Tapping the Private Sector:

Approaches to Managing Risk in Water and Sanitation

David Haarmeyer and Ashoka Mody

 Contents

ForewordÊÊÊÊiv
PrefaceÊÊÊÊv
Why are Private Initiative and Capital Important?ÊÊÊÊ1
Strategies for Attracting Private Initiative and CapitalÊÊÊÊ4
Management and Lease ContractsÊÊÊÊ4
Build-Operate-Own (BOO) and Build-Operate-Transfer (BOT) ProjectsÊÊÊÊ5
Full Utility ConcessionsÊÊÊÊ6
Privatization of AssetsÊÊÊÊ6
Managing Risks through Project FinanceÑand BeyondÊÊÊÊ7
The Fundamentals of Project Finance for Water and Sanitation ProjectsÊÊÊÊ8
Risk ManagementÊÊÊÊ8
Elements of Financing: Structure, Maturity, and SourcesÊÊÊÊ12
Beyond Project FinanceÊÊÊÊ15
Corporate FinanceÊÊÊÊ15
Overcoming the Disadvantage of Small Size: The Role of the Public SectorÊÊÊÊ16
ConclusionsÊÊÊÊ18
Commitment and StrategyÊÊÊÊ18
Financing ResponsibilitiesÊÊÊÊ18
Contracting and RegulationÊÊÊÊ18
NotesÊÊÊÊ19
ReferencesÊÊÊÊ20
Boxes
Box 1Ê The legacy of public sector managementÊÊÊÊ2
Box 2Ê How is the water and sanitation sector different from other infrastructure sectors?ÊÊÊÊ2
Box 3Ê Successful contract transformation in C™te dÕIvoireÊÊÊÊ5
Box 4Ê Mitigating the risk of nonpayment through credit enhancement in MexicoÊÊÊÊ10
Box 5Ê Easing the policy transition with partial risk guaranteesÊÊÊÊ14
Tables
Table 1Ê Access to safe water and sanitation in developing countries, 1993ÊÊÊÊ1
Table 2Ê Allocation of risks and responsibilities in alternative contractual arrangementsÊÊÊÊ4
Table 3Ê Risk and cash flow profiles of alternative privatization mechanismsÊÊÊÊ8
Table 4Ê Types of risks and mitigation mechanismsÊÊÊÊ9
Table 5Ê Mechanisms used to mitigate market riskÊÊÊÊ9
Table 6Ê Mitigating regulatory and political risksÊÊÊÊ12
Table 7Ê Summary of project financingÊÊÊÊ13
Foreword

The economic and environmental importance of the water and sanitation sector is driving governments around the
world to seek innovative approaches to harnessing private sector management skills and investment capabilities.
This review of recent experience was undertaken to determine the extent and form of private involvement, the
successes achieved, and the problems faced both by governments and the private sector.
The study highlights the variety of risks that occur in the provision of water and sanitation services and describes
in considerable detail the mechanisms used to allocate and mitigate those risks. Where risks are clearly identified
and managed, the prospects of success go up. Clearly, there is no magic bullet here: even the successful projects
have faced challenges. However, the experience thus far leads to an optimistic prospect for the future. A variety of
experiments are ongoing in all parts of the world. Some projects have faced challenges but typically all parties have
demonstrated a willingness to find solutions that improve the basis for success. Looking ahead, the interests of
governments and the private sector lie in continued efforts to identify arrangements that provide cost effective and
quality service while rewarding risk bearing.
This study on the water and sanitation sector follows earlier reviews undertaken by the World BankÕs Project
Finance and Guarantees Department on private electric power generation and toll road projects. The Project Finance
and Guarantees Department provides technical support in project structuring and is responsible for the World BankÕs
Guarantee Program. Further information on the BankÕs GuaranteesÑand on the DepartmentÕs publicationsÑcan be
obtained by calling 202-473-1650.

Nina Shapiro
Director
Project Finance and Guarantees
Preface

Worldwide, the public sector finances, builds, operates, and owns most of the assets in the water and sanitation
sector; facilities are often inefficient, service coverage and quality are inadequate, and cost recovery is poor. To
extend coverage and improve the quality of service provided, municipalities around the world are turning to the
private sector to rehabilitate and expand existing systems and build and operate new ones.
Based on accumulating experience, this monograph describes strategies to sustain private involvement and
investment in the water and sanitation sector. It is addressed both to policymakers and to private operators,
investors, and lenders that are engagedÑor are likely to participateÑin meeting the rapidly growing demand for
water and sanitation services. The ability of the public and private sectors to recognize and acknowledge each otherÕs
viewpoints and expectations will be key to sustaining the efficient use of private initiative and capital.

*****

Valuable comments and inputs were received from John Briscoe, Laurence Carter, Penelope Brook Cowen, Brad
Gentry, Vincent Gouarne, Ellis Juan, Jamal Saghir, Ben Shin, Thelma Triche, Guillermo Yepes, and Katarina Zajc.
Dilip Patro prepared an early draft, which helped to get the project started. Without implicating them in any way,
we would also like to thank several industry specialists, project sponsors, and lenders who generously responded to
our queries with detailed inputs: Alan Booker (Office of Water Services), Brieuc Le Bigre (Bouygues), William
Bulmer (International Finance Corporation), Ron Daigle (Global Environment Fund), Eduardo Daniello (Aguas
Argentinas), Michael Deane (Air and Water Technologies), Luis F. Diaz Guerrero (Secretaria de Obras y Servicios),
Wanchai Ghooprasert (East Water Resources), Richard House (Institutional Investor), Lum Weng Kee (Department
of Sewerage Services, Malaysia), Chew Seng Kok (Zaid Ibrahim and Company), Thierry Krieg (Tecnologia y
Servicios de Agua), Santiago Lobeira (Secretaria de Medio Ambiente Recursos Naturales y Pesca), Alain Locussol
(World Bank), Peter Mansfield (Lend Lease), Jim Martin (International Finance Corporation), Steve Moon
(Dresdner, Kleinwort, and Benson), Bosworth Monck (International Finance Corporation), David Naylor (Welsh
Water), Louis Petershmitt (Saur International), Alain Poinard (Lyonnaise Sdn. Bhd.), Gauthier Prate (Lyonnaise
Sdn. Bhd.), Rebecca Reehal (Dresdner, Kleinwort, and Benson), Partho Sanyal (International Finance Corporation),
Hugh Sowerby (Agua de Mexico), Hector Vela (Atlatec), and Hakan Ymsen (Anglian Water).
Why are Private Initiative and Capital Important?

Governments worldwide are turning to private initiative and capital to address the significant
operational failures and funding gaps in the provision of water and sanitation services. Although
private investment in the sector has been much more modest than in telecommunications, power
plants, and toll roads, considerable private activity has occurred in recent years. As the nine case
studies described in the paper show, private capital has relieved pressures on government budgets and
private initiative has increased operational efficiency. Private water and sanitation projects have,
however, been concentrated in only a few countries, and they have encountered a variety of
challenges. Despite these problems, pressures for moving ahead have resulted in pragmatic
approaches to risk reduction and risk sharing in a variety of contexts, and the prognosis for the
future is positive.

