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Water has no substitute. Unlike electricity or the telephone, it is essential to life. As such, it traditionally has been
considered a public responsibility and its provision and allocation a charge of government. However, in many parts of the
world the public sector still lacks the resources needed to keep up with the burgeoning demand for water services and ameliorate
the shortages and environmental damage that threaten the health and economic future of these regions. As a result, governments
increasingly are turning to the private sector for assistance in managing and financing water services and new water facilities.
Unique Characteristics of Water Industry
Foremost among the unique characteristics of the water industry is the perception of water as an entitlement. Water is the
most politicized of utilities. Water suppliers often face a population accustomed to diverting fresh water or simply not paying
for what they consume and governments reluctant to collect from or even charge the poor (or even other government agencies).
Governments bear the burden of not only a mandate for universal service regardless of their constituents' ability to pay but
also the health and environmental consequences of disconnecting users from water and sanitation services. Thus, water remains
in many regions underpriced and oversubsidized. This prevents governments from financing the maintenance, much less the improvement
or expansion, of water and wastewater services. Yet, in the perception of many, water is too essential a resource to turn
over to the private sector and its attendant profit motive.
While publicly-owned power utilities often are run by national governments, water utilities commonly are in the hands of municipal
or provincial government. For a number of reasons, this makes water a more difficult investment. The local operation of water
utilities has resulted in a fragmented market of smaller operations and created the potential for conflicts among the different
levels of government and undue interference from the national authority. In addition, local governments tend to be financially
and politically weaker and less stable than their national counterparts. This situation contributes to the perception that
in developing countries water transactions are less creditworthy than private power deals.
The water industry tends to be more heavily regulated than other utilities, partly because it is regarded as even more of
a "natural monopoly" than electricity or natural gas. Water distribution networks are capital intensive, and duplication of
water and sewage lines is generally not economical. The unbundling of services that has made competition in the power sector
possible is less feasible in this sector because the transportation of water is so expensive. Extensive regulation is intended
to prevent monopolistic pricing and promote service quality, but it also creates a risk of undue interference from and conflict
among public authorities and may make it difficult for investors to obtain a reasonable return.
Need for Private Sector Involvement
The water industry's distinguishing characteristics may deter private sector participation, but they do not reduce the need
for it. Involvement of the private sector is driven primarily by the need for investment. Water and sewage services rank among
the largest financial burdens of municipalities and will become only more onerous. The water industry is plagued by deteriorating
facilities, inadequate service coverage, inefficiency and environmental hazards, especially in developing countries. According
to the World Bank, ninety percent of the population of developing countries do not have access to clean water, while demand
is rapidly increasing. The world's population is expected to double within the next fifty to ninety years. Meanwhile, per
capita water consumption is increasing twice as fast. The World Bank estimates that a global investment of over $600* billion
is required to bring the industry in line with the growing demand for water and sanitation services.
The need for investment is not limited to developing regions. An infusion of private capital is necessary to bring advanced
technology and modern management techniques to an industry that even in developed countries is frequently undercapitalized
and inefficient. Governments everywhere seek private sector participation to obtain capital to upgrade and expand facilities,
increase the efficiency of existing facilities, comply with rising environmental and water quality standards and reduce financial
burdens.
So far, international competition among private water companies remains limited to a small number of players. The most prominent
and well-established are the French companies Suez Lyonnaise des Eaux and Vivendi. Newer entrants include the British companies
Thames Water and Anglian Water and the American upstart Azurix, an Enron subsidiary. Greater competition is desirable, as
it would increase the transparency and effectiveness of the private sector's participation.
Options for Private Sector Participation in Water Projects
The extent of private sector participation in water projects can range from discrete service contracts to outright acquisition
of an entire system. The approach taken by a host country will depend on a number of factors, including the extent of its
willingness to allow the private sector to participate in the water industry and the condition of existing water facilities.
