Improving Sub-Sovereign Project Risk Approach

1. Improving sub-sovereign projectsRisk approach CDA – Washington – October 1rst, 2004

2. Foreword • Access to basic services (water and sanitation, energy, transport, habitat, waste disposal and health) are affected by three major trends: • Urbanization: more than 50 % of the world population is now living in urban areas; 60 % by 2030 according to UN - Habitat • Decentralization is considered as a key element in improving the quality and cost efficiency of basic service • Private Sector Participation (PSP) has been advocated in order to ensure good quality services as cost effectively as possible • These trends however have to overcome various hurdles: • If decentralization of local services is widespread and considered as a core element in improving the quality and cost efficiency of local infrastructures and services, it has not always been accompanied by clear and predictable sources of local government revenues; • The PSP as a mean of achieving public service efficiency can be developed only if specific legal, political, economic and social conditions are met • Last but not least, financial institutions (especially international) are either prohibited or reluctant to take a direct (or indirect) sub-sovereign risk;

3. Table of contents From Veolia Environnement experiences, the sub-sovereign project risk approach can be improved by: • 1rst step: Making the sub-sovereign risk approach “more readable” • 2nd step: Bringing more financial discipline by involving private management practices • 3rd step: Developing access to local long term financial sources

4. Part I Making the sub-sovereign risk approach “more readable”

5. Difficulties to assess sub-sovereign risks (1) Two main obstacles which make sub-sovereign risk difficult to assess: • Revenues predictability: • Decentralization of responsibilities has not always been accompanied by commensurate fiscal allocations: • Most local governments rely heavily on central government tax sharing arrangements and transfer for the bulk of their revenues 3 Consequences: • Revenues often provide only for operating costs but not for capital investments • Revenues do not have multi-years predictability and therefore are not suitable for long term planning and financial commitments • Uncertainties reduce the ability of local officials to make investments decisions • (One additional consequence: many municipalities are supplementing their revenues with sales of assets to finance capital investments)

6. Difficulties to assess sub-sovereign risks (2) • Measurements of public service performance:Public service accounting rules which: • Are traditionally based on yearly budgetary concept: • Receipts and expenditures are entered as a function of changes in cash position • Recognition of revenues and expenses is not linked to the provision of services or transfer of goods Therefore it is difficult to measure the performance of public service • Are traditionally characterised by the absence of balance sheet concept: • No distinction between expenses and fixed assets • No recognition of commitments received or given • Therefore no true image of the public service assets base (and therefore no provisioning for assets obsolescence) Conclusion: Public services provided through sub-sovereign budgetary framework very seldom benefit from cost recovery, adequate cost management and services standard approach.

7. Difficulties to assess sub-sovereign risk… (3) • Revenues unpredictability and public and public accounting rules (may) explain the historical reluctance (and the prohibition) of Multilateral development Banks and Commercial banks to take a direct sub-sovereign risk. However, the World Bank and IFC have jointly established a “Municipal Fund” for investments in “well run” sub-sovereign operations. The Municipal Fund has completed 25 transactions in 12 countries. • “Well run” sub-sovereign operations roughly mean investment grade rated entities which are for the time being mainly concentrated in North-America and Western Europe. • Moreover, the European Bank for Reconstruction and Development (EBRD) which is not prohibited by its Charter to lend to sub-sovereign entities shows a very significant evolution of its central Europe and Russia infrastructure portfolio: Risk portfolio: 19972003 • Sovereign: 82 % 37 % • Municipal: 16 % 36 % • Private: 2 % 27 %

8. … which has led to promote two main forms of PSP • Such difficulties explain also an approach followed by many countries (like Popular Republic of China) to transform a sub-sovereign budgetary framework into an operating utility company • “Ring fencing”the management, the assets, the cash flows (revenues), by transforming the public service into a sub-sovereign owned operating utility under laws and corporate accountancy rules, allows a: • More precise evaluation by the lenders (and the private sector) of • The sustainability and predictability of revenues • The assets base and amortization rules • The provisions for unpaid customer receivables • Commitments given and received • The real cost of services rendered

9. Part II Bringing more financial discipline by involving private sector’s management practices

10. Financial discipline • If “corporatizing” the sub-sovereign public service allows a better evaluation of the revenues predictability and real costs of services rendered it may not provide the (financial) discipline used (traditionally) by private sector’s management practices • Such financial discipline is provided by: • Project finance approach: • Whereby the risk is evaluated an the basis of predictable future cashflows which should cover the operating cost, the debt service and the operator’s remuneration • This approach is used to: -Build new assets - Without being supported by budgetary ressources - With a direct or limited recourse on the private operator The “bankability” of such project financing: • Derives from the operator’s expertise to build a long term business plan based on hypothesis which are judged realistic by the lenders • On the other hand, the lenders, especially international institutions, are very reluctant, (if not prohibited), to take an “early termination risk” (which means being faced to take a direct sub-sovereign risk)

