58255 NOVEMBER 2010 ABOUT THE AUTHORS Thinking Outside the Pipeline: VIKRAM KUMAR (vkumar3@ifc.org) part of the IFC Infrastructure Venturing into Distributed Off-Grid Water Team in Nairobi since February 2009, joined IFC in December Markets 2006 as an Investment Officer based in New Delhi and covering India, Nepal, Bhutan, Traditionally, IFC's engagement in the water sector has focused on large Sri Lanka, and the Maldives. municipal infrastructure projects, where individual transactions are of Prior to that, Vikram held positions as a Corporate sufficient scale to attract commercial project finance. Such projects, involving Investment Banker for ICICI Bank and YES Bank in India, capital-intensive network infrastructure, can often be commercially attractive and Credit Officer with Bank of but have generally failed to provide access to poorer consumers living America in India and the United Kingdom. outside of formal urban centers. So what about the "base of the pyramid" populations that those large utility systems fail to reach--rural communities, WILL DAVIES (wdavies@ifc.org) and sometimes poorer urban customers living within informal settlements joined IFC in Nairobi in January 2010 to set up the SSAWA and rapidly growing peri-urban areas? New business models are needed, program. For four years prior adapted to the reality of water-supply necessities in the developing world, to that, he worked on the economics of water in East but with the economies of scale required to achieve financial sustainability. Africa, including as an economic advisor to the This SmartLesson describes some early ventures by IFC to invest in and Ethiopia Ministry of Water develop market opportunities in the challenging but potentially far-reaching Resources and as a consultant for the Water and Sanitation area of distributed off-grid water supplies. Program of the World Bank. APPROVING MANAGERS Background the private sector to provide affordable and Usha Rao-Monari, Global Head, sustainable water supply services to the Water. How do you increase access to water for the "bottom billion" at the base of the pyramid Khetsiwe Dlamini, Business hundreds of millions of consumers living who currently lack access to clean drinking Line Leader, Africa Sustainable outside of large formal urban centers? This water.2 One such opportunity is in the area of Business Advisory. question has long been considered a concern off-grid, distributed services (or "micro- of the public sector, to be dealt with by utilities"), an approach to delivery of basic governments and subsidized by donor and services, such as power and water, to rural nongovernmental organization (NGO) communities across the developing world programs. However, despite huge investment through small-scale, decentralized facilities. and effort--registered aid to Sub-Saharan The economic driver behind this approach is Africa alone for water and sanitation is close the lowering of capital costs as a result of to $3 billion per year1--sustaining increased reduced grid-connection infrastructure (pipes access to clean water remains a challenge. and transmission cables), thus increasing the And even where public investments have potential for financial sustainability, even for succeeded in putting in place the necessary utilities serving small populations. IFC infrastructure, the technical capacity and cost- estimated the size of the global distributed recovery mechanisms required for long-term water market to be about $114 billion as of sustainability of operations are often lacking. 2005 (including packaged water and The prospect of greater water scarcity, due to purification equipment and related services). population growth and climate pressures, compounds this challenge. This concept of distributed services is not new; throughout the world, water has long been IFC has been seeking new ways to harness the supplied via decentralized systems, from the innovation, technical skills, and financing of 2 According to the WHO/UNICEF Joint Monitoring Program for Wa- 1 African Minister's Council on Water (AMCOW), September 2010, ter Supply and Sanitation (2010), about 900 million people lack Country Status Overview on Water and Sanitation. access to any improved source of drinking water. SMARTLESSONS -- NOVEMBER 2010 1 Box 2: The Operational Value of Private Sector Management in Water Doing business in water supply is not easy. Returns in regulated markets--in which most utilities operate--are low, and in the water sector they can be restrictively low, especially in developing countries, where customers face financial constraints. In such an environment, efficiency is critical, and success depends on economies of scale, both in volume and in operations. It is therefore not surprising that a major constraint facing small- scale water-supply systems in the developing world is the capacity A WaterHealth Centre in India. of the operators to sustain service quality. In Kenya, for example, an estimated 40 percent of rural water systems are nonfunctional, level of basic village wells upward. What is new is the recent consistent with figures elsewhere in Africa. Such systems can fail emergence and growth of such models in market-based for financial or technical reasons, the latter often due to a shortage form. In 2004, a shining example of such innovation came in of technical skills or simply a lack of spare parts needed to sustain the shape of WaterHealth International (WHI) in India. (Box operations. The World Bank estimates lost investment due to 1.) nonfunctional systems in Sub-Saharan Africa at about $1.25 billion over the past 20 years. The demonstration effect provided by the investment in WHI has provided a further impetus for IFC to think more Private sector participation has proved to be one potential means systematically about the range of potential market to overcome such constraints. For example, in the case of WHI, opportunities in the water-supply sector. (Box 2.) In 2009, supply chain