Service and Management Contracts
At one end of the spectrum, private sector participation is restricted to the servicing, operation or management of an entire
water system or specific areas within it. By contracting with private operators to provide particular services, public authorities
can take advantage of private sector expertise while retaining ownership of a system's assets. This is an important option
in situations where privatization is not favored. Service providers receive a fixed fee or one linked to performance and therefore
are not affected by tariff changes. The private operator assumes little risk. These services can vary from discrete services
such as meter reading and repair to the operation and maintenance of an entire system or facility.
Service and management contracts address primarily the need for improved efficiency and service quality (especially if performance
incentives are provided) and require little or no capital investment from the private operator. They are useful in areas where
tariffs are too low for supporting long-term arrangements. They also help build trust in the private sector, thereby paving
the way for more extensive private sector participation.
BOT, BOO, and BOOT Projects
The BOT (build, operate, transfer) approach, including its variations, is the investment structure traditionally used to finance
discrete infrastructure facilities in developing countries. This approach requires the private operator to build and operate
a new facility. BOT and BOOT (build, own, operate, transfer) projects require the private operator to transfer the assets
back to the public authority after a period of time calculated to retire the private operator's debt and provide a return
to equity investors. This makes BOT and BOOT projects a useful transition to privatization in countries where the private
sector previously has not had a role in providing water services. BOO (build, own, operate) projects do not require a transfer
of the assets to the public authority.
These types of projects address the need for specific new water or sewage facilities that require a large amount of financing.
They entail an initial period of construction before revenues are generated and therefore expose lenders to greater credit,
political and regulatory risks than do concessions for already established facilities. Most of these projects are funded on
a limited recourse basis and secured by offtake or take-or-pay agreements with local governments and, where necessary, additional
credit enhancements from the national government or third parties. Examples of BOT projects include the $933 million Izmit
project in Turkey, that included completion of a dam and construction of a water treatment plant and water distribution system.
Leases and Concession Contracts
Leases and concession contracts have the potential for improving overall water and sanitation performance. They generally
require the private operator to provide the working capital needed to rehabilitate the system, expand services, or finance
other agreed-on capital improvements. Combining the responsibility for operation and investment promotes efficient investment
decisions as the operator benefits directly from improvements in productivity or technical innovations. The contract term
must be long enough to allow the private operator to recover its capital costs. The fixed assets return to the public authority
and the private operator is compensated for the residual value of the facilities it has financed on termination of the contract.
Under leases and concession contracts, private operators generally sustain payment risk as well as commercial risk. The private
operator usually pays a fee for the use of the assets, and the compensation it receives for operating and maintaining the
utility is tied directly to the tariffs. The private operator usually is responsible for billing and collection.
Asset Acquisition
Acquisition of a partial or full equity interest in an existing facility is the most extensive form of private sector participation.
Asset sales provide the greatest potential for productivity gains because the private operator assumes all commercial and
performance risks as well as the ongoing costs of capital improvements. The acquired assets provide the private operator with
collateral it can use to obtain long-term financing. Tariffs and performance standards generally remain under control of the
government or independent regulatory entities.
Equity sales have taken place in Great Britain, Chile, and Thailand but so far remain rare. Great Britain led the way by privatizing
its water industry in 1989 and establishing the Office of Water Services (OFWAT), an independent regulatory authority, to
set price limits, monitor quality, and ensure that the companies earn a reasonable rate of return on capital.
Financing: Methods and Sources
Private operators have financed asset acquisitions and facility improvements by either generating funds internally, borrowing
from commercial banks against the parent company's balance sheet or contracting debt on a limited recourse model. This last
method (a form of project finance) is promising, because it would facilitate the participation of more companies in water
projects and thereby generate more competition. It also would allow access to a broader range of capital sources.
However, implementing this approach is challenging. Lenders typically require enforceable security interests in a project's
assets and revenue generating agreements (especially in offtake agreements). Depending on the extent to which a project is
expected to yield a predictable and reliable revenue stream, lenders also may require additional security in the form of sovereign
guarantees or credit support from third parties such as export credit or multilateral agencies.
Moreover, water projects require long-term debt because water assets have long lives and governments want to keep tariffs
low. However, long-term domestic debt is available only in countries with relatively high credit ratings. For instance, recent
projects in Australia and Malaysia were financed in part with domestic bank and government loans. Projects in developing countries
generally require offshore financing.
