46576 Policy Note No.1 Microfinance for Rural Piped Water Services in Kenya Using an Output-based Aid Approach for Leveraging and Increasing Sustainability by Meera Mehta and Kameel Virjee The water sector in Kenya, especially in to invest in maintenance and business rural areas, has suffered from significant expansion through capital investments. constraints in the availability of finance. These trends exist against a backdrop of Government resources have been limited sector reforms that seek to increase the and non-governmental organizations autonomy of water providers. (NGOs) and faith-based charities have to some degree filled the financing gap. The Kenyan financial sector has seen However, this finance suffers from a increasing levels of liquidity resulting lack of coordination and predictability. from reduced domestic borrowing by the With the newly set up Water Services government. Local finance institutions Trust Fund (WSTF), donor resources are investigating the introduction of more have increased and focus on reaching the innovative financial products to expand poorest. As a result, local community- their portfolios and diversify their assets. based organizations (CBOs) have Kenya has a well-developed microfinance generally developed water supply systems sub-sector that has expressed interest in using their own internal resources and the water sector as it fits well with its available grants; often this extends the mandate to serve the poor. Mehta and development period of a project to over Virjee (2003) have noted that the water five years. Many CBOs are interested in sector provides an entry point for local commercialloanstoexpeditethefinancing finance institutions to develop expertise of their infrastructure as demonstrated by in infrastructure lending. the comprehensive field assessments by government and other agencies, such as The confluence of these factors makes the Athi Water Services Board (a public Kenyaanidealcontextforthedevelopment asset holding company), K-Rep Bank (a of innovative credit-based finance microfinance bank) and the World Bank's products for community-managed small Water and Sanitation Program. piped water systems. This paper describes a pilot project which uses an output- Donor funds focus on new projects or based aid (OBA) approach to leverage those that have completely collapsed as it co-financing from a private commercial iseasiertoshowresultant"impacts"ofnew microfinance bank (K-Rep Bank Ltd) to infrastructure. Thus, there are minimal increase the sustainability of CBO owned incentives for existing small projects and managed small piped water systems. The pilot project enyaK The pilot project has been designed to address these in The design of the pilot project in Kenya has been constraints in lending to small water projects: the viceserS facilitated by the Water and Sanitation Program's OBA capital subsidy helps to address affordability office in Kenya, and is supported through constraints and technical assistance provides aterW additional financial assistance from the Public support to the communities and K-Rep Bank. The Private Infrastructure Advisory Facility (PPIAF) capital subsidy is paid only upon the delivery of ipedP and Global Partnership for Output-based Aid pre-determined and agreed outputs resulting in two uralR (GPOBA). Full operational details can be found in major benefits: for K-Rep Bank (2007). The subsidy reduces the total loan sizes and Thepilotprojectisdesignedtominimizetheneedfor ensures debt service remains affordable. ofinance icrM grant finance in the development of infrastructure The subsidy and the linked project development and to be scalable in the Kenyan sector context. In support provide better risk management from designing the microfinance pilot project a number the lender's perspective. of constraints to the introduction of commercially As the subsidy is only realized upon the delivery priced debt finance were considered: of outputs incentives for project completion and subsequent performance are increased. Finance institutions in Kenya have had very little exposure to "project finance" in the water sector. Institutional and financing arrangements They have either been exposed to balance sheet Figure 1 shows a simple institutional schematic of lending to corporate clients or to microfinance the OBA pilot project. The borrower is the small lending to group-based commercial activities piped water project, a legal entity, owned by its Despite the liquidity in the financial market, members and registered under the Societies Act prevailing tenors and interest rates pose by the Auditor General. In most of the pilot's sub- affordability constraints for potential borrowers projects, the small water project will also be the to meet the minimum investment requirements. operator of the service, though the possibility of Potential projects often lack traditional contracting out operations will be also explored collateral sources, which necessitates in the future. It will be the responsibility of the collateralization of cash flows and more water project to make debt service payments to stringent loan appraisals to ensure adequate risk the microfinance institution (MFI), namely K- management. Rep Bank. Figure 1. Institutional arrangements 2007 GPOBA Microfinance Athi Water 1.oN fund Institution Services Board OBA subsidy Loan to project Debt service Service provision oteN agreement olicyP Small Piped Water Project 2 Table 1. Financing arrangements Micr ofinance Organization During construction After `outputs' achieved Community contribution 20% 20% for K-Rep Bank loan 80% 40% Rural OBA subsidy 0% 40% Piped Total 100% 100% Water TheKenyanWaterActof2002requiresthatthesmall level, where coverage will be measured by the Services water project sign a