) gLq3 Viewpoint Note No. 152 September 1998 Pooling Water Projects to Move Beyond Project Finance Davlid Many commercial banks have had little interest in water and sanitation projects not only because Haarmnyer and of noncommercial political and regulatory risks, but also the small size, weak local government Ashoka Mlfody credit, and high transactions costs (the legal, consulting, and financial costs of structuring). Most projects have been financed on a limited recourse basis, that is, with project cash flows and assets as the main security for lenders. The move from project to corporate (balance sheet) financing is occurring in stages. Financing project debt from the sponsor company's balance sheet exposes that company to significant risk and thus requires a strong and large balance sheet. Designed in part to shield a company's balance sheet and improve a project's credit strength, innovative structures and financial instruments are emerging. Ultimately, the goal is for water utilities to raise debt and equity from capital markets on the basis of their own balance sheets, strengthened by a diversified and stable rate-paying customer base. This Note reviews the new trends. In the transition from government to private finan- Integration of water and sanitation utilities cing, projects in the water and sanitation sector with other utilities (such as natural gas dis- require a heavy focus on risk allocation and miti- tribution or power generation and distribu- gation, which has often implied drawn-out tion entities) to form holding companies with negotiations before and sometimes after financial stronger balance sheets. closure. To address noncommercial risk, many projects have required some form of ongoing gov- Corporate finance and capital markets ernment or third-party support (see Viewpoint 151). To transform themselves into economically Corporate finance can simplify the transition viable enterprises, projects must mitigate com- to capital market financing because the risk of nmercial risks and gain credit strength (significaint a project's debt is absorbed in part by othei cash for investments and the ability to raise funds corporate activities. As in other sectors, projects from capital markets). Risk pooling structures and in water and sanitation have been financed with asset aggregating instruments may be one way some ("limited") recourse to a sponsor's bal- to achieve the funding objectives: ance sheet. This mechanism focuses project * Financing of project debt on the basis of the spon- performance incentives but is generally costly sor's balance sheet, or corporate finance (pool- in terms of time and resources. ing risks with the corporation's other activities). * Equity funds to leverage sponsors' equity and Increasing balance sheet financing may require attract a larger group of investors. significant industry restructuring, such as con- * Bundling of water and sanitation projects to solidating the ownership and operation of water form economically viable entities that can be utilities in a region or encouraging the integra- attractive to lenders. tion of different utility sectors (box 1). Such The World Bank Group . Finance, Private Sector, and Infrastructure Network Pooling Water Projects to Move Beyond Project Finance restructuring is already hapDening. Malaysia has nancing in the first three years and was ex- bundled its entire sewerage system under one pected to rise to 30 percent in the next three. concession, a case of project pooling. While this project has forgone the benefits of com- The use of bond financing by privately financed parative competition achieved when systems water projects and utilities is relatively new. operate side by side, it creates the potential Leading the way, the English and Welsh utili- for securing revenue streams to finance a large ties have used bond financing based on their number of small investments that would not balance sheets. In most developing countries, be commercially viable on their own. however, the development both of bond mar- keis and of economically viable water utilities In the long term, however, achieving financial is at an incipient stage. The United States has and operational sustainability will require a the most mature bond market for municipal utility to finance investments from internal cash infrastructure; its development has been aided and long-tcrm bond issucs. As the English and by tax cxcmptions and credit enhancements -Welsh water companies demonstrate, water (see the discussion below on state revolving projects have the potential to do this. Once funds). Although the funds are used primarily established, they can produce stable revenues by utilities owned by local governments, this that not only permit internal financing but also "municipal" bond market taps private financing. allow access to a much broader class of inves- tors through bond issues. Among developing Equity funds country projects, only Aguas Argentinas has moved significantly in this direction: internal Over the past few years infrastructure equity cash generation accounted for 9 percent of fi- funds have provided a means by which devcl- opers can raise financing for infrastructure projects and investors can participate in this emerging market. Such funds can be particu- __ I Ilarly attractive to infrastructure developers because they allow them to leverage their con- New investments in the water and wastewater sector tend to be tributions with those of other investors and thus much smaller