pproaches37360 J u l y 2 0 0 5 N o t e N u m b e r 0 9 Output-based aid in project finance Using World Bank guarantees to enhance credit Stephan von Klaudy and Umang Goswami When governments turn to private operators to such tariffs. In these cases investors will assess the provide infrastructure services, the reason often is to combined risk of the two types of cash flow. tap private sources of finance. To obtain market The subsidy can be structured in two broadly financing for an infrastructure project, however, a different ways. In the first the government provides an private operator needs to be able to provide potential initial capital grant during the main investment phase, investors assurance that revenue flows to the project typically the first few years. This grant reduces the will be reliable. Where those revenue flows consist in initial project financing requirements and thus the part of government output-based aid (OBA) subsidy revenues (and user fees) needed to recover full costs. payments1 , providing that assurance can be problem- In the second the initial project financing comes atic. Many governments are considered unreliable entirely from private sources, leading to a need for payers and therefore assigned a low credit rating by higher project revenues to recover costs. Here the financial markets and investors. In these cases the government needs to provide periodic subsidies after credit quality of OBA payments needs to be enhanced the initial investment phase to keep user fees afford- if they are to help attract investment financing to the able. Governments and aid agencies increasingly prefer project. The World Bank offers guarantee instruments this approach for infrastructure service provision that can enhance the creditworthiness of such pay- because periodic subsidies structured in the right way, ments. There are two main options: partial risk guar- as output-based aid (OBA) payments, offer a much antees to mitigate the risk of a government failing to better tool for introducing performance incentives, make OBA payments for individual projects, and accountability, and targeting. partial credit guarantees to help governments raise financing for a subsidy pool providing OBA payments Nevertheless, subsidies structured as OBA pay- to multiple projects. ments raise challenges for project finance. Because they form part of a project's future cash flow, they Governments entrust infrastructure service provision need to meet standards of creditworthiness high to a private operator often because they wish to tap enough to mobilize commercial financing. But many commercial financing without affecting their budget, governments are considered not creditworthy, earning particularly important when big up-front investments a low credit rating from financial markets and inves- are needed. But attracting market financing for private tors. In these cases the credit quality of government infrastructure investments requires a dependable, subsidies needs to be enhanced. creditworthy revenue stream that will cover the full cost of service provision (operational expenses, debt service) plus a reasonable return to shareholders. Stephan von Klaudy and Umang Goswami are with the World Where revenues consist entirely of user fees, an Bank's Infrastructure Economics and Finance Department, investor's decision to provide financing will depend Infrastructure Advisory Services. Farida Mazhar, Pankaj Gupta, and largely on its assessment of such factors as the cus- Scott Sinclair, all in the Infrastructure Economics and Finance tomer base, payment discipline, collection efficiency, Department, Project Finance and Guarantees, provided comments and billing system. In some projects, however, revenues and contributions. may also include government subsidies if user tariffs 1 OBA payments are targeted, performance-based subsidies used cannot be set high enough to recover full costs-- when recovering full costs through direct user fees is not justified, not because users are either unable or unwilling to pay possible, or not practical Supporting the delivery of basic services in developing countries pproaches Using direct aid agency financing · The limited recourse structure guarantees commercial debt or shareholder loans to a private company and One way to enhance the creditworthiness of OBA is particularly suited to project finance transactions. payments is to rely on development assistance to · The letter of credit structure protects a private company finance the subsidies. The credit rating and credibility against cash flow shortfalls caused by a government's of development agencies can lend a high level of default on its contractual commitments. It is particu- creditworthiness as long as the disbursement mecha- larly suited to smaller privatization transactions. nisms ensure a payment stream that is in accordance with the stipulations in the operating contract.2 Partial credit guarantees cover private lenders against all But financing subsidies from development assistance risks during a specified period of the financing term or for often will not be possible. The World Bank and other aid a specified part of the debt. They are designed to extend agencies normally will not commit to indefinite support of and improve terms for market borrowing by public entities. a subsidy scheme, but instead expect subsidy payments to These guarantees are not available in IDA countries, but be phased out (the transition model) or sustained after a