Privatesector

P U B L I C P O L I C Y F O R T H E

Note No. 151 September 1998

Financing Water and Sanitation Projects—

The Unique Risks
David A project finance structure allows water projects with attractive cash flows and risk profiles to
Haarmeyer and
secure long-term private capital. This structure provides a direct link between a project’s cash
Ashoka Mody
flow and its funding to give project sponsors, investors, and lenders strong incentives to ensure

that projects are structured and operated to generate stable revenue streams. But even in

industrial countries the credit strength of off-taking municipal governments and the sector’s

traditional monopoly structure expose lenders to potentially significant credit, regulatory, and

political risks. These risks, combined with the sunk, highly specific, and non-redeployable nature

of water investments, mean that lenders and investors are vulnerable to government

opportunism and expropriation. Reviewing some recent innovative projects, this Note shows

that private participation on a limited recourse or nonrecourse basis has required support from

multilaterals and federal government agencies to absorb noncommercial risks.

Private sector participation in water and sani- tures. As one of the last monopoly utility sec-
tation has often taken the form of special- tors, water and sanitation can be especially
purpose build-operate-transfer (BOT) projects attractive to long-term private investors. But
following the project finance or limited recourse financing water and sanitation projects has
model. These are self-contained projects that been a special challenge because of their
address the need for more water and sanita- unique risks:
tion. Although these bulk suppliers can allevi- ▪ Expensive to transport but cheap to store,
ate immediate shortages, they have virtually water is essentially a local service and sub-
no effect on systemwide revenue problems (for ject to control by local government, which
example, leakage and tax collection) or labor can be more politicized and have weaker
cost problems. These long-term problems are credit than state or federal government.
sometimes tackled incrementally through leases ▪ With most of the assets underground, their
and management contracts. An increasing num- condition is hard to assess. That makes invest-
ber of countries have gone further by awarding ment planning difficult, posing risks for con-
operating concessions for entire systems, which tract renegotiations.
require investment commitments from the con- ▪ Inadequate provision is associated with
cessionaire. Beyond such concessions lies full health and environmental risks, so govern-
privatization of assets, which facilitates financ- ment has a strong interest in extending access
ing by creating collateral. to service, regardless of ability to pay.
▪ Significant currency risk arises because cus-
The promise of steady—if not growing—long- tomers pay in domestic currency that does
term future cash flows is the basis of the not match the currency of international debt
private sector’s interest in financing these ven- and equity financing.

The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network
Financing Water and Sanitation Projects—The Unique Risks

