Financing Water & Wastewater Projects in the Current Economic Crisis

By Mark Lane & Andrew Normington

The increasing need for water projects worldwide hasn’t dampened despite global economic problems, and UK-based international law firm Pinsent Masons offers an outlook on infrastructure funding

Left: Mark Lane, Right: Andrew Normington

A combination of a rapidly expanding global population, and diminishing natural water resources, which are themselves degraded by increasing pollution, gives rise to a growing crisis of “white gold”. This can only be exacerbated by factors such as climate change. In an October 2007 report on infrastructure, Siemens noted, over the next 20 years, water sector capital spending to put the global population on a basis where it has a reasonable standard of water provision is on the order of US$6.3 trillion. From China to California, from the Murray Darling River Basin in Australia to Kenya, the picture is the same – namely one of ever deteriorating water resources and scarcity. Against this urgent and somewhat depressing background, what is to be done?

Clearly, governments, municipalities and parastatals – those organizations that work with the government in an unofficial capacity – themselves aren’t going to be able to achieve the extent and level of investment in the sector that’s required. This was the case long before the Siemens report was published, and is even more so given the advent of the global credit crisis.

Cover of latest edition of the Pinsent Masons Water Yearbook for 2008-2009, which offers a range of statistical information on the global water market for industry projections

Assistance and resources of the private sector will be required if anything like the desired goal is to be achieved. For this to happen, however, projects in the water sector need to be bankable. This article addresses some of the issues that need to be addressed if any water project is to be bankable.

Public supplies in private hands

First, since the commercial lending sector likes certainty of outcome, predictable cash flows and stable financial models in relation to the projects that it funds, it’s essential that the legislative framework of the country in which the project is located is sufficient in its extent and robust before putting a water supply into the hands of the private sector. If this isn’t the case, then any deal involving the private sector is likely to be stillborn.

One of the key issues is to establish whether the existing controlling ministry or water authority itself has the power to divest itself of its legal right to provide the local population with water/wastewater services and to vest that right in the private sector. This is a position which is easy to state, but, in practice, is often much harder to establish.

In some cases, this gives rise to a need to amend the relevant enabling “Registration,” so as to put beyond any doubt the ability of the relevant government to vest its water/wastewater provision powers in the private sector for the necessary period of time (often 20 to 30 years).

Getting paid & assurances

If the legislative framework can be established with sufficient certainty, the focus can shift to the credit strength of the project’s revenue stream, i.e., the government’s payment covenant or guarantee. Will the project receive processing or tolling fees from the local municipality? Or will end-user fees be the primary source of income?

In the first scenario, both sponsors and senior lenders must evaluate the ability (and willingness) of the offtaker – or contractual buyers of production – to pay for water supplied, or wastewater treated. A government guarantee may be necessary, or other credit enhancement such as letters of credit, but even these may be insufficient to increase the project’s overall credit rating to attract outside investment. In some jurisdictions, participation of multilaterals and export credit agencies can help close this gap.

In the second scenario, the project may be taking a degree of both demand risk and payment risk. Both will need to be modeled carefully. The project will need to have both sufficient and realistic legal recourse in the event that end-users are unwilling to pay. Working capital reserves may be necessary to protect against uneven revenue receipts and sufficient political resolve will be required to allow action to be taken against end-users who fail to pay. A realistic assessment and understanding of the legal process is fundamental.

Meeting performance standards

Another key factor, which goes to the bankability of the project is the extent to which the performance standards which the project has to achieve are clear and deliverable.

On any drinking water or wastewater treatment plant, the essence of the “bargain” is that, provided influent between parameters A and B is received into the treatment plant, the plant will achieve its objectives and produce effluent out of the plant that falls between parameters X and Y. The problem often is how to calibrate parameters A and B. This is complicated by the fact that often the local data relating to influent into an existing plant is scant or non-existent. If the plant is an entire new build, then, by definition, there will be no existing data. The question then arises as to how such data is to be built up.

This issue is further complicated by the inter-relationship between flows and concentrations within loads carried by the flows. The question of who takes the risk of out-of-specification influent is one that’s likely to occupy many hours of discussion and negotiation as the deal is developed. A further aspect of deliverability of the performance standards is the question of sudden pollution incidents. Funders will be particularly interested in the nature and robustness of local environmental legislation and powers and effectiveness of any environmental protection agency.

Cutting losses amicably

A clear termination, compensation and step-in regime is fundamental in any project finance. Procuring authorities need to be sensitive to legitimate requirements of lenders to allow them to maximise their recovery. Termination triggers should be clear and capable of objective assessment. In any scenario where there may be less than full recovery of senior debt, lenders should have the opportunity to step-in and ensure breaches are remedied before the concession is terminated. Often an area of contention between the procuring authority and senior lenders, such step-in rights should take account of the complexity and amount of senior debt being provided.

Bank liquidity crisis

As noted at the outset, demand for access to water and the treatment of wastewater has never been greater. Private investment in the sector must be encouraged if this demand can begin to be satisfied. Currently, availability of investment from the private sector has become significantly constrained, with senior lenders becoming increasingly reluctant to finance infrastructure projects on a long term basis. More than ever, projects must be structured in a way that can still attract financing. The issues outlined in this article must be addressed in a way that encourages and promotes private sector investment in the industry. Failure to do so will have a profound impact on large sections of the world’s population.