Service Provision Agreement increased numbers of shared connections. This (SPA) with the Water Services Board (WSB) in increase will reflect equity concerns as the new in whose jurisdiction it falls. The scope of the pilot investments will benefit those without the service Kenya project is confined to the areas surrounding Nairobi rather than only increasing the level of service for ­ within the jurisdiction of the Athi Water Services those already connected. Board (AWSB). The SPA functions as the primary Change in revenues collected ­ the investments regulatory tool governing the performance of the will also alleviate supply constraints through small water project and specifies both performance increased quantity of water supply. In addition, standards and tariff levels for the project. AWSB efficiency improvements through reduction will also chair a project procurement committee to in non-revenue water are envisaged. As the support procurement decisions by the community improved service levels and efficiencies are water projects. difficult to measure directly the total revenue collected will be used as proxy. The introduction of an OBA subsidy requires that the project be initially pre-financed using other Each community project will itself define the level sources of funds. Within the pilot project this of outputs it plans to achieve and this will be built will be through K-Rep Bank and the community into its loan agreement with the K-Rep Bank. project's own resources. After the release of Output verification will be done by an independent the subsidy, the MFI remains responsible for Project Audit Consultant. This auditor will perform collecting the remainder of the loan. Prior to a baseline assessment of the small water project and the subsidy release, the loan amounts to 80% of then visit the project during post-implementation the total investment and reduces to about 40% phases to verify output levels. Approval of the upon successful delivery of the outputs. Figure 2 verification report will trigger the release of the shows the financing arrangement using the OBA capital subsidy. subsidy. The sub-project cycle Policy Defining and measuring outputs The Water Services Trust Fund in Kenya has The outputs are defined for each sub-project as developed a Community Project Cycle (CPC) Note follows: that emphasizes the use of a demand responsive approach (DRA). While carefully maintaining the No.1 Change in the service coverage ­ changes in the DRA emphasis, this generic rural water supply 2007 service coverage will primarily be in the form of sub-project cycle is adapted in the Pilot Project to increased number of service connections, either include the assessments and appraisals required to at the household level or at the community ensure financial viability, debt service capacity and 3 Supporting transactions enyaK risk mitigation. Figure 3 shows the modified sub- project cycle. The assessments are supported by a in support organization and cover a number of critical Transaction support is critical in developing and viceserS elements related to: management capacity; technical institutionalizing this pilot project. The role of design and proposals; and financial viability using the support organization increases the technical aterW reasonable projections after the new investments knowledge and expertise available and makes it have been made. easier for the finance institution to obtain a credit ipedP appraisal. Central to the assessment process are uralR The community project will use these assessments credit assessment tools developed by the Water and for to submit a loan application to K-Rep Bank for an Sanitation Program with PPIAF assistance, which independent appraisal. The MFI ensures familiarity have been adapted for use in the Pilot Project's with the project applications by providing inputs Operations Manual. These allow for a systematic ofinance icrM during the assessment phase. assessment of key risk dimensions. Ultimately, the finance institution will use weighting models to The other critical departure from traditional sub- score the different risk elements and will determine project cycles is during the post-implementation the overall risk associated with the project. Such phase. The pilot provides for a one-time payment to credit scoring models can only arise from sufficient the Water Project for the procurement of a project transaction experience. Thus the detailed assessment implementationconsultant(PIC)tosupportboththe of the pilot sub-projects is critical for the finance implementation and post-implementation phases. institutions to begin to develop sector-specific The PIC provides construction project management knowledge. Over time, as transaction costs reduce, services and support to management efficiency- the MFI would be able to absorb these in their linked improvements during operational phases. interest spreads. The approach for post-implementation support is a key factor in attaining long-term sustainability and is The role played by the project implementation discussed further below. consultant during the post-implementation stage Figure 3. Modified sub-project cycle Community water project submits 1 Eligibility required documents to meet the eligibility requirements and to express demand 2 Assessment Independent assessment of project viability by support organization Finance institution appraises loan 2007 3 Loan and SPA Appraisal application; Athi WSB signs SPA 1.oN Project construction assisted by project oteN 4 Implementation implementation consultant olicyP 5 Post implementation Business development services to support project operations and strategic planning 4 is critical. This includes business development Within the country, the national social fund for Micr services (BDS) to