WATER GLOBAL PRACTICE Crowding-In Commercial Finance in World Bank Water and Sanitation Operations A How-To Guide for World Bank Task Teams SEPTEMBER 2017 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 @WorldBankWater. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations A How-To Guide for World Bank Task Teams SEPTEMBER 2017 © 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. 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Contents Acknowledgments vii Acronyms and Abbreviations ix Chapter 1  Rationale and Introduction 1 Chapter 2  Objectives and Structure of the Guide 3 2.1  Objectives 3 2.2  Structure 3 Chapter 3  Why Crowding-In Commercial Finance Is Important 5 3.1  Breaking the Over-Reliance on Public Funds 5 3.2  Diversifying Sources of External and Internal Finance 5 3.3  Improving the Governance Framework 5 3.4  Improving Information Gaps and Development of the Domestic Lending Sector 5 Note6 Chapter 4  Overview of Step-Wise Guide for Sourcing Commercial Bank Loans 7 Step 1: Set Realistic Objectives and Appropriate Strategy for Success 7 Step 2: Assess Existing Opportunities in the Domestic Finance Market 9 Step 3: Determine the Need for Loan Security and Subordinate Loan Agreements 10 Step 4: Identify which WSPs to Target 10 Step 5: Screen and Diagnose WSPs for Potential Candidates 11 Step 6: Conduct Tariff Adequacy Analysis 15 Step 7: Focus on Viable Performance Improvement Programs in Initial Financing Stage 18 Step 8: Apply the Correct Analytical Approach—The Project vs. the Entity 19 Step 9: Develop a Strategy for Leveraging Commercial Financing 20 Step 10: Develop a Blended Financing Strategy 21 Step 11: Determine the Need for Guarantees to De-Risk Lender Participation 24 Step 12: Match Candidates to Sources of Finance and Assess Capacity of Local Public Finance Institutions as Conduits 25 Notes 26 Appendix A  The Challenge of Financing Water and Sanitation WSPs in Developing Countries 27 What Makes Water Different? 27 Why Do WSS Providers Get into Financial Trouble? 27 General State of WSS Providers in Developing Countries 28 The Ladder of Financial Sustainability 30 Notes 31 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations iii Appendix B  Possible Sources of Commercial Finance for Public WSPs 33 Commercial Local Currency Loans 33 Microfinance 33 FX Currency Denominated Loans 33 Corporate and Municipal Bonds 33 Vendor Financing/Supplier Credits 34 Appendix C  Sector-Wide Considerations for Facilitating Commercial Finance 35 Establishing a Credit Rating System 35 Financial Recovery Programs for Lower Tier Utilities 36 Special Purpose Facilities for Larger Deal Flows 36 Wholesale Commercial Finance Through Local Financial Intermediaries and Leasing Companies 38 TA for Project Development 40 Appendix D  Template for a PAD/PCN Project Component for Blended Financing with Domestic Commercial Banks 41 Note 43 Appendix E  Analytical Guide for Assessing Commercial Finance Opportunities 45 Appendix F  Generic Terms of Reference Financial Analysis of WSS Investment Projects and Their Entities 49 Objective 49 Scope of Work 49 Appendix G  Components for a Diagnostic Review of the Financial and Operational Status of Water Utilities 53 Appendix H  Glossary of Financial Terms for Water Service Providers 59 Bibliography 65 Figures 4.1. Steps for Sourcing Commercial Bank Loans for WSS Entities 8 4.2. Support Options for Crowding-In Commercial Finance 9 4.3. Financial Condition of WSS Utilities in Developing Countries Based on Operating Cost Coverage Ratio 13 4.4. Adjusting Costs Leads to Different Cost Recovery Tariffs—Cases of Overcharging and Undercharging 16 4.5. How Donor and IFI Financing Can Be Structured to Address Profitability and Cash Flow Problems 22 iv Crowding-In Commercial Finance in World Bank Water and Sanitation Operations A.1. Financial Capacity of Selected Utilities 28 A.2. The Ladder of Financial Sustainability 30 Tables 4.1. Assessing for Tariff Adequacy Using a Financial Model 17 4.2. Perspectives of Individual Stakeholders Determine the Analytical Scope 20 4.3. Effects of Blended Finance on Net Present Value and Cash Flows 23 A.1. Overview of Financial Performance of Creditworthy Utilities 29 B.1. Possible Sources of Commercial Finance 34 C.1. Financial Recovery Program for Indonesian Water Utilities 37 C.2. Summary of Facilities 39 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations v Acknowledgments This guide was authored by Aldo Baietti (consultant) William Kingdom, and Sophie Trémolet. Ye-rin Um also with contributions from Meredith Kummings and reviewed portions of the document. overall review and guidance from Joel Kolker (TTL), Crowding-In Commercial Finance in World Bank Water and Sanitation Operations vii Acronyms and Abbreviations CAPEX Capital Expenditures DBP Development Bank of the Philippines DFIs Development Finance Institutions DSCR Debt Service Coverage Ratio EIRR Economic Internal Rate of Return ENPV Economic Net Present Value FIRR Financial Internal Rate of Return FX Foreign Currency GOI Government of Indonesia GPOBA Global Partnership on Output-Based Aid IIGF Indonesia Infrastructure Guarantee Fund IRR Internal Rate of Return LGUGC Local Government Guarantee Corporation MFs Municipal Funds MFIs Municipal Finance Institutions MWA Metropolitan Water Authority of Bangkok MWC Manila Water Company NPV Net Present Value NRW Non-Revenue Water OCCR Operating Cost Coverage Ratio ODA Official Development Aid O&M Operating and Maintenance OPEX Operating Expenditures PAD Project Appraisal Document PCG Partial Credit Guarantees PCN Project Concept Note PFI Private Financial Institutions Crowding-In Commercial Finance in World Bank Water and Sanitation Operations ix PPP Public-Private Partnership PPWSA Phnom Penh Water Supply Authority PRG Partial Risk Guarantees PWRF Philippines Water Revolving Fund ROI Return on Investment SFR Self-Financing Ratio TORs Terms of Reference Task Teams World Bank Task Teams WASREB Water and Sanitation Program Regulatory Board of Kenya WSP Water Service Provider WSPF Water and Sanitation Pooled Fund WSS Water and Sanitation Sector x Crowding-In Commercial Finance in World Bank Water and Sanitation Operations Chapter 1 Rationale and Introduction For several decades, the water sector has been working accountability and governance – both important side to close the financing gap that exists between required benefits. Without these developments, it will be nearly service levels and historical levels of investment impossible to make any substantive progress on clos- financing. Accordingly, the World Bank along with its ing the funding gap. government clients and international development This guide is specifically designed for World Bank partners have been seeking mechanisms and Water Task Teams (Task Teams) and lays out in a sim- approaches for expanding the pool of total funding to ple and practical manner, how to start the process of the water and sanitation sector. accessing domestic commercial finance alongside Yet, the gap continues to grow and current estimates concessional IBRD and IDA resources in WSS sector indicate that the water and sanitation sector (WSS) is operations. This is consistent with the Bank’s overall financing only 15 percent of the current needs. The goal for leveraging additional commercial finance in growing size of these investment requirements has the water sector, and more recently, operationalizing made it clear that public and concessional finance the Cascade Approach. The focus of the guide is alone cannot resolve the funding shortage. At the same primarily oriented to access local currency loans time, it is recognized that a large majority of Water from commercial banks. However, Task Teams should Service Providers (WSPs) across emerging markets are examine the full spectrum of commercial finance from in poor financial health, and as a result, local banks in microfinance, to vendor or supplier finance, and ulti- these same markets are rightly reluctant to finance the mately to institutional lenders who tend to look for water and sanitation infrastructure in any significant larger and longer-term investments through instru- way. At the same time, given that nearly all revenue is ments like bonds. denominated in local currency, foreign exchange While there may be a preference to continue with a (FX)  borrowing carries substantial risk and is not purely public finance model, there is also a recogni- sustainable. tion that this will not result in any substantive However, a growing consensus is emerging on two change. Indeed, bringing commercial lenders to important positions. First, that more must be done to the table requires specialized knowledge, more sub- make publicly owned and managed WSPs financially stantive diagnostic work, as well as the creation of sustainable and creditworthy and secondly, that com- arrangements for reducing their perception of risk. mercial lenders must be brought into the sector, not However, counterparts and Task Teams do not need only to increase the total pool of financing, but also to to be experts in this area, and the Global Water reduce knowledge gaps and create more breadth in the Practice is developing tools, expertise and resources local financial markets. In the longer run, participation that staff can call upon to overcome these initial by local financial institutions will also improve sector challenges. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 1 Chapter 2 Objectives and Structure of the Guide 2.1 Objectives sector providers, which are by far the Bank’s largest cli- ent group. Moreover, project financing of PPPs requires The main objective of this guide is to lay out in a simple a completely different set of approaches to the analy- and practical manner the required steps needed for sis, financing structures and selection mechanisms; accessing domestic commercial loans when consider- and much literature and toolkits have been produced ing a Bank lending operation in WSS sector. Specifically, for this purpose. It must be stressed however, that the it attempts to address the following key questions: debate here is not between implementing modality, • How can Task Teams start to break the overreliance but rather on the need to source additional finance. of public sources of financing? Finally, the focus is on WSS “providers” as opposed to • Which WSPs and investments should be targeted only “utilities,” the important distinction being that and what are the financing and security arrange- the series of steps contained herein can accommodate ments that can be immediately used to qualify for water departments of municipal governments in addi- commercial loans? tion to stand-alone legal entities with consolidated water and sanitation operations. While it is preferable • How can public funds and concessional loans be lev- for potentially viable water municipal departments to eraged more intelligently through blended arrange- transform themselves into a separate legal form, the ments to crowd-in commercial finance? guide can be applied to operations of these depart- • How can Task Teams make this part of their regu- ments if the financial accounts and performance can lar operations without delaying the overall project be properly determined and assessed. preparation process? In concert with the Bank’s overall approach for opera- 2.2 Structure tionalizing the Cascade Approach, commercial finance Following this chapter, the guide provides the is defined herein as the generic term for all forms of rationale for why crowding-in commercial finance is private financial flows that are not concessional in important to the Bank’s development goals and nature, including but not limited to domestic commer- operations. cial loans, microfinance, vendor financing, supplier credits, institutional finance in the form of bonds, in Chapter 2 is the focus of this guide and provides a addition to project financing of PPPs. step-by-step “how-to” approach for accessing domes- tic commercial bank loans within the time frame of a This guide however, specifically aims to access local typical Bank-financed operation. currency loans from domestic commercial banks as this appears to be the area where real potential exists Finally, so as not to divert attention from the focus of in most developing countries. Additionally, while the guide, several appendixes have been added to pro- some of the approaches contained in this report may vide additional background information on the com- also support PPPs, the emphasis here is also on public mercial financing challenges and opportunities for the Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 3 WSS sector, as well as analytical tools and templates • Appendix D - Template for a PAD/PCN project that can support the efforts of Task Teams to pursue component for blended financing with domestic this work successfully. The Appendixes at the end of commercial banks. the main body of the guide include: • Appendix E - Analytical guide for assessing com- • Appendix A - The challenge in financing water mercial finance opportunities. supply and sanitation WSPs in developing countries. • Appendix F - Generic TORs for financial analysis of • Appendix B - Possible sources of commercial finance WSS investment projects and their entities. for public WSPs. • Appendix G - Components for a Diagnostic Review of the operational and financial status of water utilities • Appendix C - Sector-wide considerations for facili- tating commercial finance. • Appendix H - Glossary of financial terms for WSPs. 4 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations Chapter 3 Why Crowding-In Commercial Finance Is Important Summarized here are the reasons why extra efforts should not only cover their costs but also generate suf- need to be made for crowding-in commercial finance ficient cash flow for leveraging debt. Thus, the pursuit in WSS operations. of commercial lending not only increases the total pool  of external finance for attaining the sustainable 3.1 Breaking the Over-Reliance on development goals, but also creates additional sources Public Funds of  internally generated funds through performance improvements and cost recovery tariffs. For govern- Over-reliance on limited and often unpredictable ment policy makers, this transformation can have a external sources of public grants and concessional significant impact on their limited budgetary resources loans is a main reason many WSS operators are in such that can otherwise be allocated to non-revenue gener- financial trouble. IFI loans can only address a small ating investments, but still worthwhile causes. portion of the total needs and are seldom available to many water providers, particularly in provincial capi- tals, and secondary cities and towns. When the stream 3.3 Improving the Governance Framework of public external sources is cut or reduced, WSS enti- Local banking institutions can be important stakehold- ties begin to cut corners, especially on important ers to balance potentially conflicting objectives of maintenance of the networks. This over-reliance of politicians. This is borne out by the study on the limited sources also creates perverse incentives for “Characteristics of Well-Performing Public Water WSPs to overextend themselves and create underuti- Utilities,”1 which revealed how external groups can lized capacity when IFIs do come around, creating influence water utilities to make important manage- inefficiencies in their operations and debt obligations ment decisions and hold them more accountable for that cannot be sustained over time. More importantly, performance. The study also found that well perform- these occurrences greatly undermine the WPSs’ ability ing utilities had effectively fractionalized the power to become creditworthy on its own. Being able to of  politicians in their pursuit of short-term political access commercial finance in the local markets can interests. While international donors can play a provide more assurances to WSPs for satisfying their significant role in curbing political goals, this is usually financing needs when they are required, thus allowing transitional during their specific involvement. Such a them to better plan for their CAPEX requirements and role must then be assumed by other external actors, maintenance operations, as well as to improve perfor- and no better than commercial lenders. mance overall. 3.4 Improving Information Gaps 3.2 Diversifying Sources of External and and Development of the Domestic Internal Finance Lending Sector Accessing commercial finance requires entities to be Most commercial lenders in developing countries have creditworthy or to be able to reach this status in the limited knowledge of the water sector, or more gener- short-term. This invariably means that water operators ally, knowledge in lending for infrastructure purposes. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 5 The development of the domestic capital markets in Note any given country must create this knowledge, so it is 1. Baietti, Kingdom, van Ginneken. May 2006. “Characteristics of Well essential that the international development commu- Performing Public Water Utilities” Water Working Notes No. 9. Water nity accelerate initiatives to crowd-in domestic lenders Supply and Sanitation Sector Board. The World Bank. Washington DC. h t t p : //s i t e r e s o u r c e s .w o r l d b a n k . o r g / I N T WS S / R e s o u r c e s​ through its country engagements. /­Workingnote9.pdf 6 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations Chapter 4 Overview of Step-Wise Guide for Sourcing Commercial Bank Loans This chapter presents a series of steps for achieving Step 1: Set Realistic Objectives and results in the short-term, such that these efforts do Appropriate Strategy for Success not delay or interfere with the ongoing preparation Within the context of a country assistance program of traditional Bank operations. The process is there are several short and longer-term measures that graphically shown in Figure 4.1 and is outlined can be taken to facilitate the participation of commer- below. cial financing in Bank related WSS operations. Setting The required steps include: realistic objectives and an appropriate strategy will be key in achieving any level of success. More importantly, 1. Set Realistic Objectives and Appropriate Strategy expectations must be anchored on realistic outcomes for Success and the project preparation process must not necessar- 2. Assess Existing Opportunities in the Domestic ily be delayed by extensive development work on Finance Market financial markets, or on attaining creditworthiness status among utilities. As discussed in greater detail ­ 3. Determine the Need for Loan Security and below it is possible to include marginally creditworthy Subordinate Loan Agreements WSPs if they can demonstrate a robust financial projec- 4. Identify which WSPs to Target tion that reflects an adequate repayment of debt ser- vice and positive cash flows throughout the repayment 5. Screen and Diagnose WSPs for Potential Candidates period. Additional development work that cannot be 6. Conduct Tariff Adequacy Analysis achieved in the short-term can proceed in parallel through technical support for later stage financing. 7. Focus on Viable Performance Improvement Programs in Initial Financing Stage It is therefore important to look at the process of crowding-in commercial bank loans in a strategic con- 8. Apply the Correct Analytical Approach—The Project tinuum of multiple financing stages, with starting and vs. the Entity ending goals and with realistic expectations on what 9. Develop a Strategy for Leveraging Commercial is achievable within the country context in each Financial stage. Develop a Blended Financing Strategy 10. In the short-term and within the project preparation period, focus must be oriented towards tapping the 11. Determine the Need for Guarantees to De-Risk “low hanging fruit” while improving the environment/ Commercial Lender Participation conditions for later stage financing. Tapping the low 12. Match Candidates to Sources of Finance and Assess hanging fruit means: (i) identifying realistic sources of Capacity of Local Public Finance Institutions. commercial bank loans that can be mobilized quickly Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 7 FIGURE 4.1. Steps for Sourcing Commercial Bank Loans for WSS Entities Local market Targeting, screening Financing strategy & Crowding-in Getting started Instruments assessment & key analysis plan development commercial inance Step 4: Which WSPs to target Step 9: Develop Step 5: Screen and strategy for diagnose potential leveraging public candidates inancing Step 12: Match Step 1: Set Step 2: Assess Step 3: Determine candidates to realistic objectives existing need for loan Step 6: Conduct Step 10: Develop sources of nance and appropriate opportunities in security and tari adequacy blended inancing and assess strategy for the domestic subordinate loan analysis plan capacity of local success inance market agreements public inance Step 7: Focus on institutions Step 11: Determine performance need for improvement guarantees to programs de-risk commercial lender participation Step 8: Project vs. the entity analysis for the operation; as well as (ii) identifying those utili- Task Teams must pay attention to conditions that ties which offer quick paying investments that can be can be achievable during a project preparation cycle. supported through blending arrangements or Anything beyond that should be considered for devel- enhancements. opment purposes as longer-term measures through additional technical assistance support. First stage financing should be primarily oriented towards getting some level of commercial lending par- Removing information gaps among lenders is a worth- ticipation by reasonable means, but primarily either while objective so any level of commercial lender through the implementation of performance improve- participation that achieves this objective should be ment programs to attain creditworthiness or by bring- pursued. An already creditworthy utility may still need ing together an already creditworthy utility and a assistance due to a thin capital market or due to the willing commercial lender. Bank interventions should existence of information gaps. include a full mix of situations even if the opportunity In later stages with the same utilities, the goal should for commercial financing will not be in large quanti- be to increase the participation of the commercial ties. Even a minor participation from a commercial lenders and commensurately decrease the role of pub- lender can lead to major accomplishments. The impor- lic sources of finance. In these stages, the public tance here is to start the process and expand the role of financing role should shift more towards enhance- commercial financing in subsequent financing stages. ments rather than direct public funding. However, sec- Creating capacity in the financial market where it does ond stage operations can still be constrained by the not exist is not an easy task. Some enhancements can inability of the commercial finance market to offer be made in the near-term but the more significant longer tenors and as such, leveraging of public funds improvements require longer-term measures. As such, may still be needed (see figure 4.2 below). 