THE THIRD STAGE OF WATER FINANCE:
BEYOND THE PROJECT FINANCE MODEL

 By: Roger D. Feldman

  

 The Three Phases of Water Project Development

As the emerging markets confront the need for water infrastructure financing at the millenium, there is a general recognition that we are entering a new third stage of project development market finance, and that each individual project must position itself to capture investment in this Stage III environment.

The first stage – ancient history – was reliance on multilateral to government funding of assets - which generally then in assistance to government-corporate utilities. Private economic return on the projects was not of material significance.

The second stage – the privatization/private capital markets revolution – was the paradigm of the moment until the capital markets began to question their own ebullience in the face of less than transparent host investment environments or proved fickle lovers for infrastructure projects keyed to sputtering national economics and uncertain governmental support. Even at the height of faith in private markets, it was acknowledged that water/wastewater projects were the capital markets stepchild: the spindly kin to the robust power generation sector, which in some cases even outgrew the need for external credit supports to some degree.

The third stage, which we are entering, has two related elements. First, to render each key aspect of each project statistical comprehensible enough that some person, either in the public capital or the private capital sector, whether or not involved in the transaction, is prepared to accept the return associated with the related risk. To reflect, in short, the hard learned lesson, neither to rely on public sector returns to private investors, nor to portray the realities of the water infrastructure world as spicy enough to produce unduly optimistic returns for private capital. The second element is to "synthesize" the resulting project credit profiles of those elements of water system risk allocation, and

(1) To bring together credits from multiple sources; and

(2) To hold the credits together because enough disparate cash flow strands – appropriately credit accepted and enhanced - are woven into it.

Third stage finance has resilience because it is less susceptible than "natural" credit to being mowed down by change in any one element of single project composition.

In this environment, asset backed financing, on a basis protected with sophisticated credit enhancements of tranches of debt and equity is the logical successor to the use of project financing, which while bold as a gothic tower, is as pitifully reliant on unwieldy flying buttresses of project support as it is.

How can the water industry adapt rapidly to this new Stage III? The answer is: seek to analyze and design the capital structure of each water project not as it might like the capital markets to perceive the project, i.e. as another type of powerplant, nor as a classic risk/mitigation mechanism exercise, i.e. another type of classic project finance using private capital – the flaws in each of which approaches, I will explore momentarily – but by following the following steps, on which I will expand in conclusion:

- Identify the unique economic elements of such projects free from distortions such as these presented by tax laws or allocation of limited host country credit;

- Relate those economic elements to the credit issues which they present;

- To the extent possible, assure that proposed regulatory change and project structuring will generate political momentum based on broadly perceived benefits;

- Seek external economic supports only where such political support otherwise is not likely to be present, so that the creation of synthetic Stage III credit is possible for the system in question.

Let’s begin by examining why the water industry must move from Stage II to Stage III: (1) the flaws in the power model and (2) the limitations of the project finance model.

 

The Power Model

At the height of Stage II project development, an effort was made to cram water projects into the BOT model. This ignored the differences in the two types of projects, which rendered water projects even more vulnerable to non-completion than power projects, particularly when global privatization capital markets shifted.

Briefly these differences are the following:

1. Technical. While power projects’ profiles are governed by technical considerations related to fuel delivery and transmission location, and the somewhat reduced cost of location near load centers, there is considerable room for plant standardization from an engineering and costing vantage. In contrast, water and wastewater projects necessarily are more localized, site specific designed, and subject to considerable engineering expense before final costing and pricing can be established. In summary, there are more complexities in bringing water and wastewater projects to the capital markets than is the case with respect to power.

2. Cash flow financeability.  While water and power pricing clearly are both politicized, it is a much more difficult to enforce the private provision of water through supply cut-off than it is to cut off power. Water is considered to be a necessity that rises to the level of an entitlement, whereas power falls into a distinctly different more discretionary good category. As a result, the presence of firm project cash flows is more problematic in the water and wastewater fields than in the power field. In power, many state-owned enterprises have been sinecures for employment, sources of subsidy for consumers, and financial sinks for the output of other state-owned and local private enterprises. Their willingness to facilitate payment to private firms of higher free market rates has varied, and the uncertainty of their commitment frequently has called into play the necessity of national guarantees. The ability to craft a marketable credit has not been even more problematic in the water and wastewater field, where much more of the administration is municipal and not nationally credit supported. The ramifications of this fact obviously vary with the type of municipality; but frequently it can extend to lower (or no) credit rating, limited financial expertise, changing leadership, limited borrowing ability or possession of other assets which can constitute collateral. As a general matter, it may be harder to rely on the presence of a long term "off take credit" in the water than in the power context, and to use techniques to mitigate risk exposure. While such contractual credit risk may be alleviated in either the power or the water/wastewater setting by the presence of risk equity or by equipment suppliers or construction firms willing to be subordinated debt holders or even investment equity holders, currently there is a significantly larger (albeit somewhat diminished) population of potential capital suppliers of this type in the power field than in the water/wastewater field.