De velo ping co untr ies sp end ab out $3 0 bi llio n a ye ar on in vest ment s in wa ter an d sa nita tion bu t ea sily ne ed
to sp end tw ice th at am ount to se rve th ose wi thou t es sent ial se rvic es an d to av ert an en viro nmen tal cr isis in
th e dec ades ah ead. Th roug hout th e wo rld 1 bi llio n pe ople ar e wi thou t sa fe wa ter, an d 2 bi llio n ar e wi thou t
sa fe sa nita tion . Th e mo st se vere pr oble ms ex ist in lo w-in come co untr ies, wh ere on ly ab out 60 pe rcen t of th e
po pula tion ha ve ac cess to sa fe wa ter an d on ly 40 pe rcen t ha ve ac cess to sa nita tion (t able 1) . Th ese st atis tics
fa il to ca ptur e th e fu ll ex tent of th e pr oble m, si nce ev en th ose wi th ac cess to se rvic es fa ce lo w qu alit y an d
po or re liab ilit y. Mo reov er, as ur ban po pula tion s co ntin ue th eir re lent less gr owth , pr essu res on sc arce wa ter
su pply an d th e da mage fr om po llut ed wa ter th reat en to ca use ir reve rsib le da mage to th e en viro nmen t an d
he nce to th e qu alit y of li fe in ma ny co untr ies.
The water and sanitation sector has long been dominated by the public sector, which has left a legacy of serious
operational deficiencies (box 1). The tradition and perception of water as a predominantly social service led to
neglect of the sectorÕs long-term economic viability and to massive undercapitalization.
The current situation presents both constraints and opportunities. On the one hand, the political nature of some
problems (such as overstaffing and tariff setting) may deter private participation. On the other hand, the significant
financial and operational problems of the sector provide a rationale for private participation. With governments in
many countries unable to address the pressing needs of the sector, the private sector can potentially contribute
significant financial resources to extend services. Financial resources alone will not solve the problem of inadequate
water quantity and quality, however. If services are to be enhanced and expanded, operational inefficiency (high water
losses, poor reliability, inadequate metering and billing) must also be overcome through harnessing the management
and technical skills of experienced service providers.
The shift to private participation can create large benefits, but effective private involvement requires that
governments play a new facilitation and regulatory role to create a credibleÑand hence low-riskÑcontracting and
operating environment (box 2). A recent World Bank study documents that, in a number of projects, private
enterprise has been associated with Òsubstantial benefits to consumers in terms of expanded coverage and quality of
services as well as significant improvements in productive efficiencyÓ (Rivera 1996, p. 71). But the same study also
questions the sustainability of these benefits and improvements without the implementation of complementary water
pricing, financing, and regulatory reforms.

TABLE 1
Access to safe water and sanitation in developing countries, 1993
Percentage of population with access to
Country Safe water Sanitation

Low income
ÊC™te dÕIvoire 75 43
ÊGhana 56 27
ÊGuinea-Bissau 25 29
ÊGuinea 60 14
Lower-middle income
ÊGuatemala 60 71
ÊIndonesia 42 55
ÊPhilippines 81 72
ÊSlovak Republic 77 51
ÊTurkey 92 95
Upper-middle income
ÊArgentina 64 89
ÊChile 86 83
ÊMalaysia 78 94
ÊMexico 80 66

Note: Though these data refer to 1993, the coverage ratios are unlikely to have changed much since then. Definitions of coverage vary across countries and
are therefore not always strictly comparable. Reported coverages also vary somewhat across the sources cited. The relatively high coverage ratios for sanitation
in some countries reflect extremely rudimentary services.
Source: United Nations (1996), World Bank (1995), World Resources Institute (1996).

Box 1
The legacy of public sector management
Significant opportunities for operating improvements indicate that water enterprises face weak internal (organizational)
and external (regulatory) incentives to perform. Unaccounted-for water, which measures the combined effects of physical
leakage and unauthorized withdrawal, is a frequently used summary measure of operational efficiency. For efficiently
managed water utilities, unaccounted-for water is generally in the range of 10Ð20 percent. In many developing countries
unaccounted-for water rates average between 40 and 60 percent, indicating poor management (Cowen 1995). Public water
systems also tend to be overstaffed, with five to seven times as many employees per connection as in other utilities
(Serageldin 1995). Water quality standards are also low.
The massive cost of underpricing, inadequate collection, and inefficiency is a key force driving governments toward
privatization. Revenues collected by municipal utilities cover only about a third of the cost of water; subsidies from the
underpricing of water amount to about $20 billion a year (World Bank 1994). In addition, operational inefficiency costs
governments almost $10 billion a year (World Bank 1994).
Ra isin g pr ices to co ver co sts an d re duci ng sy stem lo sses wo uld th us be al most su ffic ient to fi nanc e th e cu rren t
le vel of ex pend itur es on wa ter. In th e pa st, co ncer n fo r th e po or ha s be en st ress ed as a ke y re ason fo r ke epin g pr ices
lo w. Ho weve r, be caus e la rge po rtio ns of th e po pula tion di d no t ha ve ac cess to se rvic es, th e be nefi ts of th e
su bsid ies ac crue d pr inci pall y to th e we alth y or we ll co nnec ted. Gr eater ac cess to wa ter su pply an d ex plic it
su bsid y me chan isms wi ll be re quir ed to se rve th e in tere sts of th e po or.

Box 2
How is the water and sanitation sector different from other infrastructure sectors?
The distinctive features of the water and sanitation sector are the source of many risks, and they explain the lower levels of
private investment in the water sector relative to the power, telecommunications, and transportation sectors. All of these
features underscore the importance of government commitment to mitigate risks in order to attract private participation.
First, capital intensity is high and large sunk costs are involved, thus limiting the scope of direct competition and
creating the need for a credible regulatory framework to protect consumers from excessive charges and investors from
Òcreeping expropriation.Ó Water assets often last 30Ð50 years, with depreciation rates of only 3Ð5 percent a year. To keep
tariff levels low, the payback period for water investments is usually amortized over 15Ð30 years. Long-term financing i s
thus needed to finance these investments. The lack of effectively functioning domestic capital markets in most developing
countries represents an important obstacle to private investment, and reliance on long-term international lending creates
substantial currency risks.
Second, multiple public policy objectives (economic efficiency, environmental enhancement, the protection of health,
and the affordability of tariffs, as well as broader fiscal and political goals) accentuate political and regulatory uncertainty.
All infrastructure sectors must meet multiple policy objectives, but the problem is particularly acute in water and
sanitation because of the serious health and environmental consequences of substandard service provision.
Third, the sector is highly fragmented. Water differs from other network industries in that, relative to its value, the
product is expensive to transport and cheap to store. This reduces the scope for long-distance transmission (except t o
water-stressed areas) and makes water a more local service than other infrastructure services. The local nature of water and
sanitation services means that investments tend to be smaller than they are in infrastructure sectors, such as power, i n
which investment is centralized.
Finally, the water and sanitation sector is characterized by a high degree of uncertainty about the condition of assets
and thus the investment requirements. Private investors have only limited information about the state of the physical
infrastructure (the pipes) and the customer base (the extent of illegal connections, for example). The condition and value of
water and sanitation infrastructure is generally more difficult to determine than assets of other utility sectors because many
of these assets are underground. As a result, underinvestment and improper maintenance can go unnoticed for years.
Because private companies taking over water and wastewater systems may have difficulty estimating the costs of
rehabilitation, tariff setting and adjustment can be subject to considerable uncertainty.
The problem of valuing assets has significant implications for the risks faced by private investors. If more investment i s
required than was expected in the initial tariff determination and tariff renegotiation is costly, private developers and
investors may find that contractually agreed upon returns are insufficient. The difficulty of assessing the value of water and
sewerage assets suggests that regulatory provisions for tariff adjustment and contract renegotiation will play a critical role
in attracting and securing private capital to the sector.
Strategies for Attracting Private Initiative and Capital