8 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations FIGURE 4.2. Support Options for Crowding-In Commercial Finance Creditworthy but not bankable Creditworthy and bankable • Payback period is too long and greater than available on private finance terms. • Lack of lenders experience in the sector or concerns Financially viable about the governance environment. • Support can be made through partial credit guarantees to extend maturities and lower cost of No support required lending or facilitating bond issuance in nascent markets. • Additional support may also be needed through partial risk guarantees to assure lenders of regulatory stability. Not creditworthy and not bankable Not creditworthy but bankable • These comprise the bulk of utilites which would • Not common occurrence for water utilities or other benefit from blended financing structures infrastructure assets. Such condition occurs mostly in designed to lower the cost of capital and to deal venture capital placements and in start up situations with long payback periods. This group may where there are significant payoffs for going public. also require other enchancements such as, policy risk guarantees, or a mix of all instruments. Bankable Source: Authors’ elaboration. Step 2: Assess Existing Opportunities in • Identify the existence of any special purpose facility the Domestic Finance Market and whether water projects would be eligible. Such facilities could include wholesale programs, pooling Many of the emerging market countries particularly in facilities, OBA programs, ODA supported funds, etc. Latin America and East Asia have the capacity to offer One of the quickest ways to achieve the financing longer-term loans and bonds at reasonable costs, while objectives is to link IBRD or IDA operations to Global the rest of the developing world has relied heavily on Partnership on Output-Based Aid (GPOBA) programs Official Development Aid (ODA) or IFI support to fund also executed by domestic commercial banks. Such public projects. So, it is essential that at the outset programs are already being implemented in many some assessment is made on what in fact are the reli- client countries. able sources of commercial finance in the domestic market. An analytical guide for carrying out this • Identify the existence of other programs or financ- assessment is presented in Appendix E. This requires a ing sources. review to: The assessment should also include realistic measures • Determine the capacity of commercial banks includ- for strengthening opportunities for greater use of com- ing: (i) lending terms; (ii) experience if any in financ- mercial sources of finance such as, developing facilities ing infrastructure and particularly water; (iii) main for risk mitigation and viability gap financing, closing constraints and reservations and level of interest information gaps through creditworthiness indices, in participating in the sector. developing financial recovery programs for failing Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 9 utilities, etc. Finally, the process should also involve • Transfer payments from the national government creating a dialogue with potential commercial lenders to local municipalities are also a common way of and discussing their concerns and requirements. securing loans of local WSPs. These are set up as automatic intercepts in the event of default. Step 3: Determine the Need for Loan Security and Subordinate Loan Agreements Subordinate Loan Agreements In situations where the commercial loan is not the only Loan Security Instruments financing source for the investment plan (i.e., where there Commercial loans can be either secured or unsecured. is a blending of public and commercial funds) a subordi- Unsecured loans are primarily made on the borrow- nate loan agreement can significantly de-risk the com- er’s creditworthiness, rather than by some sort of tan- mercial lender’s participation. Subordinated debt is a gible collateral. Generally, a borrower must have a loan that ranks below other loans with regard to claims on high credit rating to receive an unsecured loan. A a company’s assets or revenues. In other words, the sub- secured loan is backed by collateral, and if it is not ordinated loan won’t be paid out until after senior lenders repaid, the lender can seize the collateral and sell it to are paid in full. By providing the commercial lender with recover the loan. senior status on its loan in a blended financing structure, a  subordinate loan agreement essentially gives these Asset-based security for commercial debt is practically commercial lenders priority on any loan repayment. This meaningless for water utilities since the assets are gov- together with escrowing receivables can provide a pow- ernment owned and mostly underground. However, erful enhancement for crowding-in commercial lenders, some assets, such as equipment and vehicles could be even for marginally creditworthy utilities. used as collateral for loans if utilities are corporatized under commercial law or expressly authorized in the entity’s legal charter. Step 4: Identify which WSPs to Target Albeit, commercial financing relies mostly on securing In the short-term, there are two main categories of cash flows rather than asset or collateral-based WSS providers that should be targeted for assistance financing. There are various ways in which this can for commercial borrowing. be  done, but in principle the approach is to create • Creditworthy utilities that have not previously sourced legal control of various cash flows to secure debt ser- commercial finance. Such WSPs would most likely vice payments through trust agreements or escrow benefit from credit enhancements including third party accounts. These could include such approaches as: guarantees, but may also require some blending sup- • As indicated, creating a collection account through port in the event the tenors of the commercial loan are escrow within the lending agency to receive all or too short to accommodate the cash flow requirements. a portion of all collections from user fees in order • Utilities which can achieve creditworthy status cover debt service requirements. This may also through the implementation of a performance include setting up a reserve fund. This is probably improvement program, but with minimal tariff the simplest measure that can be taken to secure a increases. These would mostly benefit from viabil- WSS loan. ity gap financing through blending arrangements as well as additional credit enhancements. • Municipal governments can also pledge local tax revenues or user fees for either a bond issue or During project preparation, WSP candidates can be ini- corporate loan. tially screened by applying the six “quick assessment 10 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations indicators,” which can later be followed by a more initiation and through a well-funded TA program of thorough diagnostic during project implementation. assistance as this may require significant effort if the These indicators relate to operational performance, initial screening contains many potential candidates. and financing capacity. During project preparation, However, a quick assessment can be undertaken to Task Teams should recruit specialized consultants to spot key problems and opportunities through selected perform these screening and selection activities. indicators. The assessment must also determine whether the tariffs The objective of this quick assessment is to single out cover appropriate costs through a tariff adequacy analy- those water entities which are the most likely to reach sis as discussed below. This is key since the implementa- creditworthy status through the implementation of tion of a performance improvement plan that leads to a performance improvements, or that can potentially creditworthy status for utilities should be achievable increase their total cash flow by utilizing excess treat- with minimal or no tariff increases. Utilities that require ment capacity through a connection program. substantial tariff increases to attain appropriate cost Six of the more important indicators for water utilities recovery would not only require more difficult policy include: decisions, but would also raise the risk level for commer- cial lenders and deter them from participating. A pre-req- • Operating Cost Coverage Ratio (OCCR). The OCCR uisite for significant tariff increases could be met with assesses the operational efficiency of a water service significant resistance by policy makers as well as con- provider (WSP) by comparing operating expenses, sumers well into the improvement program which could excluding depreciation and financial charges and the undermine the original financing arrangements. As income taxes against total operating revenues. An such, the selection process must focus on utilities that OCCR of 1.0 means that the utility is just covering can achieve the maximum financial benefits through its operational expenses but not any other charges. performance improvements and not by tariff increases. As such, it is incurring a financial viability gap which can mean that either: (i) the WSP is inefficient with The selection should also be demand-based, meaning many performance problems; (ii) tariffs are too low; that policy makers as well as utility managers should or (iii) the WSP is inherently unviable. In reviewing be wanting to participate and acknowledge the bene- the OCCR, the analyst should seek to identify WSPs fits of bringing in commercial lenders to the sector. that fall into item (i) as improvements in efficiency Conferences with utility managers, policy makers and can increase the capacity for borrowing. lenders are always good starting points for introducing the elements of a program, identifying key obstacles, • Collection Period. This indicator measures whether and incentivizing the appropriate parties. the utility is getting paid on time. If the utility ­ operates a monthly billing cycle, anything less than a 95 to 97 percent collection ratio can highlight Step 5: Screen and Diagnose WSPs for late or non-payments. The quality of receivables of Potential Candidates a water entity can be further assessed by carrying Generally, a full diagnostic review should be under- out an aging analysis of receivables. This involves taken to assess performance issues in addition to categorizing receivables by number of days out- determining creditworthiness and whether tariffs standing and then determining whether there are are  adequate. Appendix F provides generic Terms specific categories of consumers that are habitually of Reference (TORs) for the diagnostic assessment. late in making their payments. This review would Such a review should be performed during project also show whether the receivables are stale and Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 11 non-recoverable and technically should be written • Debt Service Coverage Ratio (DSCR). This ratio mea- off. Moreover, it can provide good information for sures the ability of the WSP to meet its debt service stepping up targeted collection efforts. Many utili- obligations in terms of current interest charges and ties use the “months collection ratio” which equates the repayment of the current portion of the principal. the number of months held in receivables against The DSCR implicitly incorporates both operating current sales revenue. Although this ratio can be and financial performance of the enterprise. Hence useful, it has significant limitations because a declin- a review of the debt service coverage ratio will ing ratio, may not necessarily mean improvement in provide a good indication of whether the utility is collections. If  for example, revenues are increas- meeting its external debt obligations. While  his- ing (through tariff or coverage increases), this ratio torical results are important, lenders review this could seriously overstate collection performance. indicator closely with simulations of financial pro- jections as historical ratios may be biased in the • Non-Revenue Water (NRW). NRW is probably the event the utilities have not had a good history of most important indicator for a water utility because borrowing. A DSCR of 1.2, means that the projected it not only measures the technical efficiency of operating cash flow is 20% greater than debt service the operation, but also the commercial efficiency requirements. This has often been regarded as a rea- through the control of theft and the billing and col- sonable value for a WSP to achieve. However, the lection process. In measuring NRW, it is important to ratio must be closely reviewed by considering the analyze commercial versus technical losses and to changing parameters of the entity, its capitalization determine the cost effectiveness if each is reduced. structure and expectations for a reasonable return High water losses can be particularly important on the investment. More importantly, the debt ser- if the utility is running out of treatment capacity, vice coverage needs to be analyzed under projected which in most cases would require a significantly cash flows incorporating the corrective measures. larger investment program. Actions to improve As such, much of this analysis would be carried out commercial losses may entail a crackdown on thefts, during Bank project implementation. installing water meters and improving the billing and collection system. On the other hand, actions • Self-Financing Ratio (SFR). This is a prospective to improve technical losses mainly requires reduc- ratio  that would allow the analyst to determine ing leakages in the system but, the cost impacts whether the entity has the capacity to contribute a associated with technical water losses can vary portion of their planned CAPEX program from inter- significantly from one system to another. Systems nally generated financing. Lenders review this indi- that are largely gravity fed and have significant cator closely to determine, not only the available water resources do not realize as much cost sav- free cash flow of the WSP, but its capacity to con- ings as systems that require significant pumping or tribute to the financing plan for a proposed invest- have limited water resource capacity. Therefore, it ment program. Indeed, such a review can provide is important to measure the cost impacts to deter- important information on financing sources needed mine the value added of remedial measures. Finally, for new capital investments. Many WSPs that strug- for WSPs short on water treatment capacity, NRW gle financially would not have a capacity to inter- reduction combined with increasing service con- nally fund significant amounts of new investment nections can add significant financial benefits and requirements. Local or national governments would such circumstances should be a priority for selec- then need to step up to fund the desired equity tion among the different candidates. component of the financing plan. 12 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations • Return on Investment (ROI). The ROI measures recovery TA programs that can be implemented in the overall profitability of the utility and whether parallel; (ii)  middle tier providers that have some the utility is generating an adequate rate of return level of cost  recovery are the main target group of on total capital invested. WSPs that have received this guide;  and (iii) creditworthy utilities that have substantial external ODA grants may be financially not yet accessed commercial finance should also be healthy with ROIs ratios well below what may be considered. generally accepted since the grants don’t constitute Figure 4.3 shows the three broad groups of WSS a repayment obligation. However, the cost of grant providers from the IBNET sample based on their oper- ­ contributions from national or local governments ating cost coverage ratio. should be benchmarked at the opportunity cost of capital for those entities. Step 5.2- Loss Making and Pay-As-You-Go The best way to approach a quick assessment is to Utilities review the results of these indicators together. For Utilities in the bottom two tiers of the Ladder (see example, if a utility has a low OCCR but an adequate Appendix A) are either loss making at the operational DSCR, it may mean that the utility is carrying little level or barely recovering operating and maintenance debt, but also may not be able expand borrowing (O&M) expenses. These are entities with a OCCR of less significantly. Alternatively, if same WSP is also show- than 1.00, meaning they do not cover operating costs. ing high NRW and collection problems, it could indicate the opportunity for performance improve- ­ ment which would allow it to expand its borrowing FIGURE 4.3. Financial Condition of WSS Utilities in capacity. A low collections ratio may signal cash flow Developing Countries Based on Operating Cost Coverage Ratio problems, unless the tariff levels are already com- pensating for this problem and overcharging customers. Following a quick assessment using the above indica- 4% tors, possible problems or opportunities can be fol- lowed up by drilling down on specific issues. Step 5.1- Initial Grouping by the Operating Cost Coverage Ratio 36% As a first step, WSS providers can be easily grouped 60% into three broad categories along the financial sus- tainability framework (the Ladder) presented in Appendix A. This selection process is an important step for early screening of possible beneficiaries for accessing commercial finance and can be initially accomplished by calculating the operating cost coverage ratio of WSS providers under review. These ­ broad categories include: (i) lower tier WSS providers Creditworthy Major target group Too weak (>1.51) (>1.00 but <1.51) (<1.00) which are loss making and “pay-as-you-go” should not be considered but would be eligible for financial Source: Authors’ elaboration of IBNET data. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 13 Even with grants for CAPEX programs these utilities It is with this group that donor institutions and IFIs can further deteriorate financially by expanding access can play a truly effective role by: (i) improving service because if they sell below cost, the financial viability delivery and lowering the cost of finance; (ii) mitigat- gap would only get wider. According to IBNET, this ing some of the risk elements to crowd-in private group would constitute approximately 60% of the money; and (iii) blending public with commercial water service providers in developing countries. finance to reduce the overall cost of financing and stretch out repayment requirements. While performance improvements could address their situation, this group would benefit more from financial However, it is important to underscore that entities in workout/recovery programs that would not only imple- this group are not at full cost recovery levels since they ment performance improvement action plans, but also are probably not earning an appropriate return on their address possible debt overhangs through debt restruc- invested capital. As indicated above, this can be mea- turing or total relief of liabilities. Some WSPs are inher- sured by the other indicators, such as the ROI ratio. ently unviable and should be retained as municipal Consequently, this group of utilities would have departments. As such, entities from this group would problems qualifying under a completely commercial be included as possible candidates for financing only financing structure because they would be exhibiting a after they have gone through their restructuring pro- financial viability gap, which is largely the reason for grams and by so doing, have improved their financial not attaining a creditworthy status. sustainability status and have moved up the Ladder. Step 5.4- Creditworthy Utilities Step 5.3- WSS Providers in the Middle Tiers Creditworthy utilities are those that have demon- These entities include those that can finance only part strated the capacity and willingness to pay their finan- of their CAPEX requirements as well as those that are cial obligations in full and will likely have an OCCR not yet fully creditworthy. This group should be greater than 1.5. Unfortunately, this group currently regarded as the entities that can benefit most from represents less than 4% of the total number of utilities direct blended financing and deployment of various in developing countries. guarantees and credit enhancements. As per IBNET, these represent approximately 36% of the total num- To be creditworthy, the utility must demonstrate a reli- ber of WSPs and register an OCCR between 1.0 and 1.5. able stream of positive cash flow from operations While this group is not yet fully creditworthy it may (operating cost coverage) and sufficient cash reserves be  able to attract commercial finance under several in case future cash flows are not sufficient. Equally conditions: important, the creditworthy utility must take steps to adequately deal with contingent or implicit charges • If the improvement of performance and related such as, sudden cost increases and FX losses, if action plan provide a convincing and reliable stream applicable. While positive and reliable cash flows of cash flow and a debt repayment capacity; are  essential, many commercial lenders will also • If other donors and IFI are key stakeholders in the require other forms of security such as, countervailing financing and can exert influence for transparency deposits, asset collateral and escrowing of receivables. and proper governance; Creditworthy entities can still benefit from World Bank • If certain measures such as enhancements and and donor assistance where there is little familiarity guarantees are provided to de-risk the commercial among commercial lenders in the sector, or where lenders’ participation in the financing. the  terms of lending are too short in maturity or are 14 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations expensive for consumers. Given the lumpiness of • The assessment on the fair value of cost reflective major water investments, utilities require long-term tariff can provide a good indication on policies for loans to maintain affordable tariffs for major network rate increases. The two graphs below illustrate the expansion. concept behind the analysis for determining the adequacy of consumer tariffs. Step 6: Conduct Tariff Adequacy Analysis Figure 4.4 illustrates how financial costs and revenues need to be recast to determine the true cost-reflective Gaining financial independence and becoming credit- tariff. This is achieved by: worthy requires a steadfast process of adopting cost recovery tariffs. Cost recovery tariffs enable govern- • Deducting the performance related costs caused by ments to fully eliminate the need for operational non-revenue water, collection problems and other subsidies as well as capital subsidies. performance type problems such as overstaffing, poor inventory management and cash management Cost recovery tariffs provide governments with an exit practices. NRW and collections indicators can pro- plan when the WSP is capable of sourcing long-term vide an early idea whether the entity may measur- investment financing from commercial lenders. On ably affect financial sustainability if corrected; and this basis, a tariff should be able to cover all costs of operation of the utility plus earn a reasonable return • Adding back other costs which should have occurred on capital invested. such as inadequate maintenance, the provision for FX losses (if applicable) as well as capital costs to However, there are several obstacles in determining recover return on investment. what in fact are truly “cost-reflective tariffs.” In the top portion of Figure 4.4, the recast leads to a • In financial terms, tariffs should recover all costs, slight overcharge of the consumer tariff indicating that but consumer tariffs can also be paying for a lot of it is close or just over the justified cost-reflective tariff, inefficiencies. In a sense, consumers might be over- whereas on the lower portion, the analysis leads to an charged for the service they are receiving. It is there- undercharge. fore important to separate performance issues to In cases where utilities may have overextended them- determine whether tariffs are adequate or not under selves by taking on too much debt, a deeper analysis more acceptable performance standards. would need to be undertaken to determine the appro- • Accounting rules fail to fully capture contingent priate level of debt that should be assumed by the util- or implicit charges such as, provisions for FX ity by assessing the underutilized capacity of the plant losses or scheduled maintenance not performed. in service. These implicit charges may also need to be closely Properly sizing the plant to the overall operation would reviewed. also ascertain the appropriate amount for carrying • Being able to consider both these factors leads to a debt. Again, in such circumstances a financial recovery true and fair value of cost-reflective tariffs. program should be implemented. • Implicit subsidies brought about by performance This process is only intended to determine whether inefficiencies need to be corrected before con- the tariff is truly cost-reflective under better perfor- sumers are charged with new tariff increase. mance conditions. It also helps to determine whether Consumers should not be charged for significant financial sustainability requires tariff increases, per- inefficiencies. formance improvements or both. It does not mean that Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 15 FIGURE 4.4. Adjusting Costs Leads to Different Cost Recovery Tariffs—Cases of Overcharging and Undercharging Tari Total costs revenues Costs related to Tari poor performance Recast revenues costs Overcharging Bad debts NRW Staf ing Costs not considered Capital costs FX risk Maintenance Tari revenues Total costs Costs related to Recast Tari poor performance costs revenues Undercharging Bad debts NRW Staf ing Costs not considered Capital costs FX risk Maintenance Source: Authors’ elaboration. the analysis provides justification for tariff adjust- recast under more acceptable performance standards ments either up or down, particularly if the tariff was to determine whether the average consumer tariff calculated to be below cost recovery levels. is adequate. The simulation shows the results of a utility in Again, it is better policy to make such adjustments Indonesia which charged an average tariff of $.37/m3. once services have improved, rather than increase tar- The utility had been seeking to increase its water iffs under poor performance conditions. Once the core resource capacity and to expand coverage to new com- business model is corrected, tariff adjustments should munities in the coverage area. The financial advisors proceed in line with periodic cost increases. considered the new treatment plant viable under the Using a financial projection model, Table 4.1 illus- assumptions of more than 50% grant (between $60 to trates when actual financial results of a WSP are $80 million) from the Government, a loan default 16 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations TABLE 4.1. Assessing for Tariff Adequacy Using a Financial Model Average Tariff (Indonesian Rupiah) 3,660 3,660 Average Tariff (In US $ Equivalent) $ 0.37 0.37 Performance Parameters NRW 66% 20% −70% Bad Debt Expense 15% 2% −87% Connection Per Employee 225 500 122% Inventory Levels (months of OPEX) 5 2 −60% Water Shortage/Surplus (2,322) 12,238 Return on Fixed Assets −37% 25% Revenues 28,621 31,511 10% Operating Expense Chemical Treatment 1,725 807 −53% Power Costs 7,130 3,336 −53% Repairs & Maintenance 790 1,200 52% Depreciation of Operating Assets 4,025 4,025 Operating Labor 4,050 1,820 −55% Other OPEX 104 104 Production Costs 17,824 11,292 −37% ADMIN EXPENSES AND OVERHEAD General & Administrative 13421 13421 Bad Debt Expense 4293 630 −85% Depreciation Office Equipment 1350 1350 Total Administrative Charges 19,064 9,000 Total Expenses 36,88B 20,292 −45% NET OPERATING PROFIT (8,267) 11,219 19,486 Interest 3,386 3,386 NET PROFIT/(LOSS) (11,653) 7,833 Operating Cash Flow (3,514) 14412 17,926 Working Cap lnc/(Dec) 6100 (3,849) (9,949) CASH BEFORE DEBT SERVICE (7,566) 20,644 28,210 CASH AFTER DEBT SERVICE (12,738) 16,149 28,887 Source: Authors’ elaboration. guarantee and a tariff increase of 6.4% annually over appropriate performance indicators and that the new the following 25 years of operation to approximately investment could be achievable without the $1.80 m . 3 Government subsidy or tariff increases. However, if the advisors had carried out a tariff ade- The additional analysis on tariff adequacy shows that quacy analysis they would have concluded that the even with modest operational improvements (i.e., prevailing tariff would be adequate under more reduction of NRW to 40%) the utility could meet all its Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 17 current debt obligations, as well as fully service the Yet, with 66% non-revenue water, there was ample new debt. Moreover, the same utility could throw off a opportunity to expand service through reductions in significant amount of cash that could help contrib- technical losses as well as to increase revenues by ute to the debt servicing requirement for a new treat- reducing theft, billing errors and other commercial ment plant. losses. The utility may not have been able to connect all the targeted new customers, but would have cre- The analysis also indicated that a new water source ated the foundation for a later stage financing with less would not be needed immediately due to a reduction in government subsidy support or additional tariff NRW, but after more than 5 years out into the future to increases. While this type of scenario may seem iso- coincide with new consumer requirements. lated, in developing countries there is a tendency to This also did not preclude the possibility of further over-reach when an opportunity for financing arises, reduction in NRW. For example, moving from 40% to and such a situation unfortunately has been all too 35% of technical water losses could release an addi- common and has contributed to countless of WSPs tional 1.7 million cubic meters of water and allow for underperforming. connections to 4,500 additional customers. Financial While sources of development finance may be scarce, returns would also increase dramatically. Finally, these a  coherent performance improvement plan greatly simulations were carried out at the prevailing tariff lev- improves the chances for a water provider getting ade- els which were assumed to be adequate for executing a quate financial support and to bring in commercial performance improvement program. Assuming tariffs lenders. Performance improvement programs tend to would keep up with inflation, the financial return on a be much less costly than developing an entirely current basis would improve to the extent that the rev- new water source and in many cases, can offer quick enue base was now greater that the cost base. returns and short payback on invested capital. For The example shows the extent of financial gains that these reasons, they are safer investments for commer- can be made by performance improvements under cial lenders. prevailing tariffs, and if such tariff levels are adequate Moreover, such programs as opposed to programs they can provide a robust platform for achieving requiring longer term payback periods are: (i) much financial sustainability. easier for lenders to comprehend, and (ii) easier to assess the related risks and consider positively. For Step 7: Focus on Viable Performance example, combining NRW reduction with a connection Improvement Programs in Initial Financing program in existing core areas leads to immediate Stage benefits which can accommodate loans of a shorter maturity. This combination of actions not only reduces The prior illustration also underscores how planning costs and increases total water resources but also decisions can be ill conceived. On the surface, the abil- increases revenues from new paying customers. On ity of the utility to expand service to new customers the other hand, a new water source with trunk lines to was constrained by a lack of water resources and the an unserved area is probably not within the interest of seemingly apparent solution was to develop a new a local banker. Such programs are lumpier and raise water source and treatment capacity. Given the utili- several risk factors that the lender would likely ty’s poor financial standing, much of the new infra- consider insurmountable. structure assets would have to be paid through government subsidies combined with substantial tariff To attract commercial lenders, both struggling and increases. well-run water providers must demonstrate that they 18 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations have done their homework and that they’ve developed into the consolidated financial condition of that entity. a coherent strategy to address their main weaknesses This mean that a financial projection of the entire WSP or expansion plans. The preparation of a convincing must always be undertaken which should include business/performance improvement plan is one way all current and near-term operating, investments, and of conveying the competence and commitment of financing assumptions. management which creates a great deal of credibility The financial viability of a project, by meeting or to a third-party lender. exceeding the financial internal rate of return (FIRR)1 One fundamental weakness of both well run and threshold, means nothing if the consolidated utility marginally performing water providers in developing cannot meet all its overall financial obligations. While countries is the lack or an organizational approach to ringfencing project has been commonly applied in PPP planning. In most of these countries, the technical schemes to overcome the problem of unviable utilities, inputs usually drive the planning process. In contrast, this approach is often short-sided as it will not only an organizational approach considers that all utility create additional strains the utility, but may also create operations are part of a dynamic system, and that all winners and losers among the customer base. So, it is operational and commercial variables are intrinsically still essential for governments and development prac- linked to financial outcomes. As such, technical inputs titioners to assess the financial capacity of the overall should not be the sole driving force as they generally utility, and not just the project. are. Rather, technical inputs like other organizational So, a consolidated financial analysis of the utility with inputs should be subjected to financial feasibility and the proposed project is critical to the assessment of bankability tests. creditworthiness, where not only profitability is The organizational approach requires that all depart- assessed but also the ability to meet all cash flow mental units participate in the planning process, and requirements over the projected term of the loan(s). not be dictated by technical requirements only. One Table 4.2 illustrates the perspectives of different stake- excellent way to ensure the adoption of an organiza- holders purely in terms of rate of return indicators and tional approach to planning is for the entity to utilize a analytical scope. For these reasons, government pol- fully integrated financial planning model that effec- icy makers may be more interested to ensure that a tively links all technical and operational variables with project meets the economic viability threshold which financial results. Such models can facilitate options for typically is reflected in the Economic Net Present different actions to ultimately identify the desired Value (ENPV) or Economic Internal Rate of Return solution, not only for the utility but for the other (EIRR). The economic threshold should meet or key  stakeholders. It also requires that different exceeds the government’s opportunity cost of capital. departments within the organization work effectively In contrast, a private investor would be primarily con- towards a common goal. cerned about the project’s return to its equity position Step 8: Apply the Correct Analytical and will ringfence a project to improve the chances to Approach—The Project vs. the Entity such returns. If properly developed, individual projects can be A commercial lender on the other hand, is mainly designed to be financially viable or close to being interested to determine whether the WSP as a consoli- viable. But ultimately the true test of viability and dated entity will be able to meet all its debt service creditworthiness is based on the overall financial requirements. So, while the project’s rates of return is standing of the entity when a given project is collapsed important, more important for the commercial lender Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 19 TABLE 4.2. Perspectives of Individual Stakeholders Determine the Analytical Scope Stakeholder Analytical Objective Financial and Economic Test Government Should be principally concerned about the project’s Project’s Economic Rate of Return or net present value to society and best use of available resources. value against the government’s opportunity cost of capital. Utility Manager Should be concerned about the overall financial Consolidated cash flow analysis drives the sustainability of the utility and the capacity to requirement for profitability and borrowing service debt obligations. capacity. Development Professional Should support the government’s, the manager’s and Project ENPV, consolidated analysis and overall lender’s objectives. financial sustainability of the utility. BOT Water or Wastewater Should be concerned about reliability of the project Project’s cash flow analysis, and FIRR calculation Treatment Operator cash flows driven by rate of return requirements. against required weighted average cost of capital. However, PPP operators should also analyze the overall health of the utility. Private Lender Should be concerned about overall capacity of the Consolidated debt service analysis and overall utility to service debt. profitability of the utility. Source: Authors’ elaboration. is for the utility to maintain positive cash flows The guide has already discussed several elements of throughout the projected period. This means that a leveraging strategy as follows: blending to drive the financial cost down and to stretch debt service payments can be particularly helpful for • Targeting utilities that are either already credit- worthy or that can attain that status though a per- commercial loan approval. formance improvement program with minimal tariff The point to be made by Table 4.2 is that development increases. In other words, that tariffs are already professionals must not only ensure that the project is close to a cost-reflective status. justifiable from and economic perspective , but also 2 that the WSP will remain financially sustainable over • Arranging for one of several methods for securing cash flows, namely: (i) creating a collection account the long run. This means these objectives should be with the lender; (ii) creating national transfer inter- fully in concert with the government policy makers, cepts; (iii) LGUs pledging taxes of user fees for their WSP management as well as commercial lenders. utilities. Commercial lenders may also request util- As such, a fully integrated financial model that puts forth ities they finance to become their depository bank. projected cash flows of the WSPs consolidated financial position is essential for consequential assessment. • Utilizing subordinate loan agreements to provide the commercial lender with senior loan status and where the public loans are subordinate to the com- Step 9: Develop a Strategy for Leveraging mercial exposure. Actions that invoke a “negative Commercial Financing pledge” consisting of borrower actions such as: Governments can effectively leverage their public (i) promise of additional security to other lenders; funds in two distinct ways: (ii) take on additional debt; (iii) dispose of borrowed assets could be waived under certain IFI Loans. • Through blending financing structures; and Pari  Passu3 financing would negate the senior-­ • By providing risk instruments and/or other subordinate relationship as it would likely give equal enhancements status to all lenders, unless it is expressly stated 20 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations otherwise in the loan agreements. More impor- CAPEX program is initiated and well monitored to tantly, if disbursements are made on a Pari Passu assess the consequences on collections. Consumers fashion, it is more difficult to structure the financ- are generally more prone to pay their bills when the ing so that the commercial lender kicks in periods of service improvements have already been made. lower risk during project implementation. • And finally, utilizing a mix of grants and conces- • Identifying third-party guarantees that can be sional loans to make the cash flows work over the offered by either the national or local government projected period. This means being able to: (i) attain or through existing guarantee facilities. The govern- the required Debt Service Coverage Ratio through- ment or IFIs may allow senior lenders to enhance out the projection period, focusing particularly security for their debt, even with a minority lending on  the senior commercial debt obligations; and position overall. (ii) achieving a net positive cash flow over the pro- jected period without the need for additional exter- • Integrating the commercial financing and related nal funding, apart from what had been structured loan servicing in periods during the projected period into the original financing plan. where the default risks are substantially lowered. These periods tend to occur either prior or suffi- Step 10: Develop a Blended ciently after major CAPEX investments have been Financing Strategy made. Examples of viable strategies for reducing the risk of commercial lenders include: Blended finance involves a mix of public grants and con- cessional loans with commercial loans to derive a finan- 1. Commercial funding to correct performance issues cial solution. This solution is achieved by deriving a prior to major expansion of treatment capacity; projected cash flow for the consolidated water entity 2. Commercial financing for the connection programs such that all debt obligations are amply satisfied after such expansion, but where the core financial throughout the entire projection period. Blended finance model of the utility has already been corrected. arrangements can achieve the following key benefits: 3. Commercial financing after performance improve- 1. Improve sustainability levels of water entities, and ments have kicked in (e.g., to expand consumer by crowding-in commercial finance the develop- access). ment of the financial sector is accelerated. • Being able to amply illustrate the project’s effects on 2. Reduce the overall cost of finance to close the finan- cash flow through well-developed projections can cial viability gap of marginally creditworthy entities have significant benefits in drawing in commercial and lengthen maturities. lenders. The important point here is to structure 3. Create financially viable and bankable lending the cash flows such that the debt service coverage arrangements and bridge creditworthiness status. of senior debt is adequate and that the cash flows are reliable during the debt repayment periods. 