Characteristics
Water services greatly contribute to human welfare and economic growth. In a growing economy it makes sense to borrow to invest in water, counting on future gains in productivity to repay debt and service equity. According to the “3Ts” model (see Tool A3.03) a country enhances and consolidates its stream of basic revenues and uses this to leverage repayable sources of funds, which are principally loans, bonds and equity. These funds, which have to be repaid are not alternatives to tariffs and subsidies, merely ways of deferring the impact of these financial costs on society.
Loans are an essential part of the financial structure of heavy-investment projects. Loans are of various kinds:
- Short term loans to cover working capital requirements and to cushion irregularities in cash flow are normally available from local banks, although these are usually of commercial character (e.g. a high interest rate).
- Longer term bank loans (several years in duration) are less common for water and typically involve guarantees and other kinds of public comfort.
- Lending from International Financial Institutions (IFIs) is an attractive option, since the terms and length of the credits are more appropriate to the cash flow of the underlying water assets, though they typically entail forex risk. Some agencies lend in certain local currencies, usually where they can raise bonds in the same currency.
- Non-OECD countries, such as China, India and Brazil, (for instance, under the New Development Bank), offer loans on concessional terms. These concessional loans are available for items such as dams that traditional donors and IFIs are less inclined to fund, but are tied to procurement of their own goods and services.
- For small-scale, local and community projects, microfinance is another source of funding, especially for schemes with a short payback period.
Bonds are securities issued by central or municipal governments, or by utilities and companies, offering a fixed rate of interest for a number of years and full repayment at a specified date. Bonds can be issued either to local or international investors, or occasionally to both – though international issues are subject to rating by credit ratings agencies. Bonds issued by municipalities and other sub-sovereign bodies often depend on credit enhancement of various kinds.
Equity is a form of finance in which the investor shares the risks of the venture in return for a share in the profits. Equity capital can be provided both by private and public partners. Although equity is the most flexible form of capital, in the long term it needs to earn rates of return conforming to market expectations.
The following are examples of the use of equity to finance water projects:
- Acquisition of full or partial ownership of assets (e.g. water distribution company);
- Partial divestiture of a publicly-owned water undertaking by sale of equity to private investors to finance growth;
- Debt-equity swaps – conversion of debt into equity to relieve the borrower’s financial difficulties, and improve its balance sheet;
- Purchase of an equity stake in a water provider (e.g. by IFC or EIB) in order to improve its equity-debt ratio and thereby its credit standing in preparation for raising more loan capital.
Public-private partnerships (PPPs) come in various forms. They typically involve the public sector retaining ownership and a degree of control over water assets (dams, distribution systems, treatment works), while ceding certain functions and powers to private concessionaires. The deals tend to involve private expertise, management and fundraising, recompensed either by performance-related fees, or a share of the profits for the duration of the concession contract. Many freshwater and wastewater treatment works, including desalination plants, are being built and financed under concession contracts of the Build-Own-Operate-Transfer (BOOT) (see Tool B2.02). There are also a few examples of concessions for the supply of irrigation water (e.g. West Nile in Egypt, El Guerdane in Morocco).
Risk-sharing, guarantees & credit enhancement. The leverage of a given flow of basic revenues (“3Ts”) for attracting repayable finance can be enhanced by using various kinds of risk-sharing and guarantees. These work either by mitigating specific risks that would otherwise hamper financing, or by packaging the finance in a form that is more attractive to potential suppliers.
There are various types:
- Partial credit guarantees – parts of loan repayments (e.g. later tranches) are insured against default;
- Partial Risk Guarantee – insurance against regulatory and contractual risk;
- Bond insurance – offered by “monoline” insurance companies to bond issuers against the risks of default;
- “A/B loans” – lenders enjoying preferred creditor status (such as members of the World Bank Group of IFIs) extend their privileges to other banks taking part in syndicated lending operations;
- Output-Based Aid – a product of the World Bank that offers aid only when the project can be demonstrated to be complete and delivering results.
Lessons learned
- Attracting commercial (repayable) finance for water projects depends on good prospects for the future flows of basic revenues from the “3Ts”. Commercial finance cannot substitute for the absence of these basic revenues, which are needed for future debt and equity service payments.
- Loans from the IFIs are particularly appropriate for water infrastructure because of their terms and maturities. However, the due diligence procedures and conditionality of the IFIs can be onerous to borrowers.
- Several high-profile water concessions have failed due to the mismatch between revenues arising in local currency and financial liabilities incurred in foreign exchange. Funds raised from local capital markets avoid such risks, even though they may be on less attractive terms.
- Most major water projects are funded from several different sources, often with credit enhancement from guarantees and other risk-sharing products. Blending of grant and loan finance is typical.
- For stand-alone projects such as treatment works or desalination plants, public-private partnerships such as BOOT concessions are quite common. These “off balance sheet” options may be attractive to national treasuries in the short term, but their long term costs tend to be overlooked.
- The capacity to repay the contracted loans heavily depends on the political and economic stability of the country and the region. Steep inflation and currency devaluation are associated to more difficulties in making debt payments.