The source of most water project financing has been offshore debt from international banks and multilateral and bilateral
agencies, including the European Bank for Reconstruction and Development (EBRD), the Inter-American Development Bank and the
World Bank's International Finance Corporation, and export credit agencies such as Japan Exim Bank, US Exim Bank, and Great
Britain's Export Credit Guarantee Department. In the United States, George Mu�oz, President of the Overseas Private Investment
Corporation, has announced that water will be a high priority for that bi-lateral agency. These institutions also provide
credit support and guarantees.
International lending creates substantial currency risks as revenues from locally operated water utilities are generated in
local currency rather than the hard currency in which the financing is provided. This exposes lenders to the risk of devaluation.
It also is difficult to increase tariffs to protect a foreign investor when the local economy is not doing well. These risks
can be mitigated in part by a reasonable tariff scheme that allows for exchange adjustments.
Direct access to capital markets for specific transactions remains rare in the water industry. The use of capital markets
can be expected to increase as the markets in developing regions mature and water utilities build stronger balance sheets.
Recent developments such as project pooling and the consolidation of small utility providers into regional multiutilities
will help strengthen balance sheets and facilitate the transition toward corporate financing. For instance, the EBRD's multiproject
financing facility (MPF) provides a framework for financing a series of projects pooled together that individually would be
too small to consider.
The sale of an equity interest in a water project or utility has the advantage of ensuring a long-term stake in a project
and reducing the debt service burden on cash flow, an especially important factor in the incipient stages of a project. Equity
financing is available from international banks such as the EBRD, which has helped finance such projects as wastewater treatment
plants in Maribor, Slovenia and Zagreb, Croatia. The EBRD also is expected to play a lead role in financing the restructuring
of the water system in Sofia, Bulgaria.
A new development is the availability of equity financing through infrastructure equity funds. In 1995, Suez Lyonnaise des
Eaux introduced a $300 million equity fund for water projects in Asia. Contributors included Allstate Insurance Company, the
Employees Provident Fund Board of Malaysia and the Lend Lease Corporation of Australia. Other funds include the Atlantis Water
Fund, LP, a $250 million private equity fund co-sponsored by the Global Environment Fund and the Poseidon Resources Corporation
and the Darby Latin American Mezzanine Fund, which has raised $225 million for infrastructure investments in various Latin
American industries.
Legal and Regulatory Considerations for Private Sector Participation
Successful private sector participation in the water industry requires an understanding of the attendant legal and regulatory
risks. Our experience in water project development in such countries as China, Argentina, Brazil, Chile, Panama and Peru has
taught us to identify those factors that best ensure a hospitable climate for private sector investment.
Host Country Considerations
A host country's political and legal environment needs to be stable and conducive to private investment. Factors to consider
range from the existence of laws protecting foreign private investment to the commitment of the government toward privatization.
A favorable legal framework for private investment includes protection for property and contract rights and for the rights
of foreign investors in general, mechanisms for limiting liability, minimal foreign exchange restrictions and the means of
enforcing applicable laws and securing remedies. Of special concern to foreign investors are the risks of expropriation and
contract erosion. Countries that encourage private investment generally provide legal protection against such risks. The constitutions
of Argentina and Chile guarantee property rights and permit expropriation only when authorized under the particular circumstances
by an enabling law and after indemnification. Each country also officially recognizes the sanctity of a contract (even where
the government is a party), affords foreign investors equal treatment under the law (Argentina by treaty and Chile pursuant
to constitutional guarantees) and permits the limitation of liability through the formation of corporations and limited partnerships.
Favorable convertibility laws provide additional protection. Argentina and Chile guarantee equal treatment of foreign and
local capital and the right to invest and repatriate profits and dividends in foreign currency, though with some restrictions.