3. Regulation. Perhaps the largest difference between water/wastewater and power is that the former services are still perceived – and regulated – as a natural monopoly whereas electric generation has come to be recognized as a commodity in which competition or the creation of competitive markets can provide consumer protection. In addition, water/wastewater also has been perceived as an area where technological change is relatively slow and availability of information is high. Therefore, direct regulation - as opposed to institutional restructuring to encourage competition – is perceived to be the more appropriate mode.

4. Risk of Change. While regulatory risk obviously affects the water/wastewater as well as power sectors, its characteristics differ. The clear overhanging possibility of environmental regulation through interposition of tougher or more toughly enforced standards, probably is perceived as a greater threat on the water/wastewater side than on the power side. Agricultural and urban political issues are drawn into the regulation mix. As the risk of environmental enforcement grows, the ability to secure capital is jeopardized.

 

The Project Finance Model

The adaptation of project finance techniques as a frame of reference for water project development derives from powerplant analysis thinking, and may inadvertently have the effect of putting blinders on the realistic feasibility of water project finance, in other than a Phase III mode. It does so by leading to mechanistic: problem-solution type thinking.

You are all familiar with these elements which are central to analysis, but not necessarily sufficient to judgment as to current environment financeability:

1. Nature of construction contracts/completion risk (will the project be completed on time and within budget?);

2. Timing of sponsor funds/debt injection;

3. Capacity risk (sufficient capacity being built to meet current and future demand expectations);

4. Tariff structure/pricing ("fair" from both government and investor rate of return perspectives);

5. Technical risk (construction to specifications and operations to standards);

6. Upstream/downstream project risk (e.g., dam construction, pipeline distribution maintenance);

7. Extent of concession exclusivity;

8. Sponsor guarantees/right to changes in shareholding "clawback provisions; and

9. Termination for convenience/termination for default/termination procedures/curing periods.

Likewise, you are familiar with, and recognize the potential value of, the risk mitigation prescriptions associated with project finance analysis:

 

Risk

Mitigation Mechanism

Market or Customer Risk

Independent tariff and demand studies

Utility combinations or regionalization

Loan covenants (debt service coverage ratios)

Offtake or Non-Payment Risk

Take-or-pay contract with two-part tariff

Credit support (guarantees)

Construction/

Completion Risk

Turnkey contracts with performance bonds, liquidated damages, and insurance

Selection of reputable firms, recourse to sponsors' balance sheet during construction

Performance/ Operational Risk

Performance-based operation, maintenance contracts

Long-term ownership interest

Selection of reputable operators

Currency Risk

Indexed tariffs

Debt service payment escrow accounts

Regulatory Risk

Credible concession agreement

Independent regulatory authority

Fair arbitration procedures

Partial risk guarantees

Political risk insurance

It is a necessary, but not necessarily sufficient approach.

 

Operative Credit Definition in the Water Industry

To obtain a clear eyed profile of project cash flow, and thus which projects in a Phase III setting are likely to fend with these risks, so that a financing can be completed, requires both a greater focus on (1) how host government motivations may affect transactions cash flow, as a practical matter, and, in particular, (2) what the cash flow life cycle ramifications of these motivations.

Key considerations for transactional options arising out of host system motivations include:

1. Status of host system characteristics such as a) present and desired future level of system coverage; b) need for repair and network renovation, metering, loss reduction, and treatment upgrade; c) current sources of funding and ability to preserve funding in the future; d) growth projections and needs; e) status of regulation; f) extent of future budgets; g) current and future employment targets; h) current collection rates; and i) sources of current system deficiencies.

2. Key host objectives in seeking private sector involvement including a) attraction of private equity; b) attraction of multinational funding; c) reduction of governmental financial exposure; d) environmental objectives; e) key regulatory and financial concerns; f) desire for asset ownership; g) desire for worker training; h) desire for ancillary economic development; i) limitation on private sector rate of return; and j) maximization of risk shifting to private sector.

