WATER GLOBAL PRACTICE Easing the Transition to Commercial Finance for Sustainable Water and Sanitation AUGUST 2017 Amanda Goksu, Sophie Trémolet, Joel Kolker, and Bill Kingdom About the Water Global Practice Launched in 2014, the Word Bank Group's Water Global Practice brings together financing, knowledge, and implementation in one platform. By combining the Bank's global knowledge with country investments, this model generates more firepower for transformational solutions to help countries grow sustainably. Please visit us at www.worldbank.org/water or follow us on Twitter at https://twitter.com/search?q=%40WorldBankWater&src=tyah. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation AUGUST 2017 Amanda Goksu, Sophie Trémolet, Joel Kolker, and Bill Kingdom © 2017 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Contents Acknowledgments vii Executive Summary ix Abbreviations xv Chapter 1  Introduction 1 1.1 A Global Commitment to Water and Sanitation for All 1 1.2 Purpose and Scope 1 1.3 The Broader Agenda: It’s Not Just About Money 2 1.4 Target Audience 4 1.5 Report Content 4 Note4 Chapter 2  Why Is a New Financing Framework Needed? 5 2.1 The Status Quo Is Not Enough 5 2.2 The Investment Gap Is Widening 5 2.3 The Financial Landscape Is Changing 7 2.4 The Potential Benefits Are Immense 8 2.5 How Is the WSS Sector Currently Funded? 10 2.6 Conclusion 14 Notes 14 Chapter 3  A Proposed Framework for Financing Universal Access 17 3.1 Easing the Transition 17 3.2 Why Does WSS Not Typically Attract Commercial Finance? 19 3.3 A New Financing Framework 21 3.4 Conclusion 21 Notes 21 Chapter 4  Component 1: Plan, Budget, and Allocate Public Resources More Efficiently 23 4.1 What Needs to Change? 23 4.2 WSS Sector Strategy and Policy 23 4.3 Sector Financial Planning and Budgeting 25 4.4 More, and Better, Subsector Allocation 26 4.5 Better Use of Tariffs and Subsidies 27 4.6 Funding and Capacity Building of WSS Sector Institutions 31 4.7 Conclusion 32 Notes 32 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation iii Chapter 5  Component 2: Improve Service Providers’ Performance and Governance 33 5.1 What Needs to Change? 33 5.2 The Status Quo 33 5.3 Incentives for Efficiency 34 5.4 Conclusion 39 Note40 Attract Commercial Finance Chapter 6  Component 3: Leverage Public Funds to ­ 41 6.1 What Needs to Change? 41 6.2 How Blending Can Help Bridge the Finance Gap 41 6.3 Building Demand 43 6.4 Building Supply 46 6.5 Conclusion 49 Notes 49 Chapter 7  Bringing It All Together 51 7.1 Recapping the Objectives 51 7.2 Finance as Part and Parcel of Broader Sector Reform 51 7.3 Conclusions and Strategic Recommendations 52 Appendix A  Types of Commercial Finance 57 Appendix B  Analysis of Lending Parameters on Borrowing Costs 61 Debt Service: Short Term Affordability versus Total Cost 61 The Impact of Foreign Exchange Fluctuations 62 The Cost of Delay 63 Note66 References67 Boxes ES.1. What Is Commercial Finance? x 1.1. SDG 6: Water and Sanitation for All by 2030 2 1.2. Relevant WGP Publications on Financing Universal WSS Access 3 2.1. Three Key Differences between the MDGs and the SDGs 5 2.2. The Camdessus Panel: A First Attempt to Break the Status Quo 7 2.3. The Potential of Climate Finance 8 2.4. The Real Cost of Water for the Poor 9 3.1. Lessons from the East Asia Financial Crisis 18 4.1. The Cost of Misaligned Incentives 24 iv Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 4.2. The Capacity to Spend Effectively 25 4.3. Strategic Financial Planning (SFP) 25 4.4. Implicit Subsidies Cannot Be Well Targeted 30 4.5. Making Fiscal Transfers Dependent on Good Performance in Egypt 31 5.1. What Makes a Service Provider Creditworthy? 35 5.2. Key Considerations for Promoting Efficient Service Delivery 36 5.3. Cost-Recovery Policy Catalyzes Utility Turnaround in Vietnam 38 6.1. Blended Finance to Reduce Rural Sanitation Costs in Bangladesh 43 6.2. Typical Blended Finance Strategies 44 6.3. Incentives for Sector Performance in Kenya 46 6.4. Colombia’s Municipal Development Fund 47 6.5. A Pooled Municipal Bond Issue to Help Small Providers Access Private Finance in India 48 7.1. The Evolution of WSS Sector Reform in Mozambique 53 Figures ES.1. WSS Financing Framework xi 1.1. The Cycle of Improved Sector Performance 4 2.1. Costs of Extending WASH Access under SDGs (2016–30) Relative to MDGs (2000–15) 6 2.2. Access to Improved Sanitation and Under-Five Mortality Rate, by Population Size, Selected Countries, 2015 9 2.3. Traditional Revenue Sources for the Water Sector 10 2.4. Uses of Commercial Finance, by Borrower Size and Financing Need 12 2.5. Sources of Finance vs. Implementation Models 13 2.6. Composition of WASH Sector Funding, by Type, for Brazil, Ghana, and Mali 14 3.1. Proposed WSS Financing Framework 21 4.1. Example of Financing Strategy for the Rural Sanitation Subsector 24 4.2. Virtuous Cycle of Providers’ Customer-Orientation and Financial Sustainability 28 5.1. Vicious Cycle Affecting Many Service Providers 34 5.2. Efficiency Improvements that Help Utilities Reach Financial Viability 38 5.3. How Tariffs, Taxes, and Efficiency Can Transform Each WSS Subsector 40 7.1. Potential Pathways to Fill the WSS Financing Gap 52 B.1. Effect of Loan Maturities on Tariffs 62 B.2. Affordability vs. Total Debt Service: Loan Repayment Amounts, by Year, at Different Maturities 63 B.3. Foreign Exchange Costs on a 15-Year Concessional Loan 64 B.4. Consequential Costs of FX Concessional Loans, with and without Five-Year Delay 65 Tables 2.1. WASH-Related MDG and SDG Definitions, by Target 6 3.1. Benefits of Mobilizing Commercial Finance for the WSS Sector 18 3.2. Objectives of Service Providers and Lenders 20 4.1. Global Population Still Lacking Access to WSS, by Type and Subsector, 2016 26 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation v 6.1. Measures that Help Commercial Finance Work for Borrowers and Lenders 42 6.2. How Select Blending Instruments Can Support Different Types of Commercial Finance 44 B.1. Loan Repayment on a Local Currency Loan at Different Maturities 62 B.2. Comparison of Foreign and Domestic Currency Loans 63 B.3. 15-year Foreign and Local Currency Loan Repayment at 3 Percent Interest 64 B.4. Concessional Loan Costs, with and without Five-Year Delay 65 vi Easing the Transition to Commercial Finance for Sustainable Water and Sanitation Acknowledgments This report was written by Amanda Goksu (Consultant, Water Global Practice), Sophie Trémolet (Sr. Economist, Water Global Practice) and Joel Kolker (Lead WSS Specialist, Water Global Practice) under the leadership and guidance of Bill Kingdom (Lead WSS Specialist, Water Global Practice). The authors are grateful to Aldo Baietti ­ (Consultant, Water Global Practice) for his critical contributions. This work forms part of a larger effort undertaken by the Water Global Practice of the World Bank, led by Joel Kolker and Sophie Trémolet, to address the need for further guidance and advocacy on financial options for meeting the Sustainable Development Goal (SDG) for water. An initial version of this report was prepared for the High-Level Panel on Water (HLPW), which was con- sitting vened by the United Nations Secretary-General and the President of the World Bank Group, consisting of 11 ­ Heads of State and Government and one Special Adviser, to provide the leadership required to champion a com- prehensive, inclusive and collaborative way of developing and managing water resources, and improving water and sanitation related services. Subsequent development was undertaken jointly by the World Bank and UNICEF in support for the preparation of the Sanitation and Water for All High-Level meetings held in April of 2017 in Washington, DC. These meetings gathered Ministers of Finance and Ministers responsible for Water, Sanitation and Hygiene from over 50 low- and middle-income countries to discuss the way forward for achieving universal access to water and sanitation services. The team would like to thank peer reviewers Yogita Mumssen (Sr. Infrastructure Economist, Water Global Practice),  George Butler (Principal WSS Specialist, IFC), Charles Delfieux (Sr. WSS Specialist, Water Global Practice), Helen Mary Martin (Sr. PPP Specialist, Water Global Practice), John Ikeda (Sr. Financial Specialist, Water Global Practice), Mark Giblett (Sr. Infrastructure Financial Specialist, Water Global Practice) and Jemima Sy (Sr.  Infrastructure Specialist, Water Global Practice) for their inputs. Dominick de Waal (Sr. Economist, Water Global Practice), Guy Hutton (UNICEF) and Sanjay Wijesekera (UNICEF) also provided input into the earlier version of this report for Sanitation and Water for All. Finally, the team is very thankful for the support and guid- ­ ance of Guangzhe CHEN (Sr. Director, Water Global Practice), Jyoti Shukla (Director, Water Global Practice) and Maria Angelica Sotomayor (Practice Manager, Water Global Practice). Easing the Transition to Commercial Finance for Sustainable Water and Sanitation vii Executive Summary The Challenge in many low- and middle-income countries relies on public funds that are insufficient, poorly targeted, Since the turn of this century, many countries have and often crowd out, rather than crowd in, new made significant progress toward meeting their water sources of financing. This model will not deliver on and sanitation access goals. At a global level, the the SDG targets. Millennium Development Goal (MDG) target for water was achieved by 2010, but the target for sanitation A new paradigm is therefore needed that turns this was not achieved by 2015. During the MDG period a approach on its head and asks governments to work total of 2.6 billion people gained access to improved toward “crowding in” commercial finance to supplement water, and 2.1 billion gained access to improved existing sources of finance. This approach will help ­sanitation (WHO/UNICEF 2015). ensure that service providers strive toward more effi- cient services and that scarce public funds are used in Despite this worldwide effort, 660 million people still a more targeted manner. The overall objective is for lack access to clean water, and 2.4 billion lack access to those currently without WSS services, who are sanitation. Coupled with the growing challenges of the predominantly poor, to have the same access that ­ 21st century—rapid urbanization, climate change, wealthier citizens already receive—and at a price that is pollution, and higher demand for water resources—the ­ affordable to them. challenge of bringing water supply and sanitation (WSS) to all remains immense. The Possibility Eager to meet this challenge, the global community has responded by endorsing Sustainable Development Goal Increasing the level of commercial finance for the sector 6 (SDG 6)—the so-called “water SDG”—which calls for would allow service providers to borrow and invest in universal access to WSS services by 2030 that are safe, expanding and improving the quality of WSS services, affordable, and available when needed. In addition, without having to wait for scarce public resources to be there are targets for increasing efficiency of water use made available. A gradual move to mobilizing more across all sectors, protecting and restoring water-­ finance requires improving the financial performance related ecosystems, and improving water quality. of service providers through a mix of improved techni- cal and commercial efficiencies and through gover- The cost of meeting the targets of SDG 6.1 and 6.2 is nance and regulatory reforms. These improvements substantially higher than current annual WSS invest- will generate the financial surplus needed to access ment levels. Historical levels of funding for extending commercial finance, thus complementing limited access to water supply, sanitation, and hygiene ­public funds. services during the MDG era were estimated (WASH) ­ at $16  ­ billion in 140 countries, whereas what’s Although commercial finance generally comes at a higher needed to ensure universal access to safely managed up-front cost, it has many significant benefits over con- services by 2030 is around $112 billion per year (World cessional finance, including faster access to finance, Bank/UNICEF 2017). In  essence, the sector is cur- more flexibility in the use of the funds, and greater rently only financing about 15 percent of the esti- responsiveness to changes in circumstances (box ES.1). mated needs. Clearly, the status quo financing model Taken together, these advantages will translate into Easing the Transition to Commercial Finance for Sustainable Water and Sanitation ix BOX ES.1. What Is Commercial Finance? In this report, commercial finance refers broadly to various types of finance that are neither concessional finance nor official development finance, and which are usually provided at market rates. In the water sector, this can range from microfinance loans to bonds and can be offered to service providers, local governments, individual users or user groups. Providers of commercial finance may include domestic commercial banks, microfinance institutions or capital market investors (via bonds or equity). faster results and benefits on the ground. Commercial The question is not whether to finance with public or finance is also associated with further improving the private money. More of both will be needed—and governance and accountability of service providers. sooner rather than later. This will require a transition Moreover, commercial finance can help countries tap to a more balanced mix of public and commercial into domestic financial resources that are new to the financing, which must be driven by changing mindsets sector, such as pension funds or institutional inves- across all sector stakeholders: central governments, tors. And when dominated in local currency commer- local governments, customers, donors and financiers. cial finance does not carry foreign exchange risk. The proposed framework (figure ES.1) advocates a Borrowers can blend concessional with commercial transition that uses public funds to leverage commercial ­ loans  to reap some of these benefits while maintaining finance. This transition is not just about money. affordability, as evidenced by the many countries that It requires attention to better targeting of scarce public have already started the transition: funds, improving the efficiency and governance of ser- vice providers, using capital more efficiently, and • Indonesia’s ambitious WSS targets are backed by a developing new financing relationships in the sector— financial strategy that leverages commercial finance. between service providers (as borrowers) and banks • The Arab Republic of Egypt is using public funds as (as lenders). an incentive for improving the performance of sani- The net effect is to build a sector that uses every dollar of tation service providers. scarce public funds to deliver maximum benefit to • Kenya is pioneering the use of shadow credit ratings ­society. Countries can prioritize efficiency and leverage to attract a new cadre of financiers. their resources through working on the framework’s • In Colombia, donor-funded credit enhancements three components (figure ES.1): have already paved the way to a commercially ­viable sector. • Plan, budget, and allocate public resources more efficiently • Countries from Bangladesh to Malawi are expanding the use of microfinance in WSS. • Improve service providers’ performance and governance The Proposal • Leverage public funds to attract commercial finance This report calls for countries to place a greater priority The three components of the framework can progress in on leveraging commercial finance into the sector while at parallel. However, in nearly all cases it will be critical to the same time bolstering public funds for the sector. first work on the main foundational components so as x Easing the Transition to Commercial Finance for Sustainable Water and Sanitation FIGURE ES.1. WSS Financing Framework additional funding (particularly domestic financing) from tariffs, charges, and government taxes. Given the range of possible government financing sources in the sector, this will require close coordination and 3 Leverage public policy enforcement across a range of line ministries— funds to attract including finance and water and sanitation—as well as commercial inance local governments. Component 2: Improve Service Providers’ Performance and Governance 1 2 Efficiency gains are a source of untapped finance, and Plan, budget and Improve service inefficiencies represent an opportunity cost to the allocate public providers’ resources more performance government or service provider. Improving both opera- ­ ef iciently and governance tional and capital efficiency allows service providers to deliver better services more cheaply, thereby freeing up resources to invest in improving or extending services. Moreover, improved efficiency and service ­ Note: WSS = water supply and sanitation. quality can help justify increased tariffs and transfers from government sources because stakeholders are to improve sector efficiency and targeting of existing more willing to pay or allocate funding when services resources and thus enable the leveraging of commer- improve. cial finance. Governments should expect more from service providers Reforms made within each component will be iterative and incentivize improved efficiency, in terms of both and incremental to allow for policies and capacity to operational performance and the use of capital. Under align. There are also significant feedback loops among the right corporate governance and incentive struc- the components as represented by the overlapping tures, service providers will recover more costs, use ­ circles. For example, investor scrutiny resulting from less capital, and become more self-sufficient—building actions in component 3 can improve transparency and the foundations that will enable them to attract com- efficiency in component 2. mercial finance on their own. Component 1: Plan, Budget, and Allocate Public Resources More Efficiently Component 3: Leverage Public Funds to Attract Governments need to establish the policy, planning, and Commercial Finance governance frameworks that will improve sector effi- Public funding should be used to leverage commercial ciency and creditworthiness to attract the commercial finance to the extent possible at any time. This will finance required to meet WSS goals. In most countries, require governments, through their line ministries and major sector reforms will be needed. Sector policies local governments, to take leadership in the design need to be realistic, fully funded, and integrated with and implementation of an integrated and consistent investment plans that, at the local level, include approach to sector financing built around policies that well-defined and well-targeted subsidies. Incentives encourage efficiency and mobilization of new sources need to be created to improve performance. Policies of capital. Such leadership is based on an acceptance need to encourage mobilization and  efficient use of that change is needed, and that financing costs may Easing the Transition to Commercial Finance for Sustainable Water and Sanitation xi increase, but that the benefits flowing from faster sector that has traditionally relied on public or conces- access to improved WSS services will outweigh the sional funds for the bulk of its investments, particularly cost of failing to act now to mobilize these new sources in emerging markets. It will require new thinking and of financing. new policies that are not yet readily available. It will also require all stakeholders to buy into, and support, Building the foundations for commercial finance in the this new paradigm and for each to take responsibility sector will take time. Creating new markets between for those parts they can influence. The goal is to deliver lenders and borrowers will also require ongoing sup- universal access to sustainable WSS services. port from the public sector. Commercial borrowing terms will normally be less attractive at face value than It is important to note that accessing commercial or pri- those of concessional finance, but using domestic vate finance does not equate to privatizing the sector. In commercial finance has the potential to save money fact, in many high-income countries, publicly owned in  the long run, especially in countries with high water service providers have leveraged substantial com- ­currency risk. mercial finance without relinquishing control over man- agement of the service or selling shares. For example, Affordability is often given as a reason for not accessing the majority of people living in the United States are commercial finance. However, such concerns can be served by publicly owned water utilities. Many of these addressed, in a practical and transitional way, by utilities have relied for the past 40 years on State blending concessional or public funds with commer- Revolving Funds created by the Clean Water Act to tap cial finance—for example, with grants and tenor exten- into domestic bond investors. This is because the source sions. These approaches will mitigate the potentially of finance is separate and different from the implemen- higher borrowing costs of private finance relative to tation model (that is, who owns or manages the assets). concessional funds, which currently dominate the sector. As with any paradigm shift, the transition will require It is important to recognize the “supply side” of this strong political will and government leadership. new paradigm. Even if service providers are efficient Recognizing that the current funding model will not and well governed, that doesn’t mean lenders will deliver WSS goals by 2030, governments need to take immediately respond to new lending opportunities a holistic and long-term policy view of the sector. when they are presented. Certain financing tools can Initial investments will have high rewards in the be catalyzed to de-risk the sector and make it more medium and long term, but will require the strategic attractive to lenders—including, for example, guar- use and targeting of limited public and donor antees, benchmarking, creditworthiness assess- resources to facilitate the new model. Consistent ments, and project preparation funds. Political application of a national sector policy to encourage leadership is needed to pioneer the use of de-risking new sources of finance will be important. Regression tools in nearly all countries, and especially in less-de- to a politically expedient public-finance-only model veloped countries where financial markets are still will undermine progress toward the new, balanced evolving. financing model proposed here. Political leadership is therefore critical if the sector is to reach the ambi- The Paradigm Shift tious goals of universal access. Crowding in will take the place of crowding out, or simply The Water Global Practice (WGP) of the World Bank sup- ignoring, commercial finance. This is a new mindset for a ports this paradigm shift, which is in line with the xii Easing the Transition to Commercial Finance for Sustainable Water and Sanitation Financing for Development agenda outlined at the Addis and governance that guide institutions via the  right Ababa conference in July 2015. Access to finance incentives. This paper refers to other recent publica- requires technical and financial efficiency of sector tions prepared by the WGP on these broader topics. institutions, as well as a strong enabling environments Easing the Transition to Commercial Finance for Sustainable Water and Sanitation xiii Abbreviations GLAAS Global Analysis and Assessment of Sanitation and Drinking-Water IBT increasing block tariffs IDA International Development Association KPI key performance indicator LMICs low- and middle-income countries MDB multilateral development bank MDG Millennium Development Goal NGO nongovernmental organization NRW non-revenue water O&M operations and maintenance ODA Official Development Assistance OECD Organisation for Economic Co-operation and Development PPP public-private partnership PSP private sector participation RBF results-based financing SDG Sustainable Development Goal SFP strategic financial planning SOE state-owned enterprise SSIPs small-scale independent service providers TA technical assistance WASH water supply, sanitation, and hygiene WSCs water and sanitation companies WSS water supply and sanitation Note: All dollar amounts are in U.S. dollars, unless otherwise noted. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation xv Chapter 1 Introduction 1.1 A Global Commitment to Water and Moreover, rural areas are likely to remain relatively Sanitation for All poorer and isolated from the benefits of urban develop- ment, including access to WSS services. In 2015, most Providing sustainable water supply and sanitation (WSS) people without WSS services were poor and living in services in developing countries remains an immense, rural areas in Africa and Asia. Fewer than 15 percent of and increasingly urgent, challenge. Although the countries in Africa report having ways to explicitly Millennium Development Goal (MDG) target was met— reduce inequalities in access to sanitation for the poor, to halve, by 2015, the gap in access to improved WSS and less than one third for access to water (WHO/ services—some 660 million people still lack access to UN-Water 2014a). In Nigeria, 34 percent of rural resi- clean water. The MDG target for sanitation was not dents live more than two hours from a functioning achieved, and approximately 2.4 billion people lack water source (World Bank, 2017a). The high levels of access to improved sanitation, while 1 billion people inequality in some countries will continue to deepen still defecate in the open. unless governments make a concerted effort to rebal- Adopted in 2015, the Sustainable Development Goals ance the use of public resources. (SDGs) set the bar even higher. These global goals call Meeting WSS goals, whether SDGs or lower levels of ser- for universal, safe, and affordable WSS access by 2030, vice, will require multiple institutions working in parallel along with other improvements in the way water is toward the same end, each within its own sphere of managed as a resource. The costs are commensurate influence. All sector stakeholders must not only bolster with the heightened ambition. Existing sources of their individual performance—in governance, policy, funding do not come close to covering the need for technical capacity, and public and private finance—but new infrastructure investments, and countries will also integrate these reforms in a way that can translate need to tap into new sources of finance to meet the more and better-targeted investments into more and growing demand for WSS services. better services. The water sector, as a composite of At the same time, global demand for water—in urban multidisciplinary institutions, must address multiple areas especially—is rising alongside population growth challenges, from regulation to efficiency to affordability. and economic development, while the quality and avail- The sector can only attract the financing needed to ability of this resource is becoming more variable. The ensure sustainable services for this generation and the urban populations of Africa and Asia are expected to next if substantial progress is accomplished on such double between 2000 and 2030, changing where and foundational elements. how water is being managed to generate energy, fuel  industry, produce food, and keep more people 1.2 Purpose and Scope living healthy and productive lives. The opportunities afforded by development will come at an environmen- The purpose of this report is to bring together the current tal cost as urban centers find their surface and ground- state of knowledge on water sector finance in developing water resources more polluted. These water stress countries and to set out the World Bank’s vision for factors combine to put a higher price tag on delivering how countries can finance their WSS-related goals under sustainable WSS services. increasingly challenging contexts. The report articulates Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 1 a framework to help countries use public resources reach, putting in place fair regulatory arrangements more effectively to crowd in new sources of finance and that maximize efficiency gains while ensuring afford- formulates practical recommendations for doing so. ability for the poorest, and dealing with rising uncer- tainty due to climate change. All of these aspects will It focuses specifically on financing the Water SDG have an impact, either direct or indirect, on how sector (Goal  6), particularly on the WSS-related SDG targets financing can be mobilized. 