A variety of approaches have been used to attract private participation in water and sanitation (table 2). Different
approaches have been adopted to varying degrees around the world. Even within countries at similar income levels,
the nature and extent of private sector participation varies widely. In the United States, for example, less than 20
percent of the population is served by privately managed water utilities, and an even smaller portion of the
population is served by assets that are privately owned. In contrast, public-private partnerships are more common in
Europe. Activity among middle-income countries, such as Argentina and Malaysia, is growing, and they are likely
to experience the greatest growth in private participation in the coming decades. But among middle-income
countries, too, experiences vary. Chile, for example, a leader in privatization in other sectors, has been slow to seek
private participation in the water and sanitation sector, primarily because its public water utilities have a reputation
for efficiency. Private participation in low-income countries has been even more limited, and the value of the projects
has been small. Given the enormous need for investment, however, activity is expected to grow, particularly as
governments adopt economic, legal, and regulatory reforms that stimulate growth and attract foreign investment.

Management and Lease Contracts

Tackling the long-term weaknesses in the distribution sector can also be done incrementally (box 3). This approach
of gradually increasing private participation through contracting mechanismsÑoperations and maintenance (O&M)
and lease contractsÑhas been adopted in many countries because of concerns about raising prices and the need to
deal sensitively with the interests of the utilitiesÕ staffs. Management contracts give the private sector full
responsibility for O&M services for a specific facility (such as a wastewater treatment plant) or an entire system. The
private O&M contractor typically accepts performance-based fees, which are generally based on physical parameters,
such as volume of water treated and achievement of environmental quality standards; the contractor may also bear the
risk of legal liability for failure to meet environmental standards. The O&M contractor does not take on the
investment and financing risks. The duration of management contracts is generally less than 10 years.
Because they may not require tariff increases or significant downsizing of staff, short-term management contracts
may be politically more acceptable than forms of private participation such as concession contracts, which require
cost recovery. Like corporatization, which involves transforming a utility into a financially and institutionally
independent entity, management contracts offer a way to improve operational and service performance and thus
prepare a utility for fuller privatization options. However, under this approach, the degree of private involvement is
fairly limited and hence private initiative and capital are harnessed only to a limited extent. While this Òstepping
slowlyÓ approach goes some way toward improving operational and financial performance, lines of authority and
responsibility remain blurred and reliance on government budgetary resources for funding remains unchanged.

Build-Operate-Own (BOO) and

Build-Operate-Transfer (BOT) Projects

The most frequently employed form of private participation has been through special-purpose build-operate-transfer
(BOT) projects for water sourcing, transmission, and treatment. In countries with limited financial resources and
urgent needs for specific facilities, such as water or wastewater treatment plants, BOO/BOT contracts can be an
efficient way to channel private investment and initiative to new facilities. Under a BOT contract the government-
owned utility pays a private company to source water or treat a certain volume of raw water or sewage. To provide
the basis for project financing, the revenue stream is secured through a take-or-pay arrangement, under which fixed
payments are made whether or not the service is used. The contract length is negotiated to allow for retirement of
debt and provide a return to equity investors. At the end of the contract, which generally lasts 15Ð25 years, the
private company transfers the facility back to the government. In contrast, the private company owns and operates
the facility for perpetuity under a BOO contract.
While placing greater capital at risk than in management or lease contracts, the BOT/BOO arrangements do not deal
with the inefficiencies of the distribution sectorÑ water losses, lack of metering, and inefficient tariff setting. Indeed, these
arrangements are often perceived as a short-term mechanism by which to avoid dealing with the long-term, less tractable,
problems. In this respect, they follow the same philosophy that led to independent power generators under long-term take-
or-pay contracts in the power sector. In both sectors the danger exists that the supply sources thus created will be inefficient
because they supply a service that is not needed (in the worst situation the extra supply will be wasted where distribution
losses are not stemmed). Greater coordination of supply and distribution investments is, therefore, required.

Full Utility Concessions

A few countries have gone farther by awarding concessions for operating entire water and sanitation systems for fixed
periods (25Ð30 years) and requiring an investment commitment on the part of the concessionaire. Although the
outcomes are sensitive to the precise contractual and regulatory arrangements, recent evidence suggests that
significant gains are possible.

Privatization of Assets

Beyond such concessions lie the full privatization of assets, which has been done only in England and Wales, where
privatization has transformed the once undercapitalized and underperforming water companies into viable and
competitive enterprises.

TABLE 2
Allocation of risks and responsibilities in alternative contractual arrangements
Allocation of Management Lease BOO/BOT Full utility
responsibilities contract contract concession concession Asset sale

Ownership Government Government GovernmentGovernment Private sector

Investment Government Government Private sectorPrivate sector Private sector

Operation Private sector Private sector Private sectorPrivate sector Private sector

Tariff collection Government/

private sector Private sector GovernmentPrivate sector Private sector

Selected recent cases ¥ Puerto Rico ¥ Guinea (water) ¥ Johor, Malaysia (water) ¥ Macao (water) ¥ Ten regional
(water and sewerage) ¥ North and South ¥ Sydney, Australia (water) ¥ Buenos Aires, water authorities
¥ Mexico City (water) Bohemia, Czech ¥ Izmit, Turkey (water) Argentina (water and in England and
¥ Trinidad and Tobago Republic (water ¥ Chihuahua, Mexico sewerage) Wales (water
(water and sewerage) and sewerage) (wastewater) ¥ Malaysia (sewerage) and sewerage)
¥ Antalya, Turkey ¥ Gdansk, Poland (water) ¥ Puerto Vallarta, Mexico ¥ Limeria, Brazil
(water and sewerage) ¥ Szeged, Hungary (wastewater) (water and sewerage)
¥ Gaza City (water and sewerage) ¥ C™te dÕIvoire (water)
(water and sewerage) ¥ Cartagena, Colombia ¥ Batam, Indonesia (water)
¥ Indianapolis, U.S. (water and sewerage) ¥ Manila, Philippines (water
(sewerage) and sewerage)
¥ Gabon (water and
electricity)

