Innovative Water Sector Financing - Legal Implications, Risks and Market Constraints

1. Innovative Water Sector Financing - Legal Implications, Risks and Market Constraints 11th November 2011 Bernadette Njoroge WASREB

2. Traditional sources of finance for WSS • Tariffs charged by water utilities – usually able to cover operation and maintenance • Taxation- money raised from the public from the Treasury which is directed to utilities through the ministry of water and irrigation • Used for capital development of assets in the urban and the rural areas • May not be sufficient for all as it is competition for resources with other sectors • Allocations based on political decisions and not on evaluation of need or on demonstration of performance • Disbursements not coherent leading to absorption problems 3. Transfers- from development partners on a multilateral or bilateral basis usually dedicated to fund specific projects and money provided on specific times • Takes time to prepare , design and finally disburse • Deals mainly with the central government and not lower level • Specialised skills needed to manage and implement the project

3. Consequences of traditional sources on WSS Over reliance on central government • Weak governance structures at lower levels of government • Weak capacity in project preparation • Weak capacity in business development • Weak culture of cost recovery – low cash flows Water services sector deemed high risk low return • Weak /overlapping legal and institutional frameworks that govern the business • Lack of sufficient cash flows to cover costs • Achieving sustainable cash flows the 3Ts have to be bridged by attracting repayable finance. • Repayable finance can be debt finance in the form of loans , bonds issued through capital markets and project finance • Equity finance – can be listed or non listed equity

4. What is innovative finance • Innovative finance – shift from who can provide finance as well as how finance can be supplied and demanded. • Innovative finance moves beyond central government and development partners to national NGOs , local banks , financial intermediaries , private investors • Innovative finance moves from capital works development to other areas for operational efficiency , business development skills , connection fees for the poor and longer term sustainability of the services

5. Blending grants and repayable finances • Innovative use of grant finance to stimulate governance reform in utilities at the lower level and improved governance leads to other finance • Using grants to aggregate small scale providers to qualify for larger financing envelopes • Grants have also been used as seed financing for revolving funds • Main objective of blending – it attracts funds that would otherwise not be attracted to a given project while ensuring public policy goals are met

6. Microfinance • Democratising borrowers and lenders to wider stakeholders • Creates an incentive for microfinance lenders to penetrate a new market through concessional loans and grants • Suitable for households and Small Scale WSPs • Small scale operators are allowed to borrow from a micro finance institution to expand their assets • Output based aid (OBA) – subsidies are paid based on effective and measurable results by service providers in implementing the project ( example of K-Rep and GPOBA) • May have complexity and high transaction costs • There may be need for pre-financing from the community – combine OBA subsidies with access to microfinance

7. Risk Mitigation -Guarantees and Insurance products • Guarantees- form of risk mitigation that can be used with debt or equity to provide coverage against political , regulatory, policy and sovereign risks associated with projects • Improve the credit of a borrower and may lower cost of debt- • Not used in WSS because of political interference in tariff increase, low cost recovery and governance levels in WSS • Fairly suitable for large projects - • Interfere with a country’s debt ceiling since counter guarantee is required

8. Grouped financing vehicles • Basically this is pooled financing • Accessing finance for a large number of small borrowers with small projects for combined use • Hallmark is the creation of a reserve fund – to mitigate the risk of cashflow problems • Assists small operators to access finances which would not otherwise be available to them • Transfers repayment capacity to the portfolio rather than to individual projects

9. Raising equity • This will help strengthen the balance sheet of undercapitalised water operators • Equity will strengthen the balance sheet • And provide sound basis for leveraging additional finance • Investors may swap debt for equity • PSP contracts with equity contributions risk premium built into expected returns does not lead to unfavourable tariff increases

10. Project preparation facilities • Preparation of bankable projects in an accelerated manner

11. Constraints to innovative financing in the WSS Potential providers of innovative finance are hampered by: • Lack of understanding by lenders and investors • Lack of funds at decentralised level small utilities unable to access market based payable finance • Weaknesses in management and governance systems of decentralised units • Affordability constraints difficult to increase tariffs to cover costs • Short tenor of available financing - • Undercapitalized balance sheets – high debt levels compared to equity • Lack of bankable projects – or poor project preparation capacity • Risk profile and difficulties in managing risks

12. What to do on innovative finance • Establishing institutions at national level that can channel funds both private or public into the sector in-order to finance small projects using flexible methods • Strong governance and institutional framework in all operators to inspire confidence in an investor • Capacity in project identification and preparation suitable for demands • Use of partnership and aggregation in utilities to enable knowledge and skill transfer and also improve credit history • Change thinking of who can be an investor – • Share experiences on successful innovative financing

13. Commercial financing • For the credit worthy companies • Regular loans from the commercial banks • Due to the market interest rates it is only good for bridging the gap from 3Ts finance • Comes with its own covenants which have positive aspects and negative aspects • Covenants – contractual restrictions placed on a borrower • Set minimum standards for borrower future conduct and performance • Borrowers with strong credit history attract fewer covenants

14. Consequences of covenants • Negative covenants –restrain the borrower from particular actions such as new borrowing, expenditure on unauthorised items • Affirmative covenants – require a borrower to meet certain standards such as discharging license requirements ,providing information , pay taxes • Violation of covenants leads to action by lender which may accelerate loan repayment or lead to penalties or imposition of constrictions in operations

15. Classes of covenants • Operating activity • Investment expenditure • Asset sale • Cash payouts • Financing – limitations on debt or debt like contracts or changes in capital structure • Reporting and disclosure • Preservation of collateral / seniority • Management control and ownership • Going financial concern- liquidity, debt and leverage, cashflow

16. Key concerns for commercial lender • Level of operation – town, municipal ,city , • Size- turnover , number of connections, license area • Degree of corporatisation – does the owner observe arms length principle, professional team running operations or does owner interfere • Credit worthiness depending on cost recovery • Legal status – how valid is the license , what period of time • Collateral – what can secure the loan – can debentures be issued (an equitable charge on the assets for the time being of a going concern) • Potential for cost coverage and surplus • Allowed ambit of operation in regulated sector

17. Conclusion • To attract more commercial forms of finance credit worthiness of all WSPs is imperative which means: • Bankable projects • Good governance structures • Recordkeeping of accounts and finances • Demonstrated cashflow • Ability to manage debt • Given cash flows and assets • Stable macro-economic framework