small water projects or, to put it water, the Water Services Trust Fund (WSTF), ofinance more correctly, the small water enterprises (Mehta could develop a specialized grant window that et al., 2006). provides a fast track partial OBA subsidy linked for to mobilization of domestic commercial resources. Rural Many projects do not have the capacity ­ and given This would result in a reduction in the total grant their scale, cannot justify the permanent acquisition finance required to achieve national targets. In Piped of capacity ­ to perform detailed technical and addition, and more importantly, it will improve Water financial audits of their performance. Over time, incentives for better performance by small water the development of a commercial BDS sector project owners and managers, and reduce the risk of Services specifically supporting small water enterprises poor asset management. This risk would be further would be one way of providing these services reduced by promoting a viable BDS sector. in on demand. Similar systems exist in developed Kenya countries, such as the United States, where small A number of lessons are emerging from the Kenyan water systems subscribe to maintenance support experience: services that provide on-demand repair services and system audits. The creation of such a sector The need for a project incubator ­ as financiers requires that there be sufficient demand for services are wary of totally new sectors so there is the and that a number of demand drivers exist. For need for a credible facilitator partner to develop instance, the regulatory reporting requirements background information for local finance should stimulate the demand for information on institutions and to ensure "hand-holding" for system performance. The reporting requirements the initial period. This process is not simply a of the finance institution that provides loans will data collection exercise but requires that the also promote this demand. Ultimately however, finance institutions be involved in guiding the the demand will only be sustainable when the BDS development of relevant information to inform start to provide information and services to the the credit appraisal process. It is important that managers of the community water project in order the MFI views this phase as product development to enhance value through increased revenues and for a future business line in its own portfolio. customer satisfaction. The need for simple tools for credit assessment ­ given the high transaction costs, simple credit In addition, the development of comprehensive assessment tools are required to control costs information systems makes system operations more and systematize project assessments. This has transparent and increases accountability of the the added benefit of leading to the development management to members and customers. of specialized lending products based on key indicators deemed as critical for creditworthiness by lenders. Policy Scaling up and the way forward The need for a conducive enabling environment ­ a number of wider sector issues will influence Note The pilot project described here has considerable the viability and scaling up of such transactions. potential for being scaled up in Kenya and for Most critical is the potential market size in a No.1 replication in other countries. The pilot project given country or region as that will determine 2007 size of approximately 21 sub-projects with a total the possibility of a viable business line for the investment of 2 million US dollars will provide a finance institutions. This affects their decision sufficient pool for lesson learning. to allocate sufficient resources to build 5 enyaK internal capacity. The potential market size approaches,thegovernmentswillalsoneedtofocuson will be influenced by macro factors, such as an enabling sector policy and financing framework. in the regulatory framework, the levels of donor viceserS funding and a policy and financing framework in the country that provides "financing space" aterW for domestic finance institutions and does not "crowd out" the demand for commercial ipedP finance from water projects from ad-hoc grant References uralR funding. for In summary, the Kenya Pilot Project combines Mehta, M. and Virjee, K. 2003. Financing Small a number of innovations: use of microfinance to Water Supply and Sanitation Service Providers: leverage commercial resources; an output-based aid Exploring the Microfinance Option in Sub-Saharan ofinance icrM structure to ensure appropriate incentives; and the Africa. WSP-Af, World Bank. Nairobi. development of a market for business development Mehta, M., Virjee, K., Evans, B. and Wathobio, services to increase sustainability of small water K. 2006. Business Development Services for projects. The lessons from this pilot project will be Community-managed Small Water Enterprises: valid in all those countries where there are reasonably Evolving a new paradigm to enhance sustainability. good domestic microfinance institutions and some Working Paper,. WSP-Af, World Bank. Nairobi. level of community entrepreneurship in running and K-Rep Bank. 2007. Operational Manual, Kenya managing small water projects. To develop similar Microfinance for Water Services Project. Nairobi. Acknowledgments 2007 1.oN This paper has been authored by Meera Mehta (Sr. Financial Specialist) and Kameel Virjee (Financial Specialist). It represents an update of ongoing WSP-Africa-supported activities in Kenya. The initial oteN investigations around this work were funded by the Public-Private Infrastructure Advisory Facility (PPIAF). The pilot project discussed in this paper is being implemented by K-Rep Bank in Kenya, olicyP partly funded using a subsidy from the Global Partnership on Output Based Aid (GPOBA). 6