Viewpoint Note No. 151 September 1998 Financing Water and Sanitation Projects- The Unique Risks David A project finance structure allows water projects with attractive cash flows and risk profiles to Haarmeyer and Ashoka Mody secure long-term private capital. This structure provides a direct link between a project's cash flow and its funding to give project sponsors, investors, and lenders strong incentives to ensure that projects are structured and operated to generate stable revenue streams. But even in industrial countries the credit strength of off-taking municipal governments and the sector's traditional monopoly structure expose lenders to potentially significant credit, regulatory, and political risks. These risks, combined with the sunk, highly specific, and non-redeployable nature of water investments, mean that lenders and investors are vulnerable to government opportunism and expropriation. Reviewing some recent innovative projects, this Note shows that private participation on a limited recourse or nonrecourse basis has required support from multilaterals and federal government agencies to absorb noncommercial risks. Private sector participation in water and sani- tures. As one of the last monopoly utility sec- tation has often taken the form of special- tors, water and sanitation can be especially purpose build-operate-transfer (BOT) projects attractive to long-term private investors. But following the project finance or limited recourse financing water and sanitation projects has model. These are self-contained projects that been a special challenge because of their address the need for more water and sanita- unique risks: tion. Although these bulk suppliers can allevi- * Expensive to transport but cheap to store, ate immediate shortages, they have virtually water is essentially a local service and sub- no effect on systemwide revenue problems (for ject to control by local government, which example, leakage and tax collection) or labor can be more politicized and have weaker cost problems. These long-term problems are credit than state or federal government. sometimes tackled incrementally through leases * With most of the assets underground, their and management contracts. An increasing num- condition is hard to assess. That makes invest- ber of countries have gone further by awarding ment planning difficult, posing risks for con- operating concessions for entire systems, which tract renegotiations. require investment commitments from the con- * Inadequate provision is associated with cessionaire. Beyond such concessions lies full health and environmental risks, so govern- privatization of assets, which facilitates financ- ment has a strong interest in extending access ing by creating collateral. to service, regardless of ability to pay. * Significant currency risk arises because cus- The promise of steady-if not growing-long- tomers pay in domestic currency that does term future cash flows is the basis of the not match the currency of international debt private sector's interest in financing these ven- and equity financing. Iu The World Bank Group * Finance, Private Sector, and Infrastructure Network Financing Water and Sanitation Projects-The Unique Risks * There has so far been little scope to introduce entity in a BOT or BOO project. For the BOT in direct competition in treatment, transmission, Chihuahua, Mexico, for example, Banobras, the and distribution. domestic development bank, provided credit support to the local government entity. In Izmit The risk profile of a project is also influenced the Turkish government stands behind the lo- by its type and by its stage of development. cal government's water purchase agreement. In Greenfield projects with a build-operate-transfer Sydney the state government guarantees the pay- or build-own-operate (BOO) structure, because ment of the city water utility (Sydney 'Water they involve a period of construction before rev- Corp.) to the private project company even enues are generated, generally expose lenders though the utility's debt is rated AAA by Stan- to greater credit, political, and regulatory risks dard & Poor's. In Buenos Aires the Argentine than concessions for infrastructure services that government's guarantee to pay compensation if are up and running. Similarly, older and more the concession is terminated early provides the efficiently run systems with longer operating his- chief form of security for lenders. tories tend to have more secure and predictable cash flows and mature investment profiles, and Sources of debt thus expose lenders and investors to fewer risks. In countries with weak sovereign credit ratings The water and sanitation sector's exposure to financing has been provided by multilateral