6.1–6.4 (box 1.1). The scope includes both urban and rural services provided for domestic, commercial, and This report draws on a series of publications that the limited industrial uses. World Bank’s Water Global Practice (WGP)—in its support to the High Level Panel on Water—produced to articulate 1.3 The Broader Agenda: It’s Not Just a proposed approach to tackling the challenge of financ- About Money ing universal access to WSS.1 These documents are high- lighted in box 1.2. Mobilizing finance, while the main topic of this report, is clearly not the only challenge to achieving universal This report is in line with the agenda outlined at the July access. Strong institutions are a prerequisite for trans­ 2015 Financing for Development conference in Addis lating investments into safely managed services. Other Ababa, and it proposes a new approach to bringing challenges include identifying the right technological the  sector toward universal and sustainable WSS solutions that can extend services to the hardest to service  delivery. The stepwise approach to finance, BOX 1.1. SDG 6: Water and Sanitation for All by 2030 SDG 6 comprises eight ambitious targets rolled into one, including both universal and equitable access to safe and affordable water supply, sanitation, and hygiene by 2030, as well as more sustainable water resource management. These goals go far beyond the challenge of access to services. They address the entire cycle affecting the availability and quality of those services. This starts with abstraction—to ensure efficient and sustainable use of water resources—and ends with the proper treatment and disposal of waste generated by WSS services, including wastewater and fecal sludge. This report focuses on the four targets most closely related to WSS: 6.1. Achieve universal and equitable access to safe and affordable drinking water for all. 6.2. Achieve access to adequate and equitable sanitation and hygiene for all, and end open defecation, paying special attention to the needs of women and girls and those in vulnerable situations. 6.3. Improve water quality by reducing pollution, eliminating dumping, and minimizing release of hazardous chemicals and materials, halving the proportion of untreated wastewater, and substantially increasing recycling and safe reuse globally. 6.4. Substantially increase water-use efficiency across all sectors and ensure sustainable withdrawals and supply of freshwater to address water scarcity, and substantially reduce the number of people suffering from water scarcity. Source: Adapted from the United Nations Sustainable Development Knowledge Platform 2015. 2 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation BOX 1.2. Relevant WGP Publications on Financing Universal WSS Access 1. Achieving Universal Access to Water and Sanitation by 2030: The Role of Blended Finance (Leigland, Trémolet, and Ikeda 2016). The WGP prepared this discussion paper and associated case studies to support countries’ efforts to mobilize commercial finance for service provision. 2. Financing Options for the 2030 Water Agenda. (Kolker et al. 2016). Targeted to multilateral development banks, this WGP Knowledge Brief was prepared to orient the actions of the High Level Panel on Water (HLPW) to mobilize financial resources and scale up investment for SDGs 6.1 and 6.2. It aimed to underpin the formulation of recommendations and commitments at the Budapest Water Summit 2016 and beyond. 3. Aid Flows to the Water Sector: Overview and Recommendations (Winpenny et al. 2016). This paper, in support of the HLPW, provides a complete picture of recent trends in aid to the water sector. 4. Training courses on creditworthiness and financing access were delivered to World Bank staff and clients in 2016 and 2017. 5. Sanitation and Water for All: How Can the Financing Gap Be Filled? (World Bank and UNICEF, 2017). This discussion paper supported preparations for the Sanitation and Water for All Finance Ministers’ Meeting, held at World Bank headquarters in April 2017. 6. Briefing Note on Capital Efficiency in the Water, Sanitation, and Wastewater Treatment Sector (World Bank, forthcoming [a]). This discussion paper recommends the most efficient use of capital spending funding flows for delivering the municipal and rural domestic elements of SDG 6. 7. Global Study on Institutional, Policy, and Regulatory (IPR) Incentives for WSS Services (World Bank,  forthcoming [b]). This WGP flagship output consolidates the experiences of 11 countries in WSS sector reform. 8. Utility Turnaround Framework (World Bank, 2017b). This WGP flagship publication conceptualizes key attributes of successful turnarounds based on recent global experiences. presented  in figure 1.1, aims to instigate a virtuous must be put in place through institutions, policies, and/ cycle of sector performance such that service provid- or regulation for service providers to start efficiency ers will climb the ladder toward creditworthiness to improvements. be able to attract increasingly larger volumes of com- This cycle of continuous improvement happens over a mercial finance. long period of time, with many incremental steps happen- Two foundational components are required for the transi- ing within each block in a given country. Thus, to give the tion to commercial finance to take shape. As shown in the audience a more realistic view of how reforms happens orange bars in figure 1.1, an enabling environment must in an incremental and iterative way, this report proposes first be created through strong governance and institu- a “financing framework” (figure ES.1) derived from the tional arrangements. Second, performance incentives cycle shown in figure 1.1. Rather than providing steps to Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 3 FIGURE 1.1. The Cycle of Improved Sector Performance out how they can engage in the water sector more actively. Goal Universal and sustainable WSS service delivery 1.5 Report Content Chapter 2 sets out how the sector Commercial inance is currently funded and why busi- ness as usual is insufficient for meeting WSS-related goals, cov- Approach Creditworthiness ering the size of the investment gap, and the challenges presented Ef iciency and cost recovery by the status quo. Chapter 3 proposes a financing framework toward more effective Foundation use of existing funds to enable the Governance and Performance institutional mobilization of new sources of incentives arrangements finance, and explains the benefits and costs of commercial finance. Chapters 4 to 6 detail the three the ultimate goal, the framework is organized around components of the financing framework, providing three entry points (called components) where sector practical advice and global experiences that demon- stakeholders can begin the transition. strate how countries can begin to make progress. 1.4 Target Audience Chapter 7 summarizes how stakeholders can bring the three components together to mobilize commercial The intended audience for this report includes water sector finance, and provides the main conclusions and rec- and other development professionals working on the ommendations of the report. delivery of safely managed WSS services. These include staff from central governments (line ministries, minis- tries of finance, regulatory agencies, and so on); subna- Note tional governments; local or municipal governments; 1. The High Level Panel on Water (HLPW), convened by the UN Secretary-General and the President of the World Bank Group, and service providers, development agency staff, foun- focuses on the commitment to achieve SDG 6 and to contribute dations, and nongovernmental organizations (NGOs). to  the  achievement of other SDGs that rely on the develop- The report also seeks to engage financiers—domestic ment and management of water resources. For more information, see the  HLPW website on the UN Sustainable Development financiers in particular (including banks, microfinance Knowledge Platform: https://sustainabledevelopment.un.org​ institutions, institutional investors, and others) to lay /­HLPWater. 4 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation Chapter 2 Why Is a New Financing Framework Needed? 2.1 The Status Quo Is Not Enough $500 billion annually—excluding environmental and other nonmonetized impacts (Sadoff et al. 2015). Inadequate water supply and sanitation (WSS) service costs low- and middle-income countries (LMICs) an 2.2 The Investment Gap Is Widening estimated $260 billion per year through various economic impacts—from poor health to environmen- Providing sustainable WSS services in LMICs remains an tal degradation—which equates to 1.5 percent of immense, and increasingly urgent, challenge. Although global gross domestic product (GDP) (WHO 2012). the Millennium Development Goals (MDGs) were par- In some very poor countries, this figure may rise to tially met, none of the 48 least-developed countries 10 percent of GDP. met the WSS targets. The achievements left behind large parts of the global population—primarily the Access is highly unequal within countries and can be a poor, rural residents and many people living in South significant factor in exacerbating poverty. For example, Asia and Sub-Saharan Africa. in Mozambique, 90 percent of underweight mothers also only have access to an unimproved sanitation Adopted in 2015, the Sustainable Development Goals facility. The divide is also clear between urban and (SDGs) set the bar even higher (box 2.1). These global rural areas: in Ecuador, 93 percent of people in urban goals call for achieving universal and equitable access areas have access to improved water services, but to safe and affordable water supply, sanitation, and 24 percent of the rural population still drinks contam- hygiene (WASH) and for ending open defecation—and inated water (World Bank, forthcoming [c]). the costs are commensurate with the heightened ambition (figure 2.1, table 2.1). Existing sources of New global water stressors, from urbanization to climate funding do not come close to covering the need for change, are compounding the challenge at a steady pace. new infrastructure investments, and countries will LMICs are becoming more urban and more industrial- need to tap into new  sources of finance to meet the ized. They have higher standards of living and evolv- ing tastes that demand more and higher-quality WSS BOX 2.1. Three Key Differences between services. By 2030, under current water management the MDGs and the SDGs and pricing regimes, water demand will exceed supply by about 40 percent (2030 WRG 2012). 1. Universal coverage: From halving the pop- Communities also need better ways of coping with more ulation without access to achieving univer- intense water-related hazards. Floods and droughts are sal access particularly menacing, destabilizing communities and 2. Comprehensive coverage: From a focus on creating humanitarian crises. Drought has been WSS to considering the whole water cycle deemed the deadliest physical hazard that exists today, affecting more than 2 billion people since the begin- 3. Sustainable coverage: From basic access to safely managed access ning of the 20th century (WWAP 2012). Water insecu- rity is a drag on economic development on the order of Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 5 FIGURE 2.1. Costs of Extending WASH Access under SDGs (2016–30) of a lack of an adequate system for Relative to MDGs (2000–15) tracking WSS sector spending, investments in extending access to 50 46 WASH services were estimated at $16 billion per year during the MDG 40 period (Hutton and Varughese 2016). This is less than the capital Expenditures ($, billions) costs of expanding basic access to 30 26.6 WASH services. (What now quali- 25 fies as “basic” under the SDGs was 20 referred to as “improved” under 14.5 14.8 the MDG definitions.) What’s needed to deliver universal access 10 7.8 6.8 to safe services under the SDGs is 5.5 4.0 2.5 around $112 billion per year (rang- 1.4 1.4 0 ing from $74  billion to $166 bil- Rural Urban Rural Urban lion), or 0.39 percent of GDP. Most Drinking water Sanitation and hygiene of this investment will be needed Annual spending, 2000–15 for sanitation, with 40 percent for Annual requirement to meet basic WASH by 2030 urban sanitation and 20 percent Annual requirements to meet safely managed WASH by 2030 for rural sanitation (figure 2.1). Source: World Bank/UNICEF 2017. Moreover, O&M costs are expected Note: WASH = water supply, sanitation, and hygiene. to be 1.6 times more than capital costs per year by 2029 (Hutton and TABLE 2.1. WASH-Related MDG and SDG Definitions, by Target Varughese 2016). MDG SDG Basic accessa Safely managed access To provide safely managed services Drinking water • Within a 30-minute • On premises in a sustainable manner, both the round trip • Available when needed assets and the quality of service • Free from contamination they deliver must be maintained over time. Many countries do not Sanitation and • Hygienic separation of human • Not shared with another household hygiene excreta from human contact routinely consider the long-term • Proper disposal and treatment of waste O&M costs of existing infrastruc- Note: MDG = Millennium Development Goal; SDG = Sustainable Development Goal. a. Formerly known as “improved” under the MDGs. ture or include those costs in costing exercises. Moreover, few growing demand, not just for more services for more countries have monitoring sys- people, but also to fund adequate operations and tems in place to measure the functionality of rural water maintenance (O&M) as well as supervision for more points, or the use of septage treatment facilities several sustainable services. years after construction. A  recent calculation by the Capital and operating costs for WSS service provision U.K. Department for International Development (DFID) needed under the SDGs will be much higher than current of value for money of rural WASH services in six coun- spending levels. Although information is scarce because tries showed that information on sustained outcomes 6 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation was lacking in all but one country—Bangladesh—and redirected in a way that would facilitate more private also showed that 85 percent of public deep tube wells sector lending or lending to subnational governments. remained in service after six years (Trémolet et al. Most concessional financiers have continued to lend 2015). To deliver sustainable services, more funds will primarily to national governments and to benefit from need to be directed to measuring the continued use sovereign guarantees, with little or no effort to lever- and quality of WSS infrastructure. age private finance. Second, on the demand side, ser- vice providers have remained largely inefficient and 2.3 The Financial Landscape Is Changing unable to attract private finance on their own.2 Previous attempts at changing the approach to sector Today’s financing landscape has been further altered by financing were made more than a decade ago. Shortly the 2008 global financial crisis and subsequent banking after the MDGs were articulated, the World Panel on sector reforms. The resulting banking regulations Financing Water Infrastructure (referred to as the (including Basel III) have generally reduced interna- “Camdessus Panel,” after its chairman) was formed to tional financiers’ risk appetite for longer tenor loans. identify what was needed to mobilize finance in the Moreover, new international development partners water sector (box 2.2). The panel’s report was one of are joining the field, including the Bill and Melinda the first comprehensive investigations into a wide Gates Foundation, the Asian Infrastructure Investment range of financing options for WSS (Winpenny 2003). 1 Bank (AIIB), and a number of national development banks in middle-income countries. Finally, another Neither the Camdessus report nor subsequent reports of potential new source is climate finance. this nature triggered significant increases in flows of pri- vate finance to the water sector. Change has been mini- Given that most of the impacts of climate change will be mal, and LMICs have experienced varying levels of felt through water resources, climate funds hold the success with leveraging private finance. There are two promise of mobilizing additional aid and private flows to likely reasons for this. First, from the supply side, the sector. In 2014, $392 billion was invested globally although ODA has since doubled, flows were not toward climate action, more than a third of which BOX 2.2. The Camdessus Panel: A First Attempt to Break the Status Quo The World Panel on Finance Water Infrastructure presented its findings in March 2003 at the 3rd World Water Forum in Kyoto, Japan. The report’s extensive list of 90 recommendations included improved governance, tariff reforms, sector planning, and using official development assistance (ODA) in a more catalytic way to facilitate more private finance. The report called for doubling all financial flows to the sector from all sources, including private finance. Among the options for accelerating private investment flows were credit ratings, multilateral development bank (MDB) guarantees, and political risk coverage; the use of securitization and collateralization of loan-debt obligations by banks; public-private partnerships (PPPs); output-based aid (OBA) subsidies; and credit pooling by subnational governments. To mitigate foreign exchange risk for international water financiers, the report also recommended the creation of a devaluation liquidity backstopping facility. Source: Winpenny 2003. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 7 came from and was invested in LMICs (Buchner et al. $15 trillion (IMF 2016). Total development finance 2015). Overall, domestic investment constitutes from MDBs in 2015 was equal to just 1 percent of this, at 74 percent of all climate finance, mostly from private around $127 billion (World Bank 2015a). project developers. There is huge potential to match water projects with increasing opportunities for cli- 2.4 The Potential Benefits Are Immense mate finance (box 2.3). However, some of these funds The projected global (average) economic return on uni- are concessional and are constrained by certain versal access to water supply and sanitation is $4.3 for requirements (such as sovereign guarantees), while every $1 invested (WHO 2012), and is higher for sanita- some are not. tion than for water. The benefits of improved liveli- As private participation in the water sector is decreasing hoods include reduced mortality and morbidity, and commercial banks are being more selective, it is more-productive people (less illness and less time more important than ever for development partners and spent collecting water), improved dignity, lower rates governments to work together to make the sector more of sexual violence, and a clean environment. attractive. Only through attracting new sources of Investments, particularly in sanitation, can reap huge ben- finance, including commercial finance, will govern- efits for long-term economic growth. The link between ments be able to achieve their WSS goals. access to improved sanitation and reduction in mortal- In contrast, there is a large global savings glut, with much ity for children under age 5 is clear. Countries with of the money looking for reliable investments. Globally, higher sanitation access have lower mortality rates. In pension funds, insurance companies, mutual funds, figure 2.2, the size of each circle represents a country’s and sovereign wealth funds hold around $100 trillion population. A second correlation, between poor sanita- in assets under management. Sovereign wealth funds tion (and high population density) and stunting, a and central banks alone currently have assets of about form of undernutrition, has also been proven. In India, BOX 2.3. The Potential of Climate Finance Water is a small piece of the global climate action agenda; most funds are used to finance renewable energy projects. An estimated 80 percent of funds are for mitigation and 20 percent for adaptation. The WSS sector’s share of mitigation funds is split under an array of measures, including energy efficiency, nonrevenue water reduction, pump replacement, network optimization, and reductions in greenhouse gas (GHG) emissions. For adaptation, water and wastewater management received $15 billion in funding, of which 71 percent went to low- and middle-income regions of East Asia and the Pacific, Sub-Saharan Africa, and Latin America and the Caribbean (Buchner et al. 2015). A larger portion of these emergent funds could be tapped if water projects were better prepared to articulate the cobenefits and the impact they could have on mitigating the effects of climate change. The World Bank aims to increase its support of climate resilience and GHG reductions to nearly one-third of its annual commitments ($16 billion) and to leverage cofinancing of $13 billion per year by 2020, or the equivalent of all ODA currently going to WSS. 8 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation FIGURE 2.2. Access to Improved Sanitation and Under-Five Mortality Rate, by Population Size, Selected Countries, 2015 200 Angola 150 Congo, Dem. Rep. Nigeria Mortality rate, under 5 (per 1,000) 100 Pakistan Bangladesh India 50 Ethiopia Indonesia China 0 –50 0 20 40 60 80 100 120 Access to improved sanitation (%) Source: World Bank 2015b. where nearly half of all children are stunted, a 2013 study BOX 2.4. The Real Cost of Water for shows that a 10 percent increase in open defecation the Poor increases stunting and severe stunting by 0.7 percentage points (Spears, Ghosh, and Cumming 2013). Fifty liters of water per person per day (the minimum World Health Organization [WHO] Finally, the poor will pay less for water. Studies show requirement) from a private vendor costs the that purchasing water from vendors, or drilling wells at following, based on a typical daily salary of a the household well for self-supply, can cost 10–15 times low-income person living in each city: more than what is charged by service providers. Living without access to a formal and improved water service • Port Moresby, Papua New Guinea: 54 percent of daily salary forces many communities to buy from private ven- dors, some of which operate illegally and charge exor- • Accra, Ghana: 25 percent of daily salary bitant rates. For the poor, buying water can take a large • Maputo, Mozambique: 14 percent of daily portion of their low incomes (box 2.4). Formalizing salary service can cut these rates by 10 to 15 times while at Source: WaterAid 2016. the  same time generating tariff revenues for formal service providers. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 9 2.5 How Is the WSS Sector by water users themselves in exchange for a service Currently Funded? they receive, including, for example, household payments for on-site sanitation or “sweat equity” The WSS sector is funded by a mix of public and private contributions to family-owned, small-scale inde- sources, some of which need to be repaid (figure 2.3). pendent service providers (SSIPs). Water service Service providers receive revenue from three main providers are generally in charge of collecting tariffs sources: tariffs, domestic tax revenues, and voluntary to cover their costs. In LMICs, tariffs generally only transfers from external sources (commonly known as cover, or do not even cover, O&M costs. the “3T’s”) (Winpenny 2003). These sources are pre- ferred because they do not require repayment, but • Domestic tax revenues include all funding alloca- they are seldom sufficient to fill the financing gap tions from the public budget. These funding flows when there is a substantial coverage deficit. Many are allocated by governments (at the central or local countries and service providers also borrow money on level) for investment, subsidies, and general sector concessional or commercial terms to be repaid over funding (for example, to pay for government staff time. Regardless of whether funding or finance is used, who are in charge of supervising or monitoring the reductions in one revenue stream require increases in sector). They are used to contribute to both O&M another to meet the shortfall. costs and capital costs. 2.5.1 Funding Sources • Transfers from external sources refer to funds from international donors, charitable foundations, NGOs, There are three main traditional sources of sector funding, decentralized cooperation, local civil society orga- which are nonrepayable (figure 2.3): nizations, or remittances from nationals working • Tariffs, user fees, and household investment include abroad. These transfers typically come from sources all payments, charges, or direct investments made external to the country: that is, they are contributed FIGURE 2.3. Traditional Revenue Sources for the Water Sector Funding sources (”3Ts”) Repayable inancing Tari s Concessional inance Pre- inance User fees for services provided and Provided by development agencies with a grant households’ investment for self-supply element (e.g. “soft loans”) Transfers Private inance Transfers from external sources, such as Repay Provided by private sector inanciers at market international donors (ODA grants), rate (vendor inance, micro inance, loans, foundations, NGOs, remittances bonds, equity) Taxes Key Domestic taxes levied by local and central Private funds governments and provided as grants or Mixed public and private funds subsidies Public funds Note: NGOs = nongovernmental organizations; ODA = official development assistance. 