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Sophie Trémolet

Private money for public waterA safe haven in the midst of a

financial storm?

A presentation to ICEA, 16th June 2009

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Introduction

The problem Water and sanitation (WATSAN) are essential services High investment needs

BUT Notoriously difficult to finance Perceived to be a highly political sector: high risks / low returns

Question: what innovations are required to mobilise private sector finance for WATSAN in the current financial crisis?

Based on recent work Innovative financing mechanisms for the water sector (draft available) Client: OECD (part of Horizontal Water Programme) Focus: OECD and developing countries (more on the latter)

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Structure of presentation

Contextual elements A financing gap or a perception gap? Sources of finance: FCR is out, SCR is in Innovative approaches: from concept to reality but still

short of scaling-up In the midst of a financial storm Going forward

Leveraging, leveraging, leveraging Building sustainable financial mechanisms

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Contextual elements

Key drivers for investment OECD: renewals and upgrading to meet environmental standards (e.g. Water

Framework Directive in EU) Developing countries: reduce losses, develop resources, increase access in line

with MDGs (estimated cost = USD 18bn/year)

2003: Publication of “Camdessus Report” Panel of experts, chaired by Michel Camdessus (ex-IMF) – Rapporteur: Jim

Winpenny First time that sector took a hard look at financing challenges Hostile reception at Kyoto World Water Forum

Six years on What has changed in the sector and beyond? What recommendations have been implemented? What recommendations are still valid / or not?

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A financing gap or a perception gap?

Early 1990s: public sector cannot do it alone

Water sector in England & Wales: not the norm PSP introduced via asset sale (only a handful) Private operations and private finance are combined Financial innovations to reduce CoC as a result of tightening

regulatory regime Mobilised considerable private financing (but EIB main lender)

1990s to early 2000s elsewhere Hopes that private sector would fill the “financing gap” Private operation “naively” associated with private finance

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Developing countries: PSP in question

Disillusions with PSP since 1997 Asian crisis Several high-profile concessions failed

Bad design: Cochabamba (Bolivia) Impact of exchange rate crisis: Manila, Buenos Aires Political crisis: La Paz (Bolivia)

Main market players have lost appetite and withdrawn to home markets, China and a few isolated transactions / contracts

Expectations mis-match IFIs, donors and client governments keen to let concessions (most investment

obligations, best to increase coverage) Private operators: “We are not bankers”

Preference for low-risk contracts (e.g. Management contracts, BOTs)

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Current market structure

Mostly public operators (~ 95% of total market) and mostly decentralized (municipal / regional operators) Some have greatly improved (e.g. PPWSA in Cambodia) Renewed interest in improving public utilities

“Locally grown” private operators (40% private market) Medium size: China, Philippines, Colombia, South Africa, etc... Small scale water service providers (SSWSPs)

Can cover more than 50% in some countries, particularly in peri-urban areas in capital cities (e.g. Maputo – Mozambique or Lusaka – Zambia)

Were not always reckoned with but are increasingly recognised

Common features All have substantial financing needs and different constraints Common “critical mismatches” limit fund availability

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Financing sources: FCR out, SCR in

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Commercial loans

Usually available in OECD countries Main issue: tenor does not match asset life, refinancing

costs can be high

In developing countries Long-term loans rare (maximum tenor in Kenya: 3 years) Commercial banks not familiar with water sector Ability to repay limited by insufficient revenues

Tariffs kept at artificially low levels Affordability constraints given as key limiting factor

SSWSPs have particular constraints (often not legal, no access to formal banks )

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Bonds

OECD countries ~90% of bond issuance in water in US, UK, France Corporate bonds for private companies (UK, France) Municipal bonds: main source of finance for US water sector

Municipal bond markets from 1837; USD 2.3 trillion outstanding 2007 90% US water utilities are government-owned ~ 11% for water and sanitation investment (USD 9bn per year) Monoline insurers provided guarantees to small municipalities

Developing countries In most countries: bond markets small or non existent India and Philippines leading the way Limited issues in SSA (South Africa, failed attempt in Uganda)

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Project finance

OECD countries Project Finance Initiative (UK)

Developing countries PSP did not bring in substantial investments:

Only 5% of total PPI deals between 1990-2000 (WB PPI database) Investment commitments down (USD 10bn to 3bn following Asian crisis) Recent WB studies: investment does not always increase with PSP Exchange rate risk remains key stumbling block

Activity currently focused on Chinese market Up to 2007: 350 PPP contracts for water in China 2004-2006: 60 contracts/ year

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Equity

In 2005, about 94 listed water companies, 32 unlisted with private shareholding (Lloyd Owen, 2006) Listed companies

Majority in Europe, North America, China Rise in market listings for public & private companies

Public: SABESP, COPASA, SANEPAR in Brazil Private: Manila Water (Philippines), Tallinn Water (Estonia),

LYDEC (Morocco)

Key constraints: under-developed capital markets Unlisted companies

Rise of private equity model in Europe (esp. UK) Developing countries: private equity holdings limited

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Critical mismatches and innovation

Critical mismatches Examples of innovative financial mechanisms

Affordability constraints Micro-finance, output-based aid, blending grants and loans

Limited availability of funds for domestic operators and SSWSPs

Micro-finance, Output-based aid and innovative contracts

Risk profile and difficulties in managing certain risks (e.g. political risk, foreign exchange risk)

Guarantees, insurance, devaluation backstopping facility

Local-currency financing, revenue agreements

Lack of funds at decentralised level

Municipal bonds, pooled funds, revolving funds, bond banks

Instruments to increase sub-sovereign lending

Short tenor of available financing Guarantees and equity contributions

Under-capitalized balance sheets Raising equity to strengthen the balance sheet, convertible

loans, debt-equity swaps, “asset-light” expansion models

Lack of understanding by external lenders and investors

Blending of public and private finance, credit ratings

Lack of “bankable” projects Project preparation facilities

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At the “lower” end of the market...

Micro-finance Great potential but limited use in water sector (lack of awareness) Potentially negative impact from financial crisis Donors to provide seed finance, blend micro-finance with other financing

instruments such as OBA See K-Rep project in Kenya

Output Based Aid (OBA) Growing number of OBA projects in watsan but limited scale-up Mostly focused on financing connections Reputation for complexity and high transaction costs Need to recognise pre-financing constraints Mainstream the approach in countries’ financing strategies:

See OBA facility in Honduras

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OBA & microfinance: K-Rep (Kenya)

WSP with K-Rep (Kenyan micro-finance bank) Microfinance to address lack of commercial finance for SSWSPs OBA subsidies to focus investments on network extensions

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Guarantees and risk insurance Guarantee products widely available from IFIs & donors BUT limited take-up in water sector

PCGs: IFC (City of Joburg), USAID-DCA (15% in water, e.g. Tamil Nadu) PRGs: MIGA (Guayaquil concession in Ecuador - 2001)

Main issues: IFIs have rigid in-house rules about guarantees (leads to high costs) Guarantees from IFIs suited to large transactions: does not suit current characteristics of

the water sector Foreign exchange risk remains a thorny issue (Devaluation Liquidity Backstopping

Facility never implemented)

Promising way forward Establishment of domestic guarantee facilities, e.g. LGUGC: guarantees for domestic

loans in local currency But guarantees not a panacea! (still need good projects)

Risk mitigation instruments

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Guarantees: LGUGC (Philippines)

Water services underfinanced in Philippines Provided by LGUs, water districts (corporatized entities) , private operators or

SSWSPs Commercial lenders unfamiliar, unwilling to take risks Many providers had weak balance sheets

Local Government Unit Guarantee Corporation (LGUGC) Set up 1998 - owned by public and private owners Guarantee mechanism Credit rating services

Outcomes Supported development of a small but growing LGU bond market (rarity in developing

countries ): USD 60 mn outstanding 01/09 Most municipal bonds got LGUGC guarantee 9 out of 26 projects guaranteed for the water sector

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Combining types of finance

Strengthening the balance sheet with equity injections Mobilise equity to leverage other types of finance for investment Private model: raising equity through capital markets

Asset-light capital structures (Hyflux Water Trust, Singapore & China)

How donors can contribute Donors to enter into debt-equity swaps (Senegal) Requests for equity contributions in PSP deals (IFC in St Lucia)

Blending public and private financing At project level: lead financier to prepare overall project and combine private

and concessionary finance (e.g. EIB) At “institutional” level

Underlying premise for PIDG facility – not been very active in the water sector, now considering a concessionary “Water Window”