Legal protections are all but useless in countries where the rule of law is not yet well established. Ideally, the dispensation
of legal remedies should remain untainted by politics or corruption. An independent and honest judiciary with a reputation
for fairness adds credibility and transparency to the host country's legal system and provides comfort to investors. These
factors should not be disregarded in transactions that contemplate international arbitration if there are disputes. The scope
of arbitration clauses vary and may not cover certain disputes (e.g., injunctions may require recourse to the local courts).
In China, the rule of law is not yet well established. Certain key provisions of contract law do not, on their face, apply
to government entities and legal remedies are vulnerable to the political process. Consequently, the country's history of
enforcing security interests is suspect.
An inhospitable or unstable political climate may undermine privatization efforts. Privatization of Panama's water industry
was stalled by intense political opposition and threats of a general strike in the wake of skyrocketing rates in the country's
newly privatized telecommunications' industry.
Industry Considerations
In the long run, the sustainability of a water utility may hinge on the quality of its regulatory scheme. The success of privatization
in Great Britain is attributed partly to the establishment of OFWAT, a technically sophisticated and independent regulatory
authority. The ingredients of a good regulatory scheme include an independent regulatory authority to minimize the risk of
undue political interference, transparent enforcement and conflict resolution procedures, and appropriate and predictable
incentives.
Above all, a good regulatory scheme requires a fair and transparent tariff-setting mechanism. The tariff system is the key
to securing cash flows that make long-term investment profitable. Tariffs that take into account changes in cost and inflation
as well as fluctuations in currency exchange and interest rates are more likely to provide a reasonable rate of return. Otherwise,
rates may not reflect the embedded cost of funding from offshore sources. A reliable dispute resolution mechanism also is
crucial.
Project Considerations
From a private sector perspective, an adequate risk assessment of a water project requires (at minimum) a transparent and
fair bidding process, sufficient information to conduct due diligence and well-drafted transaction documents. Competitive
bidding generally is regarded as the most effective means of ensuring a transparent and fair process and of allocating risk.
Unlike negotiated contracts, competitive bidding allows bidders to concentrate on cost and technical factors rather than time-consuming
negotiations and political caprices. Assuming all bidders receive equal treatment, competitive bidding yields better terms,
lower tariffs and results that stand up to political scrutiny and are less likely to be overturned after a change in government.
For bids to reflect the true value of a project, bidders must have access to the information necessary for a complete due
diligence. This information includes everything relevant to operating systems and personnel, financial statements and systems,
technical reports, title documents for water rights or concessions, property, contracts, and litigation and claims.
Equally important is the quality of the transaction documents. They should provide predictable procedures for renegotiations
and workable remedies for non-performance and be flexible enough to adapt to changing circumstances. Representations and warranties
should at least cover property rights, financial conditions and obligations, pending claims and litigation, existing contracts
and compliance with labor and environmental obligations. Other key terms include protection for the bidder for the period
between the award and takeover, the ability to "sell down" and leverage interest in the deal and limits on parent company
guarantees.
Lessons From the Field
The history of private sector participation in other utility sectors does give us some insight. Nevertheless, the unique characteristics
of the water industry and the relative novelty of private sector participation compel the conclusion that to date there really
is no clear paradigm for water project financing. Reminiscent of the early days of independent power projects, each transaction
must be custom made.
The message for any individual project is clear: using lessons learned "in the field" can reduce the cost and increase the
probability of carrying a water project to a successful conclusion. It is important to take advantage of the experience of
advisors who have learned these lessons under live fire and to staff projects with equally experienced personnel. On a broader
front, there is a clear role for all those who are interested in encouraging the private sector to participate in the water
industry: to participate in a dialogue among the industry's various constituents and, in this way, help improve the transparency
and effectiveness of private sector participation.
Table 1: Important Considerations
Host Country
- Stable government
- Sanctity of contract
- Equal treatment for foreign investors
- Independent judiciary
Industry Considerations
- Transparent regulatory scheme
- Independent regulatory body
- Fair and transparent tariff-setting process
Project Considerations
- Transparent and fair bidding process
- Adequate information
- Well-drafted transaction documents
This article originally appeared in the February 2000 issue of Water/Engineering Management Magazine.