10 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation by taxpayers or donors in other countries. They are both national (from domestic sources) and interna- mostly grants and are used mainly to support capital tional, despite higher costs. costs. They are not predictable and therefore most As shown earlier (figure 2.3), there are two kinds of often used to support capital, rather than operating, repayable financing: expenses. Tariffs should be the largest and most stable source of • Concessional finance is repayable finance offered by multilateral and regional development banks, bilat- sector revenues.3 When they are insufficient, the gap eral donors, and domestic development banks. It is needs be filled by taxes or transfers from external provided at a lower interest rate with a longer tenor sources. Many of the world’s poorest countries keep than commercial finance. These “softer” payment tariffs low and seek to rely on public funding and exter- terms are made possible thanks to a grant element nal transfers to build and maintain WSS infrastructure. wrapped into the interest rate and grace period of However, these are seldom sufficient, and deficits in the financing terms. It tends to be available in hard building or maintaining assets cannot be overcome, currencies. because service providers are locked into a vicious cycle of inadequate maintenance and limited services. • Commercial finance is defined as market-based finance, including debt, equity, and certain kinds Most countries allocate a small portion of government of guarantees. It is market-based in the sense that budgets to WSS. During the MDG era, governments in the cost of this type of financing is determined by Africa would have needed to spend an estimated supply and demand in capital markets rather than 2.58  percent of GDP on average to meet WSS by governments or other regulatory bodies. Most MDG  targets. Indeed, Morocco and South Africa forms of market-based finance are repayable to their spent 2 percent and 4 percent, respectively, with sig- providers. nificant improvements in WSS access. However, a review of public expenditure in five low-income countries in Africa showed an average annual invest- Concessional Finance ment of just 0.32 percent, or $1.71 per person, with Although it makes up only about 10 percent of the more funding going to the urban than rural sector investment costs needed to achieve SDG targets 6.1 and (van Ginneken 2011). The global average is not much 6.2, concessional finance can be critical for some higher; in 2017, government coordinated expenditure countries. Concessional finance is the single largest for WSS was estimated at 0.42 percent of GDP flow for 24 of the world’s 45 most underresourced (WHO/UN-Water 2017). countries (WaterAid 2015). ODA to water is about $13.3 billion per year (2012–14 average).4 One-third of 2.5.2 Financing Sources ODA comes from MDBs, with the rest from bilateral In many countries where financing needs are high, invest- funders. ODA, provided as a mix of grants and loans, ments need to be front-loaded to meet WSS targets. To includes investment not only in infrastructure but that end, it will be necessary to mobilize repayable also in technical assistance to prepare for implement- financing up front, which will then be repaid over time. ing loans, project preparation, and guarantees that Concessional finance sources, which have been the can serve as a bridge to private finance. About two- main source of repayable financing in most developing thirds of official development finance is ODA, with countries up to this point, have not been and will not another one-third (about $6 billion per year between be sufficient in the future. Much greater emphasis 2009 and 2014) provided in the form of nonconces- will  be needed on leveraging commercial finance, sional loans to mostly middle-income countries. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 11 However, donor incentives are not always aligned with Commercial Finance supporting the countries or subsectors with the highest Commercial finance comes from various sources and need for aid. ODA in WSS is mostly targeted to large sys- can  be used to meet the great diversity of investment tems in urban areas rather than toward providing basic needs.  This type of financing can be grouped into WSS services or services in rural areas. And although five categories: vendor or supplier finance, microfi- the regions in greatest need (Sub-Saharan Africa and nance, commercial bank loans, bonds, and equity South Asia) received nearly half of all aid in water, the (figure 2.4). Providers of commercial finance can largest country-level recipients are generally not the include water equipment suppliers, microfinance insti- lowest-income countries. tutions, commercial banks, private investors, or invest- ment funds via capital markets. (For definitions of each Unlike concessional finance—which tends to require a sov- category of commercial finance, see appendix A.) ereign guarantee and therefore typically flows to national governments—private finance can be accessed by both This report focuses on commercial bank loans, which public and private water sector providers and local gov- make up a large portion of commercial finance and ernments, depending on the financial architecture in the are the most straightforward instrument to compare particular country. Project finance can also be used in with alternative public sources, including conces- cases where specific projects are investment ready. sional finance. FIGURE 2.4. Uses of Commercial Finance, by Borrower Size and Financing Need Size of financing needs Large Bonds Commercial Medium Bank loans Vendor/Supplier Finance Microfinance Small Households SSIPs Communities Medium sized Utilities/ entrepreneurs Municipalities Size of borrowers Source: World Bank/UNICEF 2017. 12 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation The various providers of commercial finance are generally sharing of risk (figure 2.5). Private participation in willing to take on varying levels and types of risk, which financing simply means that public or private opera- can be complementary. For example, banks may have the tors can access private finance to fund their infrastruc- capacity and interest to lend at commercial rates for the ture needs, usually through debt instruments. construction phase, while capital market instruments Although no aggregate numbers are available on total can better match the longer tenor requirements to amounts of commercial finance in WSS, the sector on aver- finance the operational phase. Commercial bank finance age attracts only 3 percent of all PSP in infrastructure constitutes the largest share of private finance to global (energy, transport, and water) projects (2009–14) (World infrastructure. In the aftermath of the global financial Bank 2016c). This number tends to reflect only PPPs and crisis, commercial banks face greater restrictions on not debt instruments that supported water-related long-term financing, making capital markets a more infrastructure. To grow this number, it will be critical for attractive source (Garcia-Kilroy and Rudolph 2017). governments to support private sector finance by invest- Commercial finance can come from both domestic and ing in sound enabling environments (such as economic international sources, each with its respective costs and and environmental regulation or governance frame- benefits. International financiers generally have signif- works) that protect consumers. Governments also need icant volume and sector expertise, including project to ensure that potential lenders understand the risks and finance expertise, but are active in a subset of coun- benefits of investing in WSS. In addition, governments tries. International commercial finance is provided by may need to advocate for and engage citizens on financiers operating in global markets and is typically the  benefits of private finance, especially in countries provided in hard currency such as U.S. dollars or euros, where there is strong opposition from prior negative PSP except in cases where currency swaps are  available, experiences. making service providers—whose revenues are in domestic currency—susceptible to foreign exchange FIGURE 2.5. Sources of Finance vs. Implementation risk. Although global interest rates are at a historical Models low, high country and borrower risk premiums applied by international finance providers make such financing costly for water service borrowers. Sources of inance Implementing models Accessing commercial finance is not equivalent to privat- izing the sector. In fact, in many high-­ income coun- National tries, publicly owned water service providers have PPPs, management leveraged substantial amounts of commercial finance contracts, etc. Public Subnational without relinquishing control over management of the service or selling shares. This is because the source of Concessional finance is separate and different from the implementa- tion model. The implementation model determines Debt who owns or manages the assets and who delivers the Public service Commercial service. Various models exist, from fully public to fully provision Equity (SOEs, etc.) private. For those that involve some form of private sector participation (PSP), this can come in the form of service contracts, management contracts, or leases Note: PPPs = public-private partnerships; SOEs = state-owned that leverage private sector expertise and enable the enterprises. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 13 Financing in the water sector can FIGURE 2.6. Composition of WASH Sector Funding, by Type, for Brazil, come from either public, private, or Ghana, and Mali mixed sources. As noted earlier, 100 the source of finance—whether a concessional loan from an MDB or private equity from an individual 80 investor—differs from the imple- menting modality selected to 60 deliver a service. Implementing modalities include a host of options, including an SOE, a 40 private operator, a public utility ­ under a management contract, 20 local government, and others figure 2.6). (­ 0 No “Typical” Financing Regime Brazil (2014) Ghana (2014) Mali (2014) Repayable finance External sources Government Households Because each country has its own unique mix of public and private Source: World Health Organization data. Note: NGO = nongovernmental organization; WASH = water supply, sanitation, and hygiene. sources of finance, there is no aggregate view of the way the WSS sector is currently funded at a private finance is not equivalent to the potential bene- global level. A WHO-UN-Water TrackFin initiative is fits a country can reap from a well-functioning WSS making such data available at the country level to sector—which can be immense not only for the enable comparisons. Brazil, Mali, and Ghana, show poor but also at a national and macroeconomic scale. drastically different arrangements, with relatively These benefits should be weighed in decisions about larger shares of repayable finance in Ghana, household how to scale up sector funding. (self-supply) in Brazil, and external sources and This stark reality calls for a major shift in the way government funds in Mali (figure 2.6). ­ resources are allocated and used in the sector. Each Different countries leverage their WSS revenue (tariffs, country is different and will require a customized solu- transfers and taxes) to mobilize different types and vol- tion that, where possible, leverages public funding and umes of repayable finance. Many LMICs extensively concessional finance to mobilize commercial finance— borrow concessional finance for capital works, com- either international or domestic. It is critical to note pared to high income countries where commercial that commercial finance is not the same thing as finance often makes up a large share of capital expen- privatized service delivery; private finance can be ­ diture finance, even when WSS services are owned mobilized by service providers owned and operated by and managed by the public sector. government entities. 2.6 Conclusion Notes The status quo is insufficient to meet the widening WSS 1. The Camdessus report was the first in a series of water sector investment gap. The supply of public funding and reports  focused on financing, including a report by the Gurria 14 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation Task  Force, released at the 4th World Water Forum in Mexico 3. In some higher income countries national policy dictates that gov- (Van  Hofwegen 2006); recommendations formulated for the 6th ernment funds cover most or all of the cost of service, for various World Water Forum in Marseille (WWF/CS2 2012); and a 2015 report reasons, with only a small portion coming from tariffs. However, by the Organisation for Economic Co-operation and Development this is often not possible in many LMICs. (OECD) with the World Water Council and Global Water Partnership 4. Official development assistance (ODA) is a measure of aid flows. (GWP), released for the 7th World Water Forum in Daegu, Republic of It refers to flows of official financing that have the main objective of Korea (WWC/OECD 2015). promoting the economic development and welfare of developing 2. “Service provider” refers to all entities that are responsible for water countries and that are concessional in character, with a grant element services, which can include, but are not limited to, the delivery of of at least 25 percent (using a fixed 10 percent rate of discount). By WSS services through utilities, small-scale independent service pro- convention, ODA flows comprise contributions of donor government viders (SSIPs), subnational governments, or specialized state-owned agencies, at all levels, to developing countries (bilateral ODA) and to enterprises (SOEs). multilateral institutions. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 15 Chapter 3 A Proposed Framework for Financing Universal Access 3.1 Easing the Transition that may not be able to attract commercial finance but that yield high economic returns for the country (such Facing a lack of funding, some countries can only invest as rural sanitation). in the water supply and sanitation (WSS) sector if and when money becomes available from donor agencies. Moreover, although commercial finance will likely be Grants and concessional loans, coupled with low tar- costlier, there are also some short-term benefits com- iffs, can create a stop-and-start mode of investment pared with pure concessional finance. These include that does not culminate in sustainable sector improve- faster access to and implementation of finance, more ments. Moreover, this status quo, tolerated by both control over investment decisions, and lower transac- governments and donors alike, entrenches poor gover- tion costs. These countrywide and sectorwide benefits nance and inefficient service delivery and fuels further are summarized in table 3.1. deterioration in performance. While, at face value, commercial finance seems to have Transitioning toward more commercial finance, and less higher financial costs than concessional finance, that is concessional finance, can help reverse these trends. For not always the case. If all implicit costs are quantified, example, commercial finance, working within a pub- commercial finance can sometimes be less expensive lic sector framework, brings incentives, innovation, in the long run than concessional finance. The major transparency, and fiscal discipline that can be hard cost considerations are as follows: 1 to replicate with grants or concessional finance alone. • The repayment terms, which affect affordability A 2017 case study of a well-performing utility (CESAN) in Espírito Santo, Brazil, found that “Securing pri- • The implicit costs associated with borrowing in vate  funds compels CESAN to be contractually ­foreign currency accountable and to generate expected financial • The implicit costs associated with waiting for returns.” (World Bank 2017b). By setting the right ­concessional finance governance framework, governments can meet their ­ WSS goals. First, costs can be quantified in annual payments as well as in total debt service. Commercial loans are generally 3.1.1 The Relative Benefits of Commercial Finance paid off over a shorter period (3–10 years) than conces- The main benefits of mobilizing commercial finance can sional loans (15–20 years). Thus, governments and ser- materialize in the long run, as efficiencies are realized for vice providers constrained by their annual capital service providers and the country and sector as a whole. budgets (and potential to increase tariffs) will see con- Mobilizing commercial finance where it is feasible cessional loans as more affordable: they can be paid frees up scarce public resources for other important over a longer period and at a lower interest rate, mak- purposes, including support of sector institutions to ing their annual payments smaller. Commercial loans, deliver important functions such as policy setting, generate larger annual payments but could cost less monitoring, or regulation; and investment in activities overall if the impact of creeping currency devaluation, Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 17 TABLE 3.1. Benefits of Mobilizing Commercial Finance for the WSS Sector Benefit How the benefit is realized Countrywide benefits Fiscal discipline Commercial finance does not increase sovereign borrowing or crowd out other ­sovereign borrowing. Economic growth Public funding can be reallocated to other water subsectors (such as sanitation) that cannot access commercial finance, enhancing the prospects for economic growth. WSS sectorwide Improved governance The additional scrutiny of investors fosters improvements in governance at both the benefits sector and corporate or service provider levels. Sustainability Commercial finance reduces dependence on concessional flows, putting service providers on the road to financial sustainability. ­ Improved performance The involvement of commercial lenders provides another layer of transparency and accountability for maintaining service provider performance. Faster financing Compared with concessional finance, commercial finance is not dependent on the availability or timing of donor funds. Lower transaction costs Compared with concessional finance, commercial finance can be accessed directly by subnational service providers and is more often available in domestic currency. Note: WSS = water supply and sanitation. BOX 3.1. Lessons from the East Asia Financial Crisis Many service providers in East Asia during the 1990s had foreign currency loans without accounting for foreign currency risk in their tariff formulas. The sudden and sharp devaluations of their local currencies as a result of the 1997 financial crisis drastically increased the cost of their financial commitments. The service providers attempted to confront the dilemma by increasing tariffs under conditions of substantial economic downturns, an exercise that proved largely unsuccessful. It was politically impossible to adjust tariff levels upward in the short term to recover current costs and regain lost ground. The impacts can still be felt today in Indonesia, where 300 service providers have successfully restructured through agreements with the Ministry of Finance and their local governments, yet most are still under significant financial turmoil and others bankrupt. This resulted in suspended investments and a decline in national coverage. Source: Baietti 2001. inflation and potential delays in arranging conces- expenses. If a local currency devaluation occurs, the sional financing, are factored in. repayment in foreign currency becomes costlier. This was a major lesson learned from the 1997 East Asia Second, although governments and service providers can financial crisis (box 3.1). Local currency loans carry no borrow in either foreign or domestic currency, conces- such risk. sional finance is almost always denominated in foreign currency except in a few countries.2 Revenues from WSS Even without incurring such a catastrophic devalua- provision, on the other hand, are earned in local cur- tion, most currencies in developing countries would rency, providing a mismatch between earnings and typically incur a “creeping devaluation”, partly linked 18 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation to high inflation rates. The impact of such creeping In conclusion, governments should rely less on conces- devaluation when borrowing in hard currencies whilst sional finance in foreign currency for investments that generating revenue in local currency can be significant have the potential to leverage some commercial finance for water service providers, as shown in appendix B. in domestic currency. From a purely financial perspec- Modelling presented in this appendix shows that, tive, this is because it can cost them less in the long under relatively conservative assumptions, the impacts run—once the costs of currency risk, delay, and interest of domestic currency devaluation and of inflation can are factored in—while also conferring other social and add about 30 percent to the total debt service of a con- economic benefits associated with faster implementa- cessional loan. All else being equal, a 15-year local cur- tion of loans. However, concessional finance will rency loan at 10 percent interest can cost about the remain crucial going forward but should be better tar- same as a 15-year concessional loan at 3 percent interest geted to support upstream sector reforms and capacity in the event of a deterioration of the local currency. building, in turn better enabling the unlocking of com- mercial finance in the long run. Third, securing concessional loans can add another hid- den cost: the cost of potential delays. Concessional financing can take time to arrange, due to internal 3.2 Why Does WSS Not Typically Attract bureaucratic processes both at the level of lenders and Commercial Finance? borrowers and taking account of the time needed to WSS as a sector has the potential to attract commercial arrange sovereign guarantees, which are typically pro- finance, but it does not frequently happen in low- and vided with such loans. Estimates summarized in middle-income countries (LMICs). Investors that lend appendix B show that, if a concessional loan is delayed money for infrastructure assess the credit strength of by five years, the hidden added costs can exceed the intended borrower, including the willingness and 80 percent of the loan value due to the impact of infla- ability of the borrower to pay back the money. In tion and creeping devaluation during the “wait” high-income countries, lenders see the sector as pre- period. Under such conditions, a concessional loan senting low-risk operations, with reliable, reasonable would become up to 30 percent more expensive than a returns and clear and transparent governance struc- commercial local currency loan. This estimate does tures. In LMICs, in contrast, they frequently conclude not even consider the impact of “delayed benefits” that water service providers are financially weak or not from the investment, which would be even more sig- creditworthy. Several challenges contribute to this nificant and directly felt by the local population. weakness. Overall, the issue is not whether a borrower should First, water service providers (and particularly those at choose concessional or commercial finance, but rather the subnational level) lack sufficiently reliable revenue how best it can leverage the benefits of each (or blend streams. They have been constrained in their ability to them) for specific investment needs. Commercial increase tariffs to levels that would cover their costs, finance, for example, could be preferred for short-term have limited access to tax revenues, and are supported investments (such as non-revenue water [NRW] reduc- by a mix of domestic subsidies and international con- tion, increasing coverage, and performance improve- cessional financing that vary over time. ments) where investment costs are quickly recovered. In contrast, concessional finance or commercial Inadequate tariffs are the major constraint to reliable finance, which attracts institutional investors, is more revenue streams. Decision makers need the political appropriate for large projects with long repayment will to make smart policy choices and to communicate periods, such as network extensions. them effectively. For example, without tariffs the WSS Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 19 sector cannot afford to provide sustainable services at These  prescribed investments reduce the need for all, and without well-targeted subsidies, the poor will credit analysis but in turn keep these investors from not be protected. When subsidies are not well targeted, developing knowledge of the water sector. they keep service providers in a low-level equilibrium. Even when the supply and demand for commercial Second, given the monopolistic nature of the sector, finance align, lenders and borrowers are further con- commercial financiers would look for a strong sector strained by their mismatched priorities. Service provid- regulatory regime to ensure predictable, transparent ers need to borrow money over long repayment tariff-setting and service regulation—characteristics sel- periods, while the lenders that are most active in the dom encountered in LMICs. Service providers often sector (commercial banks) generally want short matur- cannot provide accurate, detailed information about ities and high returns (table 3.2). Institutional lenders, their technical operations (assets, quality of service, on the other hand, while well suited for long-term losses) and financial operations (revenues, costs, cus- investments, are in lower supply in LMICs and have tomer data). Audit or disclosure rules may not be less exposure to the WSS sector. One way to address strictly enforced, and credit rating agencies may not these issues is to use different financiers at different exist or may be unfamiliar with the operations of the stages of the project cycle (that is, during construction water sector. as opposed to during operations and maintenance [O&M]) given the changing risk profile. Third, providers may lack sufficiently strong leadership, management skills, or corporate structure to enable Despite these challenges, a few private and public water them to prepare properly to access private finance. service providers have tapped into local and international Together, these factors create a high-risk environment, financial markets. These providers include Manila Water which either demands higher returns for investors in the Philippines, Companhia de Saneamento Basico (meaning higher interest rates, which in turn could do Estado de São Paulo (SABESP) in Brazil, Nairobi lead to higher tariffs) or causes investors to go else- Water in Kenya, and the Phnom Penh Water Supply where and place their money in other infrastructure investments or sovereign bonds. The bedrock of this TABLE 3.2. Objectives of Service Providers challenge is weak operational efficiency and sector and Lenders governance. Institution type Objectives Fourth, institutional and legal restrictions may also be Governments and • Long-term, stable financing limiting private investment. Pension funds may be service providers • Payments that match the useful life of prohibited from purchasing securities that have not ­ the infrastructure been listed on public exchanges for certain minimum • Low annual debt service costs periods, and are thus also prohibited from investing in Commercial banks • Short maturities with high returns initial sales of bonds. Banks may be allowed to invest • Dedicated revenue streams in place of only up to a certain percentage of their capital in secu- collateral rities sold by service providers. Service providers may • Securitization measures for timely repayment be prohibited from issuing corporate bonds and l ­ imited • Ability to shift quickly into different to borrowing from government sources like intergov- investments if needed ernmental loan funds or development banks. In Institutional • No up-front risk some  countries, banks are required to lend a certain benders • Long-term, stable investments percentage of their overall portfolio to local infra- ­ • Willing to take lower returns structure projects in targeted sectors or regions. 