than those in other infrastructure sectors because of to spread their capital. For investors, equity funds the market's fragmentation. Municipalities are in charge of water and mitigate project and country risk by creating a sanitation, so investments in facilities reflect demand only within portfolio of projects under one company. their jurisdictions. The Mexican wastewater program, for example, The French water and sanitation companv will build many small wastewater plants, with an average cost of Lvonnaise des Eaux, for example, introduced an about US$25million to US$30 million. Even where large investments infrastructure equity fund in Asia in 1995, a are expected, they are spread over time, keeping pace with growth in IUSS300 million water fmnd. Besides Lyonnaise, demand. The massive Buenos Aires concession is expected to make contributors to the fund include Allstate Insur- investmentsworthafewbilliondollarsoveritslifetime buttheinitial ance Company, the Employees Provident Fund finvestmentas worlessthafwblin domllaiovr itStimel , btthe anitial Board of Malaysia, and the Lend Lease Corpora- financing was for less than US$200 million. Similarly, the Manila tion of Australia. Investors are expected to ben- concessions are expected to invest about US$5 billion over thirty efit from the water companvys significant market years, but the initial round of financing probably will not exceed position and deal flow in the region. The fund US$350 million. This pattern of small, incremental investments refinances the equity of the original sponsors. contrasts with that of power and transportation projects, which Thus it conserves sponsor equity for the riskier typically require large investments over a short period and gain the devel ent phase sonsor ply thrtexper- tise in the early phase to get projects started and attention, and often the support, of national governments, can then move on to other projects, Investors in the fund expect to receive steady. utility-like re- turns and potentially stand to gain significantly if companies will also receive financial support in the fund or a portion of it is publicly listed. the form of a guarantee from the East-West Fund of the Austrian Finanzierungsgarantie GmbH. Houston-based Enron Corporation used a similar strategy, though the fund took the form of a pub- State revolving funds licly listed company. In 1994 Enron packaged its emerging market power plants and natural gas In the United States the federal government has pipelines in a new company that it floated on supported state and local governments in the New York Stock Exchange. Capitalized at financing the construction of wastewater treat- about US$165 million, Global Power and Pipe- ment plants since the 1950s. In 1987, in an effort lines (GPP) included the assets of two power to delegate more responsibility to state and local plants in the Philippines, a power plant in Gua- governments, the U.S. Congress replaced the ex- temala, and a natural gas pipeline system in Ar- isting grant funding with a program to capitalize gentina. Enron retained a 50 percent share of the state revolving funds (SRFs). States are required company and sold the rest to investors. GPP has to contribute an amount equal to at least 20 per- the right to buy into projects developed by Eriron cent of the federal capitalization funding. The at favorable prices, providing Enron an ensured program is aimed at leveraging federal resources exit mechanism to free up capital for high-risk, and creating a renewable and perpetual source high-return development opportunities. of financial assistance for wastewater infrastruc- ture. Unlike with grant funding, the need to re- EBRD's private multiproject financing pay SRF loans introduces an important element facility of accountability, as well as a basis for new loans. To mobilize private investment in Eastern Eu- The structure of each state's revolving fund pro- rope, the European Bank for Reconstruction gram depends primarily on the state's needs and and Development (EBRD) has developed a circumstances (such as its borrowing limit and multiproject financing facility (MPF) that pro- ability to repay loans). Some states use program vides a framework for financing a series of funds to provide direct loans to local govern- projects that may be too small to be consid- ments of up to 100 percent of a project's cost at ered individually. The MPF is made available below-market rates. Others provide excess re- to a private company, which uses the facility serves or excess debt payment coverage that to make equity investments in and loans to pri- helps secure bonds backed by the revenues of vate water and sanitation projects. Under this a wastewater facility. Program funds may be used arrangement the company largely takes on the as collateral to borrow new resources: because task of due diligence, which helps to reduce several jurisdictions borrow on the basis of the the transactions costs for each project financed. same collateral, spreading the risks, the overall costs of borrowing are lowered. EBRD signed its first MPF in July 1995-a US$90 million equity and loan facility with Lyonnaise The large, diversified pools of municipal borrow- des Eaux. The company was recently awarded ers created under SRF programs are attractive to a project that could be the first to access the lenders because they spread the risks of debt facility, a USS41 million, twenty-five-year BOT payment interruption or default. Pooling projects (build-operate-transfer) wastewater