could be used to enhance OBA credit in an IBRD country if time through the domestic budget (the long-term subsidy the government or a government entity borrows from model). Even under the transition model aid resources may financial markets to finance OBA payments. But since not be available for the entire transition period if it exceeds governments are unlikely to take on debt simply to finance the project implementation periods to which aid agencies subsidies for an individual project, partial credit guarantees normally commit (for the World Bank, around five to six will probably be used only for subsidy pools for multiple years). Moreover, governments may not wish to borrow for projects. subsidy payments, and agencies' country programs may lack the resources for that purpose. Enhancing credit for Relying on World Bank guarantees individual projects Where OBA payments need to be financed directly World Bank guarantees can be provided for individual from government budgets, their credit quality can be OBA projects large enough to justify the transaction raised through guarantees by the World Bank. Devel- costs. Guarantees for OBA schemes need to backstop oped to help mobilize commercial financing for private as directly as possible the government subsidy pay- investment projects or for public funding, World Bank ments to the project company, to increase the per- guarantees mitigate the risk of a government failing to ceived reliability and creditworthiness of its revenue meet its contractual obligations. The World Bank's stream. Most suitable for individual projects is the unique relationship with its member countries and partial risk guarantee under the letter of credit struc- their governments puts it in a good position to back- ture, which allows direct compensation of the project stop certain government obligations. A World Bank company for revenue shortfalls caused by government guarantee, coupled with the mandatory government default. Compensation is paid to the project company counter-guarantee, can raise the creditworthiness of an through a letter of credit arranged by the government OBA scheme because it reinforces the incentives for the with a commercial bank. If the government fails to govern-ment to comply with its contractual obligation reimburse the bank for the amount drawn from the to pay the subsidies. The World Bank offers two kinds letter of credit within a specified period, the World of guarantees that could be used to enhance OBA Bank would do so. structures. But the letter of credit structure protects a project Partial risk guarantees ensure debt service payments by a against only one kind of risk--government nonpayment-- private company in default as a result of a government's to its ability to generate revenue and service debt. It does failure to meet its contractual obligations. These guaran- not address other risks relating to government perfor- tees can be arranged for borrowers eligible for International mance. Where risks are complex, guarantees that back- Bank for Reconstruction and Development (IBRD) loans as stop OBA payments could be combined with partial risk well as those eligible for International Development Association (IDA) credits. Two structures for partial risk 2The World Bank is attempting to mainstream OBA payments from aid guarantees have been developed, suitable for different resources. Similarly, GPOBA recently introduced a window to finance OBA types of transactions: payments. Supporting the delivery of basic services in developing countries pproaches guarantees against government default on policy and from external assistance, followed by credit-enhanced regulatory undertakings (such as tariff increases) or government budget payments­or credit enhancement against political and other government performance risks. could be provided from the beginning. And again a These partial risk guarantees would reduce the risk of loss partial risk guarantee under a letter of credit structure of revenues from user fees. The guarantee structure does would be appropriate choice. But here the guarantee not address operational and market risks (such as cover would be uniform, not declining. consumer acceptance), typically assumed by the operator. Over time the aim should be to establish the reliabil- The limited recourse structure would be less effective, ity and creditworthiness of the government payments so since it would reduce the risk of government nonpayment that the credit enhancement can eventually fall away. only for project lenders, not equity providers. And the partial credit guarantee could not be used in this case Long-term Subsidy without user Fees because it is designed to backstop borrowing only by public entities, not private ones. Enhancing transitional subsidies Transitional subsidies are used where a private operator takes over from a high-cost, inefficient public service provider and tariffs are heavily subsidized. During the transition period the private operator is required to increase efficiency and reduce costs. Meanwhile investments and better operating performance improve service quality, increasing consumers' willingness to pay and thus allowing the operator to raise tariffs, eventu- Long-term Subsidy with user Fees ally to a level that ends the need for subsidies. A guarantee could be provided for the entire transi- tion period under the letter of credit structure. Since the periodic subsidies needed would decline over time, the guarantee cover can decline