in need for public sector funds and sovereign borrow- attracting commercial finance and improving service ing, reduce the foreign exchange risk exposure of delivery. the water sector, and help build a dynamic financing • Donors must use their concessional funds to climate in which investments are undertaken by a catalyze, not crowd out, private financing for variety of actors who can access financing directly at water. Donors are the source of much of the below- the domestic level. These long-term benefits would market concessional financing that is currently avail- most likely dwarf the short-term financial costs asso- able to the sector. A critical element going forward will ciated with leveraging higher-cost commercial sector be to examine how a portion of the available conces- financing. sional financing may be used to stimulate commer- • Governments must support adequate governance cial financing and avoid crowding out such private arrangements and transparent financial informa- financing. tion for the water sector. These basic foundation • Donors and governments must support project requirements are key ingredients for well-run and preparation to build a pipeline of viable commer- sustainable service providers. Sector enabling institu- cial investments. At present, there is more money tions, such as ministries and regulators, must con- available than there are viable projects attractive for tinue to push for progress in these areas, in parallel commercial finance. Project preparation should ideally with using blended finance in order to mobilize com- include economic cost-benefit analysis, the use of mercial finance in a sustainable fashion. In essence, competitive bidding whenever possible to determine good governance and financial transparency support the size of needed subsidies to make private sector commercial finance and, in turn, leveraging of private financing viable, and fully transparent assessments finance enhances the governance structure and the regarding subsidy size, policy objectives, types of financial discipline and creditworthiness of service beneficiaries, payment mechanisms, etc. (Kingdom, providers, thereby starting a virtuous cycle. Baeumler, & Guzman 2012). 10 Water Global Practice Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance developing countries where financing is predominantly Conclusions based on subsidized public funds, a new long-term solu- tion is needed. This solution will have to help the sector The Sustainable Development Goals provide an ambi- move towards mobilizing more commercial funds over tious vision for the water sector. Achieving access to time: blended finance can be a stepping-stone in that safe, affordable water and adequate sanitation for every transition. It is a necessary step given that the risk of person on earth in less than 15 years will require a dra- underinvestment vastly outweighs the risk of distorting matic increase in investment. non-existent markets. Public and donor money is far from sufficient to fill this National governments and donors must use their funds gap. Commercial financing is an important financing in a catalytic manner, as part of broader financing strate- source for the water sector in many developed and gies that mobilize funding from sector efficiency gains, middle-income countries. However, there has been tariffs, domestic taxes, and transfers to crowd in domes- minimal commercial financing in most of the countries tic commercial finance. If they are able to do so, coun- where it is needed most. Blended finance has tradition- tries will be much more likely to access the resources ally been used as a tool to stimulate interest from the they need to improve and expand the infrastructure commercial financial sector, with the use of concessional needed to deliver and sustain universal coverage of finance then tapering off to avoid distorting markets. water and sanitation services. Given the embedded distortions in the WSS sector in www.worldbank.org/water 11 References Carter, P. 2015. Why subsidise the private sector? What Seetharam, K., & Rao, B. 2010. Index of Drinking Water donors are trying to achieve, and what success looks like. Adequacy: International and Intra-National Exploration. Overseas Development Institute. 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