NOVEMBER 2010 57913 ABOUT THE AUTHOR Using Market Finance to Extend Water Supply RAJESH ADVANI (radvani@worldbank.org) Services in Peri-Urban and Rural Kenya is a Finance Specialist with the Water and Sanitation Program This SmartLesson explains how donor funds have been used to leverage and is based in Nairobi, Kenya. He manages the program and domestic market finance and equity for investment in small piped water is working on other projects to improve utility access to infrastructure in the peri-urban and rural areas of Kenya. Given the immense market finance in Africa. pressure on government and donor resources to achieve the Millennium APPROVING MANAGER Development Goals, this approach shows that leveraging donor funds not Wambui Gichuri, Regional only increases the volume of investments financed but improves the Team Leader, Water and Sanitation Program - Africa. sustainability of these investments by linking debt service to system functionality. Background equity from the CBOs. The typical value of investments ranges from $75,000 to $170,000. In Kenya, community-based organizations On completion of project implementation, up (CBOs) are important providers of water to 40 percent of the total project cost is paid supply services in peri-urban and rural areas to the CBO as a subsidy. The subsidy is provided that are not served by publicly owned utilities. by the Global Partnership for Output-Based Some 1,200 small piped water systems serving Aid (GPOBA), and the Water and Sanitation 3.7 million people are operated by CBOs Program-Africa (WSP-Af)1 provides technical throughout the country. However, much of assistance and supervises the program. The the infrastructure in these facilities is run subsidy is paid against predetermined output down as a result of years of underinvestment targets set at the time of taking the loan. in maintenance, with leaking distribution and These targets are measured as follows: storage and inadequate water sources a common feature of these systems. But the · Coverage: Increase in the number of demand for rehabilitation and expansion is active water connections served by the significant, especially as the price of alternative project sources of water supplied by vendors is much higher than that sold through piped systems. · Revenue: Increase in average monthly Access to finance for infrastructure investment revenuerealizedbytheproject in community-run piped water systems remains a considerable constraint because To cover the lender's exposure during project government and donor resources are mostly implementation, K-Rep Bank purchased a channeled into public utilities and areas partial credit guarantee from USAID's inhabited predominantly by the very poor. To Development Credit Authority that is payable address the demand for infrastructure finance, if the subsidy is not awarded to the borrower. an innovative program that blends commercial If projects do not achieve the entire output debt with subsidies to finance investments in target, the subsidy is paid against the community water projects (CWPs) was initiated percentage to which output targets are met. in the Athi Water Services Board service area The creditworthiness of the CBOs applying for of central Kenya in 2006. loans is assessed according to K-Rep's internal risk criteria. CBOs must be formally registered Under the program, CBOs can borrow up to as cooperatives or societies in order to borrow 80 percent of the cost of infrastructure and must secure the legal right to sell water rehabilitation and development from K-Rep 1 The Water and Sanitation Program (WSP) is a multidonor Bank, a Kenyan commercial bank specializing partnership administered by the World Bank to support poor in microfinance lending. The remaining 20 people in obtaining affordable, safe, and sustainable ac- cess to water and sanitation services. For more information, percent of the project cost is financed by visit http://www.wsp.org SMARTLESSONS -- NOVEMBER 2010 1 within their demarcated area of operation, which is essential for giving the lender the necessary comfort to lend to the CBO. In Kenya, the right to supply water is granted by one of the eight regional Water Services Boards (WSBs)2 that provide a CBO with a service provision agreement (SPA). The SPA is a management contract that assigns the water services operating mandate to the water services provider, giving it a monopoly over the supply of water within its area of operation. The SPA defines the operational and performance characteristics between the two parties and is subject to regulatory oversight. Since the program's inception in 2007, K-Rep Bank has lent $1 million to 12 CBOs, 9 of which have completed implementing their projects and have received subsidies. The investments financed include water resource development and augmentation, water treatment, distribution, and meters. These investments are expected to increase the number of connections in the projects financed from 5,300 to 9,900 Community water point at Gitaru Water Project in Kiambu district, and target about 67,000 beneficiaries. The program is now Kenya. Gitaru received a loan of $60,000 to equip a new borehole being scaled up to target 50 projects countrywide, targeting and install distribution tanks in the project area. As a result, resi- 165,000 beneficiaries; the disbursement rate is expected to dents now have a constant water supply and the project has been increase significantly, as the implementing agency has come able to expand the number of connections it supplies by 20%. some way down the project management learning curve. Lessons Learned concept. A key factor in K-Rep's decision to implement the program is the fact that CBOs are an important part of the 1) The lender should have in-house credit appraisal bank's customer base. skills typically used in project finance and should be prepared to lend to projects without tangible collateral, 2) The willingness and ability to pay for water must be as borrowers generally do not have a financial track evident among the consumers being served by the CBO; record or assets that