20 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation Authority (PPWSA) in Cambodia. In these cases, tap- The components are not necessarily sequential and can ping into commercial finance has brought major bene- be implemented in parallel depending on local capacity fits as commercial financiers hold the service providers and readiness for reform. However, where possible, to a high standard, keeping them on the track toward the  use of existing resources in the sector should be continuous improvement and better performance. reformed first before new resources are mobilized. In each country, this framework needs to be underpinned 3.3 A New Financing Framework by the right governance and incentive structures at both This report proposes a new sector financing framework the sector and service provider levels, and requires to help countries withstand external shocks while achiev- strong and sustained political support. The framework ing their WSS goals. The three components of the promotes the financial autonomy and self-sufficiency financing framework (figure 3.1) are designed to bring of service providers to ensure that recurring costs are commercial finance into the sector. Changes made paid for via user fees and tariffs, and with the limited within each component will be iterative and incremen- use of well-targeted subsidies if needed. It then recom- tal to allow policies and capacity to align. There are mends ways to mobilize finance for capital invest- also significant feedback loops among the compo- ments from other sources. nents. For example, identifying and generating service provider efficiency gains allows for better planning 3.4 Conclusion and budgeting. Increasing the level of commercial finance for the sector would allow service providers to borrow and invest in FIGURE 3.1. Proposed WSS Financing Framework expanding and improving the quality of WSS services without having to wait for scarce public resources to be made available. However, given that the current start- ing point is nonexistent or limited use of commercial 3 finance, there needs to be a gradual move toward Leverage public funds to attract mobilizing such funds. This means improving the commercial inance financial performance of service providers through a mix of improved technical and commercial efficiencies and through governance and regulatory reforms. These improvements will generate the financial sur- plus needed to borrow funds through private chan- 1 2 Plan, budget and Improve service nels, thus complementing limited public funds. allocate public providers’ resources more performance ef iciently and governance Notes 1. For a more detailed explanation, see appendix B. 2. Some concessional lenders, such as the Asian Development Bank and Agence Française de Développement (AFD) are beginning to lend Note: WSS = water supply and sanitation. more in domestic currency but in a limited number of countries. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 21 Chapter 4 Component 1: Plan, Budget, and Allocate Public Resources More Efficiently 4.1 What Needs to Change? 4.2 WSS Sector Strategy and Policy Public funds are critical, scarce, and pivotal resources in WSS services have been recognized by many countries that they are the main funds available to support estab- around the world as essential services through the human lishing the right framework and incentive structure right to WSS.1 Adopting the human right to WSS does not to achieve sector goals. These funds should be used to mean that water should be free; rather, it means that support policies (such as those for water supply and water tariffs should be affordable and that where subsi- sanitation [WSS], health, or poverty reduction) that are dies are needed, they should be allocated on a transpar- integrated and aligned with national objectives and ent basis with clear allocation criteria and monitoring. enforced by institutions with sufficient capacity. Public Where there is a legal mandate, this provides the legal funds can be most effectively used when the following basis for defining long-term financing strategies for the elements are in place: water sector that realistically identify what revenue requirements can be covered through which funding • Sound design of sector strategy and policies source, and which consumers may benefit from subsi- • Comprehensive financial planning and budgeting dies to cover the residual financing gap (figure 4.1). In the cases where tariffs are insufficient to cover costs, tax • The judicious allocation of resources and subsidies revenues must be allocated to make up for the shortfall across WSS subsectors to maintain or achieve target service levels. • Funding and capacity building of sector institutions Defining sector goals is the first step in designing a real- (for example, regulators or public-private partner- istic sector strategy. Policy makers in national and local ship [PPP] units) governments will have a sound understanding of what it will take to achieve targets (like the Sustainable Development Goals [SDGs] or other WSS goals), how 3 much it will cost, and where funding is likely to come Leverage public funds to attract from (including impacts on revenue requirements). commercial inance The goals can then translate into policy statements or national plans and strategies that demonstrate the government’s commitment. Countries are at liberty to set their own WSS goals in line 1 2 with, but not necessarily as ambitious as, the SDGs. For Plan, budget and Improve service allocate public providers’ example, Indonesia’s “100-0-100” national policy targets resources more performance universal access to water and sanitation, ideally having ef iciently and governance zero people living in slums by 2019. Indonesia’s targets are backed by a financial plan whereby national and sub- national government funding makes up more than half Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 23 of the required funding and is used to leverage about Policies should be part of a comprehensive framework to 20  percent in commercial and other forms of private ensure that institutions work cohesively toward the same investment (World Bank, forthcoming). Regardless of objectives. For example, Uganda set a policy target of the level of ambition of WSS targets, they need to be real- 100 percent WSS coverage in urban areas by 2015, as one istic and achievable given the existing (or planned) insti- country’s frame- of several sector strategies under the ­ tutional capacity and financial architecture. work Poverty Eradication Action Plan. The National Water  and Sewerage Corporation Example of Financing Strategy for the Rural FIGURE 4.1. (NWSC) then implemented pro- Sanitation Subsector poor tariff policies and subsidized connections for the poor. These Costs Costs Funding policies led to new services for Maintenance Provide subsidies to and Reduce more people (World Bank 2014b), costs Maintenance Household reduce up-front financing operating costs, internalize and by 2015 nearly 96  percent of costs through and recurrent innovation operating payments externalities, address affordability constraints urban residents had access to costs Targeted improved water yet only 29 per- Capital Lower cost Capital subsidies costs technology costs Household cent to improved sanitation. capital investment Where policies do not align or are Micro-finance not pragmatically linked, they can Support/leverage micro-finance to create confusion and stall reform. support household investment Indonesia’s prior attempts at sec- tor reform show how perverse Source: World Bank. incentives structures can take BOX 4.1. The Cost of Misaligned Incentives Indonesia’s 1999 decentralization law gave local WSS service providers (PDAMs) the mandate for WSS service delivery and local governments the responsibility for investing in the sector. However, 90 percent of local government revenues were still coming from the central government. Moreover, under the corporatization law, local governments were allowed to corporatize PDAMs from which they could extract revenues, even when they were unprofitable. PDAMs were created in an ad hoc manner and had no real power over tariff setting, leaving no incentive to improve performance, increase access, or cut costs. To bolster investment, a donor-funded, output-based aid program called Water and Sanitation Hibah was introduced in 2009 to expand access to water to 70,000 and access to sanitation to 10,000 poor residents. Local governments were required to install and pay for 50 percent of all connection costs. Although Hibah expanded much-needed services to the poor, the program was not aligned with the existing incentive framework. In 2016 there were 421 corporatized PDAMs, 20 percent of which were financially “sick.” Those that expand coverage through such programs will have higher operating costs that will continue to be subsidized at low efficiency unless more effective incentives can be introduced. Source: AusAID 2011; World Bank, forthcoming. 24 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation hold when policies are not interlinked (box 4.1). Having and in support of sector policies and targets, or may be learned from this experience, Indonesia’s new 100-0- too high if they do not properly account for absorptive strategy has been designed as part of the National 100 ­ capacity constraints (box 4.2). Development Program rather than as a stand-alone Of those countries responding to the 2017 GLAAS survey, sector strategy, which enables the corresponding only 34 percent and 42 percent, respectively, have and incentives to be better aligned. consistently follow an urban sanitation and urban water 4.3 Sector Financial Planning and financing plan (WHO/UN–Water 2017). The rural subsec- Budgeting tor figures are even lower. Where capital investment plans exist, they are often developed with inadequate In many low- and middle-income countries (LMICs), the data, unrealistic service levels, poor links to affordabil- process for determining national sector budgets is polit- ity, and little or no relationship to financial plans. ical, top-down, led by the Ministry of Finance, and often not done on a consultative basis. In some cases, line Sector planning is a highly technical process that needs ministries, local governments, and service providers— to be based on reliable data. Public funds should be all with a great stake in sector performance—do not strategically used to develop accurate and comprehen- provide strategic input into the process, such as the sive capital expenditure plans and associated financial identification of long-term sector investment needs or plans for water service providers. To promote compre- where funds could be put to the most efficient use. hensive and realistic planning, the Organisation for Budgets may be too low when they are not linked to Economic Co-operation and Development (OECD) has introduced an approach called strategic financial planning (SFP) (OECD 2009) (box 4.3). BOX 4.2. The Capacity to Spend Effectively During the Millennium Development Goal BOX 4.3. Strategic Financial Planning (SFP) (MDG) era, governments in Africa on average needed to spend an estimated 2.58 percent SFP is a national approach to policy of gross domestic product (GDP) to meet dialogue that looks at the demand and WSS-related MDG targets. A review of public supply of finance for the sector over expenditure in five low-income countries 20–30 years (GWP 2016). The country first showed an average annual investment of just sets a baseline, an economic forecast, and 0.32 percent, or $1.71 per person. Of this sector targets and then looks at the amount, 12 percent went to recurring costs, trade-offs (including costs and financing with more than 87 percent to infrastructure. options) between different options for Budget execution (the portion of the total meeting the targets. SFPs can be done allocation actually spent) during this period using standardized tools or financial (2000-15) was only 63 percent, showing a models that are tailor-made for the need for capacity building and skills country. However, for some countries, an development to more effectively spend SFP is the gold standard, and other, existing funds, and as a prerequisite for interim analyses using readily available increasing funding to the sector. data will be needed first. Source: Van Ginneken, Netterstron and Bennett 2011. Source: OECD 2009. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 25 Multiyear financial planning, whether as SFP or through TABLE 4.1. Global Population Still Lacking Access to more rudimentary processes, should provide a consoli- WSS, by Type and Subsector, 2016 dated look at revenues and financing sources, presenting Safely managed Subsector Basic access a basis for priority setting. These plans should also access identify annual cash flow requirements, facilitating a Urban water 1.4 billion 2.0 billion link to the general budget process. Rural water 0.9 million 2.6 billion Urban sanitation 1.7 billion 3.2 billion 4.4 More, and Better, Subsector Allocation Rural sanitation 1.7 billion 2.1 billion Source: Hutton and Varughese 2016. Local tax revenues to fund the sector can be targeted to Note: WSS = water supply and sanitation. improve what are essentially localized services. A good use of existing funds is to provide incentives for effi- • What are the policy trade-offs (for example, between providing basic access for all and safely managed ciency gains or to correct market failures. Moreover, services for a smaller population which generally additional public funds can be mobilized at the local already has basic access)? Although safe access level, such as through increased use of property taxes costs three times more than basic access (global or land value capture instruments, through which a estimates), there are opportunities to “leapfrog” to portion of the increase in property or land values higher service quality without the added cost, espe- (residential and commercial) that results from nearby cially if using lower-cost, decentralized systems. WSS investments is recovered. • How can policy goals be met at the lowest cost? Urban Allocation is a political process and subject to various areas account for 70 percent of capital costs needed factors, but it can be done in a way that ensures the most to achieve universal access globally (Hutton and cost-effective investments are made and that resources Varughese 2016), but more people will be served are used in a catalytic manner to crowd in other types of from urban investments than rural investments. Unit investment. There are six questions to consider when costs vary greatly across countries and cities and it is looking to allocate funds across and within WSS important to consider relative unit costs in order to subsectors: assess overall investment needs per sub-sector, before • Do we need to address a market failure? In rural delving into more detailed planning assessments. areas, poor households often bear much of the cost • Can investments be financed with commercial finance of WSS services, and it consumes a higher propor- instead? Public resources are often allocated toward tion of their income. Where services are unafford- infrastructure investments with high visibility—in able, government failure to step in can have large urban areas and to service providers that can gener- negative economic and health impacts. In sanita- ate significant tariff revenues and thus recover costs tion, low demand coupled with high negative exter- on their own. If a portion of these funds would be nalities presents a market failure that only public reallocated away from such providers, there may be funds can correct. a net positive impact in two ways: (a) reduction in • Where are the biggest investment gaps? To answer perverse subsidies that keep providers from financial self-sufficiency, and (b) potential leverage of finance this question requires understanding not only how through other sources, including domestic commer- many people, but also who, would benefit. Globally, cial finance sources. more people need access to basic sanitation than to basic water (table 4.1), but the numbers vary greatly • What is the benefit-cost ratio of a particular invest- by country.2 ment? Estimated economic benefit-cost ratios of 26 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation reaching universal access are higher for sanita- covered by tariffs. Greater rates of cost recovery tion (5.5) than for water supply (2.0) (WHO 2012). through tariffs lead to better sustainability of the However, these will vary at the project level. investments because more funding is generated by CESAN,  the utility serving the state of Espírito users for operating, maintaining, and eventually Santo, Brazil, uses a ranking system to prioritize replacing the investments that have been made usu- projects based on cost-benefit and net present value ally with public funds. analyses. Those that cannot provide a positive eco- Service providers tend to be more focused on their cus- nomic return on investment are not considered for tomers, and on the quality of their services, when their public funding (World Bank 2017b). customers are the main source of their revenue. Users 4.5 Better Use of Tariffs and Subsidies who directly pay for the amounts of water they use and 4.5.1 Tariffs who contribute to the upkeep of the investments are more likely to use water responsibly and to maintain The way in which tariffs are set affects whether a govern- water infrastructure when it breaks down. The link ment can meet its WSS objectives. Tariff setting entails between customers and service providers, made via both defining how much should be recovered via tar- properly set tariffs, creates a virtuous cycle of improved iffs (setting the tariff level) and defining how revenues performance (figure 4.2). should be recovered from different customer classes via tariff structures. Some typical sector objectives Systems that are funded with tariffs also have more include cost recovery, efficiency in the provision and predictable revenue sources and are therefore better use of water, and affordability of the service. A service able to invest in service expansion and conduct regu- provider’s ability to generate revenue is linked to the lar  maintenance. For example, the World Health tariff levels and tariff structure, and to the associated Organization’s (WHO) TrackFin initiative found that incentives that they both generate. in Brazil, 80 percent of total WASH sector costs were A primary purpose of tariffs is to generate funding for covered by tariffs as of 2011. By contrast, tariffs cov- service providers. In high-income and some middle-­ ered only 25 percent of total water sector financial income countries, tariffs provide the vast majority of requirements in Ghana—a country now confronted revenues for the water sector. No subsidies are pro- with a reduction in concessional finance because it vided for water services, on the principle that “water has achieved middle-income status, while tariffs or service should pay for water service.” This has not domestic taxes have not been raised sufficiently to always been the case, however, and it is not true compensate for this drop (WHO 2015).3 everywhere. Most countries that have now achieved Wherever tariffs do not fully cover costs, a more moder- universal coverage mobilized domestic taxes or inter- ate approach to “sustainable cost recovery” is war- national transfers at different stages of their history. ranted. The 2014 GLAAS Report found that two-thirds They have all gone through various stages of financial of the 94 countries participating in the survey indi- sustainability—from being heavily dependent on pub- cated that tariffs were insufficient to recover O&M lic finance to becoming creditworthy enough to access costs (WHO/UN-Water 2014a). Government subsidies more mature private financial markets. Service provid- were most often cited as the means for covering the ers that currently mobilize commercial finance usually operational finance gap. In such cases, it may be more cover their costs through tariffs. practical to aim toward “sustainable cost recovery,” Countries that are better able to fund their sector sus- whereby the revenues of water service providers tainably tend to be the ones with higher levels of costs are  covered through a mix of tariffs, subsidies, Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 27 FIGURE 4.2. Virtuous Cycle of Providers’ Customer-Orientation and Despite these benefits, many gov- Financial Sustainability ernments are reluctant to conduct tariff reforms because they are afraid of the social implications of Sustainable water sector such reforms. Affordability and cost recovery can both be addressed through well-designed Private nance mobilized to increase investment capacity tariff mechanisms, however. To Investments in new achieve these objectives, the access expand revenue base design of tariff structures needs to Subsidies for new access provided in transparent and take into account local consump- targeted manner tion patterns. For example, System assets adequately maintained increasing block tariffs (IBTs) are often considered to be more pro- Service providers fully cover operating costs gressive than volumetric tariffs Consumers use water because consumers who consume more e ciently more face higher charges. An anal- Tariffs increased to cover greater portion of efficient ysis of three countries with exist- costs ing IBTs shows that a flat tariff More satis ed customers are more would make water unaffordable willing to pay Service quality for 65–85 percent of the popula- improves tion, greatly reducing the revenue Reduced losses: base of the service provider.4 In reduced costs Technical e ciency these cases, a large majority of improves households only consume the first Sta motivation (lowest) consumption block. improves Sta and managers There can, however, be concerns rewarded for improved performance about using IBTs in service areas where lower-income families have many family members in one © World Bank. household, which means that poor families would end up con- suming water in a higher tariff and  voluntary transfers (if available from external consumption block. Governments donors, for example). Since 2001, Burkina Faso has should carefully consider the implications of the vari- been using a financial equilibrium model to adjust tar- ous trade-offs involved in setting tariff structures and iffs and provide justification for fiscal transfers levels. They also need to evaluate all charges faced by between the central government and the utility (World consumers: in many countries, high initial charges to Bank, forthcoming). In the absence of such predict- connect to the service often prevent poor families from able and reliable revenues for the water sector, the connecting. As a result, they are often reliant on infor- ability of water service providers to plan investments mal water sources, which can cost 10–15 times more is significantly weakened. than network water (as discussed earlier in chapter 2). 