Box 3
Successful contract transformation in Côte d’Ivoire
C™te dÕIvoireÕs water utility is one of the oldest and longest-running privately operated systems in the world. Its
operations are financially self-sustaining, its shares trade on the Ivorian stock market, it is operated almost entirely b y
Ivorians, and it is beginning to export its expertise and management experience to neighboring countries.
In 1959 the government organized an international tender for the right to operate the water supply system in the capital
city of Abidjan, a city of about 300,000 at the time, under a lease agreement. The French water company Saur was awarded
the 25-year lease contract. Two years later Saur signed agreements to manage five other municipal systems. After C™te
dÕIvoire gained independence in 1960, a private Ivorian company, SODECI (the C™te dÕIvoire Water Distribution
Company), took control of the lease, leaving Saur as the major shareholder.
Under the lease agreement, SODECI was responsible for the operation and maintenance of the system, tariff billing and
collections, and new connections; the government was in charge of major investment, such as network extension.
Operations were self-financed and tariffs collected by SODECI were allocated to the lessee as remuneration, to the
Development Fund (for low-income connections, renewals, and new works), and to the National Water Fund (for debt
service and sewerage). To ensure that low-income households had access to piped drinking water, SODECI structured a
special tariff rate for poor households and offered free connection for pipes 15 millimeters in diameter.
In 1978 the companyÕs shares began trading on the countryÕs stock market. Over time the company took over
responsibility for the management of sewerage and drainage systems. In 1987 the government broadened SODECIÕs
responsibilities to include financing investments by granting the company a 20-year concession for the urban water
supply. By 1997 SODECIÕs capital of about $15 million was held by Saur (47 percent), SODECI WorkersÕ Funds (5
percent), private Ivorians (45 percent), and the Ivorian government (3 percent).
Through the adoption of professional management techniques that have included a heavy emphasis on training and
motivating staff, SODECI has transformed the countryÕs water utility into a highly productive stand-alone business that
serves more than 345,000 customers in 409 centers (136 towns and 273 villages), up from 40,071 customers in 38 centers
in 1973. Staffing efficiency is high (about four per thousand connections), collection from private customers is 97 percent,
and unaccounted-for water in Abidjan is only 17 percent.
Managing Risks through Project Finance—and Beyond

Tapping substantial new sources of finance is a prime motivation for attracting private participation. Successful
transition from the current system of government financing to private financing will depend on the establishment of a
sound pricing and regulatory framework, which determines the future flow of earnings and their stability.
Governments would ideally like to eliminate their financial support to private projects. Incomplete reforms,
continued subsidies to certain low-income consumers, and the risks associated with the transition from public to
private management, however, require direct and indirect government financial assistance. To phase out such support
over the long-term, it will be necessary to transform poorly performing utilities into economically viable enterprises
with access to significant internal cash for investments and with the ability to raise resources from diverse sources on
the basis of their balance sheets.
The evolution of private financing may be viewed as a three-step process. In the first step, the key mechanism is
limited-recourse financing. Project equity and commercial lending are supported primarily by the cash flows and
assets of the project, which may be a discrete BOT or a concession for a distribution system. Financing is also
supported in part by recourse to the balance sheets of project sponsors and by various implicit and explicit
government guarantees. In the second step, a stable set of rate-paying customers and some confidence in the
regulatory system is established, and the basis for a sustainable water utility is created, leading to substantial
investments through retained earnings. In the third step, capital market financing, especially bond financing, is
likely to develop as the track record of stable revenue sources become evident.1 Where private ownership of assets
exists, equity markets can play an important role in disciplining the management of water utilities. Governments can
support the development of capital markets through general measures and also those specific to the water and
sanitation sector.
Project finance techniques have been the preferred method of attracting equity investors and lenders to water and
sanitation projects. Like other privately financed infrastructure facilities, such as power plants, toll roads, ports, and
airports, these projects are structured around a projectÕs ability to generate a stable stream of future revenues.
Nonrecourse or limited-recourse financing is based primarily on a projectÕs future cash flows and its assets, rather
than on the balance sheet of the government or the project developer. The direct link between a projectÕs cash flow
generation potential and funding gives the project sponsors, investors, and lenders strong incentives to ensure that
projects are structured and operated to generate positive cash flows.
The high capital intensity of water projects and consumersÕ sensitivity to tariff increases indicate that the
financing challenge for the water sector is to access long-term financing at reasonable rates to match the long-term
payback period associated with the large investments required to rehabilitate and expand existing assets and
construct new facilities. Additionally, for new investments such as BOT projects, the long gestation period from
initial construction financing to operation and stable revenue generation may represent two or three years without
debt repayment.
To date, debt has been the major component of the financing package. Most of this debt has come from official
sources, including several international financial institutions and the export credit agencies (ECAs). Domestic
financial institutions have provided financing in local currency in the more advanced countries, including Malaysia
and Thailand; international commercial lenders have been unable to lend on their own account for tenors of 10 years
or more, as required by these projects.

The Fundamentals of Project Finance

for Water and Sanitation Projects
Under limited-recourse project finance, a projectÕs cash flow and risk profile determine the financial structure, sources
of finance, and terms of lending. These profiles are affected by four main factors: (a) the type of contractual
arrangement, (b) the stage of the projectÕs development, (c) the availability of local finance (the presence of exchange
rate risk), and (d) the underlying political commitment to secure private participation, as reflected by government
undertakings (such as establishing an independent regulatory authority or raising tariffs to cost recovery levels before
privatization).
The cash flow and risk profiles, security interest, and customer type for the different approaches to private sector
participation in the water and sanitation sector are shown in table 3 (exchange rate risk, which is not shown,
depends on the quality of local capital markets). The significant variation in the cash flow and risk profiles across
projects and phases of project development suggests the need for different risk mitigation and financing strategies.
Financially, certain entities are better suited to participating in project financing than others. Commercial banks, for
example, may have specific sectoral and country expertise that enables them to shoulder and manage a projectÕs
financial risks; multilateral and export credit agencies may have specific knowledge and experience analyzing and
managing country risk.
Allocating more risk to the private sector (that is, moving to the right along the continuum shown in table 3)
entails increased commercial responsibilities, greater control, and a longer duration of private participation. Under a
concession agreement, a project companyÕs shares cannot be freely transferred or pledged; only under full asset
ownership can the private operator use such assets as collateral. With rights to cash flows in perpetuity and a clear
security interest in a utilityÕs assets, asset ownership has the greatest long-term certainty of revenues, and it thus
generally provides the greatest flexibility for financing new investment. At the same time, the greater monopoly
concerns associated with asset ownership mean that government oversight will play a greater role, and thus
regulatory risk will be higher.

Risk Management

The reliability and timing of the cash flows and the allocation of risks influence the ease and sources of funding. All
parties have an interest in requiring that risks are fully transparent and allocated to the project participants best able
to mitigate them. The process of identifying, assessing, and assigning commercial and regulatory risks is, however,
a difficult one. In water and sanitation projects, a variety of strategies have been adopted to deal with market and
payment risks, construction risks, operational risks, currency rate and convertibility risks, regulatory and policy
risks, and force majeur (table 4).

Market risks

Market risks in the sector take the form of demand (ability and willingness to pay) risk and payment (or credit) risk
(table 5). Under BOT/BOO arrangements, demand risk is mitigated through a long-term contract with the
government utility, which bears the risk of nonpayment by customers. The utility commits to purchase a minimum
amount of service over the life of the contract through so-called take-or-pay contracts. These contracts oblige
payment even when services are not required; they thus give comfort to lenders that a project can service its debt.
Payment risk exists nevertheless in BOT/BOO contracts, however, since the government entity purchasing the
services may not be creditworthy. If the government entity is viewed as uncreditworthy, lenders and investors will
require some form of credit support from the federal government or other third party (see box 4). In addition, escrow
accounts may be set up to provide a cushion in the event of nonpayment.
In a lease contract, full utility concession, or asset privatization, the demand and payment risks are borne by the
private operators, who sell services directly to individual consumers. Market risk arises because consumption by
retail consumers may decline as a result of increased tariffs or greater measurement of consumption through metering.
Uncertainty associated with the drop in demand may be particularly high in developing countries in which meters
have never been used or tariffs have been kept artificially low. Accurately predicting the consumerÕs response to a
tariff increase is critical to ensuring that future revenue requirements are met. Lenders will generally seek independent
appraisals of market demand and include sponsor guarantees and loan covenants to ascertain the ability of a project
to service its debt out of cash flow.2 Such risk protection measures have been used in concessions in Malaysia and
Argentina and in the regional utilities in England and Wales.
Market risk may be particularly problematic in the case of sewerage concessions that are not bundled with
concessions for potable water services. Consumers are generally more sensitive to paying for sewerage services than
water services. This is especially true where individual households have traditionally relied on their own sewage
disposal methods. Bundling the water and sewerage bill tends to reduce the risk of nonpayment.
An important aspect of market risk is the ability to secure payment from customers through the threat of
disconnection. Private developers will be less willing to operate a water or wastewater system if this right is not
contractually guaranteed and will look for some other form of guarantee to cover fixed costs. For example, in the
national sewerage concession in Malaysia, where private operators do not have the legal authority to shut off
sewerage service, the government guarantees a minimum rate of return.