4. Improve information gaps among commercial lend- Governments can also backstop cash flow short- ers by establishing financial relationships with WSPs. falls during implementation to provide additional 5. Bring additional stakeholders into the governance comfort to the lender. As indicated, water entities process. requiring a substantial increase in tariffs to attain cost recovery status would be extremely risky for 6. If donors and IFIs are involved in the financing lenders unless such tariffs are increased before the structure as honest brokers, they can provide and Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 21 extra element of comfort to commercial lenders to a subsidiary loan agreement to meet this objective. reduce their perception of risk. Likewise, if an IDA credit is being complemented to a government, but the results of the blending analysis Under most circumstances a blended financing strat- requires not only concessional funds, but also grants to egy will encompass the consolidated financial condi- be provided as the public component, a subsidiary tion of the water enterprise, although it is also likely loan agreement would stipulate how the terms of the that ring-fenced municipal water departments could IDA credit to the government would be passed on and also take advantage of this strategy using guarantees subsequently restructured for the WSP to crowd-in the as well as collection or trust accounts that escrow commercial finance. In contrast, the commercial terms water revenues. are not as flexible and are typically provided as a given. However, ring-fencing only the commercial loan por- Lending terms, such as maturity, grace period and tion from the rest of the financial operation of a water interest rate provided to the ultimate water borrowers entity would defeat the original purpose of the strat- should be concessional only to the extent of creating a egy (i.e., to ultimately elevate the entity to a credit- financial solution; and no more. Any more concession- worthy status). Indeed, ring-fencing a given project ally than is required would erode accountability and would reduce the inherent risks of that project for the financial discipline of the entity and would not be commercial lenders but as indicated, other approaches appropriate. can be instituted to better target potential water enti- ties and leave the weaker ones for alternative correc- The subsidiary loan agreement can also be utilized to tive actions. convert FX loans to the government into local currency loans to the ultimate borrowers, thus removing import- Unlike commercial finance, public funds can be struc- ant currency risk to the blended structure. tured to be flexible so they can be molded to financially engineer a financial solution as needed using a combi- The process of structuring the subsidiary loan agree- nation of grants and concessional loans. In other ment should consider: (i) the appropriate mix of grants words, if the financing structure requires longer tenors and loans; (ii) the tenor and grace period of concessional for example, the IFI financing can be reshaped through loans; (iii) the interest rate to be applied; as well as (iv) FIGURE 4.5. How Donor and IFI Financing Can Be Structured to Address Profitability and Cash Flow Problems Loan/grant Subsidiary loan Finacially sustainable agreement agreement terms to the utility to government • Terms to government • Local currency inancing • Extended grace and maturity periods • Low cost of funds • Grant allocation Source: Authors’ elaboration. 22 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations the timing of disbursements which should be coordi- Under the blended option the average cost of capital is nated with disbursements of commercial loans. Since reduced from 11.25% to 1.73%, allowing the Debt several workable options can be derived through this Service Coverage Ratio to increase from .28 times process, this work requires skillful financial engineering to  1.22 times overall, and 1.32 times on the senior followed up by policy dialogue to identify the preferred debt only. The illustration underscores several import- solution for government and the commercial lender. ant points (Reed 2017): Table 4.3 illustrates the results of a given blending First, it shows the difficulty in channeling commercial strategy, showing primarily the effects of closing the finance when utilities are struggling financially, even viability gap of the borrower as well as deriving ade- with enhancements. Strict commercial finance terms quate debt service coverage ratios for the  utility and are not malleable. Investments either conforms to the for the senior commercial lender. The example com- financing instruments or are not bankable. pares a $30 million base case CAPEX program under a typical private structure (base case) against a blended Secondly, the financing solution of the blended option financing option utilizing a mix of grants, concessional was achieved without increasing consumer tariffs. loans and commercial finance. 4 This does not imply that tariffs should not be increased, TABLE 4.3. Effects of Blended Finance on Net Present Value and Cash Flows Base Case Blended Option (Amounts in millions except where otherwise noted) Investment Program CAPEX 30.0 98% 30.0 99% Interest During Construction 0.7 2% 0.2 1% Total Financing Required 30.7 100% 30.2 100% Financing Sources Equity 10.9 35% — — Commercial Financing 19.8 65% 4.2 14% Up-Front Subsidies — — 8.0 27% Concessional Loans — — 18.0 60% 30.7 100% 30.2 100% Financial Structuring Results Financing WACC 11.25% 1.73% Consolidated Utility NPV (MM) −15.9 25.9 Consolidated Utility IRR 4.76% 7.33% Projected Cash Flow Positive no yes Lowest Annual DSCR (Total) .28x 1.22x Lowest Annual DSCR (Senior Debt Only) .28x 1.32x Source: Authors’ elaboration. Note: Calculations are based on the following: (i) 19% return on private equity; (ii) 7% interest on commercial debt with maturity of 5 years and no grace period; (iii) concessional debt at .05% with 20-year maturity and 5-year grace period on principal repayments; and (iv) government CAPEX subsidy at zero percent. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 23 but rather that such decision should be predicated on financing structure that will achieve the objective cri- affordability concerns, and whether tariff levels are teria of all stakeholders. equitable and affordable. If consumers are already over paying for performance problems, there should be no Step 11: Determine the Need for basis to support tariff increases. Guarantees to De-Risk Lender Participation Third, while the blended option shown above requires a significant contribution of public financing as first- Guarantees are a specialized form of insurance related stage financing, the illustration is not totally different to financial transactions in which the risk of non-­ from the reality of current market conditions. compliance by one of the two sides in a transaction is Governments and donors alike must recognize this an taken up by a third-party external to the transaction. initial step of a longer-term strategy to squarely Guarantees essentially transfer risks related to a por- address the funding gap, as well as to attract commer- tion of a specific financial transaction.5 cial finance. Guarantees can work in several ways to transform Fourth, viability gap financing creates a robust plat- potential opportunities into effective investments. form for second-stage financing where commercial First, they can mitigate risks that lie outside the inher- lenders can assume a greater financing role. Further, if ent project fundamentals (e.g., political, regulatory, these proposed investments are oriented to perfor- and policy and sovereign risks). Second, they can mance improvements, substantial operational savings enhance the creditworthiness of the borrower, extend could be realized which can then be applied to sec- maturities and lower the effective cost of debt. ond-stage expansion of services—and potentially While there are many types of guarantees, this paper is without the need for additional public financing primarily focused on two types. These include: support. There is no single best option for creating an appro- • Partial Risk Guarantees (PRG). PRGs cover com- priate mix of grants, concessional loans and commer- mercial lenders against the risk of the govern- cial loans. The preferred option is really a function of ment (or a government-owned entity) failing to the inherent objectives of three main stakeholders: perform its policy or contractual obligations. (i)  government; (ii) lenders (both commercial and Indeed, Bank PRGs are mostly oriented to Public- concessional); and the utility management as they Private Partnerships for regulatory risk, but very will be responsible for attaining the performance few have been issued for water since they were targets set out by the financing and performance developed. Indeed, governments will commonly improvement program. issue comfort letters against policy changes which may impact negatively the sustainability While the process is similar for all cases, the analytical of a financing arrangement. This can be an area work must be case-specific, not only because each util- to explore if domestic commercial lenders desire ity is different, but also because the objectives and risk this form or enhancement. PRGs can cover several tolerance of stakeholders such as commercial lenders risks, including changes of laws and regulations, will differ from one situation to another. non-allowance for agreed tariff adjustments, or The process requires both technical and financial government (or government entity) contractual expertise working collaboratively together, not only to payment obligations (e.g., periodic or termination develop the appropriate action plan and CAPEX pro- payments; agreed subsidy payments; minimum gram, but also to financially engineer a blended revenue guarantees). 24 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations • Partial Credit Guarantees (PCG). PCGs cover Consequently, an important determination must be non-payment of a portion of the debt service obli- made whether third party guarantees can be made gations. In that sense, they are considered a com- available in the short-term. Unless the intended Bank prehensive guarantee for both principal and interest operation is to provide either a partial credit or partial for maturities beyond what can be obtained by com- risk guarantee to existing lenders, putting in place a mercial lenders without enhancements. Credit risk Bank supported guarantee, especially for a small guarantees are more important for domestic lend- transaction may not be realistic. In some markets, guar- ers and bondholders than PRGs. As an example, a antee mechanisms have emerged among private finan- credit guarantee could be offered for debt service in cial institutions. For example, the Local Government years 8 through 10 on a financing plan that requires Guarantee Corporation (LGUGC) was introduced in the a 10-year loan, but domestic commercial loans are Philippines in 1998 as a joint venture between Bankers available for only 7 years. Additionally, the guaran- Association of the Philippines and the Development tor could assume first loss (up to a specified percent- Bank of the Philippines to offer partial credit guaran- age or amount) on debt service that falls short of the tees for local development projects. total requirement. If IFI guarantee facilities are not in place, Task Teams Despite the benefits of guarantees in extending matur- should consider other forms of enhancements such as ities and lowering costs, they cannot or should not make loan security (as discussed earlier) or guarantees that projects viable that are fundamentally unviable. can be provided by either the municipal or national Guarantees only work if the financial viability gap is governments. closed or will be closed through blended financing. By extending maturities or by lowering the cost of debt, Step 12: Match Candidates to Sources guarantees may contribute to this objective, but blended of Finance and Assess Capacity of Local structures can have substantially greater impacts in this Public Finance Institutions as Conduits regard. Guarantees however, can work well with blended This step focuses on identifying the most promising structures and loan security arrangements for strength- sources of commercial finance available based on the ening the viability and bankability of borrowers. earlier assessment made of the financial sector and its Much like international loans, guarantees can be con- capacity. In addition, there will be a need to determine strained by transaction costs. So, the application of the appropriate implementation vehicle and whether international guarantees can turn out to be difficult if existing public finance institutions such as, develop- the commercial lender’s exposure is small. Even with ment finance institutions (DFIs) or municipal funds large PPP deals, IFI guarantees have been rarely used can effectively play a role in the desired operations. as other ways were found to mitigate the credit or pol- Regarding sources of commercial finance, domestic icy risks. In many ways, it is much easier to obtain commercial lenders will likely be the more realistic comfort letters from the sovereign government to choice for carrying out a joint blended operation. This backstop a financing agreement. National or local gov- is particularly true if these lenders have already had ernments may also provide specific guarantees in case some experience in the sector, even as purely deposi- of default. IFI sponsored guarantees can require some tory agencies. time to process, so the best opportunities for either partial risk or partial credit guarantees exist where Also, OBA and microfinance programs that are either facilities have been developed and are currently being contemplated or already under implementation operating. offer an excellent opportunity for linking programs, Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 25 and could speed up the process in identifying private providers, this assessment would be required in any partners as these approaches also seek local commer- case as the overall operation would require an assess- cial banks and microfinance agencies to supplement ment of the most appropriate implementing agency. subsidies with loans. Kenya has had a good history The commercial finance portion of the blended finance with these programs but more could be done to better plan should be largely coordinated by the implement- integrate other strategic priorities of water entities ing agency but kept outside the its specific procedures. with providing access to poor communities. This would mean better integration of IDA assisted financ- Notes ing in the sector with OBA and microfinance initiatives 1. The Financial Internal Rate of Return (FIRR) is the rate of that contemplate commercial finance participation. return expressed as a percentage that an investment yields over its useful life. This process also requires determining whether the 2. The economic analysis focuses on incremental benefits and costs operation that is being considered is a single large pro­ arising from a given project. This is typically best achieved through ject or multiple smaller ones. Single large projects can a “With and Without Test” since it is easier to identify the incre- mental values. While the “project” specific analysis is important attract international sources of finance while smaller for the financial test, the consolidated analysis is even more transactions would necessarily require either an imple- important to ensure sustainability of the entire utility. The eco- menting government agency, a financial intermediary nomic test is carried out without the inclusion of financing assump- tions as the ENPV or EIRR assess viability on a total return basis and or an existing facility of private capital. whether these indicators surpass the Opportunity Cost of Capital of the Government. The ENPV is the value of the sum of projected Local Development Finance Institutions (DFIs) and cash flows discounted at the selected cost of capital. Any value Municipal Funds (MFs) can act as important conduits above zero indicates an adequate economic return, but the higher for wholesale programs supported by IFIs and conceiv- positive value indicates a higher return. The ENPV calculation does not calculate an exact rate of return as does the EIRR. It just indi- ably, could also participate by augmenting IFI loans cates that the project return is either above or below the desired with their own sources. These may already have exist- threshold level. ing programs with the support of IFIs or bilateral aid. 3. Side-by-side or an equal footing. Each lender would have equal However, the importance here is to assess whether claim  in repayment of debt obligations which negates the senior-­ subordinate relationship. these institutions are financially sound and have the capacity to do proper credit analysis as well as finan- 4. The illustration uses a private finance structure to illustrate the effects of blending and of de-risking the commercial lenders portion cial engineering. of the financing plan. While an entirely public mix of grants and con- cessional loans could achieve similar results as a blended option, the While a TA program can be designed and implemented intention here is to discontinue the purely public model. to assist these institutions, institutional capacity must 5. For more information on guarantees see Humphrey and Prizzon be present to make the operation successful. For Task (2014), and for more information on IFI guarantee products for water Teams contemplating financing operations of WSS see Baietti and Raymond (2005). 