management and technical skills are "internalized" the Sustainable Business Advisory business line published within the company, providing built-in operational capacity for the report Safe Water for All: Harnessing the Private Sector any WHC for the length of the contract period (usually at least to Reach the Underserved, which provided an in-depth look 10-years). Quality assurance is also motivated by the need to at the barriers to greater private sector delivery of water maintain brand quality and avoid reputational risks, while the and sanitation products and services to consumers at the profit incentive drives an emphasis on "counting the pennies" by base of the pyramid. pushing volumes and reducing costs at the same time. This study, in turn, has triggered the development of a Sanitation and Safe Water for All (SSAWA) program to sanitation services.3 The program supports the development support market-based approaches with the potential to of scalable business models in these markets with the expand access to water and sanitation services for lower- potential to achieve significant scale. income consumers. The program, developed under Sustainable Business Advisory, Africa, began in Kenya in The lessons below are based on experience gained from October 2010. It is exploring the potential of a range of the WHI investment and on the early knowledge market-based approaches, including in distributed off-grid generated from the establishment of the SSAWA program markets such as vended-water kiosks, private operation of in Kenya. micro-piped community systems, and private provision of Lessons Learned Box 1: The WaterHealth International Model 1) Some form of aggregation is key to commercial viability and scalability. WHI is a private company that installs, operates, and maintains WaterHealth Centres (WHCs) in villages and peri-urban areas in In the case of large municipal water-delivery networks, high India and Ghana. WHCs have the capacity to purify large volumes fixed costs mean that profit margins are closely tied to of water, sourced locally, to provide safe water to communities of volumes of water billed. For small, decentralized systems, several thousand residents. The local community is responsible opportunities for increasing volumes are limited, while for providing land, access to a perennial water source, and in fixed operating costs (primarily labor) will be high. So the some cases a percentage of the down payment for the installa- challenge is that individual operating or management tion cost (which is generally in turn sourced through donor sup- contracts are often too small to attract private interest. port). Only via some form of aggregation can the model be financially sustainable, and therefore scalable. Under this model, WHI can provide reliable access to treated drinking water at prices as low as $0.08 for 20 liters. The faith Aggregation can be achieved in different ways. WHI, for shown by IFC in the company through an early-stage equity in- instance, aggregates operating costs across systems, thereby vestment of $1.2 million in 2004 has paid off, catalyzing over $29 reducing marginal costs of new installations. Technicians, million in external equity financing, a $15 million loan investment for example, will be much more cost-effective servicing in 2009, and a follow-on $5 million equity investment in 2010 several locations rather than one. "Scaling across" provides from IFC's Infrastructure Department. 3 Experiences from Kenya described here are primarily based on market research conducted in the process of designing the SSAWA program. 2 SMARTLESSONS -- NOVEMBER 2010 the economies of scale and volume needed to make the business model work. In Kenya, the SSAWA project is designed to support businesses looking to develop similar scalable models with the potential to reach base-of-the-pyramid consumers. One approach being explored in the vended-water market is the franchising of purified-water kiosks to individual entrepreneurs, managed by a centralized operating business with existing expertise in water purification systems. Such approaches have achieved scale in Southeast Asian markets, and early research suggests that a similar opportunity may exist in Kenya. Children in India enjoy access to clean water through a WHC. Aggregation does not necessarily entail standardization, thereby maximizing the reach of scarce public resources. and the interests of the private sector are well suited to Different mechanisms are available to achieve this. For adapting business models to local demands. For example, in example, WHI is exploring an approach whereby the subsidy Kenya, as in many water-scarce countries, water for drinking is tiered according to village size, with larger villages is often just one of many sources of demand that can be requiring lower subsidy levels than small ones. In another tapped to reach the volumes needed to recover costs. approach, the government uses a competitive bidding Companies testing the market have found that demand for process to determine levels of subsidy needed for a cluster water for micro-irrigation and for livestock can make the of water supply systems. Conversely, if an installation in a economics of decentralized water systems viable in some particular higher-income or densely populated area can be locations where demand for drinking water alone is fully commercially financed, then the private sector can insufficient. In these cases, the viability of the business proceed on a purely market-financed basis, allowing public model will depend on whether the additional volumes funds to go where they are needed most. offset the cost of the micro-piped systems needed to distribute supply. Take for example one promising market opportunity identified in the sanitation sector in Kenya. A local company, 2) Commercial finance can increase the reach of scarce Ecotact, has pioneered a distributed service model for pay- public funds, while public funds can be a catalyst to