support balance sheet lending. it drives the cash flows needed to repay the loan. The lender needs to blend the capacity to work with While the program targets communities that are relatively community groups with the sophisticated credit analysis poor, consumers in projects borrowing under the program and monitoring skills used in project finance. Adequate pay an average monthly water bill of $10 to $25, depending capacity is required to appraise a CWP's ability to meet its on system operating and debt service costs. A CWP must operating and finance costs from future water sales. This also have sufficient scale to generate the necessary revenue requires an understanding of water utility operations, cost to meet costs; a typical project financed under the program and tariff structures, water supply capacity and constraints, has between 350 and 600 individual connections, and tariffs and the nature of demand for paid water. The principal vary from $0.50 to $1 per cubic meter. Poorer residents who collateral that a borrower can offer is its cash flow from cannot afford individual connections benefit by being able water sales that will be generated from the investments to purchase water from point water sources installed by financed by the lender, and so the credit analysis must these projects at lower rates than those prevailing in the establish financial viability from this perspective. The area prior to the project. borrower's exclusive right to supply water to customers within the project area provides collateral by way of the Kiamumbi Water Project serves as a good example of a lender's being able to require a change in management to typical project financed under the program. The project secure debt service payments in the event of default. draws water from a dam built by a farmers' cooperative society in the 1970s for irrigation. As farmers switched to In this program, the lender built its in-house credit appraisal more intensive dairy farming and subdivided the land for capacity by putting together a project appraisal team led by residential use, there was less demand for irrigation water. an experienced water engineer who works closely with the On the other hand, growing population pressure increased specialized project development and implementation the demand for water for domestic consumption and consultants employed under the program. These activities introduced the idea of using the dam to supply households are aimed at obtaining project-specific technical and with water. At the time, residents obtained water for financial data to inform the lending decision. Training and domestic and livestock use from vendors and shallow wells. support in developing project appraisal tools and in The community borrowed $135,000 from K-Rep Bank to marketing the loan product have been provided by WSP- finance a system that would supply potable water to 750 Af, which initially identified K-Rep Bank as an implementing households. The project was completed in August 2009, partner that was keen to support this innovative financing and the community contracted with a private operator to run its system on a five-year management contract. The 2 Under the Water Act 2002, WSBs are mandated to provide water services and en- sure that consumers within their region have access to water for human consumption. project generates monthly revenues of $7,500 from the sale WSBs do not directly engage in the provision of water supply services but license of 9,000 cubic meters of water to 450 individual connections water services providers and communities to do so. 2 SMARTLESSONS -- NOVEMBER 2010 and a water kiosk at an average tariff of $0.81 per cubic of projects in geographical proximity, while ensuring that meter. The CBO makes timely debt service payments of there are enough operators in the program to promote $1,750 to K-Rep Bank every month, after having received a competition. This also provides the necessary motivation for subsidy of $80,000 that went toward reducing its outstanding an operator to invest resources into making the construction debt at the end of the construction phase. and management of small piped water systems a viable business. A design-build-operate contract inherently contains Hence, in appraising the financial viability of a project, the an incentive for an operator to ensure that the systems built lender must be able to establish that consumers in the are functional for the term of the five-year loan, thereby project area can afford to pay monthly water bills and that improving their sustainability. Given that transferring risk demand for water from the project area is not eroded by from the CBO to the specialized operator will reduce risk to competing sources of water supply. CWPs financed under the lender, the program may also want to consider financing the program must be able to generate enough cash from the operator rather than the CBO. water sales to cover operating costs and complete their debt service payments within the maximum loan repayment 4) Disbursing subsidy funds on a pari passu basis with period of five years. commercial debt results in significant cost savings; paying the subsidy on project completion increases 3) It is critical to have a pool of capable companies overall project costs significantly. providing business development services to support CBOs financed under the program; projects should be Under the current program structure, disbursing subsidy pooled to enhance their attractiveness to a specialized funds at the end of the construction phase increases total operator; and qualified operators should be encouraged project cost by 12 to 18 percent because of interest costs, to undertake design-build-operate contracts. and it increases the risk of default if construction cannot be completed within one year. While the objective of the Experience from the pilot project suggests that communities output-based subsidy is to ensure that specific project lack the skills and experience needed to implement and objectives are met before subsidies are paid, the lender's manage water projects