26 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations Appendix A The Challenge of Financing Water and Sanitation WSPs in Developing Countries What Makes Water Different? Why Do WSS Providers Get into Financial Trouble? Water supply and sanitation operations in developing countries present many challenges to potential lenders. There are many reasons why WSS providers get into Like power and transport, water is capital intensive financial trouble, often driving them into a vicious with high up-front costs and long payback periods. For performance spiral (Baietti 2006). ­ major network expansion, this necessitates financing • Often, utilities are starved of sufficient finan- in long-term maturities and with sufficient grace peri- cial resources because of competing budgetary ods to accommodate long construction schedules. resources and thus cut corners to meet expenses, However, unlike other infrastructure sectors most particularly for maintenance of the network. The water assets are underground, consisting of civil works reliability of financing sources is critical to finan- that cannot be pledged as collateral. For this reason, cial sustainability but public funds are also scarce. many international sources of finance available to If WSS providers compromise their opportunity to other sectors with high imported equipment, such as fully recover costs through tariffs, they become sub- supplier or export credits, are not significant for water stantially reliant on government transfers to sustain investments. Moreover, with most assets underground themselves. But poorer countries often struggle to lenders have less recourse for getting their loans back fully fund WSS operations, let alone meet the fund- in the event of default. It is practically impossible to ing needs for new CAPEX requirements. As such, shut down a water entity in the event of default or sub- utilities that rely on governmental transfers for their mit it to forced bankruptcy as is typically done for financial sustainability are in fact jeopardizing their commercial businesses. Loans to water entities must status since any failure to fully meet revenue and therefore be made on the strength of the balance sheet O&M requirements will erode service levels, not to and ultimately, strong positive cash flows that ade- mention halt the opportunity to expand coverage. quately show ample debt repayment capacity. • Utilities fundamentally misinterpret their mission and overextend themselves. They must effectively These factors may, in part, explain the reluctance of balance the need for their own financial survival commercial lenders to get involved in the sector, but with the development needs for greater customer water’s most fundamental finance-related problem access. Effectively rationalizing the need to sustain arises from its social dimensions. Water is commonly the core business model is essential before any risk- regarded as a public good and a necessity for life, ier operations are undertaken. prompting greater interference from policy makers. Politicians have been hesitant to authorize cost recov- • Because utilities often lack adequate financial ery tariffs, especially to low-income communities; and resources, they take on too much when they are in developing countries this is by far the largest con- offered by donors and IFIs, leading to underuti- sumer segment (Reed 2017). lized systems with a substantial debt overhang Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 27 that customers cannot sustain. This is a significant tariffs; or (iv) by requiring the WSP to extend service problem, especially when there is little cooperation to unviable areas without first correcting the busi- among donors and IFIs and all desire to participate ness model or providing adequate subsidy support in the financing a selected utility. Overbuilding for such initiatives. becomes a significant structural problem if the WSS provider is not able to quickly utilize the underuti- General State of WSS Providers in lized capacity. Developing Countries • Cost structure and balance sheets can materially Ideally, water entities should be able to provide reli- change due to external shocks, particularly if the able cash flows at minimal risk for commercial lenders. entity is carrying liabilities in FX currencies. Also, In the more developed economies, water companies a change in governance policies can materially alter that are listed in the stock exchanges have low volatil- the financial sustainability of the utility. ity indices, reflecting the more stable and the lower • Finally, a water entity can be fundamentally mis- risk nature of such investments. Moreover, most pub- managed or inherently unviable. However, WSS lic water entities in the developed countries are funded services are not particularly difficult operations to from commercial sources. manage. Water operations are relatively stable busi- In developing economies, the situation is markedly nesses in developed countries; and with a proper different. Saddled with consumer affordability con- incentive framework, managers can usually apply cerns, the politization of tariffs and unreliable regula- good management principles to their operation. tory frameworks, the sector is generally at a low level However, the governance framework can create of financial sustainability. many constraints on the proper management such as: (i) not allowing the shutting off services when According to a recent sample of almost 700 utilities customers do not pay; (ii) requiring the utilities to within the IBNET database of financial and operational assume more staff than are needed; (iii) not allowing data representing almost 5,000 utilities in 186 coun- legitimate costs to be recovered through consumer tries and territories, less than 60% were not able to FIGURE A.1. Financial Capacity of Selected Utilities a. OPEX cost coverage ratios of selected utilities b. Utilities breaking even on OPEX 800 120% 350 45% 700 40% 100% 300 600 35% 250 80% 30% 500 200 25% 400 60% 150 20% 300 40% 15% 200 100 10% 20% 50 100 5% - 0% 0 0% >0 >.26 >.51 >.76 >1.01 >1.26 >1.51 >.99 >1.19 >1.34 No. of utilities Cumulative Source: Authors’ elaboration of IBNET data. 28 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations TABLE A.1. Overview of Financial Performance of Creditworthy Utilities Benchmarking Performance to Creditworthy Utilities Manila Water Company MWA 2013 2014 2015 2013 2014 2015 Rate of Return on Equity (%) 17.2 15.6 14.8 15.1 13.4 13.1 Debt to Equity Ratio (%) 104.4 84.7 63.1 13.3 12.7 13.2 Debt to total Assets (%) 45.5 40.9 32.3 10.5 10.3 10.8 Rate of Return on Assets (%) 9.4 9.6 9.9 12.0 10.9 10.7 Current Ratio (times) 1.02 0.96 0.60 1.23 1.82 2.79 Total Revenues (pesos/baht MM) 14,794 14,882 15,088 19,115 19,492 19,917 Operating Expenses (pesos/baht MM) 6,421 6,537 7,069 11,870 12,615 12,767 Operating Cost Coverage Ratio (times) 2.30 2.28 2.13 1.61 1.55 1.56 Net Profit (pesos/baht MM) 5,103 5,149 5,385 7,245 6,877 7,150 Net Profit Margin Margin (%) 34.5 34.6 35.7 38.4 35.8 36.5 Source: Authors’ elaboration. Note: MWA = Metropolitan Water Authority of Bangkok. fully cover their O&M expenses, and far fewer are prof- higher cost of operations as reflected by the lower itable or capable of fully servicing debt obligations of OCCR. Its lowest ratio over the 2013-2015 three-year any significant amount. Just 17% of these utilities gen- period was 1.55 times, whereas MWC’s lowest ratio was erate a surplus just 20% over operating costs. 2.13 over the same three-year period. Depending on their financial structure, a very low per- Following its financial turnaround, the Phnom Penh centage (between 2% and 6%) of these utilities could Water Supply Authority (PPWSA) in 2004 achieved an assume and service debt of any kind. A comparison OCCR of 312% or 3 times. But at 17%, its profit margin with two creditworthy utilities explains this. was much lower than either MWC or MWA, given the fact that its tariff was still not at full cost recovery lev- Both Manila Water Company (MWC) and the els due to a large infusion of donor grants which had Metropolitan Water Authority of Bangkok (MWA) have not been reflected in the revenue requirement. It’s a net profit margin after taxes in the mid-30s in per- return on equity was just 2.2% and return on assets centage terms. This means that the net profit ratio is just 1.9%. 1.3 times revenues, after covering non-operating costs including interest and depreciation as well as income Several additional points about the IBNET sample. taxes. This already explains how far below the rest of the sector stands when just 17% of the sampled utilities • First, many are saddled with performance issues generate a surplus over operating costs of just 20%. that drive up operating costs significantly or alter- natively, reduce cash receipts. The greater the per- With regards to the Operating Cost Coverage Ratio formance issues, the more that the OCCR can be (OCCR),1 which compares directly to the IBNET sam- increased if they are corrected. ple, the two utilities show markedly different num- bers, but they are still substantially higher than the • Secondly, for proponents of increasing consumer averages of the sample. MWA shows substantially access at any cost, the data set provides a startling Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 29 reality – that even with grant funding for expand- for understanding the dilemma that WSS providers ing access, most utilities would deteriorate finan- face in financing their operations. cially because their revenues don’t even cover WSS providers in developing countries face formidable operating expenses. As such, an expansion to only challenges in achieving long-term financial sustain- increase access can only be sustained with a com- ability in part due to a widespread failure of many to mensurate increase in OPEX subsidies support. recover the full legitimate cost of service from user tar- If operating costs are greater than revenues, WSPs iffs, but also because external sources of financing, would require both CAPEX and OPEX subsidies, particularly from government budgetary transfers, are otherwise their financial viability would deterio- often unreliable. rate further. Water operators can effectively improve their financial • Third, rather than cherry picking the same WSS sustainability status by increasing the role of consumer operators for Bank operations, a more comprehen- tariffs in meeting total costs and being given assur- sive approach is needed for addressing the financing ances that CAPEX financing will be available to correct gap of financially weak water entities. performance inefficiencies or for greater expansion • Finally, most financing instruments and guarantees objectives. Figure A.2 illustrates how the financing do not work if WSS providers do not have the capac- options increase as WSS services become increasingly ity to borrow, and certainly crowding-in commercial reliant on user tariffs and less so on public finance finance is impossible under such conditions. transfers to cover O&M and CAPEX costs. As WSS pro- viders generate sufficient income from their own oper- ations they can begin to attract commercial finance The Ladder of Financial Sustainability which is generally much more abundant. Concurrently, Developed more than a decade ago, the Ladder of they are decreasing their total dependence on public Financial Sustainability provides a useful framework funding which can often be unreliable. FIGURE A.2. The Ladder of Financial Sustainability Reliable re inancing sources & Creditworthy security for loans Private inance Anticipates long term cost Sustainable cost recovery impacts (i.e., FX, asset revaluation) Guarantees Pro itable in any given year & intl. donors Cost recovery but not sustainable in long term Pay-as-you-go Capital recovery of cash outlays subsidies Public inance Unviable loss making Capital & operational utilities subsidies Source: Baietti, 2005. 30 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations As such, achieving long-term sustainability entails a performance improvement, asset replacement, and steadfast process of: expansion. • lessening a utility’s dependence on subsidies while World Bank and other international financing can create increasing reliance on user tariffs as the main source an important bridge for WSS entities to improve their of funding operations; financial sustainability status and to provide them the opportunity to expand their total sources of financing. • allowing the utility to generate excess cash flow that Concessional lending and guarantee products are quite can be reinvested and potentially re-leveraged; flexible and can often be tailored to a specific situation • adopting a long-term horizon in setting revenue to find a “financing solution” that can bridge various requirements, ensuring that the utility will have interests to keep tariffs affordable while at the same access to cash in case of sudden cost increases, time maintain a financially sustainable WSS provider. contingencies, and future outlays; and Blending can achieve several objectives while at the same time maintaining affordable tariffs for consumers. • ultimately, allowing the entity to gain greater financial independence to source external com- mercial financing based on the enterprise’s own Notes creditworthiness.2 1. The Operating Cost Coverage Ratio (OCCR) measures operational effi- ciency of a water entity and is calculated by operating costs divided Reaching the highest level of the ladder requires by operating revenues. It does not include other non-operating charges to the income statement such as, depreciation or interest that the utility becomes creditworthy and that the expense. For more information on the OCCR, please refer to the glos- banking sector and local capital markets are well sary of financial terms. established so that utilities can routinely source 2. For more information on the Ladder of Financial Sustainability see adequate funding from commercial sources for Baietti and Curiel (2005). Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 31 Appendix B Possible Sources of Commercial Finance for Public WSPs The list summarized here focuses on sources of com- peri-urban water communities to invest small distribu- mercial finance that can be available to publicly owned tion networks. In concert with the objective of aligning and managed water providers. It does not include pri- their services to consumer needs, utilities can also vate equity or project finance structures, which typi- provide small peri-urban communities a bulk service cally would be associated with PPPs in BOTs and water and grant licenses to communities or local entrepre- concessions. In rare cases, however private equity neurs to manage the distributions network in their can be sourced through the equities markets for WSS communities. Such communities could be financed providers that are still majority owned by the state. through microfinance loans and facilitated by the utility. Phnom Penh Water Supply Authority for example, was the first publicly traded company in the Cambodia’s FX Currency Denominated Loans stock exchange. To get to this point, the utility had to Many private arms of international finance agencies go through several distinct phases of structural reform can offer long-term debt on a selected basis. However, and gradually increase its financial standing. most of these loans carry foreign currency risk, and would not be recommended unless a third party Commercial Local Currency Loans assumes the FX cover.Some of the same institutions These are typically provided for a maximum duration have the capacity to make loans in local currency or of three to five years in most developing countries, provide guarantees that will source local financing. depending on the financial standing of the utility. The IFC, through its Municipal Fund invests in AAA- These could include working capital lines of credit or rated balance sheet and has access to IFC’s full line of one-year revolving loans provided on the same financial products of loans and guarantees. Lending basis.  Longer-term loans are possible in emerging instruments include long-term senior, subordinated, market countries like the Philippines, China, India, and convertible loans.However, in the water sector the Mexico Brazil, Argentina, Turkey, Chile, Malaysia, and experiences of the Municipal Fund have been primar- Thailand, among others. But if the depth and breadth ily oriented to PPP structures, such as concessions. of the financial markets are not significant, the contin- ued development of this sector can require a fair Corporate and Municipal Bonds amount of time. As distinguished from sovereign bonds, corporate and municipal bonds are additive as they do not Microfinance reduce the fiscal space of the sovereign as per IMF In water and sanitation, microfinance is generally guidance. These are feasible in the short-term where associated with providing small loans to households there is already a history of bond issuance, again and community based suppliers to access water and mostly in emerging markets that have more resilient sanitation services. Microfinance institutions can also and developed capital markets. Two of the more provide small loans to small water supply systems or successful programs for water have been in the Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 33 Philippines and India. But the incidence in other Vendor Financing/Supplier Credits countries is not significant. Infrastructure project Supplier credits can provide some level of financing bonds can appeal to institutional investors such as for equipment (primarily pumps and meters in pension funds and insurance companies looking for a addition to other non-water specific equipment stream of reliable cash flows. Pension funds are open purchases), and vehicle purchases. Local suppliers to other financing arrangements and can be a good may be able to offer purchases on an installment source of long–term domestic finance, but generally basis, particularly if the manufacturers are multina- are restricted in how much they can invest in infra- tionals and well known in the industry. However, structure services. Pension funds also do not favor there are practical limits for this type of financing the origination of loans or dealing with construction in  the water sector since most investment related or other implementation risks. They prefer investing costs for utilities comprise of civil works, which in securitized assets where most of these risks have would not be appropriate for supplier credits. On already past, leaving a reliable stream of cash flows large internationally procured orders, supplier for the investor. Such securities allow the original credits could amount to a considerable value, which financiers to exit the transaction and go on to new should not be discounted. projects. TABLE B.1. Possible Sources of Commercial Finance Commercial What it Offers Constraints Possible Corrective Actions Finance Source Domestic Currency Loans Domestic currency financing. Usually short-term maturities at higher Partial credit guarantees could nominal cost than FX loans. However, lengthen the maturity and lower no foreign currency risk exposure. interest rates. Microfinance Retail loans for households Greater access to poor communities. Appointing liaison for appropriate and small rural communities Should be properly coordinated with timing and extent of expansion of for greater access. overall improvement program of access by the utility. the utility. FX Currency Longer maturities and Carry FX currency risk and normally Government to assume currency risk Denominated Loans lower cost. available for larger transactions. and charge a premium for FX cover on loan to borrower. Corporate/Municipal Domestic currency financing Few LDCs have the capacity to issue Thin capital markets will take Bonds with longer term maturities. bonds. Utilities or municipalities must time to correct. Special donor also be creditworthy. backed programs may jump-start the process. Supplier Credits/Vendor Sources of finance at Few assets of WSPs could be included Larger deal flow and professionally Finance reasonable cost. Usually for vendor finance. CAPEX component managed facilities could reduce paid in installments. for supplier credits may be too small constraints. to justify. Typically financed through installments of short duration. Source: Authors’ elaboration. 34 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations Appendix C Sector-Wide Considerations for Facilitating Commercial Finance Every Bank WSS operation should include TA compo- Assuming the success in assisting several utilities in nents for engaging the government as well as other key obtaining creditworthy status, the second stage strate- stakeholders in improving the environment for greater gies can expand the involvement of commercial commercial finance participation. The specific type of finance along the strategic continuum established assistance should stem from the initial assessments early in the process. Creditworthy utilities should be carried out to address weaknesses observed with the able to expand commercial finance involvement for commercial finance market. either expanding or diversifying operations. Under sector-wide programs, Task Teams should solicit the participation of other key stakeholders Establishing a Credit Rating System where their comparative advantage can lend to the A credit rating measures the creditworthiness of a improvements of the financing environment or the potential borrower and it is presented in the form of financial sustainability of utilities following the initial a symbol or investment grading. The rating is gener- interventions. ally a formal opinion by an independent, specialized Such interventions can be in the form of TA programs agency (a credit rating agency) on the long-term ability or direct financial support, and can include: and capacity of the borrower to repay its commercial debt on a timely basis. While credit ratings are import- • A system for assessing creditworthiness where the ant for the systematic assessment of entities on their number of potentially eligible utilities have increased; creditworthiness, in the short-term they can be substi- • Developing a program for financial recovery for tuted by a thorough diagnosis of the entity by qualified lower tier utilities in the financial sustainability specialists. ladder; A credit rating system is particularly useful where • Establishing specific facilities for viability gap there are several water utilities in a country that are financing, guarantees, FX cover and project either creditworthy or marginally creditworthy, and development; can benefit from greater access to commercial finance. While such a system benefits utilities through a more • Promoting wholesale operations, including equip- systematic diagnostic approach, it equally benefits ment leasing schemes with local banking institu- potential lenders by reducing their knowledge gaps of tions; and the sector. As such, a viable credit rating system must • Fostering the development of municipal and corpo- also engage potential lenders and educate them on the rate bonds. various aspects of the credit rating system and the risk associated with lending to water utilities. Equally important will be assistance designed to strengthen the governance framework through appro- As such, a TA program must focus on both counts to be priate financial sustainability policies and regulatory truly beneficial in the country environment. Not only oversight. does it require a pipeline of utilities that can be Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 35 screened for accessing the market, but lenders must be utilities that have no existing financing capacity, favorably inclined to see this as a useful tool for deter- public or private. As defined earlier, these are WSS mining creditworthiness. It should also be the basis for providers that just marginally cover their operating participating in the sector under favorable results. costs, and according to IBNET these constitute the majority share (roughly 60%) of utilities in develop- Again, the benefits of such systems increase when ing countries. there are multiple parties from both the demand and supply side of the equation, but in single case situa- These can be categorized as WSS providers that not tions the costs-benefits can be greater by just focusing only have performance issues but also possess more the diagnostic of a given utility and by then engaging structural issues that give rise to greater risk factors for specific lenders through one-on-one meetings and lenders. These may include utilities with tariffs sub- negotiations. stantially below cost recovery levels, as well as debt overhangs from either building excess capacity and The Kenya experience provides a good case analysis overextending themselves in non-viable areas. for the benefits of such a system. The 2002 Water Act: (i) created autonomous entities incorporated under Such water providers may have more serious technical the Companies Act or the Cooperative or Trust Acts; problems such as lacking water resources, or prohibi- (ii)  promoted financially sustainable policies; and tively high cost of new water sources for consumers (iii) established a functional and independent regula- to  support. As such a well-developed performance tor that licenses water utilities, regulates tariffs, and improvement program, may not be enough to correct monitors utility performance. the core business model; and unless it can be corrected there is no conceivable way these entities can become In 2011, the Water and Sanitation Program in collabora- creditworthy in the near-term. tion with the Water Services Regulatory Board (WASREB) launched a credit assessment of 43 utilities Financial recovery programs can help in selected in Kenya using a similar methodology and assigned cases, but some water providers may never be viable as shadow credit ratings. Shadow ratings are primarily independent entities and should perhaps be returned used for diagnostic purposes and to test how financiers to their local governments as departmental entities. might evaluate a company’s credit standing. The Financial recovery programs can implement perfor- assessment resulted in thirteen utilities receiving an mance improvements, restructure existing debt by A or BBB rating (considered creditworthy) and another governments assuming the overhang, and ultimately sixteen receiving a BB rating (potentially credit- increase tariffs to adequate and justifiable levels. worthy). Subsequently, several utilities could access Moreover, new investments may need to be financed the commercial finance in conjunction with USAID through grants to maintain operational costs in guarantees and OBA programs. The methodology cre- check. But in the end if appropriate consumer tariffs ated for the Kenya rating system was also utilized for are not able to cover operational costs of the entity, utilities in neighboring countries, rather than creating financial sustainability will be a continuing concern additional systems. and risk factor. Financial Recovery Programs for Lower Special Purpose Facilities for Larger Tier Utilities Deal Flows Financial recovery programs can be an important Several special purpose facilities can be established step  to improve the financial sustainability level of for  expanding commercial finance participation. 