Construction or completion risks

Lenders and investors face the risk that the construction contractor will fail to complete a project on time, within
budget, and per contract design specifications. Construction risks are especially important in BOO/BOT projects
because of the long gestation period between the time lenders agree to finance a project and the time the first debt
service payments are made. Lenders are sensitive to delays in completion, abandonment, cost overruns, and failure of
a facility to achieve stipulated performance levels, all of which may adversely affect the timing and level of cash
flows.
Lenders and investors will generally insist that sponsors allocate construction risks to reputable engineering
construction companies through strong fixed-cost, date-certain turnkey contracts. These contracts guarantee
completion and, where applicable, performance; they provide for liquidated damages if guarantees are not met.3 The
performance of the contractor may also be backstopped with an insurance package that includes a performance bond,
letters of credit from reputable financial institutions, and pledging of the contractorÕs capital through an equity stake
in the project.
Governments are able to impose heavy penalties for failure to meet completion dates. In some agreements, for
example, the project company is required to pay the government water authority a substantial lump sum for each
week beyond the scheduled construction period that the plant remained uncompleted. Once the maximum delay is
reached, the water authority can terminate the contract. The project company may also provide a performance bond
for the construction of the plant for an amount equivalent to a substantial percentage of the value of the plantÕs
construction and equipment.

Operational risk

The main operational risk in water and wastewater facilities is that they fail to meet the agreed upon performance
parameters. Sponsors are generally required to put up performance bonds as guarantees of their operational
obligations and to pay penalties if performance standards are not met. The amount of the performance bond is
typically equal to an average yearÕs capital expenditure program, so that if the private party were to default on
performance targets and be asked to leave, the government could use the performance bond to fund capital
expenditures before a new operator was put in place.
Currency exchange and convertibility risks

A fundamental concern for foreign sponsors, lenders, and equity investors is the ability of a local project to generate
revenue in a currency that maintains value and can be converted to foreign exchange. Because water and sanitation
projects generate revenues in local currency, the convertibility of the local currency is essential to obtaining
financing. The relatively low imported content of water infrastructure projects also means that less foreign financing
is required than in other infrastructure sectors, such as power or telecommunications.
To protect against adverse fluctuations in cash flow, sponsors require that tariffs be indexed to exchange rate fluctuations
(as well as to inflation and interest rate changes). Two-part tariff formulas for BOO/BOT projects such as those in Johor,
Malaysia, and Sydney, Australia, provide a means of indexing variable and fixed costs to local inflation. In England and
Wales the price-cap formula automatically links tariffs to changes in the price level. In addition, reserve funds can be set
aside to mitigate against devaluation risk.

Regulatory and political risks

Regulatory and political risks include the risk of expropriation, regulatory interference (such as unilateral changes in
contracts), early termination, and change of law. These are risks that the private sector is not in a position to
evaluate or shoulder. The special attributes of water and wastewater projectsÑtheir local nature, the need for tariff
and environmental regulation, the difficulty of determining the asset value of underground pipesÑaccentuate these
risks. Municipalities with little if any regulatory experience often become responsible for significant regulatory
functions.
The high level of exposure to regulatory and political risks creates significant investment uncertainty. To
mitigate these risks, private parties to water and wastewater companies and concessions have relied on various
mechanisms (table 6). A basic level of protection is established by the chief regulatory instrument, the concession
contract, the credibility of which depends on how well it assigns and enforces the rights and obligations of the
concessionaire and provides for fair and workable contract and tariff renegotiation rules (Crampes and Estache 1996).
En suri ng th e cr edib ilit y an d fa irne ss of th e re gula tory en tity ch arge d wi th mo nito ring an d en forc ing a
co nces sion ag reem entÕ s ob liga tion s an d re gula tory re quir emen ts fu rthe r mi tiga tes re gula tory an d po liti cal
ri sk. Th e pr esen ce of an in depe nden t re gula tory ag ency Ñsuc h as ET OSS, in Ar gent inaÑ dimi nish es th e ri sk
of po liti cal in terferen ce.
The obligation of the government or regulatory entity in the event of early termination is of significant concern to
lenders, investors, and sponsors. Lenders in particular look for early termination clauses in concessions that,
depending on the circumstances, enable them to Òget out whole.Ó

Force majeure

Force majeure risks are those that are beyond the control of the private sector or the government parties to a contract.
Under force majeure, either party has the right to suspend obligations under the contract. Force majeure events
include domestic political events, such as wars, riots, general strikes, and changes in laws, and Òacts of God,Ó such
as natural disasters, fires, and epidemics.

Elements of Financing: Structure, Maturity, and Sources

Because water and sanitation projects create long-lived assets, with cash flows that grow slowly, financing requires debt
structures with long maturities. The limited ability and willingness of consumers to pay also requires that debt be
amortized over long periods (10 to 20 years) to help minimize annual debt repayments and reduce the necessity to increase
tariffs. The availability of long-term debt is, however, limited by the political, regulatory, and credit risks associated with
water and sanitation projects in developing countries. For example, in many developing countries financial markets are not
developed sufficiently to provide long-term lending. Consequently, foreign sources with associated currency risk must be
tapped.
For the projects examined in this study, these tensions have led to the following outcomes (table 7):

¥ A high initial debt to equity ratio, with debt constituting 50Ð85 percent of the financing (the English and
Welsh companies have a much lower debt ratio because of debt write down at the time of privatization and
Ògreen dowriesÓ)
¥ Maturities ranging from about 7 years at the lower end to 15Ð20 years in the more advanced, higher credit-
rated countries
¥ Much of the debt financing in the lower credit-rated countries coming from multilateral or export credit
agencies (domestic financing is restricted to the higher credit-rated countries)
¥ Significant government backing through payment and other obligations in the lower-rated countries.