28 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 4.5.2 Subsidies allocation to cover operating expenses (Trémolet Domestic taxes and external transfers are provided to 2009). The subsidy is transparent ($265 per house- the sector as subsidies, and are often used to support hold per year), predictable, and targeted (based on capital investments or operating costs, or to lower tariff the number of households in a municipality). levels. It is important to note that subsidies can be a Subsidies can be difficult to target to the right popula- relatively sustainable source of sector funding as long tions to meet sector objectives. First, they often reach as revenue sources for such taxes are reasonably those who are already connected to a network. Studies predictable and secure. abound showing that most poor customers must drill Subsidies should be used primarily for the following their own wells or purchase water from vendors, at a purposes: price that can reach 10–15 times the price charged by service providers. Thus, in a country where low volu- • To promote merit goods (whose value consumers metric tariffs are combined with high connection fees, may not fully realize, such as household sanitation low-income consumers would be excluded from the and hygiene) benefits of the subsidy. In Tunisia’s capital city, rich • To reward water providers for supplying public goods households receive 1.4 times the subsidy the poor (such as public health) receive for water supply, and twice as much as the poor for sanitation because they consume significantly • To generate external benefits (such as avoidance of more water and wastewater services. In this case, groundwater pollution) plans to reduce subsidies would not generally hurt the Subsidies can be provided in two ways: poor and are estimated to generate $65 million in savings, which could close the utility’s financing gap • Capital cost subsidies: These can be provided in the (World Bank 2016d). form of grants, subsidized loans, or guarantees and can either be used to (a) build new infrastructure To be well targeted, subsidies must be transparent. or connect users to a network, or (b) help users pay Governments often provide implicit subsidies in the for latrines or toilets at the household level. When water sector, by providing free equity capital or build- service providers are owned by municipalities, local ings, or onlending loans at very subsidized rates. The government budgets are often not sufficient to cover costs of these implicit subsidies are rarely known or such costs and would need to receive transfers from quantified as a subsidy. It is important to quantify the central government. these subsidies to get a complete understanding of public investment in the sector and to identify where, • Operating cost subsidies: At a minimum, service pro- how, and for whom, different sector incentives are viders should be expected to cover their operating being created that may promote or inhibit efficiency costs through tariffs and user charges, but some (box 4.4). LMICs continue to subsidize these costs. In South Africa, for example, municipalities often struggle Once implicit and explicit subsidies have been quantified, to obtain adequate revenue from tariffs because they should be aligned with sector policies and plans. In of the Free Basic Water policy, which ensures that general, they should not support inefficient operations consumers can receive a first consumption block or operators that could alternatively access other (considered to be a lifeline consumption) for free. sources of finance. Therefore, governments should The central government transfers an “equitable move away from operating subsidies toward well-­ share” to local governments, which is a need-based targeted capital subsidies that support policy Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 29 BOX 4.4. Implicit Subsidies Cannot Be Well Targeted Governments that borrow concessional finance generally onlend the funds to local service providers, transferring an implicit subsidy to the provider (equal to the difference between the concessional loan terms and those of an alternative commercial loan). A comparison of two such loans in Vietnam shows that a 20-year concessional loan at 4 percent interest and a 5-year grace period yielded a subsidy equivalent to 66 percent of the loan value, when benchmarked against a commercial loan of similar size at 10.2 percent interest and 5-year maturity. In this case, providing a capital subsidy coupled with a commercial loan would have been more cost-effective in terms of delivering long-term results, and would also make service providers more accountable by taking on more appropriate risk levels. When stakeholders do not quantify such implicit subsidies there cannot be a policy debate regarding the alternative uses of public funds. Source: Kingdom, Baeumler and Guzman 2012. objectives like pro-poor service delivery and financial Many countries have indeed had success with using sustainability of the service provider. Experience subsidies themselves as an incentive for good perfor- gained in OECD and Central and Eastern European mance. The Arab Republic of Egypt is using fiscal countries shows that transfers should be limited transfers to reduce inefficiencies in the wastewater in  time, phased out, and eventually ended when sector that amount to nearly $1 billion per year. Capital pre-agreed targets are achieved (OECD/EAP Task grants are given based on the performance of rural Force 2006). sanitation providers in meeting a series of indicators (box 4.5). Similarly, the government of the State of Targeting subsidies to the right scale and type of service Espírito Santo in Brazil provided the state water utility can generate more value for money. For example, many with $180 million over a seven-year period for capital LMIC governments tend to subsidize sewers and expenditures, contingent upon progress toward its associated wastewater treatment in urban areas while strategic business plan. This way, subsidies will taper maintaining explicit policies not to subsidize on-site off over time as providers become more efficient and sanitation in periurban or rural areas. A WaterAid able to cover their own investments. study in Dar es Salaam found that 99 percent of public funding for sanitation was allocated to sewerage and The potential for cross-subsidies needs to be further wastewater treatment, while these systems reached explored. Regarding sanitation, trade-effluent charges only 10 percent of the urban area’s population may be applied to industrial effluents to cover the (Trémolet and Binder 2013). additional treatment costs and potentially an addi- Subsidies need to be better targeted to households that tional margin, which can be used to cross-subsidize meet certain criteria. For example, Chile and Colombia poorer customers. In water supply, cross-subsidies are were early pioneers in applying targeted social tariffs used by eThekwini Water in Durban, South Africa, to in addition to applying cost-reflective tariffs to the institutionalize the country’s Free Basic Water policy, nonpoor. In contrast, Burkina Faso introduced social thereby providing a basic quantity of water to poor tariffs in 2003, but for lack of targeting geographically households for free (50 liters per person per day) while or by income, they have not supported poverty reduc- charging higher levels of service and consumption at tion targets. full cost. 30 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation BOX 4.5. Making Fiscal Transfers Dependent on Good Performance in Egypt Because of Egypt’s decentralization process, regional water and sanitation companies (WSCs) need to manage the WSS assets they have inherited from the central government. Without sufficient tariffs, government fiscal transfers attempt to cover the gap at a rate equivalent to 1.25 percent of GDP. Large investments in wastewater treatment and sewerage networks have suffered from slow implementation and high capital and operational costs. The costs of inefficiencies in the wastewater sector in Egypt have been estimated at US$1 billion per year. Under the Sustainable Rural Sanitation Services Program for Results, the World Bank is helping the government to improve rural sanitation services in three governorates in the Nile Delta. The instrument transfers responsibility to WSCs, using formula-based fiscal transfers linked to service delivery performance in the areas of operations, financial management, institutional systems, and citizen engagement. Payments are made upon meeting any of six disbursement linked indicators (DLIs), providing reasonable cash flow to enable WSCs to make sequential improvements. Those WSCs meeting performance standards can then also receive performance based capital grants to expand access. These grants are allocated on a per capita basis to ensure cost-effectiveness. 4.6 Funding and Capacity Building of legal entity, and legal frameworks must be in place to WSS Sector Institutions enable PSP in service delivery, from allowing for cer- tain contract types to allowing providers themselves to WSS policies and strategies must also be supported by borrow money on commercial terms. the appropriate institutional framework. This includes clear delineation of roles and responsibilities and an Second, regulatory frameworks need to be in place to enabling environment that supports efficient delivery monitor performance and service quality and enforce and allows for private sector participation (PSP), as guidelines for tariff setting. Regulatory institutions needed. A strong institutional framework has associ- should be designed for a specific country context. ated costs, both in terms of transitory reform costs Regulation by contract in Burkina Faso and Senegal and in terms of ensuring that well-trained staff are works as well as regulation by autonomous national adequately remunerated and equipped to deliver regulatory agencies in Albania or Portugal. However, their tasks. the more decentralized countries with higher numbers of regulated service providers (such as in Mozambique First, it is important to draw the resource and financial or the Philippines) will require more public resources implications of supporting different institutional dedicated to regulation (World Bank, forthcoming). arrangements. For example, decentralizing services can bring more accountability because the service pro- Third, institutions need staff with the right skill sets, and vider is closer to the customer, but this may also make who are technically proficient and driven to help achieve it more difficult to design and enforce uniform policies sector strategies and policies. In the end, people pro- for oversight and sustainability, including those asso- vide the leadership that can transform a sector and ciated with financing. Whether an independent thus the incentives for individual staff (in a service authority or a municipality, the borrower must be a provider or a regulator) also matter. Governments Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 31 should provide the incentives to attract and retain At the service provision level, tariffs and subsidies competent staff and managers who can lead a change should  provide the right incentives for both consum- process. Capacity constraints can present a serious ers  and service providers toward achieving national challenge if and when more financing becomes avail- objectives. Operations and maintenance (O&M) costs able. Countries should be sure they can fully execute should be covered—ideally by tariffs—and where they any new funds. Unfortunately, some of the countries are not, taxes need to supplement to cover these costs. with the highest WSS investment gaps also have low or  insufficient capacity to execute new sector funds Notes (as discussed in box 4.1). 1. Nearly three-quarters of countries (70 out of 94) that had completed the 2013 survey by the Global Analysis and Assessment of Sanitation and Drinking-Water (GLAAS) recognized the human right to water in 4.7 Conclusion their constitution (or the equivalent), and over two-thirds (63 out of 94) recognized the human right to sanitation (WHO/UN-Water 2014a). Public funds are scarce yet critical for the proper func- The GLAAS survey has been conducted by the World Health tioning of the WSS sector. They should be used pru- Organization (WHO) every two years since 2010. It aims to collect data on the “inputs” into the water supply, sanitation, and hygiene dently to correct market failures and meet poverty and (WASH) sector, including those regarding policies and financial and other sector goals in a manner that does not crowd out human resources. opportunities to tap into commercial finance. 2. See table 2.1 for the definitions of basic access and safely-managed access. At the national level, subsector allocations should be 3. WHO/UN-Water TrackFin Initiative, “Tracking Financing to Drinking- used to support integrated WSS policies aligned with Water, Sanitation and Hygiene.” For results of pilot testing initiative, national objectives. Public funds are also critical for see http://www.who.int/water_sanitation_health/monitoring​/invest​ setting the right sector and corporate governance and ments/trackfin/en/. institutional frameworks, building human resource 4. IBT analysis based on World Bank calculations using data from the capacity, and attracting talent and leadership to International Benchmarking Network for Water and Sanitation Facilities (IBNET). the sector. 32 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation Chapter 5 Component 2: Improve Service Providers’ Performance and Governance 5.1 What Needs to Change? Efficiency gains are a source of untapped finance, and 3 inefficiencies are an opportunity cost to the government Leverage public funds to attract or service provider. Improving efficiency allows service commercial inance providers to deliver better services more cheaply, thereby freeing up resources to invest in improving or extending services. Moreover, improved efficiency and service quality can help justify increased tariffs and transfers from government sources because stake- 1 2 Plan, budget and Improve service holders are more willing to pay or allocate funding allocate public providers’ when services improve. resources more performance ef iciently and governance When viewed as part of a strategic shift, efficiency improvements are a critical part of the move toward financial sustainability and, eventually, creditworthiness. They are thus the first step in enabling providers to use sanitation (WSS) services for rural and periurban areas, commercial financing. Accessing commercial finance once service providers are ready to move beyond can, in turn, increase incentives for efficiency and help traditional sources of finance. break the status quo. Service providers’ performance can be improved 5.2 The Status Quo through As discussed in chapters 3 and 4, services tend to be • More efficient upstream choices regarding capital funded through a mix of tariffs (which are typically too expenditure; low) and transfers (which can be ad hoc), with the occa- sional injection of liquidity when concessional finance is • Achievement of short-term operational efficiency secured for a specific investment. Low tariffs lead to low gains; and service maintenance and quality if shortfalls are not • Aiming for financial sustainability, with the ultimate provided through reliable and adequate subsidies. The goal of creditworthiness. inconsistency of transfers and concessional finance can make it difficult to fill the gap at the right time, and Examples of activities under component 2 are mostly the longer maintenance is deferred, the more money drawn from the urban water subsector because this is an will eventually be required. area where financial constraints and applicable finance strategies have been analyzed in more detail and are bet- Capital and operational inefficiencies are greatly inter- ter understood. However, the same logic can be applied linked and are pervasive in the WSS sector. If not to other water subsectors, such as water supply and addressed, inefficiencies quickly lead to a downward Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 33 FIGURE 5.1. Vicious Cycle Affecting Many Service Providers pay, augment the revenue base, enhance the credibility of service providers, and set them on a path Low tari s, toward delivering universal, sus- Consumers use water low collection ine ciently tainable services. High usage and system Most private financial instruments losses drive up costs and approaches work only with Investment, maintenance are postponed those providers that are already Service creditworthy, and yet only 4 per- deteriorates cent of WSS service providers in Customers are ever less willing to pay low- and middle-income countries Service provider lives o (LMICs) are creditworthy (Baietti state subsidies 2017). Even when service provid- Managers lose autonomy ers are creditworthy (box 5.1), and incentives they do not always have access to E ciency keep commercial lenders, which is dropping highly dependent on the maturity Subsidies often fail to materialize of the local financial market. Service provider can’t pay wages, recurrent The focus for most countries, costs or extend system Motivation and service therefore, should be on how to deteriorates further bring poorly performing service System assets go providers to financial viability, “down the drain” and  the marginally creditworthy closer to creditworthiness. For the former, improved efficiencies can Crisis, huge rehabilitation costs lead to achieving positive cash flows, as further discussed in the  next section. For the latter, Source: PPIAF and WSP 2002. a  blending arrangement can help service providers qualify for loans spiral of poor performance, unhappy customers, and by stretching out payments and reducing the overall cost huge rehabilitation costs (figure 5.1). If the water sector of financing (an option further discussed in chapter 6). does not break out of this cycle, countries will not be able to mobilize the finance needed to meet Sustainable Development Goal (SDG) targets. 5.3 Incentives for Efficiency Many service providers in developing countries generate Incentives for improving efficiency come from policy losses, and only a few are partially or fully creditworthy. makers and trickle down through local governments and National and local governments are the only entities service providers, including management and technical that can set the correct incentives for service provid- staff. Incentives should be set by sector policy and ers  to improve the efficiency of their operations. strategy and institutionalized through the sector gov- This will, in turn, improve customers’ willingness to ernance framework, especially regarding the way the 34 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation BOX 5.1. What Makes a Service Provider Creditworthy? Creditworthiness is a measure of a borrower’s ability and willingness to service its debt obligations, which is more likely to occur when they recover 150 percent or more of their operating costs and have good debt service coverage ratios. To be creditworthy, the utility must demonstrate a reliable stream of positive cash flow from operations as well as sufficient cash reserves in the case that future cash flows are not sufficient. It is important that the evaluation of creditworthiness be based on the entire capacity of the utility and not just on analysis of the individual project. Concurrently, the creditworthy utility must have a plan to handle contingent or implicit charges, which may include unexpected cost increases and foreign exchange losses. The degree of creditworthiness is judged through a valuation performed by lenders or independent parties to determine the borrower’s potential for defaulting on its debt obligations. There are various tools available for assessing credit, from creditworthiness indexing to shadow ratings to credit ratings. sector is financed. Sector governance has a large impact national policies to local institutional mandates on on corporate governance, which includes the legal important issues like land tenure, affordability, service status and policy mandates of the service provider. quality, and equity. Together, they provide clarity for financiers on how the sector will address such political It is imperative that service providers take full ownership issues. When properly aligned, they will promote effi- of the design and implementation of their improvement cient, well-run service providers. The criteria for effi- programs as part of their efforts to continually improve ciency for an urban water utility in Brazil is very their business. Well-performing providers are usually different than for a small, rural service provider in customer-oriented, have sound financial management West Africa, but in either case, efficiencies can be pro- systems, and benchmark their performance over time moted by considering a few key variables (box 5.2). and against peer institutions. The world’s top service providers use key performance indicators (KPIs) to 5.3.2 Capital Expenditure Efficiency constantly evaluate the key areas of their business In LMICs, most service providers are public entities that to  determine how they are improving over time. do not pay for the infrastructure they use to provide Management should have personal incentives for services. The lack of connection between the asset user meeting or exceeding their KPIs. and the asset financier weakens the accountability for proper management and use of the asset, and proper 5.3.1 Governance and Efficiency pricing of the services they provide. Sector and corporate governance frameworks set out the responsibilities of the service provider with respect to The choices governments make today about sector other WSS institutions, which is essential to measure and investments will have a big impact on future sustainabil- improve efficiency. Corporate governance also details ity of WSS service as they will significantly impact future ownership, operating principles, and oversight of operations and maintenance (O&M) costs. Governments providers. These two sets of frameworks should link can follow some general principles to improve capital Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 35 BOX 5.2. Key Considerations for Promoting Efficient Service Delivery Service standards. Standards may range from water quality parameters and hours of service to the standard at which sludge must be treated. Clarity on the standards expected is essential for measuring the efficiency of any water service provider. Some large service providers use key performance indicators, which are internationally accepted standards that enable service providers to benchmark their performance with other similar organizations. Internationally recognized service standards may not exist across all subsectors, but they are vital in terms of recognizing what service levels are expected. Financial performance. Collection rates, operating ratios, and even credit ratings offer insights on the financial status of the institution, as well as on the efficiency level at which they operate. Employee levels. This refers to the number of employees deemed adequate to achieve a given service standard; it may differ by subsector and the size of the water service providers. This number is generally a good indicator of whether the entity is operating efficiently or whether it is being used as a source of patronage. Customer orientation. Measurements of customer satisfaction are another indication of the quality of service. They enable an evaluation of how services are being delivered, the quality of those services, and how resources and personnel may be redeployed to make improvements. Energy costs. Moving and treating water are large, expensive components of water delivery systems, and their costs can be a large part of operational expenditures. Measuring the use and cost of energy per person served offers an important insight into the quality and efficiency of the water service provider. Risk identification and mitigation. Every service, regardless of the sector, comes with some risks. It is important to identify those risks, plan for the related contingencies, and undertake measures to mitigate them. The ability to undertake this analysis and put systems in place to address these risks is a key indicator in determining efficiency. efficiency (World Bank, forthcoming [a]). In general, First, in many countries, a substantial proportion of governments should ensure that WSS infrastructure is lying idle, generating a massive waste of resources. Expensive or oversized treatment • New infrastructure is indeed needed (options to plants are constructed and not used to capacity manage demand have been exhausted); while others are never connected to the sewerage • The right approach and sizing of infrastructure has network. Much of this happens because technical been selected, and lower-cost options are consid- standards are directly imported from high income ered (appropriate design standards are in place); countries with minimal adjustments. Locally driven innovation could allow the costs of technical • Overpricing is mitigated (costs and contract awards solutions that are put in place to be reduced. are benchmarked to a reasonable and transparent Greater emphasis on the potential complementarity standard); and of built (“gray”) and natural (“green”) infrastructure • Communities are engaged for local oversight. is required. 36 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation Second, providers need to better maintain existing infra- finance at reasonable rates to expand and continually structure. Too often, the preferred approach in the sector improve their services. Once service providers can is to build new infrastructure when previously built infra- access commercial finance, experience has demon- structure has fallen into disrepair for lack of adequate strated that the discipline of the market helps them to maintenance. An analysis of 20 countries in Sub-Saharan maintain service standards and reinforces transparent Africa shows that between 30 and 40 percent of rural hand governance arrangements, in a virtuous circle. pumps are not functioning (RWSN 2010). Prioritizing O&M Unfortunately, many service providers in LMICs are finan- and placing greater emphasis on full asset life-cycle man- cially weak. Although part of this can be because of a agement should be done to ensure that what gets built is lack of control over tariff setting, many service provid- also adequately maintained and operated. Funding for ers are also inefficiently operated. Decades of World maintenance is often the first to go when budgets are cut. Bank support to improve efficiency while adjusting In Tunisia, less than 5 percent of total sector costs are used tariffs levels has had mixed results. This report pro- for capital maintenance (World Bank, forthcoming [d]). poses a minimum expectation that tariffs cover O&M Third, myriad unnecessary costs are tagged on to the costs, a concept that is not so easily achieved even in design, selection, and implementation of new infrastruc- some middle-income countries. ture. These costs result from inefficient procurement processes, corruption, limited competition, overde- In fact, only an estimated 15 percent of service providers sign of systems, and use of expensive technologies. cover their O&M costs and create a surplus (assumed as having cash revenues exceeding costs by at least Better procurement and project management can cut 20 percent).1 This means that 85 percent of utilities costs. Larger projects, given their economies of scale, would have difficulty mobilizing commercial financing can have relatively lower transaction costs and can unless they implement significant reforms to improve enable access to finance at better terms. Competitive cost recovery. In doing so, they will be brought closer procurement processes that enable new technologies to to  financial viability, and thus, creditworthiness. enter the market can put downward pressure on Figure  5.2 shows how if they each implement four component costs. Performance-based contracts provide measures to cut costs and bolster revenue, 77 percent of incentives to reduce expenses. Design-build contracts the 690 utilities from the study would have sufficient save U.S. utilities an estimated 39 percent in capital cash surpluses to become financially viable, defined costs over design-bid-build projects (Adams 2003). here as recovering 120 percent of operating costs. This is Alternative technologies and scales can offer the same a step below full creditworthiness, which depends on level of service at a lower cost. In Dakar, Senegal, it was several factors, but is more likely to occur when the pro- estimated that the annualized cost for sewerage ser- vider recovers at least 150 percent of operating costs. vices is nearly $55, while on-site sanitation with fecal sludge management costs less than $12 (Dodane et al. Experience shows that such reforms may be quick to 2012). One project in Brazil cites a 43 percent reduction implement from a technical perspective but first require in costs when using condominial sewerage (decentral- political leadership and sector governance frameworks ized systems) over conventional sewerage in informal that provide incentives for reducing costs and increasing settlements (Neder 2016). revenues. For example, governments need to authorize service providers to collect bills and give them the 5.3.3 Operating Expenditure Efficiency autonomy to restrict service to nonpaying customers. The ultimate objective is to support service providers to Such reforms in the early 2000s greatly improved become creditworthy entities that can access commercial the performance of service providers across Vietnam, Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 37 including in the city of Da Nang, where between Efficiency gains also require initial investments but will 2005  and 2014 the company more than tripled its pay for themselves, via lower operating costs or higher connections (14,000 of which to the urban poor), revenues, in a relatively short time. A recent Asian reduced NRW to 17 percent, and lowered energy costs Development Bank (ADB)-funded assessment in by 23 percent (box 5.3). Mongolia concluded that replacing pumps and making FIGURE 5.2. Efficiency Improvements that Help Utilities Reach Financial Viability A 10% increase in revenue would 90 then increase this to 77% of utilities. 