36 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations TABLE C.1. Financial Recovery Program for Indonesian Water Utilities • Following the Asian financial crisis in In 1997, the Indonesian Rupiah devalued almost nine times. This increased substantially the cost of imported goods and the foreign exchange components of investment costs and debt. • The financial status of many public water utilities (PDAMs) who held loans in foreign exchange deteriorated and 63% defaulted on their debt service payments. Service quality and coverage declined as new investments and maintenance were postponed which led to lower service quality and high unaccounted for water (average 40%). • The financial crisis triggered a set of reforms and a financial rescue program was launched for ailing utilities. Under a Financial Recovery Action Plan (FRAP), utilities could reschedule debts by agreeing to a number of measures, such as: 1. Implementation of immediate and regular tariff increases. 2. Reclassification of customers into higher tariff blocks. 3. Accelerating increases in connections if the water capacity exists. 4. Controlling staff numbers. 5. Reducing unaccounted for water. 6. Improving collection period. 7. Improving water quality and quantity. • Besides PDAM management, the Ministry of Finance and the local Government also participated in FRAP. MOF and local governments stepped in with financial relief or support through debt rescheduling or new equity contributions. Source: Authors’ elaboration. The main requirement however, is that there is ample 4. Mediating with local banks on requirements for deal flow that can effectively justify them. their participation; • Viability Gap Facility. A viability gap facility can be 5. Identifying additional sources of commercial an excellent way to professionalize the process for finance; and blended financing with commercial finance partic- Monitoring the implementation progress of 6. ipation. The concept would entail mobilizing grant funded programs. and concessional loans into a fund that is profes- sionally managed. The facility would support eco- Participating utilities would submit their plans along nomically justifiable investments for performance with interested commercial lenders. The services improvement as well as expand access to the cov- could be offered on a competitive basis where the erage areas. It would include a range of services most cost-effective proposals or ones that create a including: higher leverage of commercial finance are given pri- ority for funding and implementation. The initial 1. Vetting investment programs for maximum effi- grant and concessional finance components could ciency and viability; be funded from donors and IFIs. Such a facility 2. Structuring the financing plan to include an would also seek additional donors support for proj- appropriate mix of public and commercial financ- ect development assistance as well as concessional ing and simulating projections to arrive at bank- financing. able solutions; • Guarantee Facilities. Public sector and PPP proj- 3. Providing policy recommendations to govern- ects alike may also require a facility to provide ment for improving the financing environment; partial credit and partial risk guarantees to lenders. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 37 The Local Government Unit Guarantee Corporation number of water investments of different utilities. (LGUGC) was introduced in the Philippines in 1998 The inherent premise behind pooled facilities is that as a joint venture between Bankers Association of the risk of a single borrower defaulting would not the Philippines and the Development Bank of the force the default of the entire bond and the greater Philippines and offers partial risk guarantees for diversity lowers risk factors. local development projects. It is the first private A noteworthy example of such a facility is the Water sector corporation with the primary mandate of and Sanitation Pooled Fund (WSPF) in India, which granting guarantees in the Philippines. It provides between 2002 and 2013 issued 5 separate bonds partial credit risk enhancements to water utilities in  maturities between 10-15 years for a total of and electric cooperatives covering as much as 85% $44 million. The scheme funded projects of 45 local of the loan value. entities. The default risk was reduced through inter- Similarly, the Indonesia Infrastructure Guarantee cept scheme on national transfers as well a guaran- Fund (IIGF) was set up as in 2009 with the support tee by international donors. For the initial bond of the World Bank as an independent State-Owned offerings, USAID provided a guarantee equal to 50% Enterprise (SOE) 100% owned by the Government of of the bond amount. Indonesia (GOI) to be the sole institution—or the In Kenya, a new pooled finance scheme is being “single window”—for appraising, structuring, pro- designed through the support of the Netherlands cessing claims and providing government guaran- Water Partnership. Currently the Government esti- tees for infrastructure Public-Private Partnership mates that there are 13 creditworthy utilities that (PPP) projects in Indonesia. While its focus is cur- can benefit from the program, and next year it rently on partial risk guarantees for PPPs, a similar expects to issue its first bond offering ranging from facility can be established to guarantee domestic $25 to $40 million, equivalent. lenders on public sector projects that seek commer- cial financing. Wholesale Commercial Finance Through Several other guarantee facilities have been imple- Local Financial Intermediaries and mented in the developing world with IFI support Leasing Companies but with limited success in the water sector. This is The private arms of most multilateral and regional in part due to the lack of an adequate deal flow in banks wholesale loans through local banks and equip- the sector. ment leasing companies. If such programs are already • Pooling Project Risk. Pooling schemes have been in place they can deploy loans in long-term maturities developed to deal with the shortcomings of a which otherwise would not have been offered by nascent capital market and the weak credit quality domestic lenders. Such programs also allow for smaller of both municipal borrowers or individual utilities. deals to be carried out which the IFC, for example, Such schemes allow for weak and smaller utilities would not be cost-effective on a retail basis. to gain access to the commercial finance market by However, loans from these facilities could be still be allowing them to be pooled along with stronger util- subject to currency risks unless the wholesaler of ities to diversify risks and achieve the investment funds could source local currency at the outset. One scale required by institutional investors. notable example of such a wholesale operation is the The concept involves sourcing long-term bonds Philippines Water Revolving Fund (PWRF). The PWRF from the domestic market to finance a selected provides tenor extension facilities to loans from 38 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations TABLE C.2. Summary of Facilities Facility Purpose Circumstances FX Cover Facility Mitigate currency risks of borrowers and reduce credit Works best where there is low capacity in domestic capital risk in case of sizable devaluations. markets to provide long maturities at affordable prices and where the international sources of financing either public or private are available to the market. This would include IFI loans denominated in FX. Guarantee Facilities Partial credit guarantees designed to mitigate risks Can be particularly useful when there are few other of credit default for commercial lenders and on bond enhancement mechanisms available or are insufficient, offerings, while partial risk guarantees mitigate risks such as national transfer intercepts or low credit quality from changes in policy that affects financial flows. of municipal entities. Can significantly complement other Guarantee facilities can extend maturities as well as facilities. lower the cost of borrowing. Viability Gap Facility Professionalize the process for viability gap financing Other sources of financing should be explored for and to crowd in private finance for marginally creditworthy utilities before utilizing concessional loans creditworthy utilities as well as creditworthy utilities and grants to extend maturities. For a large deal flow that are not bankable within the domestic market of marginally creditworthy utilities such facilities can given the inability to source long term financing. expedite the process, reduce bottlenecks and provide important support for vetting CAPEX programs and financing structures. It can also greatly improve dialogue with local bankers on a uniform approach. Pooling Risks Designed to draw-in institutional investors such Designed primarily for creditworthy utilities and work as, pension funds and insurance companies with best if there a good number that can be financed under long term funds available in the local market for the approach. Can include some smaller and marginally bond offerings. Designed to diversify risk and creditworthy utilities but should be already capable of for professional management of the individual meeting debt service requirements on the terms of the transactions. bond maturities. Not really suited for utilities that possess large viability gaps. Wholesale Can be an efficient way of utilizing current Attention should be placed on the capacity of the inter- Operations financial institutions for expanding deal flow mediary or should be strengthened through TA programs. and for professionalizing the process. Can work Also important to monitor total lending costs to borrowers for both marginally creditworthy as well as as costs can become quickly become unaffordable by var- creditworthy utilities. ious entities adding intermediation costs on their portion of the loan. Source: Authors’ elaboration. Private Financial Institutions (PFIs). The Fund is man- the PFI had the option to extend the maturity or accept aged by the Development Bank of the Philippines a balloon payment from DBP for the outstanding (DBP) and is funded by a loan from the Japan Bank for balance. Additionally, the LGUGC provides PFIs with a International Cooperation. credit risk guarantee of up to 85 percent of the loan. From 2008 to 2012, the PWRF facilitated tenor exten- DBP combines these funds with contributions from sion arrangements for 28 water project loans PFIs to issue a blended loan to water service providers totaling Php5.3 billion or approximately $120 million, with up to 20-year tenors. While the PFI portion of equivalent. The LGUCG is still operating but would loan has a seven-year tenor, the principal is amor- require an increase in capitalization to significantly tized over a longer period. At the end of seven years, expand its guarantee program. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 39 TA for Project Development While revolving funds have been designed for such purpose, it is particularly important to assess whether Project development funds are an essential component such funds can recuperate the cost of development by in most developing countries but become more import- charging the ultimate borrowers. On PPP projects, ant when financial engineering of a mix of public and such development costs can possibly be reimbursed at commercial funds is required to make the transaction financial closing, by adding the cost to the CAPEX viable. This capacity is typically non-existent in many which would be financed and then amortized over the country contexts, and while stand-alone projects can life of the project. Adding this to projects that don’t be supported by recruiting knowledgeable short-term materialize is questionable and TA grants may be more consultants, a greater deal flow necessitates a more effective, particularly for marginally creditworthy systematic process for project development. This can utilities. Such facilities could also add fees to projects be achieved by either funding a cadre of professionals that materialize to defray the sunken costs of failed or providing TA for strengthening local intermediaries transactions. recruited to implement such programs. 40 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations Appendix D Template for a PAD/PCN Project Component for Blended Financing with Domestic Commercial Banks The following is a sample template for including a com- C. Component Description ponent to a WSS World Bank Project designed to access 3. The project supports the use of public sector commercial finance for investment financing. The tem- funds in a blended financing structure to facilitate plate can be used for inclusion into the Project Appraisal the access by the WSP to commercial financing. Document (PAD) or shortened for a Project Concept The project will provide technical assistance for Note (PCN). implementation support activities as well as a mix A. Component Objectives of public grant and/or concessional loans for facil- itating access to commercial financing. 1. The component will have several objectives. The first will seek to expand water and sanitation 4. Pre-project preparation activities have carried out infrastructure investments by leveraging public an assessment of the financial sector and deter- finance to facilitate access to commercial financ- mined a capacity for commercial lender participa- ing in a blended finance arrangements. Second, tion under several criteria including: (i) well the project will seek to reduce information gaps developed and performance improvement pro- that have deterred commercial lenders from lend- grams; (ii) adequate loans security measures; ing to the WSS sector. Third, World Bank financ- (iii)  blending arrangement with World Bank and ing will seek blended financing arrangements donor participation, and (iv) other provisions to: (i) improve the financial sustainability of the for participations. In addition, some preliminary WSP(s) through performance improvements; and screening has been carried out of eligible WSP to (ii) better allocate financial resources by leverag- ascertain several bankable financing options. ing additional commercial domestic finance. 5. Sub-Component 1 – Implementation Support Activities – Project Management, Coordination with B. Component Beneficiaries Commercial Lenders, Final WSP Selection, Sub- 2. The primary beneficiary will ultimately be the Project/Financing Preparation, and Supervision WSS existing and future customers that receive ($1M to $2M)1. This sub-component will provide expanded and improved services from their technical assistance for the management of the utility. The WSP itself will improve its capacity to overall program as follows: finance future investments when they are in fact required. The government will benefit from being • Additional screening of WSPs to target with more thorough diagnosis of best candidates. able to crowd-in commercial sources of finance, commensurately expanding the total pool of • Carrying out tariff adequacy analysis to financing for infrastructure services and allowing determine whether tariffs are cost reflective it to allocate more limited budgetary resources to aside from needing to cover performance non-revenue generating sectors and programs. inefficiencies. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 41 • Working with the WSP to best articulate their commercial loans based on the financial engi- action plans for performance improvement and neering that derives a financial solution for the for developing preliminary cost estimates to be intended financial structure. The financial solu- submitted for financing. tion will be one that yields a projected positive cash flow for each year of the projected period • Putting together a financial projection model and that will accommodate criteria for lending and populating it with preliminary cost and rev- of the commercial lender. Besides amounts enue data encompassing the entire WSP opera- related to the mix of funds, the financial engi- tion inclusive of the current capital investment neering will also determine the appropriate requirements to assess financial viability. timing for each. • Developing a blended financing plan and deter- 7. The program will support many different WSP mining the appropriate staging of commercial investments but the following are considered the loans within that plan. Reviewing the financing most viable options for creating bankable sub-­ plan with commercial lenders and determining projects for commercial lenders. requirements for loan security and/or subordi- nate loan agreements. Assess financial viability • WSPs that may be just recovering costs but also of the plan with the inclusion of commercial possess a series of performance issues that, if financing component. corrected, can improve the entity’s long term financial viability. These are WSPs that may also • Discussing the need for additional guarantees have tariff levels that are close to cost recovery if necessary. but consumers have been overcharged in pay- • Finalize sub-plans for financing and ing for performance problems. The tariff ade- implementation. quacy analysis carried out under the TA support will be able to determine this. • Monitor post finance implementation to ensure appropriate progress against plans by WSP. • The program can also support creditworthy Troubleshooting and determine the need for WSPs but, for various reasons, have not had follow-up financing in case corrective actions access to commercial financing. Blending can are needed. increase tenor and reduce costs for economi- cally justifiable projects. • The activity will also work with commercial lenders to transfer knowledge on diagnosing • Leakage programs are indeed worthwhile and financing water sector entities. investments but these should be combined with a connection program such that it can immedi- 6. Sub-Component 2 – Public Financing Support ately create revenue from additional paying to  Leverage Commercial Loans to Sub-Project customers. Similarly, commercial loss initia- Financing ($5M to $10M). This sub-component tives must also be combined with increasing will provide the public finance component of new paying connections. Cutting off non-­paying the financing plans for sub-projects. The financ- customers or reducing water thefts does little to ing support can be a mix of concessional loans add to the bottom line unless the water saved is or grants that are provided by the implementing transferred to a paying customer. agencies under a subsidiary loan or grant agree- ment for each sub-project. The public portion • Connection programs where the system is still of the financing will be blended with pledges of underutilized. 