Sources of debt

In co untr ies wi th we aker so vere ign cr edit s, fi nanc ing ha s be en pr ovid ed by mu ltil ater al in stit utio ns an d
ex port cr edit ag enci es (s ee bo x 5) . Th ese ar e th e on ly ag enci es th at ar e in a po siti on to ac cept po liti cal an d
re gula tory ri sk an d he nce pr ovid e th e lo nger te nor le ndin g at re ason able ra tes re quir ed fo r wa ter an d sa nita tion
pr ojec ts. Th e pr omin ence of th e ex port cr edit ag ency is so mewh at su rpri sing . Th e ex pect atio n ha d be en th at
ex port cr edit ag enci es wo uld be le ss im port ant in wa ter an d sa nita tion pr ojec ts th an in po wer pr ojec ts be caus e
of th e li mite d im port ed co nten t of th e in vest ment in wa ter an d sa nita tion . Ho weve r, th e Iz mit, Tu rkey ,
ex ampl e sh ows th at ex port cr edit ag ency fu ndin g ma y be so ught ev en fo r co nstr ucti on fi nanc ing.
The fact that little financing of the water and sewerage sector has been provided by the capital market indicates
that individual investors are not in a position to mitigate the risks involved. Projects can be expected to access
longer-term debt instruments and capital markets as the level and predictability of cash flows to support debt service
becomes more stable and certain. The English and Welsh companies have drawn on a variety of sources, including
the bond markets. The low-risk profile of more mature utilities is indicated by the fact that the 24-year bond issue
Anglian Water floated in 1990 was priced at just 53 basis points over U.K. Treasury gilts due November 2006. The
English and Welsh companies have also taken advantage of low-cost loans from the European Investment Bank
(EIB).4

Sources of equity

Although debt is generally cheaper than equity, a long-term equity stake by the sponsor (who is sometimes also the
operator) ensures that management does not have a short-term bias and that cash flow growth creates capital
appreciation. Equity also reduces the burden on the cash flow required to support debt service payments, which can
be especially important in a projectÕs early development phase.
Eq uity ha s be en pr ovid ed la rgel y fr om th e es tabl ishe d wa ter an d sa nita tion co mpan ies th at ha ve sp onsor ed
an d de velo ped pr ojec ts in th e se ctor . Al thou gh th e nu mber of la rge wa ter de velo pers is sm all (w ith th e
Fr ench , En glis h, an d We lsh co mpan ies do mina ting th e ma rket ), ba rrie rs to en try ar e lo w, su gges ting th at
fe ars ov er th e la ck of co mpet itio n ma y be un warr ante d. Do mest ic, pr ivat e en gine erin g an d de velo pmen t
co mpan ies in co untr ies su ch as Ma lays ia an d Me xico ha ve be gun to pa rtic ipat e in th e se ctor , an d co mpan ies
in ot her ut ilit y se ctor s, su ch as po wer di stri buti on, ar e in vest igat ing op port unit ies in th e se ctor .
Lenders like to see sponsors achieve a reasonable return on their investment to provide an adequate incentive to
maintain support for the project, at least throughout the duration of the loans. In addition, the lower priority claims
of equity investors in a projectÕs revenues means that by absorbing unanticipated shortfalls in revenue, equity
holders partially shield lenders. In full utility concession projects and privately owned utility companies, internal
cash generation can provide an important source of equity that can be used to finance investment.
To co mpen sate fo r gr eate r co untr y an d po liti cal ri sks in mo st de velo ping co untr y pr ojec ts, th e re quir ed
re turn s ar e li kely to be si gnifican tly hi gher th an re turn s in in dust rial co untr ies an d cl oser to th ose ob tain ed in
ot her in fras truc ture se ctor s. Ba ughm an an d Bu resc h (1 994) fo und th at, fo r a sa mple of po wer pr ojec ts in As ia
an d La tin Am eric a, th e es tima ted eq uity re turn wa s 18 Ð25 pe rcen t. Fi shbe in an d Ba bbar (1 996) fo und th at
in vest ors in pr ivat ely fi nanc ed to ll ro ads ex pect an nual re turn s of 15 Ð30 pe rcen t.

TABLE 3
Risk and cash flow profiles of alternative privatization mechanisms
Indicator O & M contract Lease contract BOT concession Full utility concession Asset sale

Time horizon 2Ð5 years 10 years 10Ð20 years 20Ð30 years In perpetuity

Customer Government Retail customers Single buyer/ government Retail customers Retail customers

Cash flow profile Fixed-fee for O & M fee paid Post-construction Subject to market Subject to market
service paid directly directly from retail purchase contract, and regulatory risk and regulatory risk
by government consumers and thus typically with a
subject to market risk government utility

Security interest Not relevant Right to part of Right to cash flows Right to cash flows Ownership rights to
cash flows generated generated by assets; generated by assets; pledge as security;
by assets; no right usually no right to usually no right to shares are tradable
to own or pledge assets own or pledge assets own or pledge assets

Construction risk None Little High Medium Low

Operations risk Low Medium High High High

Regulatory risk None Medium Low High Very high

TABLE 4
Types of risks and mitigation mechanisms
Risk Mitigation mechanism

Market or ¥ Independent tariff and demand studies

customer risk ¥ Right to cut off service
¥ Utility combinations or regionalization (project
Êbundling)
¥ Loan convenants (debt service coverage ratios)
Offtake or ¥ Take-or-pay contract with two-part tariff
nonpayment risk ¥ Credit support (guarantees)
Construction/ ¥ Turnkey contracts with performance bonds,
completion risk Êliquidated damages, and insurance
¥ Selection of reputable firms, recourse to sponsorsÕ
Êbalance sheet during construction
Performance/ ¥ Performance-based operation, maintenance contracts
operational risk ¥ Long-term ownership interest
¥ Selection of reputable operators
Currency risk ¥ Indexed tariffs
¥ Debt service payment escrow accounts
Regulatory risk ¥ Credible concession agreement
¥ Independent regulatory authority
¥ Fair arbitration procedures
¥ Partial risk guarantees
 ¥ Political risk insurance

TABLE 5
Mechanisms used to mitigate market risk
Market risk faced by
Project private operator Mitigation mechanism

BOT water treatment,/Izmit, Turkey Payment risk ¥ Government of Turkey guarantees Izmit payments
¥ Take-or-pay contract

BOT wastewater treatment/ Payment risk ¥ Take-or-pay contract with debt service escrow accounts
ÊChihuahua, and Puerto Vallarta, Mexico ¥ Line of credit from Banobras

BOO water treatment/Sydney, Australia Payment risk ¥ State government guarantee of payments by Sydney Water Corporation

BOT water treatment/Johor, Malaysia Payment risk ¥ Strong credit of municipal water authority
¥ Two-part tariff
¥ Immediate cash flow availability
¥ Phased capacity additions

Water supply lease contract/Guinea Demand and payment risk ¥ Phasing in of higher tariffs, with declining government subsidies
¥ Disconnection for nonpayment

National sewerage concession/Malaysia Demand and payment risk ¥ Minimum guaranteed return

Water and sewerage concession/ Demand and payment risk ¥ Tariff adjustment process
ÊBuenos Aires, Argentina ¥ Guarantee of payment by government customers
¥ Disconnection for nonpayment

Water and sewerage asset ownership/ Demand and payment risk ¥ Five-year tariff adjustment process by independent regulator
ÊEngland and Wales ¥ Disconnection for nonpayment

Box 4
Mitigating the risk of nonpayment through credit enhancement in Mexico
Because the water and sanitation sector is fragmented, buyers of bulk water and wastewater treatment are often small, local
government utilities without track records for collecting user fees and making reliable payments. To mitigate the risk of
nonpayment, lenders look for some form of credit enhancement, such as a government guarantee of contractual performance,
direct assignment of part of the buyerÕs revenue stream, or trust funds and escrow accounts in which several months of debt
service are deposited.
In Mexico, where the need for capital to upgrade, rehabilitate, and extend the water and wastewater sector is significant,
the federal government is devolving financing responsibility to the local governments, which are exploring different
mechanisms with which to mitigate the nonpayment risk stemming from the financial weakness of the local water
authorities.
The Mexican government has given authority to its public works bank, Banobras, to provide credit enhancement t o
municipal projects. In 1994 Banobras played an instrumental role in closing a $17 million BOT water treatment plant i n
Chihuahua by providing a line of credit that was supported by a pledge by the State of Chihuahua to share its tax revenues.
In addition, to ensure that monies are appropriately allocated to items of cost and debt service, local authorities use
Fidecomiscos (trust funds) to handle incoming and outgoing funds. The payments to the contractor are deposited in the
Fidecomisco, thereby guaranteeing the banks financing the project that repayments will be made from the income from the
project. Bank loans are also handled through the trust.
The ultimate form of security against nonpayment risk, especially in the case of a default by the offtaker, is a solid
termination clause. In the power sector, sponsors may negotiate a ÒputÓ requiring that, in the event of termination, the
offtaker will Òbuy outÓ the sponsors for an amount corresponding to the discounted cash flow expected to be generated
during the remainder of the term of the power purchase agreement.