3. The suitability of different project specific options and risk mitigation strategies will depend upon the relationship between the objective fact situation and the objectives pursues. Two examples illustrate the point:

a. A system requiring major systematic overhaul and large amounts of capital in the near term must have a prospect of sufficient collections and firm cash flow to induce the associated large scale private risk taking. This will relate to issues such as rate of return adjustments, cut off rights, and management autonomy.

b. A governmental preference for continued control and public employment may be inconsistent with remedying the sources of system difficulty. This may suggest use of a series of more limited measures.

In short, it is critical not to focus abstractly on project form, but how host motivations may affect cash flow, and how in a pooled situation these risks may be accepted.

The Demand Curve and Stage III Financial Planning

In particular, these factors have key interplay in the context of the near and short term shape of the host water demand curve, where the demand is coming from, and who is backstopping payment in support of that demand. This issue is key to the feasibility of Phase III financing, and the negotiation of underlying agreements.

Perhaps more than any other type of infrastructure, water and wastewater projects must be designed to avoid any material risk for cash shortfalls. Future capacity or host country capability for rapid adjustment in capacity must be present. Attendant on this need may be significant commercial risks in cost or demand created for would-be private providers. Provision for quick resolution of capacity-induced problems must be provided. Failure to do so can result in capacity shortages or significant tariff increases. These are the realities implicit in risk allocation.

Consequently, the following elements of the water and/or wastewater project's demand curve on which the transaction will be modeled must be agreed upon implicitly by the parties in negotiations:

a. definitions of terms and concepts used in projections

b. water or sewerage loss assumptions

c. sensitivity to demographics

d. sensitivity to modification of existing resources

e. sensitivity to impact from grant of concessions to other private or public persons

f. sensitivity of usage to introduction of different tariff structures

g. extent of uncertainty with respect to longer term projections vs. current projections (e.g. possibilities of economic shifts)

h. extent of continuing public cushion/backstop in event of variation of assumptions

 

Bottom Line: Project Feasibility in Stage III Financing

With the objective host needs and life cycle cash flow profile in mind, and the recognition that Stage III synthetic-type financing will spread individual project risks more diffusely than has classic Stage II project finance, it is possible in Stage III financings to evaluate water industry projects transaction feasibility from a different bottom line perspective. The question becomes:

Is the balance of benefits large enough and broadly enough spread that the political momentum in support of system project development will be strong enough to overcome the foreseeable institutional resistance to privatization and the change which accompanies it.

Political packages designed to achieve political momentum and to deal with the uncertainties as to demand curve shape are those most likely to achieve Phase III synthetic finance. Here are two such possible scenarios:

 

  • Acceptance of mid-point estimates on the demand curve by both public and private sides; use of a split tariff structure (one portion linked to capacity available and one portion linked to actual usage; phased construction schedule, linking later stage construction schedules to actual demands in earlier stages (thereby avoiding excessive reliance or current demand curve).

  • Phase in of higher tariffs with declining government subsidies, disconnection for non-payment, and incentive payments for different usage patterns which conform to demand projections; presentation of construction flexibility on a system-wide basis.

In Stage III water finance, it will be the skill in obtaining external public and, increasingly, private support to deal with the commercial uncertainties arising out of demand curve shape variability that will separate winning water system development from important but non-financeable concepts. In that context, ability to approach capital, insurance and credit enhancement markets, will be central. It will be possible through this Stage III perspective to crest the turbulence of the capital markets.

  

Roger D. Feldman

 

Roger D. Feldman is a Partner in the century old, 325 attorney international law firm of Bingham Dana LLP, where he is Chair of the Project Finance Group, which has closed over $15 billion in project/structured financings. He is also Managing Director of its affiliated strategic and transaction planning entity, Bingham Consulting Group LLC.

Mr. Feldman is Chairman of The National Council of Public-Private Partnerships; general counsel to the Water Industry Council, an Editor of The Journal or Project Finance and of The Construction Business Review; and past Chairman of the American Bar Association’s Privatization Committee.

A graduate of Brown University, Yale Law School, and Harvard Business School, Mr. Feldman has served as Deputy Administrator for Finance and Environment of the Federal Energy Administration, the Financial Advisory Board of the Environmental Protection Agency and on the White House Staff.