▪ There has so far been little scope to introduce entity in a BOT or BOO project. For the BOT in
direct competition in treatment, transmission, Chihuahua, Mexico, for example, Banobras, the
and distribution. domestic development bank, provided credit
support to the local government entity. In Izmit
The risk profile of a project is also influenced the Turkish government stands behind the lo-
by its type and by its stage of development. cal government’s water purchase agreement. In
Greenfield projects with a build-operate-transfer Sydney the state government guarantees the pay-
or build-own-operate (BOO) structure, because ment of the city water utility (Sydney Water
they involve a period of construction before rev- Corp.) to the private project company even
enues are generated, generally expose lenders though the utility’s debt is rated AAA by Stan-
to greater credit, political, and regulatory risks dard & Poor’s. In Buenos Aires the Argentine
than concessions for infrastructure services that government’s guarantee to pay compensation if
are up and running. Similarly, older and more the concession is terminated early provides the
efficiently run systems with longer operating his- chief form of security for lenders.
tories tend to have more secure and predictable
cash flows and mature investment profiles, and Sources of debt
thus expose lenders and investors to fewer risks.
In countries with weak sovereign credit ratings
The water and sanitation sector’s exposure to financing has been provided by multilateral and
risks that are often difficult and costly to cover export credit agencies. These agencies are gen-
has two important ramifications: erally in the best position to shoulder political
▪ Fewer projects have been successfully financed and regulatory risk and thus provide long-term
with private capital than in other infrastructure finance at reasonable rates. The US$9 million
sectors, such as power and telecommunications. Chase Manhattan Bank loan to the Chihuahua
▪ Projects financed with private capital have BOT project, which received no multilateral or
tended to involve direct financial or credit bilateral funding but did receive grant and credit
support from government or third parties support from Banobras, is a rare case of com-
such as bilateral, multilateral, and export mercial bank participation. In a similar BOT
credit agencies. project in Puerto Vallarta, Mexico, the Interna-
tional Finance Corporation provided debt fi-
Case studies in finance nance backed by a revolving and irrevocable
letter of credit from Banobras.
The experience of six water and sanitation
projects and one set of utilities in accessing In countries with high sovereign credit ratings
and structuring private finance illustrates the projects have been financed by domestic com-
level of government or third-party support mercial bank loans. The BOT project in Johor,
(table 1). All the projects follow the standard Malaysia, and the BOO project in Sydney, Aus-
project finance structure except for the more tralia, were financed by commercial debt. As a
mature English and Welsh water companies, result of the project structure (existing cash flows)
which rely on corporate finance. and Malaysia’s highly developed capital market
and relatively low interest rates, the Johor project
Only the BOT project in Johor, Malaysia, was was financed entirely with local debt. The Sydney
financed on a nonrecourse basis with no sponsor project had both local and offshore financing.
or third-party support to cover risk of nonpay-
ment. All other projects were financed on a lim- The limited capital market financing of water
ited recourse basis. The recourse was generally and sanitation indicates that individual inves-
provided by payment guarantees to the parties tors are not in a position to accurately evaluate
off-taking the service (buying bulk water or and mitigate the risks. But as the experience of
wastewater services), such as a local government the English and Welsh water companies shows,
 TABLE 1 FUNDING FOR SELECTED WATER AND SANITATION PROJECTS

Debt/ Country
Project site, type, and date Project cost equity rating Source and maturity of debt

Malaysia US$2.4 billion 75/25 A+ Government soft loans due to

Concession (1993) (about US$500 million severe tariff collection problems
in first 2 years)

Buenos Aires, Argentina US$4 billion 60/40 BB– 10-year IFC A-loan,
Concession (1993) (US$300 million 12-year IFC B-loan
in first 2 years) (recourse to Argentine
government in event of
early termination)

Izmit, Turkey US$800 million 85/15 B 13-year export credit agency loans,
BOT (1995) 7-year MITIa loan,
7-year commercial bank loan
(recourse to Turkish government)

Chihuahua, Mexico US$17 million 53/15/32b BB 8.5-year commercial bank loan

BOT (1994) with limited recourse to Banobras

Johor, Malaysia US$284 million 50/50 A+ 10-year project finance loan

BOT (1992) from Public Bank Bhd
(nonrecourse)

Sydney, Australia A$230 million 80/20 AAA 15-year commercial loans

BOO (1993) (State government stands behind
Sydney Water Corp. payment.)

England and Wales US$5.24 billion 25/75 AAA Capital markets, corporate finance,
Full privatization (1989) European Investment Bank, and
other sources
a. Ministry of International Trade and Industry of Japan.
b. Debt/equity/grant.
Source: Haarmeyer and Mody 1998.

projects can be expected to access capital mar- issue priced at just fifty-three basis points over
kets as their cash flows to support debt service U.K. Treasury gilts due November 2006. Stan-
become more stable and certain and indepen- dard & Poor’s based its AA rating of the £150
dent regulatory agencies are established. million Eurobond on Anglian’s “robust financial
profile and stable operating environment,” which
The English and Welsh companies have drawn “should provide the company with a fair degree
on a variety of financing sources, including the of insulation from the impact of key regulatory
bond markets. Anglian Water, one of the ten and political risks going forward.” The English
privatized water companies, reflects the low risk and Welsh companies have also taken advantage
profile of more mature water utilities. In 1990 of low-cost loans from the quasi-governmental
the company floated a twenty-four-year bond European Investment Bank.
 Financing Water and Sanitation Projects—The Unique Risks