80 77 Percentage of utilities deemed viable 70 65 Only 15% of With operational efficiency gains 65% 60 utilities in of utilities can cover operational costs developing and some debt service. 50 countries cover O&M costs and 41 40 generate cash surpluses 29 30 20 15 10 0 Currently viable STEP 1: STEP 2: STEP 3: STEP 4: Collection rate Non-labor With reduction Increase revenue increased to cost reduced of current level of by 10% 100% by 15% non-revenue water to 25% Source: World Bank calculations based on IBNET data. Note: IBNET = International Benchmarking Network for Water and Sanitation Utilities; O&M = operations and maintenance. Estimates from data on 605 utilities in low- and middle-income countries. BOX 5.3. Cost-Recovery Policy Catalyzes Utility Turnaround in Vietnam At the start of the 21st century, service providers in Vietnam, as state-owned-enterprises (SOEs), received financial support from the government that inadvertently promoted inefficiencies. DAWACO, one such SOE serving the city of Da Nang with a population of 1 million, struggled with high levels of NRW and was only providing service to half of the population. In 2005, the government started a reform process to commercialize the water sector and eliminated operating subsidies to SOEs. A government decree required full cost recovery to be achieved by 2015, and allowed service providers to propose tariff adjustments to cover costs. box continues next page 38 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation BOX 5.3. continued These changes forced DAWACO to set out on a turnaround path and to raise its own private capital. The plan was supported by the ADB and a €1.9 million grant for a Utility Support Partnership with Dutch firm Vitens Evides International (VEI). VEI provided technical and operational training to DAWACO employees to increase managerial efficiency, lower operating costs, and expand services, especially to the urban poor. Today, DAWACO is a joint stock company with a mix of employee, government, and private ownership. DAWACO’s strategy is now detailed in a business plan and a Water Master Plan, both conducted every three years. Success factors included DAWACO staff ownership of the turnaround process and cultural prioritization of continuous learning and improvement. Source: World Bank 2017b. slight improvements to operations will save 38 percent Governments need to be careful to promote only of current energy consumption with a payback period cost-effective investments that will require a manage- of just two years (ADB 2013). able level of O&M in the long run. If taken together, the capital efficiency improvements outlined in the pre- When both capital and operational efficiency improve- ceding section could cut an estimated 20–40 percent ments are made, service providers are better able to of the costs of an urban water project or 30–60 move toward a more realistic tariff that is both percent of an urban sanitation project (World Bank, reflective of the service quality and more affordable. forthcoming [a]). Customers are more willing to pay for a better ser- vice, especially if they have been footing the bill for Cutting operating costs not only provides a quick source inefficient delivery in the past. This link between ser- of finance for the sector, but also can help move providers vice quality and revenue makes providers more closer to creditworthiness. Actions to do so are relatively customer-oriented and better able to continue mak- simple from a technical and managerial perspective, ing improvements once they better understand their but require the right incentive structure to be in place. customer base. Numerous service providers under varying types of governance structures have succeeded in making quick 5.4 Conclusion turnarounds, but generally require proper planning, autonomy, transparency, strong technical capacity, Making service providers more efficient is the first step and high-level government support. toward attracting commercial finance. It also puts them on a path of continuous improvement that will make Together, the recommendations under component 1 them financially self-sufficient in the long term while (chapter 4) and component 2 (chapter 5) can make a big delivering better services to users. Those service difference in how the financing needs of the WSS sector providers that can enhance their revenue base through as a whole can be met. The two main funding sources, better performance, free up resources for other gov- as shown on Figure 2.3, are funding from users via tar- ernment priorities, and even enable them to become iffs and other investments and public funding (includ- net tax contributors. ing from taxes and transfers). Figure 5.3 illustrates Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 39 FIGURE 5.3. How Tariffs, Taxes, and Efficiency Can Transform Each WSS Subsector Share of cost coverage by Water Sanitation source of funds Urban Rural Urban Rural Hypothetical example Reduce costs through efficiency Households’ Raise tariffs for own costs those who can afford (on-site) Tariffs and Households’ user own costs investments Households’ Households’ (on-site) own costs own costs Improve Targeted taxes efficiency Opex and transfers Opex Opex Capex Sector management Capex Capex (WWT sewerage &) Taxes and transfers Reallocate Sector taxes Sector management Sector management management Planning, regulation, ongoing monitoring Increase taxes Typical gaps Capex for new extensions Reduce costs, increase tariffs, Capital maintenance attract repayable finance Source: World Bank. Note: Capex = capital expenditures; Opex = operating expenditures; WSS = water supply and sanitation; WWT = wastewater treatment. that  the mix of funding sources typically varies for mobilizing financing from external sources, although different WSS subsectors. For example, in many devel- financing will always be required in systems that are oping countries with limited or no sewerage coverage, expanding and need to be actively maintained. the sanitation sector would largely be funded by users, Although the component discussed in this chapter in the form of user charges or direct investments in (Improve Service Providers’ Performance and building household latrines, for example. Increasing Governance) has focused on efficiency improvements funding for each WSS subsector will require different in the urban water sector, the same concepts can be strategies, including a mix of interventions ranging applied to the other three subsectors. from increasing the efficiency of operating expendi- tures and capital expenditures, increasing tariffs for Note those who can afford them, using taxes in a more tar- geted manner to catalyze investments, and ensuring 1. Although this analysis is based on data from just 690 LMIC utilities in the 2013 database for the International Benchmarking Network that critical sector oversight mandates are funded. for Water and Sanitation Utilities (IBNET), they are highly Such strategies will reduce the total needs for representative. 40 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation Chapter 6 Component 3: Leverage Public Funds to Attract Commercial Finance ­ 6.1 What Needs to Change? Attracting commercial finance—a necessity for meeting the Water Sustainable Development Goal (SDG)—requires With the correct structuring, risk management, and efforts to promote both the supply of and demand for regulation, the water sector is suitable for large-scale finance. Governments are the key to transitioning the commercial finance, as is the reality in most Organisation sector from a wait-and-see mode of investment to a for Economic Co-operation and Development (OECD) proactive engagement with commercial financiers countries. A primary challenge today in low- and as  part of a long-term strategy to meet its goals. middle-income countries (LMICs) is to prepare ­ Governments can serve as brokers between service investment-ready projects and incentivize service providers or local governments looking for finance, providers to become creditworthy. A secondary and lenders who need to better understand the bene- ­challenge surfaces when lenders are new to the water fits and risks of investing in WSS. Governments can supply and sanitation (WSS) sector and require blend commercial and concessional sources to make certain enhancements to reduce the perceived risk ­ borrowing more affordable while at the same time of the sector or country. reducing the risk of the lender.1 The eventual payoff is significant, including a more trans- 3 parent and accountable sector, and an ability to tap into Leverage public increasingly larger volumes of capital. By accessing funds to attract commercial inance these funds it is possible to bring societal benefits for- ward that would otherwise materialize only once more public funds could be mobilized or until tariffs could fully recover costs. Governments and donors can leverage their funds to help countries attract commer- 1 2 cial finance through the measures outlined in table 6.1. Plan, budget and Improve service allocate public providers’ resources more performance 6.2 How Blending Can Help Bridge the ef iciently and governance Finance Gap Blended finance refers to the complementary use—or “blending”—of both public (or concessional) and com- Commercial finance will likely have higher annual repay- mercial finance to make finance available to targeted ment costs than concessional finance, but overall projects. It is the combining of grants with loans, ­ borrowing costs could potentially be lower once other equity, or other risk-sharing mechanisms and is an factors, such as devaluation and inflation, are factored in important vehicle for leveraging additional resources (see appendix B). The costs can also be partially miti- for the WSS sector (table 6.2). Different types of blend- gated through a slow transition (just 10–20 percent) to ing can be provided to address diverse challenges and commercial finance. will result in different levels of commercial sector Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 41 TABLE 6.1. Measures that Help Commercial Finance Work for Borrowers and Lenders Demand-side measures to make commercial finance more Supply-side measures to reduce lender risk ­ affordable for borrowers Blending concessional and commercial loans Blending concessional and commercial loans Catalyzing financial tools: tenor extensions, project preparation Catalyzing financial and regulatory tools: insurance, hedging facilities, results-based financing instruments, pooled finance, guarantees, revenue intercepts, benchmarking, credit ratings Designing blended approaches that adapt to the state of Promoting advocacy and knowledge of the sector to commercial financial market development and sector investment needs in ­ ­ financiers new to the sector or country target countries and for targeted service providers financing. The ratio of public to private financing in invest in WSS in Bangladesh (box 6.1) and Cambodia, specific water transactions could also evolve over time all the way to setting up a revolving fund for providers as markets develop, service providers improve their in the Philippines (World Bank 2016a). creditworthiness, and investors become more com- Blended finance can help correct market failures by fortable with the water sector. giving an initial impetus to service providers that ­ Blending offers two main benefits: demonstrates their commercial viability. For example, it can be used to correct a classic market failure that • Demand side: Offers more affordable borrowing occurs when banks deny credit to an early market rates and reduces the annual cost of borrowing or entrant simply because the business area is new stretches out repayment schedule and  unfamiliar to them as lenders. This can even • Supply side: Entices lenders to the market by reduc- happen when ­ service providers are already ing risk perception through the participation and creditworthy. due diligence of donors or multilateral development Blending reduces foreign exchange risk and lowers the banks (MDBs) cost of borrowing. For example, a loan that is a blend of The intention behind blending is to use the concessional 80 percent concessional finance and 20 percent domes- element to catalyze more commercial investment than tic commercial finance has foreign exchange risk on would be the case without the blending. The continued only 80 percent, rather than 100 percent, of the loan. use of blended finance in a given country can create And although the total debt service will be higher new understandings, relationships, and potential than that of a pure commercial loan, payments are opportunities between the water and the financial spread over 15 years rather than the conventional sectors, which can promote the long-term goal of ­ 5–10 years. increased commercial financing. Different blending instruments (seen in table 6.2 as To date, blended finance in LMICs has not been widely well  as throughout this chapter) serve different pur- used at scale in the water sector. A few transactions poses, but when used together most help to bolster have been supported by international donors, but both the supply of and demand for commercial finance. these have mostly been in middle-income countries, The main objectives of these tools are (a) reduced and they have so far failed to be replicated at scale. costs (which support the borrower), (b) increased Examples of the use of blended finance range from transparency and reduced exposure to risk (which facilitating access to microfinance for households to support the lender), or a combination of both. 42 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation BOX 6.1. Blended Finance to Reduce Rural Sanitation Costs in Bangladesh Rural populations worldwide generally invest their own financial resources to purchase or build latrines or toilets. But the costs can be prohibitive, especially for poorer households or where there is a lack of competition between providers. This is the case in rural Bangladesh, where despite high demand for sanitation facilities, households cannot afford to purchase them without paying in instalments. To address the issue, the country is now embarking on a new project to blend output-based aid—under the World Bank’s Global Partnership on Output-Based Aid (GPOBA)—and microfinance loans to lower the cost of a latrine and spread repayment out in weekly instalments over an entire year. The subsidy consists of about $15 per household and will reduce the weekly payment by 11 percent. A second benefit of the subsidy is that it reduces the risk of the microfinance institutions in their lending. On the supply side, the financiers are also extending loans to microbusinesses that sell latrines and latrine construction. This work is augmented by World Bank technical assistance grants to train entrepreneurs for construction and help the financiers identify and reach poor households. The blending is expected to leverage $22 million in household contributions. Source: World Bank 2016a. To be effective, these tools must be utilized at a spe- 6.3.1 Where Should Governments cific place and time to support service providers that Focus Their Efforts? have the capacity to borrow but cannot yet access A range of service providers can benefit from blended markets. Their limited accessibility may commercial ­ finance—from those that can finance only part of their ­capital be due to information asymmetries or political uncer- expenditures themselves, to those that are close but not tainty. Once sufficient experience exists within a fully creditworthy. Such service providers likely account country for accessing commercial finance, the use of for about 36 percent of all providers as defined as recover- these tools should be reduced or stopped altogether ing between 100 and 150 percent of their operating costs.2 to prevent moral hazard. For the commercial lender, the ability of the service pro- vider to maintain future positive cash flows is critical. 6.3 Building Demand A range of tailored blended finance strategies can be Demand creation starts with the first two components used to help mobilize commercial finance depending on of  this framework: more efficient public resource local financial market conditions and on the way in which allocation and improved service provider performance. ­ a water sector accesses market-based financing. A blend- Service providers should have the incentives to ing strategy can have many different forms (box 6.2), improve performance and climb the ladder toward but each resulting strategy aims to achieve the required creditworthiness. Governments also have a role in debt service coverage ratio (a  measure of the cash supporting broader policies that define the legality to ­ available to pay current debt service obligations) ­borrow. Where barriers to borrowing exist, they should throughout the projection period and to do so without be identified and solutions promoted. the need for additional external finance. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 43 TABLE 6.2. How Select Blending Instruments Can Support Different Types of Commercial Finance Donor or MDB Grants and subsidies Concessional loans and equity Credit enhancements ­instrument Overall approach • Capacity building and training to bridge the Provide liquidity to commercial Reduce risk perception commercial financing gap ­ financiers • Reduce costs to private providers of services or of financing Supplier finance • Develop or pilot new models • Soft loans to vendors and • Guarantees to vendors • Results-based grants ­suppliers and suppliers Microfinance • Sensitize microfinance providers to sector needs, • Provide liquidity: loan capital via • Guarantees to support them in assessing water risks and developing lines of credit, seed funding for microfinance tailored products, train potential borrowers revolving funds providers help them • Targeted subsidies to lower borrowing costs • Take equity shares in mobilize capital from microfinance ­providers commercial banks or • Help microfinance lenders access capital markets investors Commercial loans, • Technical assistance (TA) to sensitize banks to • Blend concessional with • Guarantees to bonds, equity ­market opportunities commercial finance to soften ­ ­commercial lenders • TA to assess investment projects lending terms • Revenue intercepts and • “First loss” agreements escrow accounts • TA to structure transactions • For equity: participations with • Training of borrowers, project preparation ­ activities, shadow credit ratings expectation of below-market returns • Support of water sector pooling or grouping to access larger commercial finance providers • For bonds: transaction advice or structuring BOX 6.2. Typical Blended Finance Strategies • Targeting service providers that are either already creditworthy or close to creditworthiness through per- formance improvements • Linking commercial finance with public or concessional finance through complementary instruments • Identifying and making third-party guarantees effective in a financing plan • Arranging commercial financing and related loan servicing in periods when the default risks are lower • Mixing grants and concessional loans to ensure that positive cash flows work over the projected period Source: Baietti 2017. The ratio of a blending arrangement will depend on the investments such as network extensions. The best fit type of investment, and more importantly, on the profile for these long-term investments would be bonds. of the service provider. For example, in the urban water The  second type is short-term investments to subsector, blending can be used for two types of improve  efficiency (energy reduction, for example) ­ interventions. The first is high-cost, longer-return that would benefit most from commercial bank 44 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation loans  and potentially vendor or supplier finance. In between the short tenors typically offered by commer- either case, if the service provider already has a large cial banks and the long lifetimes of infrastructure revenue base, the investment needs for reaching assets. Tenor extensions, when properly structured, universal access will be smaller, and they can thus ­ reduce annual debt service costs and spread the rely  less on the public contribution of the blending responsibility across generations of beneficiaries. arrangement. Smaller providers with smaller revenue Project preparation funds provide grants and other bases will need greater public leverage. low-cost funds to help establish the viability of a To address the critical need for increased commercial project. Traditionally, up-front preparation costs are ­ investment in water infrastructure across a broad range of 3  percent of total project costs, but they can run as LMICs, donors need a flexible and pragmatic approach high as 10 percent. These funds can be critical for toward the use of blended finance—one that adapts to ensuring that projects are investment-ready and can the state of financial market development and sector attract the interest of concessional and commercial investment needs in target countries. A conventional financiers. Project preparation should include approach to blending could be used in higher-income upstream ­ planning studies, feasibility studies, and countries with nascent capital markets and service detailed economic cost-benefit analysis to determine providers with the potential to be commercially sus- ­ whether the project is economically and financially tainable (Leigland, Trémolet, and Ikeda 2016). However, viable as well as affordable. in  countries facing severe constraints to commercial investment in the water sector, its gradual introduction Results-based financing (RBF) is an alternative to tradi- via blending would be a legitimate objective. tional, input-based infrastructure development that provides incentives for improving performance or While not without risks, the opportunity to blend conces- expanding access in a more efficient manner. RBF ties sional finance with commercial finance is perhaps the payment to the delivery of results, transferring more most promising mechanism to begin the process of clos- risk to the service provider, as in the case of the World ing the financing gap and reaching WSS goals. However, Bank’s São Paulo Water Recovery (REÁGUA) Project in transactions will need to be tailored to the needs of the Brazil, where payment is made for each cubic meter of borrower, the domestic capital market, and the inves- water recovered in wastewater facilities (World Bank tors. The blending arrangements and ratios will evolve 2014a). RBF can reduce the risk of corruption by mak- over time and clearly depend on the country context. ing payments more transparent while also including some up-front costs for construction as well as moni- 6.3.2 Tools to Make Commercial Finance toring and supervision of outputs by a third party. More Affordable Since 2012 the World Bank has scaled up the use of RBF Tools to reduce transaction or financing costs or spread pilots to support investment projects with disburse- them out among a group of service providers, or ments linked to results, including Program-for-Results between current and future users of WSS services, all instruments in the Arab Republic of Egypt (box 4.5) and help make commercial finance a more affordable option a new series of performance-based financing (PBF) win- for borrowers. These tools include tenor extensions, dows integrated into projects in Kenya (box 6.3). In project preparation funds and results-based financing. India, a $1.5 billion facility is helping up to 500 cities Tenor extensions are a mechanism to overcome one of achieve universal access by developing and implement- the single largest challenges facing infrastructure ing turnaround programs that are partially prefinanced finance in developing countries: the mismatch by loans from municipal governments, which bear some Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 45 BOX 6.3. Incentives for Sector Performance in Kenya As Kenya attempts to keep up with rapid urbanization, reaching universal access by 2030 becomes more challenging. The Kenya Water and Sanitation Development Project, currently under preparation, will allow counties or service providers to apply for several types of RBF depending on their operational and access targets. Proposals must meet standard criteria, including financial sustainability, water-source sustainability, cost-effectiveness, and cost-reflective user charges. Projects for priority funding are those with the lowest ratio between investment costs and results: (a) people gaining access, (b) reduction of cubic meters of NRW, and (c) improved reliability of supply. To fund these improvements, the government of Kenya is tapping into the International Development Association (IDA) Scale-Up Facility, a window that offers soft loans that are considerably more attractive than commercial loans at 15 percent interest. The facility provides various options for the type of interest rates, grace periods (5–9 years), maturity limits (24–30 years), and amortization profiles. The government is considering on-lending by applying no surcharge for well-performing service providers, and a 2 percent charge for poorer performers. If combined with commercial borrowings, a blending approach could enable faster achievement of the sector targets. In time, this scheme could evolve into a sectorwide approach applied to the entire WSS sector regardless of financing source. of the risk. Service providers pay off their loans using Effective, fair, and transparent economic regulation is a grants from the facility once results—made publicly key factor for a lender assessing risk in a given country. available annually—have been achieved. Those provid- Regulation must be in place to oversee the service pro- ers