and risks that are often difficult and costly to cover export credit agencies. These agencies are gen- has two important ramifications: erallv in the best position to shoulder political • Fewer projects have been successfully financed and regulatory risk and thus provide long-term with private capital than in other infrastructure finance at reasonable rates. The US$9 million sectors, such as power and telecommunications. Chase Manhattan Bank loan to the Chihuahiua • Projects financed with private capital have BOT project, which received no multilateral or tended to involve direct financial or credit bilateral funding but did receive grant and credit support from government or third parties support from Banobras, is a rarc case of com- such as bilateral, multilateral, and export mercial bank participation. In a similar BOT credit agencies. project in Puerto Vallarta, Mexico, the Interna- tional Finance Corporation provided debt fi- Case studies in finance nance backed by a revolving and irrevocable letter of credit from Banobras. The experience of six water and sanitation projects and one set of utilities in accessing In countries with high sovereign credit ratings and structuring private finance illustrates the projects have been financed by domestic com- level of government or third-party support mercial bank loans. The BOT project in Johor, (table 1). All the projects follow the standard Malaysia, and the BOO project in Sydney, Aus- project finance structure except for the more tralia, were financed by commercial debt. As a mature English and Welsh water companies, result of the project structure (existing cash flows) which rely on corporate finance. and Malaysia's highly developed capital market and relatively low interest rates, the Johor project Only the BOT project in Johor, Malaysia, was was financed entirely with local debt. The Sydney financed on a nonrecourse basis with no sponsor project had both local and offshore financing. or third-party support to cover risk of nonpay- ment. All other projects were financed on a lim- The limited capital market financing of water ited recourse basis. The recourse was generally and sanitation indicates that individual inves- provided by payment guarantees to the parties tors are not in a position to accurately evaluate off-taking the service (buying bulk water or and mitigate the risks. But as the experience of wastewater services), such as a local government the English and Welsh water companies shows, TABLE I FUNDING FOR SELECTED WATER AND SANITATION PROJECTS Project site, type, and date Project cost rating Source and maturity of debt Malaysia US$2.4 billion 75/25 A+ Government soft loans due to Concession 11993) (about US$500 million severe tariff collection problems in first 2 years) Buenos Aires, Argentina US$4 billion 60/40 BB- 10-year IFC A-loan, Concession (1993) (US$300 million 12-year IFC B-loan in first 2 years) (recourse to Argentine government in event of early termination) lzmit, Turkey US$800 million 85/15 B 13-year export credit agency loans, BOT (1995) 7-year MITia loan, 7-year commercial bank loan (recourse to Turkish government) Chihuahua, Mexico US$17 million 53115/32h BB 8.5-year commercial bank loan BOT (1994) with limited recourse to Banobras Johor, Malaysia US$284 million 50/50 A+ 10-year project finance loan BOT (1992) from Public Bank Bhd (nonrecourse) Sydney, Australia A$230 million 80/20 AAA 15-year commercial loans BOO (1993) (State government stands behind Sydney Water Corp. payment.) England and Wales US$5.24 billion 25175 AAA Capital markets, corporate finance, Full privatization (1989) European Investment Bank, and other sources a. Ministry of International Trade and Industry of Japan. b. Debt/equitylgrant. Source: Haarmeyer and Mody 1998. projects can be expected to access capital mar- issue priced at just fifty-three basis points over kets as their cash flows to support debt service U.K. Treasury gilts due November 2006. Stan- become more stable and certain and indepen- dard & Poor's based its AA rating of the Łg150 dent regulatory agencies are established. million Eurobond on Anglian's 'robust financial profile and stable operating environment," which The English and WX'elsh companies have drawn 'should provide the company with a fair degree on a variety of financing sources, including the of insulation from the impact of key regulatory bond markets. Anglian Water. one of the ten and political risks going forward." The English privatized water coinpanies, reflects the low risk and Welsh companies have also taken advantage profile of more mature water utilities. In 1990 of low-cost loans from the quasi-governmental the company floated a twenty-four-year bond European Investment