treatment for financing on a statewide basis also makes it project in Maribor, Slovenia (population more economical for credit rating agencies to 150,000). In 1996 the second MPF was signed, evaluate credit risks. While a single project might with three Austrian companies. The agreement not be large enough to justify a credit assessment, involves a S 700 million (approximately US$140 a large group of projects will be attractive. Credit million) equity and loan facility to support an rating agencies provide important information to investment program of S 2 billion. The Austrian prospective lenders about the creditworthiness Pooling Water Projects to Move Beyond Project Finance of SRF programs by, for example, assessing and adopted in the concessions recently awarded in monitoring reserve fund and debt coverage lev- Casablanca and Gabon and is being considered els and evaluating the size and composition of for water and power projects in the Republic of the borrower pool. Size and diversity matter. Rat- Congo. However, the implications for the con- ing agencies have found that smaller pools (20- centration of monopoly power are a concern. 100 borrowers) generally face more stringent Chile recently passed a law prohibiting owners credit requirements from lenders than larger pools of water utilities from simultaneously owning because the behavior of individual borrowers has power distribution or telephone service in the an amplified effect. For pools with fewer than same area. twenty borrowers the weakest borrower tends to determine the credit rating. Conclusion The revolving nature of the funds has had a As a utility matures and its revenues become in- significant effect on purchasing power. Accord- creasingly predictable and secure, its financing ing to the U. S. Environmental Protection Agency, structure can be expected to shift to corporate funds invested in the SRFs provide about four finance or greater balance sheet support. Inter- times the purchasing power over twenty years nally generated revenues are an important source than funds used to make grants. Even so, the of funding for water projects that have achieved funds represent only a fraction of the invest- a stable and diversified customer base. And strong ment needed to upgrade municipal plants. In balance sheets permit utilities to obtain external viewpoint in an open forum intended to 1997 states were expected to make SRF loans of financing by issuing long-term debt to a broader encourage dissemina- US$3 billion, compared with US$11 billion in class of investors. As a result of high political risk tion of and debate on total capital investment in wastewater infrastruc- and shallow or nonexistent capital markets, in idean, innovations, and best practices for ex- ture from all sources (federal, state, and local). developing countries the work of building stron- panding the private ger balance sheets and tapping capital markets sec:or. The views pub- Multiutilities generallv takes time, howvever. lished are those of the authors and should not be attributed to the Deregulation and increasing competition in in- New financing techniques in other sectors and World Bank or any of dustrial countries are creating pressures for dif- their early applications in water and sanitation its affiliated organiza- tions. Nor do any of the ferent utility sectors to combine. By combining, suggest that pooling projects may be a way to conclusions represent utilities hope to achieve not only economies of move beyond project finance, particularly for official policy of the scope but also larger balance sheets and increased the many small projects that need financing. orlcutive Dir ectors credit strength (through diversity) to attract long- Multiutilities, entities that deliver multiple infra- or the countries they term private financing. The trend has been most structure services such as water and electricity, represent. pronounced in the United Kingdom but is grow- offer another approach to attracting private capi- To order additional ing elsewhere. United Utilities and ScottishPower, tal. These multiutilities can gain credit strength copies please call two of the three U.K. multiutilities, provide util- through a diversified revenue base that enhances 202-458-1111 or contact itv services that run the gamut-principally elec- the prospects for corporate finance. Suzanne Smith, editor, Room F6P-188t tft,ry genei-atioia and distfibution and water and The World Bank, sanitation, but also gas distribution and telecom- 1818 H Street, NW, munications se-vices. The Note is based on a longer paper by the auLthors "Tappinig the Washington, D.C. 20433, Prisate Sector: Approaches to Maniaging Risk in \Vater and Sanitation" or Internet address (RINC Discussion Paper 122, WNorld Bank. Resource Ntobilization and ssmith7@worldbank.org. Multiutilities in developing countries may soon Cofinancing Vice Presidencs, Tashing,on, D.C., 1998). The series is also play a growing role. Argentina and Slovenia have available on-line lwwwv.worldbank.org, combined gas and water utilities. In Cote d'Ivoire David Haarmeyer (david.haarneyer@ html/fpd/notes/ the project company developing the water sup- stoneweb.con), Stone & Webster Consultants. notelist.html). ply concession went on to develop the electric- Boston, and Ashoka llody (amody@wvorldbank. @ Printed on recycled itv distribution system and a power generation org, Project Finance and Guarantees paper. project. This multiutility approach is being Department