efficiently. To build a pipeline of rigorous disbursement processes bring a level of oversight viable projects that could be financed by K-Rep, the Public- not typically found in government- or donor-funded Private Infrastructure Advisory Facility3 provided a grant to projects. This oversight ensures that loan disbursements fund the development of bankable loan applications to be are directly linked to achieving project objectives and appraised by the lender, while WSP-Af provided technical could therefore act as output targets under the output- assistance to improve the quality of loan applications. The based subsidy approach to reduce project costs and the loan applications are developed by consultants that are risk of default. This would provide additional comfort to tasked with implementing and managing the projects for the the lender and remove the need for the lender to have a term of the loan in order to pass the risk from the communities credit guarantee to cover construction risk, thereby to private-sector companies specialized in the development further reducing finance costs. Programs considering a and management of water supply systems. These companies similar approach should therefore consider structuring can provide much-needed expertise during a period when outputs to mitigate risk to the lender and reduce project most projects will experience significant cash stress on costs. account of debt service payments. The program has short- listed three companies to provide support to CWPs under the program, and various training activities have been undertaken to build the capacity of these firms. The lender oversees procurement of consulting and management services and is a counterparty to the contracts signed between companies providing support and the CBOs, as the communities require support in contract management. Individual CWPs financed under the pilot do not appear to generate sufficient free cash, after they have paid for direct operating expenses and debt service, to be able to contract with a private operator to manage their systems in the loan repayment phase. Under existing operator contracts, there have also been problems with meeting the operator fee because control of the cash from water sales rests with the CBO. To improve the financial viability of CWPs, the projects Storage and distribution tanks at Karaweti Water Project in Git- should be clustered and specialized operators assigned to hunguri division of Kiambu district. The community borrowed design, build, and then operate the systems on concession- $50,000 from K-Rep Bank to develop a new source and install type contracts for the duration of the construction and loan meters for all its customers. As a result, revenue collection in- repayment period. To bring economies of scale and scope to creased by 90% and the reliability of water services increased individual CWPs, each operator needs to manage a number tremendously, with 87 percent of customers receiving water sev- 3 The Public-Private Infrastructure Advisory Facility (PPIAF) was created in 1999 to act en days a week, up from 8 percent before the investment. as a catalyst to increase private sector participation in emerging markets. It provides technical assistance to governments to support the creation of a sound enabling en- vironment for private service provision. SMARTLESSONS -- NOVEMBER 2010 3 Conclusion The program has shown that subsidies can be leveraged by two and a half times to secure cofinancing from the private microfinance sector in order to expand water supply infrastructure in peri-urban and rural areas. The operational life of systems financed under this approach is likely to be significantly greater than that of systems financed with government or donor grants because, in securing its interest, the commercial bank provides a level of oversight to management that is not typically found in projects financed with grants and soft loans. Public distribution point at Karanjee water proj- Programs targeting similar approaches should ect. Water purchased by vendors at such distribu- scope the market to ensure that there is a tion points is ferried to households by carts that sufficient pipeline of financially viable and are pulled by donkeys. As a result of the project, technically feasible projects to warrant the the retail price of water distributed in this man- establishment of a leveraging mechanism, ner has reduced from as much as $7.50 a cubic and that the legal framework offers the meter in times of shortage to $2.00. Sales made necessary protection to secure the interest of at public points generate cash income that help commercial lenders. Further consideration the projects cover operating and debt service needs to be given to institutionalizing the costs. support mechanisms needed to develop the project pipeline, especially if the program is to crucial that an institutional framework that achieve sufficient scale. supports the development of a pipeline of financially viable projects be established to Critically, funds for technical assistance, grants, facilitate private-sector bank lending to water and infrastructure subsidies under this projects. Any such framework must recognize program have been provided by World Bank the fact that a commercial bank will conduct Group organizations. If government grants an internal credit risk assessment of every are to be leveraged in a similar fashion, it is project it intends to finance. DISCLAIMER IFC SmartLessons is an awards program to share lessons learned in development-oriented advisory services and investment operations. The findings, interpretations, and conclusions expressed in this paper are those of the author(s) and do not necessarily reflect the views of IFC or its partner organizations, the Executive Directors of The World Bank or the governments they represent. IFC does not assume any responsibility for the completeness or accuracy of the information contained in this document. Please see the terms and conditions at www.ifc.org/ smartlessons or contact the program at smartlessons@ifc.org. 4 SMARTLESSONS -- NOVEMBER 2010