per-use urban sanitation facilities marketed under the scale up commercial approaches. IkoToilet brand. Ecotact started out in selected high-traffic parts of Nairobi, where individual facilities were profitable-- Investments in the water-supply sector often need a certain thanks to high customer volumes and innovative revenue level of capital subsidy built into the funding structure. This streams such as external advertising and cross-sales of other frequently translates into overdependence on subsidies, products. With the visibility of the brand built and economies which undermines the potential scalability of a business of scale established, the company is becoming creative in model and restricts a key benefit of private sector developing partnerships with the government and donors participation: the ability to raise commercial finance and to expand facilities into schools and urban slums through equity. blended public-private funding, thereby growing the business and increasing access to much-needed services. Private sector participation in distributed services can offer flexibility in the blending of public and market finance, 3) Maintaining focus on comparative advantage and building strategic partnerships can be the difference between success and failure. Where subsidies are necessary, the difference between success and failure frequently rests on the ability to be creative in developing partnerships. WHI achieved its current scale, for instance, in large part due to an extensive range of partnerships with development agencies, foundations, NGOs, and wealthy philanthropists. The key is to identify and leverage the added value of each partner--and potential win-wins that often go beyond financial support. For example, in partnerships with health-promotion NGOs, WHI benefits from increased demand generated by the NGO's safe-water education campaigns, and the NGO benefits from linking its education work to new and reliable clean-water supplies. While developing partnerships, the importance of A water purification kiosk on the outskirts of Nairobi, Kenya. specialization cannot be overstated. Under the WHI model, donors provide invaluable financial support, visibility, and SMARTLESSONS -- NOVEMBER 2010 3 Children benefit from safe water, thanks to WHI. oversight; NGOs provide crucial education geared to meet the needs of rural retail and awareness raising (a critical ingredient environments. It is also a fragmented market, for early adoption of services such as safe where the key to success lies in the ability to water); and the private company sets up and achieve scale through aggregation of some operates the system. Moving activities and form. However, the prize is significant, because responsibilities from one partner to another scalable distributed service models, operated can arguably compromise the health of the and managed by the private sector, may overall operation. For example, an NGO that ultimately prove to offer one of the most is effective at raising donor funding may be capital-efficient means for developing tempted to set up and operate water supply countries to accelerate increased access to safe systems within the communities it interacts water. with. It may be able to do so at competitive costs initially, but it is less likely than a private Through investments in companies such as operator to have the incentives in place to WHI and advisory services projects such as sustainably run such operations for long SSAWA, IFC is playing both a practical and a periods. In contrast, a private organization thought leadership role in the development will build operation and maintenance costs of new market opportunities in the water and into the price of the service. And any impact sanitation sector. Indeed, a key objective of on upfront costs is likely to be offset by the the SSAWA program in Kenya will be to benefits of sustainable long-term, high- encourage market development in this space quality services. and to identify and support the demonstration of more WHI-like business models. It is hoped Other examples point to the value of that this will bring together investment and partnering with local financial intermediaries advisory services in catalyzing market solutions to achieve scale. In Kenya, for instance, the to the challenge of providing access to water World Bank Water and Sanitation Program and sanitation services for consumers at the has helped establish a partnership between base of the pyramid. We hope this SmartLesson the local K-Rep Bank, the Global Partnership is just a first installment in IFC's emerging for Output-Based Aid, and local communities, ventures into distributed off-grid water DISCLAIMER to blend 40 percent market financing into markets. IFC SmartLessons is an awards small piped-water systems. In such cases, the program to share lessons learned in development-oriented advisory local bank has the potential to act as a services and investment powerful "scale multiplier," given its strong operations. The findings, comparative advantages in identifying and interpretations, and conclusions appraising commercially viable business expressed in this paper are those plans, and the incentives to reduce marginal of the author(s) and do not necessarily reflect the views of IFC costs by expanding project pipelines. or its partner organizations, the Executive Directors of The World Conclusion Bank or the governments they represent. IFC does not assume any responsibility for the Scaling up off-grid, distributed water supply completeness or accuracy of the models via market financing and private information contained in this sector operation will not come easily. This document. Please see the terms high-volume, low-margin business needs and conditions at www.ifc.org/ significant investment in operational smartlessons or contact the Water being distributed from a WHC in Ghana. program at smartlessons@ifc.org. infrastructure, plus management structures SMARTLESSONS -- NOVEMBER 2010 4