that meet minimum standards are incentivized to vider and tariff setting. Creating comparison and com- become “beacons of change” through second-stage petition in the sector via benchmarking can incentivize reforms that bring them closer to commercial viability. the sector to increase capacity and efficiency. For instance, the Kenya Water Services Regulatory Board 6.4 Building Supply (WASREB), with technical assistance from the World Bank, created the Creditworthiness Index report in 6.4.1 The Domestic Commercial Market 2015 to help estimate the financial status of select Domestic financiers in LMICs do not always have experi- water service providers. ence and knowledge of the WSS sector. Coupled with the lack of creditworthy borrowers and political econ- It takes time to transition to significant levels of commer- omy risks, domestic currency cannot always be sourced cial finance. Colombia’s experience shows how initial in long-term maturities and at affordable rates. These donor support can escalate into more-sustainable knowledge gaps can be filled by creating market commercial lending. The country created a second-tier intelligence and analytical tools, such as approaches lender nearly 30 years ago, which today has one-third for diagnosing the creditworthiness of service of its capital invested in the WSS sector. The case of the ­ providers (indexes, shadow ratings, cash flow analy- FINDETER development bank is unique in that the sis, and tariff adequacy analysis) as well as greater lender simultaneously builds the capacity of both promotion of risk mitigation products and how they ­ service providers and domestic banks. The use of an should be used. institution to slowly develop local markets has paid 46 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation BOX 6.4. Colombia’s Municipal Development Fund Colombia has been a pioneer in blended finance since 1989 when the government established FINDETER (Financiera de Desarrollo Territorial), a government-owned, second-tier lender that has maintained a AAA local credit rating. The agency provides loans to a first-tier lender, which is often a domestic commercial bank that finances infrastructure projects. Municipalities and service providers must have their loan applications approved by both the bank and FINDETER, and they can also receive project preparation support from FINDETER. The bank gets the loan at a discounted rate. Combined, these elements promote bank participation, although the bank retains a 100 percent credit risk. The service provider essentially receives commercial loans on blended terms. A voluntary intercept provision further enhances the terms for lenders as the bank has the right to intercept municipal revenues flowing from the central government, if needed. Donors were critical to the initial start-up of the fund by providing loans guaranteed by the government, and they continue to fund the facility. More liquidity is made available from the revenues of existing loans and the issuance of certificates of term deposits. The fund has extended maturities to 15 years compared with the 5-year terms usually available in the market. Source: World Bank 2016a. off now that banks are lending directly to municipali- health of a water service provider. Key performance ties with their own resources (box 6.4). indicators look at an array of factors, including service levels, employees, revenues, and costs. These stan- 6.4.2 Tools to Increase Transparency dardized measurements can be used by investors to Tools to increase transparency can help lenders under- assess and compare the overall health of the institu- stand and assess the performance of borrowers. tion over time and with other institutions. Credit ratings provide an independent assessment of the financial health of a water service provider. Ratings 6.4.3 Tools to Reduce Risk Exposure assist lenders in understanding borrowing risks and Tools to reduce risk exposure are used to mitigate provide insights for service providers on how they may the concerns of the private sector regarding repayment. be viewed by the market. Although credit ratings are In the WSS sector most assets are underground and public information, “shadow credit ratings” are not a therefore cannot be used as collateral in the case of matter of public record and can offer a first step to default. Moreover, with the potential for politicization expose public service providers to the needs and in the sector, securitization of payments on the basis of demands of the commercial lending market. Given the revenues can also be a risk. Tools that help mitigate the high resource requirements for designing and main- risk of nonpayment, by providing other options for taining a credit rating system, there should be suffi- recourse, include insurance, hedging instruments, cient opportunity. pooled finance, and guarantees. Benchmarking is another important instrument to Insurance is used to mitigate an investor’s risk. It can ­ measure and report on the technical and financial also be structured to share risk or tailored to address Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 47 very specific issues. Insurance has been used to miti- Nadu, India (box 6.5) is particularly appropriate for gate concerns addressing such diverse challenges as small service providers. the political economy, key personnel, or catastrophic Guarantees are a form of insurance and are among the circumstances, including natural disasters. most effective tools to reduce credit or political risks for Hedging instruments are another form of insurance commercial investors. The guarantor makes an used to support external investors financing an infra- obligation to pay part of the debt if the government ­ structure project with a revenue stream in local cur- borrower fails to perform in a timely manner rency. They insure investors against foreign exchange nonpayment, failure to redeem bonds, and so on). (­ risk or interest rate risk. However, hedging instruments Guarantees are offered by some AA- or AAA-rated tend to be difficult to structure in smaller economies development partners (World Bank, export credit with less stable currencies. agencies, USAID, the African Development Bank, and the European Investment Bank) as well as by the Pooled finance is a mechanism used to bundle multiple private sector. Guarantees often extend maturities. ­ water service providers with varying degrees of attrac- In select cases they can improve the credit rating of tiveness to investors. The “collective approach” diver- a  security, thereby lowering interest rates for the sifies borrower risk and can provide access to capital borrower. Guarantees are best used when the guaran- ­ markets by enabling the pooled facility to issue bonds tee is tailored to mitigate specific constraints or and on-lend to service providers, as is the case in Tamil overcome a specific risk. ­ BOX 6.5. A Pooled Municipal Bond Issue to Help Small Providers Access Private Finance in India In India, providers had been held back from accessing private finance by a lack of credit ratings or inability to cover bond issuance costs or legal fees. The State of Tamil Nadu in 2002 created a special-purpose facility—the Water and Sanitation Pooled Fund (WSPF)—to help 13 small- to medium-size Urban Local Bodies (ULBs) finance WSS services by accessing long-term domestic capital markets. The AA-rated bond was for $6.2 million, had a coupon of 9.2 percent per annum, and had a maturity of 15 years. The debt was repaid through general ULB revenues. Investor confidence was ensured through five different credit enhancement mechanisms: 1. State government debt-service reserve fund (DSRF): 1.5 times annual principal and interest payments 2. ULB escrow accounts: revenue accounts to pay annual debt service obligations early 3. Local debt service reserve fund: 5 percent of the principal borrowed by each ULB 4. State revenue intercept mechanism 5. Partial credit guarantee: provided by the U.S. Agency for International Development (USAID) to pay 50 percent of the principal in the case of default, paid through the DSRF Source: World Bank 2016a. 48 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation By enticing new lenders to a market, guarantees unlock generally fiscal transfers from the central government ­ access to new sources of finance. Guarantees also have to subnational governments, including water service an intrinsic value: the existence of a guarantee means providers, and can be provided in lieu of collateral. that a project or service provider has already been duly assessed and potential problems have been addressed 6.5 Conclusion during the loan structuring, providing more comfort Where possible, public funding should be maximized to potential lenders. Guarantees also by  leveraging commercial finance. Governments and • Promote risk sharing; donors can serve as intermediaries—both in develop- ing local financial markets and in assisting service pro- • Help the lender better manage risk throughout a viders in building a pipeline of investment-ready project; projects and improving borrowing capacity. Building • Ensure better-prepared projects; the foundations for commercial finance in the sector is • Provide a track record for borrowing from the time-intensive and requires matching the objectives ­private sector; and priorities of lenders and borrowers, often with significant public sector funding. ­ • Help develop local capital markets; A blended finance approach will help borrowers ease • Lower the cost of borrowing (longer tenors, lower into the transition. In addition to blended loans, several interest rates); and proven regulatory and financial tools are available to • Can lead to lower tariffs. bring more incentives for commercial financiers to enter a new market. Concessional financiers should While difficult to quantify, guarantees from MDBs to all consider these tools as part of a larger strategy to help sectors make up about 4 percent of all development “graduate” countries to a new playing field. The transi- lending, totaling around $37 billion between 2004 and tion from aid-dependency to circumstances where 2013 (Humphrey and Prizzon 2014).3 Over a three-year providers or governments can access commercial period (2009–11), guarantees mobilized an additional finance on their own requires donors and governments $15.3 billion from the private sector (Mirabile et al. to work together to ensure that they do not effectively 2013). Although the Camdessus report (as discussed crowd out commercial finance. Most of these tools will in chapter 2) called for an increase in guarantees for work better in countries where capital markets are water sector investments, this has not materialized more developed, but will require more effort on the on a large scale, with current annual volumes around part of donors and governments in more nascent $4 billion (2012–13). markets to be innovative. ­ There is room to expand the use of guarantees in WSS. The World Bank, for example, has committed to Notes doubling the amount of these instruments over the ­ 1. More detail on global experiences with blended finance can be found  in the World Bank discussion paper, “Achieving Universal next three years, including the use of a $2.5 billion Access to Water and Sanitation by 2030: The Role of Blended IDA  Private Sector Window which includes a Risk Finance.” (Leigland, Trémolet, and Ikeda 2016). Mitigation Facility and a Local Currency Facility. 2. IBNET database. https://www.ib-net.org/ Revenue intercepts are another form of guarantee 3. Guarantees are not adequately measured or reported in international databases, including the OECD Development Assistance Committee whereby separate sources of revenue can be used to (DAC) database. The maturities of guarantees are much shorter than cover debt service in the case of default. These are for concessional loans, which also skews the analysis. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 49 Chapter 7 Bringing It All Together 7.1 Recapping the Objectives WSS sector reform is a process that is unique to each country’s economic and political context and can be insti- This report aims to help countries take a new approach gated in various ways—both bottom-up and top-down that focuses on efficiency, targeting, and leverage of (box 7.1). The government should focus its efforts on public funds to attract commercial finance. It must grow ­ roduce designing and funding sector frameworks that p from the implementation of clear and transparent incentives aligned with efficiency and customer-­ governance structures and regulatory environments, ­ oriented service delivery. setting out a pathway that will form differently in each country to contour to the variety of political and eco- Also important are the country-level enabling environ- nomic realities. The objectives are threefold: ments that affect all infrastructure sectors, including WSS. These frameworks set out the nature and extent • To bolster the currently low level of commercial of the financial architecture and determine which finance in the sector types of commercial finance would be available, as • To help decision makers develop the political will well as the use of intercepts, credit enhancements, necessary to break out of the status quo credit provisions, and other financial provisions. Donors can help in the development of these frame- • To bring countries from the current low-level equi- works, using global best practices. librium to the achievement of their water supply and sanitation (WSS) goals The transition toward commercial finance will be a con- By following the components advocated in this report, tinuous and incremental process. Global experience service providers can begin to operate more efficiently, with private sector participation in the water sector serve customers better, save costs, and eventually has shown that service providers do not need to be attract commercial finance to fill the remaining invest- fully creditworthy to start accessing commercial ment gap (figure 7.1). finance. Governments can assist by supporting the right policies, regulations, and incentives and by pro- viding transparent oversight. Regulation is key for 7.2 Finance as Part and Parcel of Broader Sector Reform ­ lowering the risk for commercial financiers, and how the regulation is provided is less important that the Finance alone is not enough: improved service delivery lenders’ perception of its effectiveness. and transparent governance need to be built alongside new and improved financing arrangements. This includes The new framework will require multiple institutions utility managers with high professional capability, working cooperatively toward the same end, each within sound financial management, effective use of bench- its own sphere of influence. All sector stakeholders marks, strategic business plans, internal and external must not only bolster their individual performance—in auditing, and transparent governance and regulation governance, policy, technical capacity, and public and by technically capable and independent agencies. private finance—but must also integrate these reforms Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 51 FIGURE 7.1. Potential Pathways to Fill the WSS Financing Gap Costs Funding Financial Finan- Cost savings costs cing gap Capex Financial Finan- Financial Finan- Finan- Private Financial Private For ongoing costs cing costs cing cial finance costs nance Capex gap gap costs needs Capex Capex Capex Capex Conces- sional Taxes Targeted Taxes taxes only Conces- sional Tari s Conces- Conces- sional sional Tari s Opex Taxes and Opex Opex Opex Opex mainte- Taxes and and and and nance Taxes mainte- mainte- Tari s mainte- mainte- nance nance nance nance Tari s recover a Tari s Tari s large part of the costs 1. Starting point 2. Cost saving from 3. Mobilize domestic 4. Mobilize financing 5. Services financed De ne water SDG e ciency revenue sources from multiple sustainably going forward strategy. Strategic Lower Opex and Raise tari s and user sources Water SDG achieved nancial planning. maintenance costs, charges. Mobilize Leverage commercial Capex efficiencies domestic taxes and finance with blending catalytic loans and grants. Source: World Bank 2016b. Note: Capex = capital expenditures; Opex = operating expenditures; SDG = Sustainable Development Goal; WSS = water supply and sanitation. in a way that can translate more and better-targeted funding and private finance, and to leverage their investments into more and better services. The water ­complementary benefits. sector, as a composite of multidisciplinary institutions, This section sets out recommendations to address the must address multiple challenges, from regulation to financing gap. These recommendations complement efficiency to affordability. Only with significant prog- and build on those of the Camdessus panel, the Addis ress on such foundational elements can the sector Ababa “Financing for Development” agenda, and attract the financing needed to ensure sustainable other significant work, and are to be heeded by all par- services for this generation and the next. ­ ties working in tandem, including donors, govern- ments, service providers, and the private sector. 7.3 Conclusions and Strategic Recommendations 7.3.1 The New Financing Framework To meet Sustainable Development Goal (SDG) 6 and A more proactive, strategic use of public funds and country-level WSS goals, a paradigm shift is needed in concessional finance can crowd in currently untapped ­ the way water services are currently financed. With cur- commercial finance. These funds should be scrutinized rent sector funding just 15 percent of what is expected to determine how they can be used to “leverage in” to reach WSS goals, countries need more of both public commercial finance rather than exclude private 52 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation BOX 7.1. The Evolution of WSS Sector Reform in Mozambique The 20-year reform process in Mozambique was top-down and benefited from significant and long-term donor involvement. A delegated management framework (DMF) gave responsibility for WSS service provision to an asset holding company, FIPAG, which delegated asset operations to various public and private entities through management contracts. For the first decade, a national regulator, CRA, oversaw only water supply in larger cities. It expanded to water and wastewater in secondary cities in 2009 when it decentralized its operations. Financial viability of service providers is achieved via the regulation of cost recovery tariffs. Policies provided an incentive for continuous service improvements, and the DMF provided a clear concept of the ownership, operation, and management of assets. The process hit some major obstacles, such as low capacity and inappropriate incentives for staff. However, owing to the commitment to the long-term vision and a willingness to change course as needed, improvements were made over time. Today, services have improved, although coverage remains relatively low at 50 percent for water and 20 percent for sanitation. Source: World Bank, forthcoming. investment. Donors have strong incentives to lend to 7.3.2 Component 1: Plan, Allocate, and Budget progressive service providers, even after they have Resources More Efficiently reached the thresholds required for accessing commer- Recommendation 1: Integrate incentives: link strategy cial finance. Donors thus need to agree on a set of prin- to policy, and policy to finance. ciples for helping service providers gradually stand on Governments should understand how the status quo their own feet. To that end, the expansion of lending creates explicit and implicit incentives and reform and borrowing in domestic currency would be helpful. them as needed. Many countries have learned from The impact of concessional funds could be amplified if past errors and are moving on from ad hoc sector man- donors and governments made a bigger shift in the water agement toward a more proactive approach to setting subsectors they support (rural versus urban, sanitation and achieving WSS goals. Their future success will versus water). The development of dedicated climate depend on how cohesively their policies are linked to financing mechanisms for subnational entities, includ- institutional mandates and allow for an efficient use of ing water service providers, which would exclude the both public and concessional sources of sector finance. need for sovereign guarantees would be particularly Recommendation 2: Use tariffs and subsidies in a helpful. smarter way. Easing the transition to commercial finance should be an It is critical that subsidies are made explicit, quanti- incremental and iterative process. Public funds will be fied, and tied to policy objectives. To be effective, they needed to build up the foundational elements of an must also be clear, transparent, predictable, and reli- operative WSS sector, from effective regulation to able. They can even be used as an incentive for sound governance and adequate capacity of sector improved service provider performance. Governments institutions. should also be aware of the intended and unintended Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 53 incentives that public funds generate, which can Recommendation 5: Aim for long-term financial include overconsumption of water, inefficient opera- sustainability. tions, or the crowding out of commercial investment. Capital efficiency is especially important for ensuring low operations and maintenance (O&M) costs in the In principle, public funds should be allocated to those long term. Good governance and technical and financial areas that are least likely to attract commercial finance, operating efficiency are the foundation that ultimately such as sanitation or rural water supply. They may also creates creditworthiness and leads to access to com- be used to correct market failures. Although there are mercial finance. Many service providers that have made genuine concerns about affordability, these can often strides in efficiency have done so through good leader- be addressed by tariff structures that provide lifeline ship and incentives for staff to deliver on performance tariffs for basic levels of consumption but allow for improvements. Once service providers gain access to higher tariffs for those with greater capacity to pay for commercial finance, experience has demonstrated that the service. the discipline of the market coupled with effective Recommendation 3: Invest in sector frameworks and ­ regulation drives up service standards and effective institutional capacity. governance arrangements, in a virtuous circle. Service providers should have the mandates, incen- 7.3.4 Component 3: Leverage Public Funds to tives, and capacity to deliver as expected. Regulatory Attract Commercial Finance frameworks are imperative not only for measuring Recommendation 6: Match the supply and demand for progress internally but also for attracting potential commercial finance. commercial finance. Private participation in WSS will not only help fill the financing gap but also will rein- Commercial finance is a large untapped source that force good governance and efficient service delivery. could help fill the financing gap in many countries. Most service providers are unaware of the needs of commercial financiers and the diverse range of instru- 7.3.3 Component 2: Improve Service Providers’ ments they offer, while most investors are wary of the Performance and Governance WSS sector. Governments and donors must address Recommendation 4: Set in motion a culture and the challenges on both the supply and demand sides to cycle of improved sector performance. give both parties the right incentives to do business All efforts to diversify or increase the sources of finance together. An incremental approach will help build will have a minimal impact on the financing of water partnerships between the public and private sectors in infrastructure if the service providers remain ineffi- a given country, at a pace where both feel comfortable cient and unable to borrow. Service providers them- with the changing risk profile. selves must strive for clear lines of revenue, sustainable collection systems, high service standards, systems Recommendation 7: Understand the benefits and that maintain existing infrastructure, proper planning costs of commercial finance. for new infrastructure, and completed audited Borrowers should carefully consider the implicit costs accounts to help financiers and financial regulators and benefits of borrowing concessional and commer- understand the position of the service providers. These cial finance. Although concessional finance may seem incentives can be created if governments set higher more affordable at face value, once foreign exchange expectations for efficiency and hold providers account- and interest charges are taken into account, commer- able for achieving results, and if providers themselves cial finance can be a preferred option for some types work to bring better services to their customers. of  investments. Where commercial finance is more 54 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation expensive, borrowers should also weigh the long-term service providers up the ladder of financial sustain- benefits of making the transition. ability. Once those providers can attract commercial finance, scarce public funds can be allocated to Recommendation 8: Leverage concessional support those providers that are less financially ­ funds by blending. viable. Blending concessional and government resources, even with minimal levels of domestic commercial Recommendation 10: Use tools to make commercial finance, is an efficient use of precious resources and a finance more affordable. critical start to securing the financing to close the gap. Donors should seek to help pioneer tools and instru- Blending can be used to correct market failures—such ments in new countries. Less-developed countries, as lack of credit for early market entrants when already with less-developed financial markets, have lower creditworthy—or as a bridge to bringing the marginally access to commercial bank loans and bonds. However, creditworthy closer to accessing commercial finance microfinance and vendor and supplier finance—for on their own. As with any market correction, blending such investments as solar power and water pumps— should be phased out once commercial finance can be can often provide a starting point from which accessed in its absence. Although the up-front costs of larger  or more traditional investments can be built. developing the financial architecture and becoming Tools to enhance the affordability of commercial creditworthy will likely be high, the long-term payoff finance include tenor extensions, project prepara- of eliminating the foreign exchange risk, closing the facilities, and results-based financing, such as tion  ­ service backlog, and using public and donor resources ­output-based aid. more efficiently will save significant money over time. Recommendation 9: Build demand for Recommendation 11: Use tools to de-risk the sector. commercial finance. An array of risk mitigation tools are available to Donor support should be provided to build a pipeline of enhance the attractiveness of water investments for commercially viable WSS infrastructure, even for par- commercial financiers, including hedging instru- tial commercial finance. In essence, better-­ prepared ments, insurance, guarantees, credit ratings, and projects have the potential to attract more private inter- benchmarking. Resources are available from donors to est, on better terms. Project preparation can also pro- help structure enhancements on specific transactions. vide guidance on the best implementation  model for Governments also have a broader role to play in pro- the project. For example, bulk water supply and waste- viding comfort to lenders through effective regulation water treatment tend to be more attractive for commer- and ensuring predictable and sufficient revenue cial financing, public-private partnerships, or both. streams. The transition will be incremental and slow. Governments and donors can also work with the pri- It  will have some up-front cost outweighed by very vate sector to help transition marginally creditworthy high long-term benefits. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 55 Appendix A Types of Commercial Finance Vendor or supplier finance. Supplier finance occurs credit cooperatives, and informal community-based when a private company offers financing to a customer financial service organizations. Countries like or a potential customer to purchase products or ser- Bangladesh, Cambodia, India, Indonesia, Kenya, and vices. By doing this, the company increases its sales by Malawi have growing microfinance sectors that have financing its own products. This type of financing is experimented to various degrees with lending for water used primarily in water supply. It has tended to focus sector investments. These MFIs typically offer small on pumps and solar energy units, although service loans to individuals, entrepreneurs, and communities providers also offer financing to their customers to that do not have access to traditional credit. These purchase household connections. It is important that ­ arvesting loans can finance items such as rainwater h such equipment is a relatively small portion of costs, tanks, water connections, shallow wells, pumps, venti- especially compared with civil works, which make lated improved pit (VIP) latrines, septic tanks, sanita- up the biggest portion of project costs. With nearly 10 tion slabs, and biogas toilets. Sanitation microfinance percent of all energy costs associated with moving had huge growth potential, particularly to finance water, supplier finance is an important alternative, on-site sanitation (Mehta 2008) estimates. However, particularly in low- to middle-income countries other more recent studies have concluded that, except (LMICs) where commercial lending either may not be in a few countries, existing experiences have remained available or may be prohibitive. More research and limited and have not yet been scaled up  (Trémolet, analysis identify how supplier finance might be scaled Mansour, and Muruka 2015). Water loans typically up. Financial models such as equipment leasing should make up small percentages of MFI portfolios, although also be further explored, such as for financing trucks this is impossible to track with precision because that empty latrines to improve management of fecal microfinance providers do not usually track loan port- sludge in urban areas. folios according to the purpose of such loans. Microfinance lending has yet to make any significant Microfinance. SSIPs play an active role in supplying impact in water supply and sanitation (WSS) sectors of water infrastructure in periurban and rural areas, as low-income countries. But given the important role well as in some urban areas. In most cases, they have played in the sector by SPSPs and households, and the limited access to commercial bank financing. SPSPs high repayment rates for WSS loans where such loans may lack formal legal status or be too small or informal have been provided, there is certainly a business case to have financial statements that can be audited. to be made for expanding this kind of commercial lend- Some emerging economies now have relatively ing, possibly with more support from donors and mul- strong banking sectors with a variety of financial insti- tilateral development banks (MDBs). It will be essential tutions (collectively referred to here as microfinance to develop a better understanding of how governments ­ institutions, or MFIs) that serve small businesses and and MDBs can support the scaling-up of microfinance consumers: commercial banks (many have microfi- ­ approaches in a broader range of countries to help nance portfolios), microfinance banks, savings and tackle the water infrastructure backlog globally. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 57 Commercial bank loans. Worldwide, commercial banks when they lenders lack the space to offer credit in provide local governments and service providers with the  market. This capacity is called “banking depth” a tremendous amount of debt, but most of it is rela- and is measured by a country’s domestic bank credit tively short term (three to five years) and expensive, as  a percentage of gross domestic product (GDP). reflecting the inability or unwillingness of many com- In  Organisation for Economic Co-operation and mercial banking institutions to apply the resources Development (OECD) countries, banking depth aver- necessary for adequate analysis of municipal credit ages 109 percent, whereas in Latin America (a region needed for sector-specific lending, such as that needed with relatively developed markets) the average is for project finance. A large proportion of bank lending only  44 percent (García-Kilroy and Rudolph 2017). to local governments in many LMICs is in the form of Conversely, in some countries, “captive” liquidities “overdraft facilities,” designed to assist with working (that need to remain invested in the country, such as capital needs and short-term cash flow problems. funds managed by institutional investors) may be Commercial banks tend to be very low-risk lenders and ­substantial and in search of long-term financing oppor- usually seek to minimize the risks of lending to subna- tunities on domestic markets. tional providers by requesting collateral in the form of Just as with service providers, local capital markets assets (assets considered liquid—that is, easy to sell— can improve over time to be able to offer private are preferable, but land is also often used). Long-term finance in the water sector. International and national lending for infrastructure by local commercial banks in banks can work together to offer syndicated loans to a LMICs is relatively rare. Project finance for large-scale single borrower. Through such transactions, the local water projects is mostly provided by MDBs or interna- banking sector gains sector-specific knowledge and tional commercial banks, sometimes with syndicate new skills. Moreover, the presence of international participation by local lenders. This kind of finance is banks fosters competition in the local market, which much more widely used than bonds, at least for initial lowers the cost of borrowing. These benefits and syn- tranches of project finance, because dealing with a ergies have been seen in public-private partnership syndicate of bankers to adjust things like construction (PPP) transactions in water throughout the world. milestones is seen as being much easier than negotiat- Bonds. Bonds are a debt instrument whereby the ing with bondholders. The water sector is somewhat lender provides financial resources to the borrowing unique in that most of its assets are underground and entity, which, in the water sector, might be a utility, cannot be used as collateral, making revenue inter- local government, regional development authority, cepts and guarantees much more critical for attracting state-owned enterprise, transmission company, or private finance. bulk water supplier. Regardless of the borrower, most Domestic commercial finance can provide a more water institutions are subnational institutions that attractive alternative in countries with weak curren- may borrow with, or without, the backing of the sover- cies, but markets are often not “deep” enough in eign state. They may borrow based on their total obli- countries with the greatest need. Domestic commer- ­ gations (known as general obligation bonds) or their cial financiers (international or national) located in the specific revenues (generally referred to as revenue borrower’s country provide financing in local currency, bonds). Tax implications differ by country, and the which limits the foreign exchange risk. Market condi- financial architecture and legal environment must be tions on domestic financial markets tend to be less in place to underpin any water provider’s bond issu- favorable, however, with short tenors and relatively ance. Because bond finance is generally less expensive higher interest rates. Liquidity might also be an issue than bank finance, bonds have greater applicability in 58 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation the refinancing of projects after construction is com- still putting the institutional architecture in place to pleted and implementation begins—in other words, issue long-term debt. Finally, the investor commu- after project completion risks have been eliminated. nity, which tends to target pension funds and insur- ance companies, has little experience with water Bonds are commonly used to finance water infra- investments and tends to prefer sovereign-backed structure in many high-income economies but have issuances or energy sector bonds, where revenues been used much less in most LMICs. Tenors tend to be tend to be higher. longer, and interest rates are lower than most com- mercial banks, although the up-front costs can be Equity. Equity finance is the mostly widely used capi- high. Most MDBs have been encouraging their part- tal allocation mechanism for private businesses. ners to look to capital markets to meet part of their It involves selling shares (also referred to as equity) to infrastructure financing needs. In 2013, the African finance business operations. The shares can be sold in Development Bank published a comprehensive ­ ormal regulated stock exchanges, where a variety of f report  on bond financing in Africa, identifying a listing requirements (including listing fees) must be selection of countries that were likely to be able to met by the sellers. For public infrastructure, equity issue bonds immediately (Mbeng Mezui and Hundal finance is a controversial form of finance because it 2013). A number of developing countries have tried entails some form or level of private ownership of to  kick-start municipal bond programs, including assets used to deliver a public service. This is espe- programs to finance water sector investments. cially true in the water sector. Many groups oppose Notable examples include efforts in the late 1990s private ownership of water-related assets, and world- in  India, Indonesia, and the Philippines, although wide the public sector has tended to retain the owner- none of these efforts have reached scale. ship of water sector assets (Pinsent Masons  2012). Several reasons have contributed to the slow take-up. Most listed water companies are in China, European One reason is that bond issues require significant OECD countries, North America, or the United preparation and expert assistance, which is limited in Kingdom. A few listed companies exist in Asia (such many LMICs. Grant finance for technical assistance as Manila Water Company in the Philippines) and can help in this regard. A second reason for so few Latin America (such as Companhia de Saneamento successful bond programs is that many countries are Basico do Estado de São Paulo [SABESP] in Brazil). Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 59 Appendix B Analysis of Lending Parameters on Borrowing Costs This appendix further details the discussion in Debt Service: Short Term Affordability chapter 3 on lending terms, and focuses in particular versus Total Cost on the relative costs and benefits of concessional Affordability is a major consideration for water supply foreign currency and commercial local currency loans. and sanitation (WSS) services, perhaps more so than It is for illustrative and demonstrative purposes only. for any other infrastructure subsector, and this often The appendix provides conceptual comparative and influences policy makers’ decisions on loans and simulation analyses of loans. Some of the loan charac- terms. For example, loans with shorter tenors may teristics discussed are not necessarily available in the have lower overall debt service costs but require higher markets of low- and middle-income countries (LMICs) annual payments, while loans with longer tenors can but are rather used to demonstrate theoretical differ- be more affordable in the short term but end up costing ences in financial costs. In most low- and middle-­ more in total debt service. Most countries or service income countries it is not possible to find a domestic providers thus prefer longer-tenor loans with more local currency loan with the same terms as a conces- affordable repayment plans. sional foreign currency loan. Actual loan comparisons Affordability is constrained by a service provider or should be based on local factors and a much more local or national government’s revenue streams, a rigorous market analysis. large part of which is often current or anticipated reve- The costs quantified for illustrative purposes are: nue from tariffs. Given that tariff setting is often influ- • Debt service costs as a factor of loan maturity and enced by political economy factors, revenues from interest rates; tariffs can fluctuate greatly, and if taxes do not com- pensate for a decline in tariff revenue, the revenue • Foreign exchange costs; and stream itself can fluctuate greatly. • The cost of delay. From a decision maker’s perspective, and given the The combined effect of these different factors needs long-term nature of major WSS sector investments, to be taken into account when deciding on the optimal the terms of a loan borrowed today can affect future financing package for a given investment program. tariff levels. Shorter-maturity loans will maintain or Many utilities would be put off from considering com- put upward pressure on tariff levels to enable a bor- mercial finance because they deem such financing to rower to pay back its obligations. Longer maturities be too expensive compared to what they can charge may allow for lower tariffs. Figure B.1 is based on a their customers. However, the analysis presented in compilation of data from various countries and shows this appendix shows that the true costs of securing the general principle that tariff levels would need to be concessional financing can in fact be higher than what higher (in this case, double) to back a 5-year loan com- is initially conceived. pared with a 25-year loan (Baietti and Raymond 2005). Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 61 FIGURE B.1. Effect of Loan Maturities on Tariffs TABLE B.1. Loan Repayment on a Local Currency Loan at Different Maturities 60 Repayment at 10% interest 15-Year 7-Year 50 Total principal (US$, millions) 50 50 Total interest (US$, millions) 40 20 Tari s (currency) 40 Total debt service (US$, millions) 90 70 30 Annual amortization (US$, millions) 4 8 Interest (% of total debt service) 80 38 20 Source: World Bank. Note: Exchange rate assumed (local currency [LC] to U.S. dollar): 10 LC4,500 = US$1. 0 5 10 15 20 25 the life of the loan. In contrast, the 7-year option would Loan maturity (years) cost only $20 million, or just 38 percent of the total Source: Compiled from Baietti and Raymond 2005. debt service, in interest payments. Figure B.2 com- pares the annual interest payments of the two loans: However, the pressure on tariffs also depends on the total debt service on a 15-year loan is nearly 30 percent type of investments that are being financed. Major more than on a 7-year loan. However, the trade-off is investments can include both those with longer pay- that the borrower must be able to service adequately back periods, such as expansion of the network and the higher annual debt service within the shorter development of a new water source, and those with amortization period. In addition, loans of different shorter payback periods, such as new connections and maturities would in practice be provided at different performance improvement programs. Quick-paying interest rates to reflect lending risks, depending on investments could effectively support commercial market conditions. borrowing with shorter maturities without necessarily affecting tariffs. The Impact of Foreign Exchange Longer Maturity, Higher Total Debt Service Cost Fluctuations In addition, tariffs would preferably be adjusted gradu- A simulation comparing a concessional loan made in ally over time to reflect the forecast impact of long- foreign currency against a commercial loan made in term investment plans (and their associated financing, domestic currency shows the impact of currency which would include a mix of maturities) rather than fluctuations on the annual and total debt service to cover the short-term costs of one specific invest- costs. Table B.2 shows two similar loans: one in local ment. The calculation below show that even though currency and one in foreign currency. A devaluation annual repayments associated with medium-term of the local currency will affect the repayment on a commercial financing may be high, shorter maturities foreign currency loan on both the principal and reduce the overall debt service costs. interest charges. Table B.1 presents a $50 million loan (in local currency) Assessing the potential losses from local currency at 10 percent interest with two different maturities: devaluations is no easy task, but assuming a purchas- 15  years and 7 years. A service provider choosing to ing power parity formula,1 it is possible to forecast the take a 15-year loan will pay 80 percent of the total debt likely fluctuation of the local currency against a hard service, or US$40 million, in interest payments over currency such as the U.S. dollar. As shown in the results 62 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation FIGURE B.2. Affordability vs. Total Debt Service: Loan Repayment Amounts, interest rates. For the sake of by Year, at Different Maturities comparison, the 15-year local cur- rency loan at 10 percent interest, 16.0 presented in table B.1, has a total 14.0 loan repayment of $90 million 12.0 and is just slightly more expen- 10.0 sive than the $82.5 million con- US$, millions cessional loan in terms of total 8.0 debt service. Thus, the elimina- 6.0 tion of the foreign exchange 4.0 impact more than compensates 2.0 for the higher borrowing costs of 0 using commercial finance when 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 such finance is provided at higher 15 year 7 year interest rates. Source: World Bank. Note: Figure shows annual repayment, by year, on a local currency loan (converted to US$, millions) at two maturities: 7 years and 15 years. Exchange rate assumed (local currency [LC] to U.S. dollar): The Cost of Delay LC4,500 = US$1. The second consequential cost associated with foreign cur- TABLE B.2. Comparison of Foreign and Domestic Currency Loans rency concessional loans is the Variable Foreign currency loan Local currency loan potential for delay in terms of Loan value (US$ equiv.) $50 million $50 million arranging the loans. If there is Interest rate (%) 3.0 3.0a some capacity and liquidity Maturity 15 years 15 years in  the local finance market, domestic currency loans could Grace period 3 years 3 years be accessed more quickly than Expected annual inflation (%) 2.0 5.5 concessional loans, which typi- Source: World Bank. a. Comparison for illustration only, given that it would be extremely rare to find a domestic local cally require additional due dili- currency loan with the same terms as a concessional foreign curency loan in a low- to middle-income gence on the part of international country. financial institutions or interna- of the simulation analysis (table B.3), a three percent tional banks less familiar with annual devaluation of the local currency would add the country. In addition, concessional loans often 29.9 percent to the anticipated total cost of the conces- require counter sovereign guarantees, which can sional loan ($63.5 million), which is equivalent to the also cause delays. total debt service on the local currency loan. Deferring projects while waiting for concessional Thus, if a commercial loan were to be offered at the finance can result in significant financial costs, result- same terms as a concessional loan, it would cost one- ing from the impact of currency devaluation and infla- third less because of the elimination of the foreign tion. In addition, delaying investment would generate exchange risk. However, in reality, domestic commer- foregone social and economic project benefits, including cial loans generally have shorter maturities and higher social costs (fewer people with access to WSS services) Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 63 TABLE B.3. 15-year Foreign and Local Currency Loan Repayment at 3 Percent Interest Total debt service, LC loan Total debt service, FX loan Portion of repayment (US$, millions) (US$, millions) Loan value 50.0 50.0 Total principal payment 50.0 67.1 Total interest payment (at 3%) 14.0 15.4 Total debt service FX loan (of which): 64.0 82.5   Principal FX adjustment n.a. 17.1   Interest FX adjustment n.a. 1.9   Total cost of FX currency adjustments n.a. 19.0 Inflation impact n.a. 0 Total cost w/o FX and inflation impacts n.a. 63.5 Increase due to FX and inflation (%) n.a. 29.9 Source: World Bank. Note: FX = foreign exchange; LC = local currency; n.a. = not applicable. FIGURE B.3. Foreign Exchange Costs on a 15-Year Concessional Loan 9.0 8.0 Domestic currency devaluation increases interest payments by 7.0 $1.9 million 6.0 5.0 US$, millions 4.0 3.0 Domestic currency devaluation 2.0 increases principal payments by $17.1 million 1.0 0 –1.0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 FX adjustment Interest payment Principal payment Source: World Bank. Note: FX = foreign exchange. Figure shows annual repayment, by year, on a foreign exchange loan (converted to US$, millions). Exchange rate assumed (local currency [LC] to U.S. dollar): LC4,500 = US$1. and economic costs (less water revenue taxed, less tar- five-year delay. In this illustrative example, the total iff-related income, and greater losses in economic debt service on the loan with a five-year delay is productivity). $104.3  million compared with $82.5 million for the loan with no delay. The cost of the delayed loan Table B.4 presents the foreign currency loan in table increases due to the impact of a three percent annual B.3 side by side with the same loan obtained after a devaluation of the local currency  versus the hard 64 Easing the Transition to Commercial Finance for Sustainable Water and Sanitation TABLE B.4. Concessional Loan Costs, with and without Five-Year Delay Repayment category, 15-year FX loan at Total debt service, loan with no Total debt service, loan with 5-year 3% interest delay (US$, millions) delay (US$, millions) Total principal 67.1 86.4 Total interest 15.4 17.9 Total debt service, FX loan (of which): 82.5 104.3   Principal FX adjustment 17.1 19.8   Interest FX adjustment 1.9 4.4   Total cost of FX currency adjustments 19.0 24.2 Inflation impact n.a. 16.7 Total impact of delay n.a. 40.9 Total cost w/o FX and inflation impacts 63.5 63.5 Increase due to FX and inflation (%) 29.9 64.3 Source: World Bank. Note: FX = foreign exchange; n.a. = not applicable. Table presents the cost of a foreign currency loan repayment in local currency but shown as a conversion to U.S. dollars at the original exchange rate for the sake of simplicity. Exchange rate assumed (local currency [LC] to U.S. dollar): LC4,500 = US$1. currency, including over the FIGURE B.4. Consequential Costs of FX Concessional Loans, with and 5-year interim period), adding without Five-Year Delay $24.2 million in foreign curren- 50.0 cy-related costs. The costs of the delayed loan also increase by $16.7 million due to inflation 40.0 (equal to 3.3 percent annually) on the foreign currency, which would inflate costs of foreign 30.0 US$, millions inputs. If combined, these costs would add 64.3 percent to the 20.0 total cost of the loan. This pro- vides an upper-bound estimate of what the financial costs of 10.0 delay would likely be, for illustration. 0 A comparison of the impacts of Loan with no delay Loan with 5 year delay inflation and foreign exchange on Inflation impact Interest FX adjustment Principal FX adjustment the two loans is presented in figure B.4. Under the delayed Source: World Bank. Note: FX = foreign exchange. Figure presents the cost of a foreign currency loan repayment in local loan, the impact due to inflation is currency but shown as a conversion to U.S. dollars at the original exchange rate for the sake of significant ($16.7 million) when simplicity. Exchange rate assumed (local currency [LC] to U.S. dollar): LC4,500 = US$1. Easing the Transition to Commercial Finance for Sustainable Water and Sanitation 65 compared with the no-delay scenario. Again, for the and tenors. There are very real implicit costs that can, sake of comparison and illustration only, the conces- in some circumstances, make concessional finance sional loan at 3 percent and delayed by 5 years costs more expensive than one might initially assume. 16 percent more in terms of total debt service than the Borrowers should therefore consider commercial 15-year commercial loan at 10 percent interest. finance or blended approaches given their relative benefits, particularly for investments with a relatively In conclusion, although these are hypothetical scenar- rapid return on investment. At the very least, they ios, inflation and exchange rates are significant variables should seek to model the impact of foreign exchange that impact the total long-run cost of concessional fluctuations on borrowing costs and consider alterna- finance and should be examined carefully on a tives (including domestic commercial financing in case-by-case basis. It should be noted that these results local currencies) when such impacts are likely to be were estimated based on evaluating the potential substantial. impacts of a “creeping” devaluation (that is, an annual small percentage over time). Greater losses could occur from “shock” devaluations of 5 percent or more or even Note a catastrophic devaluation such as what occurred during 1. 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