More success with domestic facilities, e.g. FINDETER in Colombia

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Lack of funds at decentralised level

Grouped financing mechanisms Make finance available to small borrowers at much better terms Initial model: State Revolving Funds in the US (tax-exempt) Used as a way to channel public finance and mobilise market finance (with

guarantees provided by private insurers to improve rating) Replicated in India, Philippines, Mexico (with USAID support)

Instruments to increase sub-sovereign lending Some IFIs have started lending without sovereign guarantee: revenue

agreements in lieu of guarantees EBRD’s Municipal and Environmental Infrastructure team leading the way in

this (MEI = 48% EBRD lending, of which 56% to water sector) World Bank/ IFC Municipal Fund Critical area to develop: local currency financing

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Blending: FINDETER (Colombia)

Government Bonds + Loans

from MDB

FINDETER

Commercial Banks

Local Borrowers

Inter - governmental

revenue transfer

Loan

Discounted Loan

Debt Equity

Recourse

Repayments Loans

Recourse

Flow of Resources Local capital

mobilized

Direct lender - borrower

relationship Local

government incentives to cost - recovery

Incentives for improving performance

MDB:

Multilateral Development Bank

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Improving information flows

Credit Ratings Limited use of credit ratings for water outside OECD countries India: significant development for local government bodies Philippines: grading municipal authorities based on credit-worthiness WSP /PPIAF supported “shadow ratings” for SSA water utilities Possible donor involvement:

Support demand for credit ratings Support development of credit agencies (and financial markets)?

Project Preparation Facilities The lack of “good projects” remains the main constraint “Too much money chasing too few projects” A few attempts to redress this

ACP-EIB Water Project Preparation Facility (€ 3 mn over 3 years) PIDG facilities (TAF, InfraCo) Establish project preparation facilities at national level?

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Impact of crisis on market finance (1)

Commercial loans Sharp drop in lending volumes, increased cost of debt, reduced tenor (increases

refinancing risk) Sovereign guarantees no panacea as sovereign credit risk increases Micro-finance institutions suffering as well

Bond markets Corporate bond markets “closed” in early 2008 but reopened for investment grade

debt, at higher costs Isolated successes: over-subscribed issue for Manila Water with domestic Aaa rating (Oct

08) No high-yield bond issuance in water since SABESP (BB- ) in 2006

Municipal bond markets in US: sharp drop in issuance, massive downgrades following demise of monoline insurers in US

Municipal bond markets elsewhere: increased costs “Bond wrapping” practices no longer possible

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Impact of crisis on market finance (2)

Project finance Many projects stalled or put on hold Even in Middle East (e.g. Shuweihat in Abu Dhabi and Ad Dur in

Bahrain), requires bridge financing or support from IFIs

Equity Listed water companies’ prices went down sharply in 2008 although

have rebounced partly in early 2009 IPOs put on hold (e.g. Maynilad, AWW) Private equity model no longer viable Pension funds (who were interested in investing in water sector) may

have to reallocate holdings to meet portfolio diversification needs

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Impact of financial crisis on 3Ts

Tariff revenues likely to remain low Economic crisis: reduced demand for traded goods (including agricultural and

raw material), lower remittances, price inflation Increased poverty: 65 million more people < USD 2/day (WB)

Tax transfers to surge only where stimulus packages target water Substantial increases in public borrowing limit government transfers Some “green” stimulus packages include water programs

International transfers will increasingly be needed Research found that ODA usually falls during economic crisis IFIs going through a very busy period (fill in the gap) Major WB initiative to support infrastructure sector (INFRA) Support to all financial market segments e.g. IFC & KfW microfinance

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Going forward

Market-based finance to the water sector: a safe haven in the midst of a financial storm? Can make a substantial contribution to public & private providers if sector can

promote itself as “low risk / low but steady returns” Some innovation no longer viable following financial crisis All financing sources to be reflected and tracked (not only PPI)

Concessionary finance needed to get credit flowing but limited funds available Leveraging and targeting of public funds are key Viable innovations need to be scaled-up with donor support Emphasis should be placed on institution-building rather than “transaction-

based” or pilot projects

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Thank you!

Contact

sophie@tremolet.com

Tel: +442076900090

Web: www.tremolet.com