TABLE 6
Mitigating regulatory and political risks
Project site Mitigation mechanism
 Malaysia (national sewerage project) ¥ Local company equity participation
¥ Tariff review and adjustments
¥ Government commitment to privatization
Buenos Aires, Argentina ¥ Compensation of concessionaire in event of early termination
¥ Independent regulatory authority
¥ IFC and local investor participation
¥ Transparent tariff adjustment process
Izmit, Turkey ¥ Significant export credit agency (ECA) participation
¥ Commitment by the Government of Turkey and credit support
Chihuahua and Puerto Vallarta, Mexico ¥ Municipal grant funding (Chihuahua)
¥ Local investors/developers equity participation
¥ Banobras credit support
¥ IFC participation (Puerto Vallarta)
Johor, Malaysia ¥ Federal and state government commitment to privatization
¥ Local developer equity participation
Sydney, Australia ¥ Credible BOO concession agreement
¥ Local developer participation
¥ Fair and competent judiciary
England and Wales ¥ Disbursed shareholding by local investors
¥ Independent regulatory authority
¥ Reputable judiciary
¥ Moving to a multi-utility structure

TABLE 7
Summary of project financing
Project site Project cost Debt/equity Country rating Source and maturity of debt

Malaysia $2.4 billion (about $500 75/25 A+ Government soft loans (for length of concession)
Êmillion in first two years)

Buenos Aires, $4.0 billion ($300 million 60/40 BB- 10-year IFC A-loan; 12-year IFC B-loan (recourse to Argentine
Argentina Êfor first 2 years) Êgovernment in event of early termination)

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

Chihuahua, Mexico $17 million 53/15/32 BB 8.5-year commercial bank loan with limited recourse to Banobras
(debt/equity/grant);
debt in US$

Johor, Malaysia $284 million 50/50 A+ 10-year project finance loan from Public Bank Bhd (nonrecourse)

Sydney, Australia A$230 million 80/20 AAA 15-year commercial loans; state government stands behind
ÊSidney Water Corporation payment

England and Wales $5.24 billion 25/75 AAA Variety of borrowing sources

Box 5
Easing the policy transition with partial risk guarantees
Multilateral development banks have recently reemphasized their guarantee powers to support private projects. The focus
has been on power projects, although several water projects are potential candidates for these guarantees, which reinforce a
governmentÕs contractual agreements. Multilateral development bank guarantees can cover the following commitments:
¥ Payments in the event of early termination of the concession contract
¥ Payments to cover the subsidy element of consumer bills
¥ Payments to cover expenses of severance pay and labor retraining
¥ Timely delivery of civil works and other structures
 ¥ Ap plic atio n of th e ag reed -upo n ta riff de terminat ion pr oces s
¥ Disconnection of nonpaying customers
¥ Foreign exchange convertibility

The World Bank requires a counterguarantee from the host national government before it guarantees a governmentÕs
commitments. Other multilateral development banks (the Asian Development Bank, the European Bank for Reconstruction
and Development, and the Inter-American Development Bank) do not always require such counterguarantees.
Other sources of international political risk guarantees include the Overseas Private Investment Corporation (OPIC)
and the Multilateral Investment Guarantee Agency (MIGA), which provide cover against currency transfer, expropriation,
and war and civil disturbance. Political risk insurance has typically not been available from private sources for large
infrastructure projects. That may be changing, however, as demand for emerging market exposure is growing. Force majeure
events can also include legislation and rulings made by a government or judicial authority, unanticipated pollution,
power failure, and raw water shortages.
Beyond Project Finance

Project finance is a costly and complex process of identifying and evaluating risks associated with future cash flows
of projects.5 The long lead times and high transactions costs associated with project finance are likely to make it
less attractive than finance raised on the balance sheets of larger companies. Before capital markets can be accessed,
however, the cost of assessing, allocating, and mitigating project-related risks must decline. Once these costs fall,
the pool of prospective investors will increase, and the sector will be able to tap a broader group of intermediaries,
including insurance companies and pension funds, which have long-term fixed rate liabilities. Corporate finance
simplifies this transition to capital market financing, since the risk of a projectÕs debt is absorbed, in part, by other
corporate activities. Financing project debt from the balance sheet, however, exposes a company to significant risk
and thus requires a strong and large balance sheet. Partly to shield a companyÕs balance sheet, innovative financial
instruments, such as equity funds, are being developed. These infrastructure equity funds provide a means by which
developers can raise capital and investors can participate in the emerging market for financing infrastructure projects.
To infrastructure developers, funds can be particularly attractive because they can leverage their contributions with
that of other investors. For investors, equity funds mitigate project and country risk by creating a portfolio of
projects under one company.
The French water company, Lyonnaise des Eaux, introduced an Asia water fund in 1995. Contributors to the
fund include the All State Insurance Company, the Employees Provident Fund Board of Malaysia, and the Lend
Lease Corporation of Australia. The $300-million fund will refinance the equity of the original sponsors, thus
allowing sponsor equity to be conserved for development. Investors in the fund expect to receive steady utility-like
returns and the potential for a significant gain in the event that the fund or a portion of it is publicly listed. A Latin
American fund is also under consideration.

Corporate Finance

Balance sheet financing may be particularly attractive for overcoming some of the obstacles to financing water and
wastewater facilities on a project basis. The nature of the risks in the sector (the small size of projects, the lack of
creditworthiness of local governments, uncertainty over asset valuation, the fact that revenues are in domestic
currency and local capital markets are undeveloped) makes raising long-term project finance at reasonable rates
especially difficult. Reducing the reliance on limited-recourse debt, especially in a projectÕs early high-risk
development years, could lower project costs.
As in other sectors, projects in water and sanitation have been financed with some recourse to a sponsorÕs balance
sheet. Corporate sponsors have provided protection in the Buenos Aires project, for example. But recourse to project
sponsors goes only part of the way, since, unlike in the power sector, relatively few highly capitalized companies
operate in the water and sanitation sector, and domestic regulations have limited the ability of the large English and
Welsh companies to shoulder international risks.6
Hence, increasing balance sheet financing may require significant industry restructuring, such as consolidating ownership
and operation of regional water utilities or encouraging the integration of different utility sectors. MalaysiaÕs approach to
bundling the countryÕs entire sewerage system under one concession is an example of project pooling. Although that project
is experiencing tariff collection problems and has forgone the benefits of comparative competition that are achieved when
systems operate side by side, the approach secured revenue streams for the project sponsor with which to finance a large
number of small investments that would not have been commercially viable on their own.
Financial and operational sustainability requires a utility to finance investments from internal cash and long-term
bond issues. Water projects are in a position to use these sources of finance effectively. Once established, water
projects can have stable revenues, which permit not only internal financing but also access to a much broader class of
investors through bond issues. Of developing country projects, only Aguas Argentinas has moved significantly in
this direction: internal cash generation accounted for 9 percent of financing in the first three years and was expected to
rise to 30 percent in the subsequent three.
The use of bond financing by privately financed water projects and utilities is relatively new. In most developing
countries both the general development of bond markets and the development of economically viable water utilities
is at an earlier stage. It is likely that just as utilities will benefit from bond market development, the growth of
strong utilities will spur the growth of domestic bond markets.