11. The concession route: synthetical financial model Financing needs Funding sources By Internal financial sources - Private - Public / Private - Public OPEX • Operational expenses • Maintenance • Equity: • Cashflows: Volume x tariff (affordability) Consumers Capex: • New assets External financial sources Debt: • Public – Private • Foreign - Local Debts are consolidated on the operator’s balance sheet Lenders Financial costs: • Debt service • Equity remuneration • Grants • Subsidies OBA

12. The lease contract Concession agreement: Lease contract (fees) Private operator Management Company Municipality Water assets Company 100% Funding catalyst Consumers (Volume & tariff) Lenders

13. Water Assets Cy Existing assets New assets Municipality Private Operator 100% Lease (fee) contract (1) Prepayment of the PV of X years of Lease fee (2) « Municipal support Agreement » Lenders for new assets Consumers (Volume x Tariff) Grants and subsidies Combining lease contract and new assets financing Three remarks: • The private operator can participate to the financing of new assets which it will operate by paying in advance the present value of X years of an additional lease fee • Lenders may pledge Lease (1) and (2) • Lenders may benefit from a “Municipal Support Agreement”

14. Whatever the form taken by the PSP agreement, one common denominator: Mastering the cost structure COSTS % TOTAL VARIATIONS DEPEND ON • Equipment sophistication • Network length • Training level • Management Staff (operational) 30 % to 40 % • Energy consumption (pumps) • Management • Raw water ressources • Treatment process 20 % to 30 % Direct operational costs • Maintenance budget permanence • Age and nature of process and network • Management 10 % to 20 % Maintenance 10 % to 25 % (Capex) : Amortization and debt service • Accounting principals • Financing structure General administration 15 % to 25 % • General policy, management Taxes

15. Part III Developing access to local long term financing

16. Developing access to local long term financing… • Contributes to enhance private operator’s development policy regarding sub-sovereign infrastructures project by • Eliminating the foreign exchange exposure (matching the currency denominating revenues and debts) • Eliminating the sovereign risk factor from the (local banks) risk analysis (which is not the case for International Banks) – Examples: Jordan, Israel, China, Colombia, Morocco • Accepting a sub-sovereign risk factor: “early termination” Examples: Morocco, Colombia, • Being less expensive: front end fees, legal fess,…

17. The financing sources • Access to local long term financing may be limited (maturity) or impossible. However, from Veolia Environnement experiences, there are more possibilities than usually mentioned by financial advisors: • Existence of an institutional investors market (insurance companies, pension funds) which has to buy assets generating long term and predictable revenuesi.e.: Colombia, Mexico, Chile, Israel, Morocco • Acceptance of the “transformation concept” at the banking system level:the banking system may accept that there is a certain proportion of their short term deposits which being stable enough allows long term lending. i.e.: Jordan, Morocco, Africa Franc Monetary Zone. • Such environment supposes in addition: • The capacity, at the local banking level, not only to accept a funding risk but also a long term credit risk • Moreover, to develop the capacity to share between several institutions the risk (syndication technique). Such capacity building is crucial and one of the IFI’s roles should be also to contribute to its enhancement.

18. Such an approach has been extensively used by Veolia Environnement (Veolia Water) • Raised with banking sector (Water sector alone) • China: 10 projects – Amount raised: CV of US$ 500 millions • South Korea: 4 projects (3 industrial outsourcing) – Amount raised: CV of US$ 300 million • Morocco: 3 projects – Amount raised: CV of US$ 330 million • Israel: 1 project – Amount raised: CV of US$ 100 million • Czech Republic: 1 project – Amount raised: CV of US$ 200 million • Jordan: 1 project – Amount raised: CV of US$ 50 million • Raised with institutional investors (in addition or not to bank lending) • China: 3 projects – Financial partner - CV of US$ 100 million • Morocco: 3 projects – Financial partner - CV of US$ 75 million • Israel: 1 project (private placement) - CV of US$ 100 million • Colombia: 1 project (Lend issue) - CV of US$ 40 million • Remarks: • Most of the financing raised are on a limited or non recourse basis • Most have a maturity exceeding 10 years

19. Conclusion

20. Conclusion (1) • The Veolia Environnement experiences derived from its global activities: • Total turnover (at June 30, 2004): euro 12 billion • Breakdown by division: Water: 39 % Waste: 25 % Energy services: 21 % Transportation: 15 % • Breakdown by revenues: France: 55 % Rest of Europe: 29 % North America: 8 % Asia Pacific: 4 % ROW: 4 % • Its clientele: • Municipal outsourcing: 70 % • Industrial outsourcing: 30%

21. Conclusion (2) From these experiences, three comments: • Yes, the sub-sovereign risk approach is manageable • Yes, access to local financing is more feasible than usually thought (by international financial institutions and consultants) • A more global approach should aim at: • Improving capacity building at the sub-sovereign levels • Developing, at the local financial levels, a better understanding of long term funding and long term credit risk

22. Thank you for your attention