accordingly. Alternatively, the transitional subsidies could initially be financed, say for up to five years, from an IBRD loan, an IDA credit, or other external assistance, then paid directly by the government, with these later subsidy payments covered by a partial risk guarantee under a letter of credit structure. Combined with the initial financing of the subsidy, the guarantee would help attract private financing. Blending instruments Enhancing long-term subsidies Where hybrid structures are used, combining aid financing Long-term subsidies are intended for infrastructure and credit enhancement for OBA subsidies, the guarantee services which full cost recovery is not justified in the may need to be approved at the same time as the initial foreseeable future because of externalities or because IBRD loan or IDA credit (or other external aid). This might users could not afford tariffs that cover the cost ( toll be necessary, for example, if commercial investment financ- roads, water supply, power distribution). Technically ing for a project has a term longer than the disbursement similar are long-term government payments that period for the initial external assistance and private finan- provide the entire revenue stream for projects where ciers want assurance of the reliability of subsidy payments levying direct user fees would be infeasible (voucher- that extends beyond that disbursement period. This require- based health services, performance-based road ment adds complexity to the transaction. rehabilitation and maintenance). But a simpler transaction with only a guarantee would Where subsidies are long term, the credit enhance- require government budget resources from the outset. This ment would also have to be long term. Just as for transi- would be a disadvantage, particularly for IDA countries tional subsidies, initially the payments could be financed with access to inexpensive development assistance. Yet it Supporting the delivery of basic services in developing countries pproaches could also provide an incentive to manage budgets well and reduce subsidies rapidly. Moreover, guarantees now offer the advantage of carrying only 25 percent weight in a country's borrowing from IBRD or IDA.3 So it may be more attractive for a country to choose a guarantee-only solution from the beginning. Enhancing credit for subsidy pools In some cases governments might want to set up a subsidy pool to finance OBA payments, such as when they plan to secure funding for several projects or for many, particularly small ones. A pool can reduce the transaction costs for each project as well as the overall financing costs. Initial financing could come from external assistance and the government's Rules for procurement and disbursement own resources. For its contribution the government could Procurement under OBA guarantees falls under the use a partial credit guarantee to raise market financing, rules for loans guaranteed (not financed) by the World extending the term and lowering the cost of borrowing. Bank, which simply stipulate that goods and works be procured with due attention to economy and efficiency While a subsidy pool could provide transitional or long- in accordance with basic quality, price, and delivery term subsidies in a range of sectors, it is particularly suited to requirements. Competitive bidding of an OBA-sup- long-term OBA schemes with continuing small investments, ported project would generally be considered to satisfy such as new power, water, or telephone connections in rural the economy and efficiency principles regardless of the areas. These schemes require small amounts of subsidy procurement methods used by the private operator. If payments for long periods to fund ongoing support to the OBA supports a project carried out by an incum- targeted beneficiaries. bent private operator, the World Bank would assess While the funding would at least initially come mainly the operator's procurement methods to determine from direct external assistance, government contributions whether they satisfy these principles. based on guarantee-supported borrowing from financial Disbursements under OBA guarantees are governed markets would allow the pool to finance streams of subsidy by the rules applying to payments from the government's payments beyond the aid agencies' customary disbursement budget and thus not subject to the World Bank's dis- periods. These contributions could later be supplemented bursement procedures. But the contractual links between and eventually replaced by sector levies and user charges or the OBA payments, the delivery of services, and the by other government revenue, including taxes. amount guaranteed must be clearly established, and A partial risk guarantee could complement this sound financial management principles followed. structure by backstopping government commitments on transfers to the pool. Once the pool has a track record of sound management and steady funding from sector levies, fees, and taxes, government commitments 3Thus a $100 million guarantee counts as only $25 million in a country's may no longer need underpinning, and the credit lending program, leaving room for another $75 million in IBRD loans or enhancement could fall away. IDA credits. Global Partnership on Output Based Aid World Bank Mailstop: H3-300 600 19th Street, NW Washington, DC 20433, USA To find out more, visit www.gpoba.org The Global Partnership on Output-Based Aid Supporting the delivery of basic services in developing countries