Overcoming the Disadvantage of Small Size: The Role of the Public Sector

On average water and wastewater investments tend to be much smaller than in other infrastructure sectors because of
the small fragmented size of the market. Municipalities are in charge of water and sanitation, and investments in
facilities reflect demand within their jurisdictions. Even where large investments are expected, they are spread out
over time. This pattern of small, incremental investments contrasts with the construction of power plants and
transportation projects (toll roads, ports, airports), where large investments are typically made over a short period of
time.
The relatively small scale of water and wastewater infrastructure projects is an obstacle to attracting finance.
Potable water and sewage treatment facilities generate little interest from commercial banks because the projects are
small, their credit is unrated (or the credit of their sponsor is weak), and transactions cost are proportionately higher
than for large projects. For banks the cost of due diligence is about the same for large and small projects; since the
fees earned are greater for larger projects, there exists a natural bias against small projects. Overall, the transactions
costs of a projectÑthe legal, consulting, and financial costs of structuring a small projectÑmay be as high as those
for a larger project (Klein, So, and Shin 1996).
To address the scale-related finance gap, small projects may have to rely on greater equity commitments and
credit enhancements by third parties and look for creative financial structuring techniques, such as bundling of
projects. Governments and official financial agencies, such as the EBRDÕs private multi-project financing facility and
state revolving funds, can also provide financing.
Formation of multi-utilities may also help overcome the small scale problem. By combining, different utility
sectors may be able to achieve the necessary balance sheet size and credit strength (through diversity) to attract long-
term private financing. Convergence or bundling of utility services creates opportunities to realize the following
economic benefits:

¥ Cost savings from rationalizing two or more complementary cost bases, especially in customer services (meter
reading and tariff collection) and finance and administration
¥ Diversification of regulatory risk
¥ Provision of total utility solutions for customers
¥ Transfer of important strategic and marketing knowledge from a deregulated business to a regulated company.

The United Kingdom has been the leader in the formation of multi-utilities. United Utilities and Scottish Power,
two of the three British multi-utilities, provide electric generation/distribution, water and sanitation, gas
distribution, and telecommunication services. The convergence of utility services can be expected to bring about far-
reaching organizational and regulatory changes. For example, British companies have already created facilities
management companies to handle ancillary overlapping services and serve the broader market, and industry
regulators have demanded strict ring fencing of the core utilities to make the ownership structure transparent.
Financial changes are also expected, as companies take on greater debt to buy assets, and new services may be
exposed to competitive markets.
 Multi-utilities are playing a growing role in developing countries. Combined gas and water utilities exist in
Slovenia and Argentina. In C™te dÕIvoire the project company developing the water supply concession went on to
develop the electricity distribution system and a power generation project. This multi-utility approach is being
adopted in the concessions recently awarded in Casablanca and Gabon and is being looked at for water and power
projects in Morocco and the Congo. The implications for the concentration of monopoly power are a concern,
however.
Conclusions

The experience of the private sector in the water and sanitation sector has been a positive one, in which the private
sector has successfully demonstrated its ability to provide water and sanitation services with increased efficiency and
at affordable rates within different country, regulatory, and contractual contexts. The growing worldwide shortage of
water, serious problems with access to clean drinking water, and the escalating requirements for waste treatment can
be expected to prompt increasingly bold experiments with private involvement in the water and sanitation sector.
While firm conclusions are premature in what is yet an incipient movement, certain lessons emerge for successful
private sector involvement in the water and sanitation sector.

Commitment and Strategy

¥ Governments must strongly commit to private participation, both financially and politically.
¥ A strategic sector view that sets a sustainable utility structure as its goal (that is, goes beyond discrete
BOT/BOO projects) must be adopted in the future. Full utility concessions and asset sales, which offer the
broadest scope for operational and financial improvements, can address systemwide problems.
¥ Where full utility concessions or asset sales are not feasible, the operation and financing of utilities should be
separated from their regulation through corporatization, and operations and cash flow should be improved
through operations and maintenance and lease contracts.

Financing Responsibilities

¥ In the transition from government to private financing, government support is likely to continue through
various types of credit enhancement and, in some cases, direct subsidies.
¥ In the long run, measures to develop financing methods for several small water and sanitation projects under
the jurisdiction of provincial and municipal governments will be required.
¥ Forms of credit pooling and enhancement should be explored.

Contracting and Regulation

¥ When possible, transparent competitive tendering should be used to generate information on asset values, tariff
levels, and qualified operators.
¥ Mechanisms for adjusting tariffs must be transparent and predictable, and they must provide incentives for
increased efficiency.
¥ Although gains in efficiency can be expected as a result of private participation, in most countries it is realistic
to expect and plan for price increases if utilities are to expand systems and meet increasingly stringent
environmental standards.
¥ Contracts must spell out the private sectorÕs obligations and clearly identify the penalties for nonperformance.
Security of contracts should be provided to facilitate financing.
¥ A contractual and regulatory structure that minimizes uncertainty and provides flexibility in renegotiation and
operational autonomy for the operatorsÑwhile ensuring that environmental and health standards are
metÑmust be established.
Notes

1.ÊIn principle, capital market financing can occur earlier. Its importance is likely to grow substantially, however, once a
track record of revenues is established.
2.ÊEverything else equal, projects that face greater market risk will have less capacity to service debt and thus lower
debt-equity ratios. Through loan covenants lenders protect their residual claims by requiring, for example, that projects
meet minimum debt service coverage ratios or that cash dividends not be disbursed if the current ratio falls below a certain
level.
3.ÊThe economic interest of each party should be borne in mind when allocating risks and responsibilities. For example,
construction companies are generally less concerned with the long-term operating performance of a facility than with the
opportunity to take out construction profits from a project. Turnkey contracts and the need to maintain a reputation for
high-quality work act to align the construction companyÕs incentives with those of the sponsor. To prevent the distortion
of incentives that may occur if a construction contractor is also a sponsor, the government may require that the sponsor
hold a significant stake in the project over the life of the concession (as it did in the Aguas Argentinas concession).
4.ÊThe European Investment Bank (EIB) is the largest infrastructure financing institution in Europe. From 1991 to 1995
the EIB lent ECU 84 billion in 15 member states in the European Union and 11 Central and Eastern European countries.
The bank is a shareholder in the EBRD and the European Investment Fund, with which it also cofinances. It raises funds b y
issuing bonds on the capital markets, where it is the worldÕs largest nonsovereign borrower (Project Finance
International 1996).
5.ÊThe prefinancial closure cost of preparing a limited recourse financing for a power project ranges between $4 million
and $8 million, with legal costs representing about half of these costs (Churchill 1995).
6.ÊThe regulated English and Welsh water companies will have difficulty exposing their balance sheets to international
project risk.
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