Equity financing ing to Ofwat, the U.K. water company regu-

lator, these returns are expected to fall as
Although debt is generally cheaper than equity, the water companies become more estab-
a long-term equity stake by the sponsor (which lished and capital expenditures decline.
is sometimes also the operator) ensures that
management has a long-term interest in the To compensate for the greater country and poli-
project and that cash flow growth leads to capi- tical risks, required returns in most developing
tal appreciation. Equity also reduces the debt country projects are likely to be significantly
service burden on the cash flow, which can be higher and closer to those in other infrastruc-
especially important in a project’s early devel- ture sectors. For a sample of power projects in
opment phase. Asia and Latin America Baughman and Buresch
(1994) estimated the equity return at between
Equity has been provided largely by sponsors. 18 and 25 percent. And for privately financed
For large projects especially, equity, like debt, toll roads Fishbein and Babbar (1996) found
is often sourced from multiple consortium that investors expect annual returns to range
members, both international developers and between 15 and 30 percent.
local investors. The Buenos Aires concession,
for example, has four international sharehold- Conclusion
ers and four local shareholders (including the
utility’s employees). The challenge for the future is in mitigating
Viewpoint is an open
forum intended to the noncommercial risks that characterize the
encourage dissemina- Lenders like to see sponsors achieve a reason- sector and moving beyond the limited capac-
tion of and debate on able return on their investment, to ensure that ity of third parties. Part of the solution lies in
ideas, innovations, and
best practices for ex- sponsors have adequate incentive to maintain generating better information about these risks
panding the private support for the project, at least through the life so that they are more transparent and their costs
sector. The views pub- of the loans. Equity holders partially shield lend- are more fully recognized by parties that can
lished are those of the
authors and should not ers, because the lower priority of their claims mitigate them. Two tracks to achieve this end
be attributed to the on a project’s revenues means that they will are independent regulatory agencies and
World Bank or any of absorb unexpected shortfalls in revenue. In full competition—for the market and for rights to
its affiliated organiza-
tions. Nor do any of the concessions and privately owned utility com- supply individual customers, as in England and
conclusions represent panies internal cash generation can provide an Wales.
official policy of the important source of equity for financing
World Bank or of its
Executive Directors investment. References
or the countries they
represent. Baughman, David, and Matthew Buresch. 1994. “Mobilizing Private
Although information on the return on equity Capital for the Power Sector: Experience in Asia and Latin America.”
To order additional for project sponsors is not widely available, the U.S. Agency for International Development and World Bank, Wash-
copies please call return can be expected to vary with project risk ington, D.C.
202-458-1111 or contact Fishbein, Gregory, and Suman Babbar. 1996. “Private Financing of Toll
and cash flow profiles. In two of the cases dis- Roads.” RMC Discussion Paper 117. World Bank, Resource Mobili-
Suzanne Smith, editor,
Room F6P-188, cussed here returns to investors are regulated: zation and Cofinancing Vice Presidency, Washington, D.C.
The World Bank, ▪ The Malaysian government has guaranteed Haarmeyer, David, and Ashoka Mody. 1998. “Tapping the Private Sec-
1818 H Street, NW, tor: Approaches to Managing Risk in Water and Sanitation.” RMC
returns of 14 to 18 percent on investment in Discussion Paper 122. World Bank, Resource Mobilization and
Washington, D.C. 20433,
or Internet address the national sewerage project; actual returns Cofinancing Vice Presidency, Washington, D.C.
ssmith7@worldbank.org. are currently at 12 percent because the con-
The series is also cessionaire failed to achieve a 90 percent tariff David Haarmeyer (david.haarmeyer@
available on-line
(www.worldbank.org/ collection rate. stoneweb.com), Stone & Webster Consultants,
html/fpd/notes/ ▪ For the English and Welsh water companies Boston, and Ashoka Mody (amody@worldbank.
notelist.html). the returns on regulatory capital (the assets org), Project Finance and Guarantees
Printed on recycled of the core business) were 11.5 percent in Department
paper. 1995–96 and 12 percent in 1994–95. Accord-