Bank. Financing Water and Sanitation Projects-The Unique Risks Equity financing ing to Ofwat, the U.K. water company regu- lator, these returns are expected to fall as Although debt is generally cheaper than equity, the water companies become more estab- a long-term equity stake by the sponsor (which lished and capital expenditures decline. is sometimes also the operator) ensures that management has a long-term interest in the To compensate for the greater country and poli- project and that cash flow growth leads to capi- tical risks, required returns in most developing tal appreciation. Equity also reduces the debt country projects are likely to be significantly service burden on the cash flow, which can be higher and closer to those in other infrastruc- especially important in a project's early devel- ture sectors. For a sample of power projects in opment phase. Asia and Latin America Baughman and Buresch (1994) estimated the equity return at between Equity has been provided largely by sponsors. 18 and 25 percent. And for privately financed For large projects especially, equity, like debt, toll roads Fishbein and Babbar (1996) found is often sourced from multiple consortium that investors expect annual returns to range members, both international developers and between 15 and 30 percent. local investors. The Buenos Aires concession, for example, has four international sharehold- Conclusion ers and four local shareholders (including the utility's employees). The challenge for the future is in mitigating Viewpoint is en open forum intended to the noncommercial risks that characterize the encourage dissemina- Lenders like to see sponsors achieve a reason- sector and moving beyond the limited capac- tion of and debate on able return on their investment, to ensure that ity of third parties. Part of the solution lies in ideas, innovations, and best practices for ex- sponsors have adequate incentive to maintain generating better information about these risks panding the private support for the project, at least through the life so that they are more transparent and their costs sector. The views pub- of the loans. Equity holders partially shield lend- are more fully recognized by parties that can lobhed are those nof tne aIthars and should not ers, because the lower priority of their claims mitigate them. Two tracks to achieve this end be attributed to the on a project's revenues means that they will are independent regulatory agencies and World Bank or any of absorb unexpected shortfalls in revenue. In full competition-for the market and for rights to its affiliated organiza- tions. Nor do any of the concessions and privately owned utility com- supply individual customers, as in England and conclusions represent panies internal cash generation can provide an Wales. official policy of the important source of equity for financing World Bank or of its Executive Directors mvestment. References or the countries they represent. Although information on the return on equity Baughmun, David, and Matthew Buresch. 1994. 'Mobilizing Private Capital for the Power Seaor: Experience in Asia and Latin America." To order additional for project sponsors is not widely available, the U.S. Agency for iternational Development and World Bank, Wash- copies please cell return can be expected to vary with project risk ington, D.C. 202-458-tit or ctontact and cash flow profiles. In two of the cases dis- Fis'h'ein GregoryM and Ssionnn Babar. 1996. "Private Financing ofToil Suzanne Smith, editor, poie.Roads." RMC Discussion Paper 117. W,Xorld Bunk, Resource Molbili- Room tP-188, cussed here returns to investors are regulated: zation and Cofiancing Vice Presidency, Washington, D.C. The World Bank, * The Malaysian government has guaranteed Haarmeyer,David,andAshokaMody. 1998. "Tappingthe Private Sec- i81a H Street, NW, returns of 14 to 1S percent on investment in tor: Approaches a Managing Risk in Water and Sanitation." RMC Washington, D.C. 20433, Discussion Paper 122. World Bank, Resource Mobilization and or Internet address the national sewerage project; actual returns Cofinancing Vice Presidency, WX7ashington, D.C. ssmith7@vworldbank.org. are currently at 12 percent because the con- The series is also cessionaire failed to achieve a 90 percent tariff David Haarnzeyer (david.haarmeyerX available on-line (www.worldbank.org/ collection rate. stoneweb. com), Stone & Webster Consultants, h:mltri/fpd!viotes/ For the English and Welsh water companies Bostonz, aned Asbgoka Mody (amody@worldbank. notelist.html). the returns on regulatory capital (the assets orgJ, Project Finance and Guarantees @) Printed on recycled of the core business) were 11.5 percent in Department paper. 1995-96 and 12 percent in 1994-95. Accord-