42 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations • Under this program, WSPs should not consider eligibility for blending arrangements with public investments that require major works such as, grants and concessional loans. A competitive investing in an additional water source. Again, process would be desirable whereby interested while these investments may be desirable they WSPs would come forward with their preferred typically do not yield quick financial returns commercial lender and with a cohesive invest- and as such may create additional risks and may ment for financing. not be bankable for commercial lenders. 8. The program should be demand-based and Note criteria would be established for prioritizing 1. For support between 5 to 7 separate blended financing transactions. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 43 Appendix E Analytical Guide for Assessing Commercial Finance Opportunities The following is a guide for quickly ascertaining whether 1.2.2 What are the lending tenors? there is capacity for pursuing a commercial finance ® less than one year ® up to 3 years opportunity for a given WSP. The opportunity arises ® 3 to 5 years ® more than 5 years both from the financial market side as well as the capac- ity of the WSP to borrow and potentially repay its debts. 1.2.3 What have been the interest rates? If the results here are considered favorable, a financial ® 5-8% ® 9-12% ® greater than 12% projection would need to follow with possible blending arrangements for strengthening the projected financial 1.2.4 What sort of security has been required? performance. The analyst would be seeking to confirm ® depository bank ® collection account that financial institutions are either already involved in ® intercept of national transfers to LGU the water sector or are interested in participating. S/he ®  pledge of tax revenues ® senior lender should also confirm the conditions for such participation status and current lending terms. On the utility side, the ana- lyst would be seeking WSPs that would have the capacity 1.3 With regard to the commercial banks, if no to become financially creditworthy through the imple- experience of lending for water infrastructure, mentation of performance improvements, without nec- is there interest? ® Under what conditions? essarily needing to increase tariff levels. An assessment __________________________ of the results of this survey can provide a good indication 1.4 With regard to pension funds, have they for including a commercial finance component to a WSS made any direct investments to water World Bank project design. entities? ® 1. Capacity of the Domestic Finance Market 1.5 With regard to bonds, have there been issues 1.1 Does the country have a diversified financial by municipalities or water entities, or any other sector? (Check all that apply) corporate entity? ® ® at least 3-5 commercial banks ® pension 1.6 Any water entities listed in the domestic or other funds ® corporate bond market ® equities stock exchanges? ® market (stock exchange) ® development 1.7 With regard to DFIs and MFIs, do either provide finance (DFIs) and municipal finance infrastructure loans? ® institutions (MFIs) ® microfinance institutions ® non-bank financial institutions 1.7.1 What are their funding sources? 1.2 With regard to the commercial banks, is there an ® IFIs loans ® bilateral donors ® national experience of lending for water or another ® other sources infrastructure sector? If yes, 1.7.2 What are the lending tenors? 1.2.1 Currencies ® less than 3 years ® 3-5 years ® 5-10 years ® local currency ® FX currencies ® more than 10 years Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 45 1.7.3 Any grace periods? requirement and perhaps more if commercial lenders are involved) ® ® on principal ® on interest, how many years? __________________________ 2.1.7 Are tariffs adequate? (i.e., if utility has poor performance and still making a 1.7.4 What sort of security has been required? profit, tariffs are likely to be too high) ® ® depository bank ® collection account 2.2 Overview of Key Operational Performance ® intercept of national transfers to LGU ® pledge of tax revenues ® pledge of tax 2.2.1 Does the utility have high NRW? revenues ® senior lender status (over 35%) ® 1.8 Have the private arms of IFIs concluded financing 2.2.2 Does the WSP have low Collection Ratio of infrastructure projects? of less than 95%? ® ® Water Projects? ® Which ones? 2.2.3 Does the WSP have a low current asset __________________________ ratio (less than 2:1)? ® 2. Financial Status of WSS Provider 2.2.4 Has the operations ratio deteriorated over the last three years? ® 2.1 Overview of Financial Results 2.2.5 Is the utility overstaffed (i.e., a high staff 2.1.1 Does the WSP have an operating cost per connections ratio to comparable coverage ratio greater than: 1.0 ® WSPs)? ® between 1.0 and 1.3 ® between 1.3 and 1.5 ® or greater than 1.5 ®? 2.2.6 Does the WSP have an annual maintenance plan? ® 2.1.2 Is the utility just breaking even on an income basis but able to have a positive 2.2.7 Has the plan being followed? ® cash position after adding back non-cash expenses such as depreciation? ® 2.3 Debt Situation and Relationship with Lenders 2.1.3 Has the utility produced an annual profit 2.3.1 Does the utility have loans outstanding in the last three years? ® from public/government sources, IFIs or National Development Banks? ® 2.1.4 If so, has this profit equate to a respectable return on fixed assets 2.3.2 Are any of these loans for other than new (i.e., equal or greater than the average investments? ® cost of funds)? ® 2.3.3 Are any of the loans in FX currencies? ® 2.1.5 Has the utility produced a net positive 2.3.4 Are any of the loans for closing a operating cash flow position which financing gap? ® allows it to fully service its debt obligations? ® 2.3.5 Does the WSP have existing loans with commercial lenders? ® 2.1.6 Does the utility produce cash after debt service that can allow it to leverage 2.3.6 Is the utility capable of meeting its additional investment financing? financial obligations (i.e., debt servicing) (typically, at least 15% of the financing to its lenders? ® 46 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 2.3.7 Does the utility have an acceptable 2.3.12 Has the utility borrowed from local debt service coverage ratio lenders for investment purposes, either (more than 1.2)? ® for expansion of the network or for performance improvements? ® 2.3.8 Have any of the outstanding loans been restructured or reduced in size? ® 2.3.13 If so, is the utility in good standing with 2.3.9 Does the utility, as a matter of policy, local lenders? ® assess its capacity to service new loans 2.3.14 Has the utility been denied a loan from as well as existing ones? ® local lenders? ® 2.3.10 Does the WSP have a relationship 2.3.15 For what reason? Not enough repayment with local commercial lenders capacity ® lenders not interested in besides its typical banking lending for water ® seen by lenders as transactions? ® too risky ® not allowed to borrow from 2.3.11 Does the utility have a revolving line of commercial banks ® other reasons credit with local lenders? ® __________________________ Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 47 Appendix F Generic Terms of Reference Financial Analysis of WSS Investment Projects and Their Entities Objective it is important that all parties are convinced that the option chosen is undeniably the desired course of The conceptual assessment both at the diagnostic action and that it can be successfully implemented. level as well as the future planning level described is intended to minimize the need for resources, while at the same time to provide a good approximation of the Scope of Work feasibility of a given option. It is intended to review Task 1: Carry out diagnostic assessment on the several alternative options to arrive at the preferred technical, commercial, and financial management one. The diagnostic review can be curtailed if there is operations of the WSS entity and sector policy still uncertainty on whether the client demand is and governance framework confirmed. A thorough diagnostic is the essential first step in under- standing the specific issues facing a utility and forming The assessment of a potential investment program for the basis on which to develop a program of institutional any given WSP requires two main components: (i) a strengthening, expansion or diversification. Generally, diagnostic assessment of the current situation which is technical, policy and governance deficiencies are often broken down into numerous sub-components closely linked to financial outcomes so it is important (see Appendix G); and (ii) the development and assess- for the analyst to identify these relationships in their ment of a coherent plan going forward, often intended overall assessment. This can be achieved by either trac- to address the main strategic objectives or corrective ing the impact of the technical deficiency to the finan- actions that have been identified during the diagnostic cial outcome, or by tracing the financial deficiency back review. The process is generic, but the outcomes can to the technical operation. (See Appendix G for detailed differ significantly from one case to another, depend- components for diagnosis of WSP.) ing on the priorities which are selected and the avail- able resources. Task 2: Develop coherent management strategy The TORs presented here are for a conceptual feasibil- and actionable items ity assessment that requires the expertise of primarily A coherent strategy is one that has considered all two highly skilled specialists focusing the technical and aspects of the operations, not just the technical financial aspects of the various tasks: (i) to carry out a issues. It is also one that is based on realistic expecta- diagnostic assessment of the WSS provider; and (ii) to tions including the expectations on financing. develop a conceptual financial and implementation Nonetheless, the WSP may have developed certain plan to address major strategic objectives. The assis- priorities for capital expenditure that have not been tance of local consultants may be needed to help in met due to shortage of funding. This task is intended data collection and interpretation during the analysis. to drive the forward planning process. However, it is The two individual specialists must work effectively important to indicate that a diagnostic is not com- with each other and with the WSP management plete without a discussion with the management and staff as well as with policy makers since ultimately, and  staff on where they wish to go in terms of the Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 49 organization and its operations, and how they believe Task 4: Develop a dynamic financial model for this will get them to their goals. Such a discussion can assessing and validating financial sustainability shed light on whether management is in sync with of technical options the condition of their enterprise and whether their The operations of WSPs involve a dynamic system plans are realistic. where many variables are linked to each other and many operational variables affect financial outcomes. The strategic plan provides the following inputs to the As such, operational and commercial units must work utility’s planning cycle: together and effectively communicate in putting a. Overall WSS service objectives; actionable proposals forward. The finance or planning unit must support these units and must be able to b. Focus and priorities such as expansion of the net- clearly demonstrate more desirable alternatives. work or improvements in performance for which Ultimately it must be able to show the utility’s capacity future capital expenditures should be directed; to assume debt financing and to repay it effectively. In c. General investment requirements for meeting spec- essence, a coherent plan requires an “organizational ified service objectives; approach” to planning, not one unit dictating the tech- d. Objectives for modernizing, diversifying, and other nical requirements as it often is the case among utili- improvements in networks, facilities, equipment, ties in the developing world. systems, process and procedures; One excellent way to ensure the adoption of an “orga- e. Priorities for replacing fully depreciated assets and nizational approach” to planning and to create added planning for unforeseen contingencies; and credibility of the plan is for the utility to have a well-­ developed financial planning model that effectively f. A realistic assessment of the value added of non- links all key technical and operational variables with core businesses and priorities for the disposal/dives- financial ones and presents them in the three main titure of such businesses. financial statements. The financial model also facili- tates an understanding of whether the utility would be Task 3: Develop investment budget envelope able to cover its debt service in future years, thus pro- Generally, the senior management is responsible for viding needed information to lenders. To this end the putting together the strategy with the help of a plan- financial specialist will first need to develop a fully ning unit. In formulating the strategy, management interactive financial projection model that can simu- should have developed a good assessment of the late financial solutions under varying investment financing constraints and opportunities, as it is fruit- and  operating costs, tariffs and volumetric demand less to direct the operational units to develop projects scenarios. that ultimately cannot be implemented because of lack of funding. Alternatively, a long-term strategy could be Task 5: Populate financial model with current segmented in discreet financeable stages and taken consolidated operating and financial information up  piecemeal. Again, if the management intends to of the WSP develop a bankable project or program, it is important This task involves developing a base financial pro- to set realistic expectations. Management should jection of the WSP consolidated operation utilizing develop a funding envelope in consultations with its current operating and financial parameters. This owners, potential lenders and government oversight means, projecting forward existing and already agencies. programmed plans and parameters including, 50 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations but  not limited to: (i) approved connection pro- Task 7: Develop financial projection grams; (ii)  investment projects already started for each technical option and derive a which will continue; (iii) projections of current debt financial solution by engineering a blended obligations that require servicing; (iv) current oper- finance strategy ating financial parameters; and (vi) other informa- The financial consultant will incorporate investment tion that would fully capture the current financial and O&M cost data and derive projected per unit situation of the WSP, projected forward. The output costs for actionable items. The consultant will also would come up with a base case projection of finan- need to develop feasible financing assumptions cial outcomes without the actionable items being which would be incorporated into the financial pro- contemplated. These should be closely reviewed jection model. The financial consultant will engineer with the management of the WSP for accuracy. More a financing structure including a mix of loans and importantly these base case projections may alert to grants that will render a financial solution. Such a a possible future problem which may require correc- solution is defined as a positive cash flow in each tive action through a revision of the strategic plan. year of the projected period while at the same time achieving acceptable ratios for debt service, profit- Task 6: Develop technical options for ability, and liquidity. In formulating these financing accomplishing strategic objectives options the consultants will need to analyze the The consultants should work with management to iden- various risk issues and recommend options for tify different technical options for achieving the strate- de-risking such risks. gic objectives. These options could be different sets of Another sub-task under this activity deals with actionable items or just different phasing of the items. developing the framework for setting and adjusting The consultants will then develop and finalize the tariffs over the projected period. This would-be part investment component and implementation plan along of an overall regulatory framework that would be with technical parameters for each option. The estimate needed to implement this project. The tariff setting of preliminary investments costs should be broken exercise must start off with overall policy objectives down for each year of implementation. The planning of the government as well as the legal framework horizon for setting investment and operating assump- that will eventually determine cost recovery levels. tions should be no longer than five years. Three-year In this regard, the consultant will hold discussions horizon for assumptions would be preferable if funding with the relevant government officials to sort is limited. The financial projections of those planning out  the frameworks and timeline for achieving assumptions should extend from 20 to 25 years. such goals. In addition, estimates of operating and maintenance expenses should be developed based on volumetric Task 8: Finalizing preferred option and confirming consumption, to derive the total anticipated costs at financing plan performance targets given production levels. Again, operating assumptions The final step, will be to agree on the preferred option should extend to 5-years maximum. The important and this must be done by the management going point in this task will be for the consultants to develop through all main assumptions and confirming their cost-benefit relationships with each actionable item of potential achievement. This task is not about setting the strategic plan. For example, if the actionable item covenants but making sure that the WSP management will be to reduce technical losses by say, 2% each year views the plan achievable. This is particularly import- for five years. ant if commercial lenders are also involved. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 51 Deliverables 5. Base Financial Projection of WSP 1. Diagnostic Report Financial Projections of Technical Options 6. 2. Assessment Matrix 7. Recommended Option with Confirmed Financing 3. Strategic Plan Structure 4. Summary of Technical Options 8. Appendix of Financial Projection Assumptions 52 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations Appendix G Components for a Diagnostic Review of the Financial and Operational Status of Water Utilities 1. Overview. This would provide a general overview of 4. Sanitation and Sewerage Service. Some utilities pro- the WSP’s coverage area with statistical information vide only water supply service to their customers, of the population, specific demographics of cus- leaving sanitation services to private septic tank tomer groups, their incomes. This will also include desludging companies. Wastewater treatment in information on customer classes including commer- developing countries is also highly fractionalized. cial, industrial and government. It would indicate These services need special attention if the WSP pro- the major service areas as well as unserved areas. vides a number of these services or competes with other companies in the coverage area. This can also 2. Policy, Regulation and Legal Authority. Identify orga- be true for drinking water if there are private water nizations that set policy and service standards and vendors that serve non-connected coverage areas. organizations that are entrusted to enforce service For both sanitation and drinking water, attention standards. How is an economic regulator set up to must be given to determine whether the WSP’s oversee the utility? Describe the economic regula- effective cost of service is competitive to what is tion and tariff setting process of the utility. Describe currently charged by private water vendors and the legal status and the ownership and governance sludge companies. While it may be true that structure of the utility. non-connected customers pay much more per m3 from water vendors, many consumers will include 3. System/Network Characteristics. The technical char- alternative sources of water in assessing the their acteristics of the system include important data on total cost. the capacity of the intake(s), treatment, transmis- sion and distribution network. The review should As such, it is particularly important to assess the include an overall understanding of the water bal- availability of substitutes, such as private wells, bot- ance of the system as well as developing an under- tled water, independent vendor trucks, kiosks, rain- standing of the ability of the system to measure water tanks, and the availability of streams and leakages through flow and customer metering. ponds that consumers may be inclined to use for The  lack of good information on the system’s non-drinking purposes. A thorough market assess- specifications can lead to non-revenue water and ment may then be needed to fully understand deficiencies in asset management as well as in water consumer purchasing behavior if the utility is con- production and distribution. Technical characteris- templating an expansion of sanitation services or for tics should also describe the level of and quality of connecting consumers in peri-urban and poor com- service (i.e., hours/day of service and water quality). munities to piped-in water. Some utilities have Many utilities also operate several different sys- adopted environmental fees that are assessed to tems  which from a management point of view connected customers as part of their total water con- should be managed as either separate cost or profit sumption. This is typically done to shore up reve- centers, particularly if they are based on a separate nue, particularly if the utility does not provide water source. either sanitation or wastewater treatment services. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 53 In such cases, new investments to start or expand preferably with three years of historical data for sanitation or wastewater treatment is problematic, benchmark comparison. Important comparisons since a given project will only yield incremental costs should be made for the following key indicators: as the revenue benefits have already been incorpo- a. Total Water Production Capacity (mld) rated in the overall financial calculation. Consequently, commercial lenders may not be interested in financ- b. Water Production (mld) ing investments with these characteristics. c. Water Sold (mld) 5. Characteristics of Customer Base and Coverage Area. d. Number of Piped-in Service Connections Seldom do utilities provide the same services to all e. Populations Served its customers and the capacity for the utility to sus- tain itself financially can often be traced to its ability f. No. of Hours of Service per Day to differentiate its services based on what its cus- g. Staff/Connections (000) tomers need and are willing to pay for. This review essentially entails a market assessment by breaking h. Average Tariff (m3) down the types of customers (i.e., households, com- i. Average Consumption per Connection/Capita/ mercial and industrial by number of connections Household and consumption patterns and income groups). Is the coverage area largely homogeneous or is it quite j. Non-Revenue Water (%), and diversified? Are there are large groups of poor com- k. Of which: Commercial Losses. munities that are served through standpipes or kiosks? Highly diversified coverage areas require Utilities with a significant customer differentiation special attention to ensure a proper estimation of would need to segment their consumer markets by revenue requirements and a careful assessment of developing data sets for each major service such as tariff structures for each main consumer class. standpipes, kiosks, vending trucks, household, commerce, industry, and isolated peri-urban areas. As explained previously, the market assessment A utility with an excellent cost accounting system should fully explore the total number of substitutes would have the capacity to develop or calculate that consumers have at their disposal as opposed to contribution margins for each main service area. By piped-in water service provided by the utility. Being contrast, a utility that cannot develop a reasonably able to understand fully the competitive forces good segmentation of its consumer markets is not which may affect the utility’s total business is also developing proper management information to key to its ultimate financial sustainability. Most util- effectively run its business. ities must not assume that they are natural monopo- When carrying out a comparative analysis of this lies when in fact consumers face several alternatives type, fluctuations between one year and another to piped water. should be fully explained. Moreover, the analyst 6. Operating and Technical Performance. This part of should explain why certain variables change while the assessment begins to connect the operational others don’t. Since most operational variables are performance of the utility with the earlier sections closely linked to one another, a change in one vari- and deal with how efficiently and effectively able should normally influence either positively or consumers are being serviced. The analysis should negatively, other variables. So, while it is important be supported by several quantifiable indicators, to understand deviations, either up or down of the 54 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations key variables, the analysis should go well beyond performance can be supported by several key indi- and determine how a change in these variables have cators highlighting financial results against prior affected other variables. years. These include the Operating Ratio, Operating Cash Flow, Debt Service Coverage Ratio, and the For example, an increase in connections would Collection Period which are described in detail in typically increase total water consumption. That is Appendix H. unless the water resources are limited and rationing begins to take place. Alternatively, piped water con- These four in addition to non-revenue water (NRW), sumption may be affected by an increase in tariffs as can provide a significant amount of insight into the consumers begin to make use of alternative sources financial and operating status of a given utility. of water. Many large customers may have resources Besides these, other key financial ratios and results to develop their own water source in the event the include: utility’s tariffs become non-competitive. a. Net Income An analyst can go overboard on collecting and ana- b. Net Profit Margin lyzing numerous indicators. Some benchmark systems have included as many as 120 operating, c. Current Assets in Cash or Cash Equivalents financial and commercial indicators. While there d. Collection Ratio may be some value added in analyzing all these, a good diagnostic assessment can be attained with e. Operating Cost Coverage Ratio many fewer indicators. In fact, past studies have f. Self-Financing Ratio shown that there are approximately 20 primary indi- g. Return on Investment, and cators that can begin to guide an analyst into a correct overall assessment because many are very h. Current Ratio. closely related. (See Appendix H for the proposed 8. Tariff Adequacy Analysis. The tariff adequacy analy- key performance indicators.) The process therefore sis attempts to determine whether the tariffs are jus- should focus on identifying issues through a limited tified or consumers are either being overcharged or set of primary indicators and if necessary, drill down undercharged. It is an important determination of on those areas to identify causal relationships. whether the tariffs are the main cause of low profit- It is important to keep in mind that systems can ability, or whether tariffs are adequate but consum- differ significantly for technical as well as financial ers are paying for management and operational reasons. Therefore, benchmarking performance inefficiencies, or a combination of both. This analy- by  comparing one utility to another should be sis needs to be carried out after the analyst has a approached carefully as this comparison can lead to good sense of the operational and financial deficien- incorrect conclusions, particularly if there are signif- cies as this will lead to identifying the exact causes icant differences in the technical characteristics of for poor financial results and more importantly, cor- the systems and the customer bases. In such cases, rective actions for putting together a strategic plan. reviewing a utility’s current performance against While the tariff adequacy analysis can be done man- its historical performance over the last three years ually, it is best conducted using a financial model in would yield more meaningful conclusions. which assumptions on actual performance can be 7. Financial Performance. Similarly to the operational recast to more standard norms. However, the devel- and technical performance, the analysis of financial opment of a projection model may not be included Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 55 in the diagnostic review and if so, it should then be carefully and discuss them with head of the finance included during the assessment of an investment unit and general management. A well-developed strategy and borrowing capacity of the entity. Still, audit report is critical to the assessment and sig- while not exact, a rough assessment can be devel- nificantly reduces the amount of time needed to oped by reviewing the bottom line financial results complete the required independent diagnostic. For on profitability against some of the key operating a thorough review, the assessment should review and financial ratios. If the utility is making adequate the last three years of audited financial statements. profits under poor performance if would clearly The development of accurate financial statements indicate that consumers are paying more than they is then dependent on a well-running automated should be. In contrast, if the WSP is incurring losses, general accounting system. but has adequate performance, the likely conclusion • Organizational Structure. Utilities are not complex is that tariffs are too low and not cost reflective. organizations unless there is the intent to make A combination of the two situations would be more them so by including non-core businesses which difficult to assess on a “quick glance basis” and complicates the analysis. In this regard, the busi- would require a more detailed assessment on the ness should be organized so that the main operating cost impact of each main performance indicator. units are managed with an emphasis on effective- 9. Management, Institutional and Other Issues. The ness and cost containment. This may mean setting institutional and management assessment of a utility up the organization in operating branches that are looks at the various management and reporting accountable for part(s) of the system. Depending systems and procedures as well as the organizational on its size, the utility may also benefit by establish- set  up that supports the efficient running of the ing separate commercial offices to effectively deal enterprise. To this end, the above analysis would with geographic sections of the coverage areas. have already revealed certain weaknesses in the orga- Such branch or commercial office structures lend nizational structure and its systems including items themselves to benchmark comparisons and create such as billing and collections, NRW management, incentives for improved performance. and adequacy of accounting and management infor- • Billing and Collection System. A good system mation systems. Below are other important criteria should be able to segment customers to enable a for management and institutional performance: good market assessment, age receivables, identify classes of customers that are slow or not paying, • Financial Statements and Audit Report. The finan- and assist the commercial office(s) in analyzing cial statements should be structured so that they the adequacy and structure of tariffs through correctly lead to the development of important the generation of consumption data by customer indicators. The statements should be audited by class. The billing and collection system should a well-recognized independent audit firm using also provide a running list of customers in default internationally accepted auditing principles. If so that corrective action can be taken or informa- local auditing principles are applied these auditors tion for writing off bad debts is readily available. should be required to identify and reflect the impact where significant changes occur. Audited reports • HR Systems. Policies for recruitment pay and should be accompanied by well summarized notes incentives need to be reviewed to ensure adequacy as well as a management report on deficiencies of in comparisons to other comparable organizations. the enterprise. The analyst should review the notes Individual staff must be motivated to excel in their 56 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations jobs and this often requires financial rewards of shortages. This is because it can be easily over- one type or another, particularly if pay is low. looked and does not necessarily show up in the • Systems of Internal Controls. While a proper sys- official statements or reports. Inadequate mainte- nance will often lead to higher NRW in one form tem of internal controls is too elaborate to sum- of another so it is imperative that specialized marize here, the principles are simple. First, no reports be developed which would capture the one individual or unit should perform functions maintenance activities against standard specifi- that can create a conflict of interest or even the cations and plans. Such reports should be made appearance of one. Second, no one individual available on a periodic basis to oversight organi- should handle funds and the recording of those zations to ensure full accountability that fixed funds. A case in point is a bill collector that reads assets are being properly maintained. and records meters and collects from customers. Generally, deficiencies in internal controls should 10. Summary of the Debt Situation. Full disclosure of be identified in the management report of the the enterprise’s debt situation should be made independent auditors. Strong controls should be available in the audit report. The financial state- placed on the handling of cash, collecting bills ment should indicate the terms, conditions and and the procurement system again to ensure that maturities of each debt obligation. While the diag- interests are not in conflict. nostic is a historical assessment, such information • Asset Management. The proper maintenance of is critical for forward planning, particularly if new the network is often neglected in times of cash investment financing is being contemplated. Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 57 Appendix H Glossary of Financial Terms for Water Service Providers Blended Financing vs. Viability Gap Financing. Blended Cost Recovery. In the simplest terms, cost recovery is finance involves a mix of public grants and conces- the ability of the WSP to cover its explicit costs from sional loans with commercial loans to derive a finan- user tariffs. However, it has been recognized that this cial solution. This solution is determined by deriving a basic definition does not fully capture the more com- projected cash flow for the consolidated water entity plex related issues surrounding WSPs. For example, such that all debt obligations are amply satisfied explicit costs may not capture foregone maintenance throughout the entire projection period. The impor- or subsidies on capital costs and rate of return require- tance here is the crowding-in of commercial financial ments. The simple cost recovery formula may also involvement in the financing plan to increase the total include gross performance problems which inherently pool of finance and reduce information gaps among increase costs or lower revenues from tariffs. For this commercial lenders. Viability gap financing is similar reason, it is important to look at cost recovery from dif- in concept but its primary objective is to close the ferent dimensions to assess the complete situation and financial viability gap irrespective of the mix of loans correct specific operational and financing deficiencies. and grants. It primarily works by financially engineer- ing a mix of grants and concessional loans primarily to Collection Period. Measures whether the utility is getting lengthen maturities and reduce the cost capital to cre- paid on time. If the utility operates a monthly billing ate financially viable cash flow stream. cycle, anything more than 30 days’ receivables out- standing can highlight late or non-payments. The qual- Capital Contributions vs. CAPEX Subsidies. Often a ity of receivables of a water entity can be further source of misunderstanding, capital contributions to a assessed by carrying out an aging analysis of receiv- public water entity are not necessarily CAPEX subsi- ables. This would show whether the receivables are dies. Like in all entities, the owners of WSPs have the stale and non-recoverable. Moreover, it can also provide obligation to properly capitalize their entity with a mix information for stepping up collection efforts. Utilities of equity and debt, the appropriate mix should be a with fairly good information systems should be able to matter of policy that incorporate several factors includ- develop an accurate ageing analysis as well as deter- ing debt leverage risk. Such a policy should not neces- mine patterns among different customer classes. For sarily give rise to the incidence of a subsidy. If there is example, government offices and military are known to a subsidy component to the capital contribution it be notoriously late in making utility payments. would arise if there are absolutely no expectations for Moreover, utilities may not be able to disconnect these the utility to realize an appropriate return on this capi- customers which often exacerbates the situation. Being tal which would cover the opportunity cost of the able to clearly isolate such problems does bring the pro- Government. Unfortunately, this is not explicitly cess one step closer to resolution, particularly if donor stated so it is often difficult to unequivocally state the agencies or other key stakeholders are involved. incidence of CAPEX subsidies on capital contributions as opposed to the interest rate difference on conces- Creditworthiness. Measures the capacity of a bor- sional loans or on OPEX subsidies where WSPs fall rower to fulfill all its debt repayment obligations. short of their explicit revenue requirement. Creditworthiness is a valuation performed by lenders Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 59 to determine the possibility a borrower may default structures of cross subsidies can be regarded to have on his debt obligations. A creditworthy borrower is some merit particularly if they do benefit lower income one that can demonstrate long term financial communities, many go counter to their intended strength and ability to pay its financial obligations in objectives and may create more economic related full and on time. problems. It has also been criticized that subsidies for the poorest communities should be direct rather than Credit Rating. A credit rating measures the creditwor- implicit subsidies. However, administratively, this is thiness of a potential borrower and it is presented in more difficult to achieve. This is why cross-subsidies the form of a symbol or investment grading. Credit rat- are so popular in the WSS sector. ings are generally assigned to potential borrowers by independent credit rating agencies and are an import- Debt Service Coverage Ratio (DSCR). This ratio measures ant step for promoting WSPs to borrow from commer- the ability of the WSP to meet its debt service obliga- cial financial institutions. A high credit rating indicates tions in terms of current interest charges and any a high possibility of paying back the loan in its entirety repayment due on the principal portion of the loan. It without any issues; a poor credit rating suggests that is calculated by taking the debt service amount (princi- the borrower has had trouble paying back loans in the pal and interest due) over the operating cash flow (see past, and might follow the same pattern in the future. definition of operating cash flow). This ratio is key Shadow Credit ratings have been utilized by govern- because it implicitly incorporates both operating and ments and WSPs to estimate the rating that would be financial performance of the entity. Hence a review of arrived at by a formal credit agency. A high credit rat- the debt service coverage ratio will provide a good ing not only improves the chances of the WSP qualify- quick assessment of whether the utility is meeting its ing for a loan but also may improve the terms the external debt obligations and possibly spot perfor- lender offers. mance problems. A DSCR of 1.2, means that operating cash flow is 20% greater than debt service require- Credit Enhancements. A credit enhancement is a way ments. This has often been regarded as a reasonable the WSP can improve its credit rating with the lender. value for a WSP to achieve. However, ratio must be Through credit enhancements, the commercial lender closely reviewed considering the changing parameters is provided with additional assurances that the WSP of the entity, its capitalization structure and expecta- will meet its debt obligation. The WSP can offer addi- tions for a reasonable return on the investment. For tional collateral such as pledging revenues, increase example, if the utility has practically little or no debt a cash reserves that are help is countervailing deposits, 1.2 value may not be sufficient if it wishes to increase obtain a letter of credit from another financial institu- borrowing to expand coverage. This ratio is best ana- tion, or obtain a third-party guarantee. Credit lyzed under projected assumptions. enhancements reduce credit/default risk of a debt, and can also lower interest rates. Depositary Agencies. A form of credit enhancement whereby the lender requires the borrower have deposit Cross Subsidies. Are commonly utilized by WSPs to accounts with the lender which can also facilitate the lower the cost of service of one class of consumer by creation of a collection account. Collection accounts commensurately taxing another. In most cases, tariff are used to secure revenue receipts of the WSP for debt structures involving cross subsidies are designed to servicing the loan. tax the commercial and industrial customers most and benefit poorer communities. This is typically rational- Development Finance Institutions (DFI). DFIs are spe- ized on the “ability to pay principle.” While such cialized financing agencies established specially to 60 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations fulfill developmental objectives in each country. In be considered operational subsidies. If customers developing countries, these are primarily public spe- instead are charged a higher tariff to cover the perfor- cial law lending institutions that act as intermediaries mance problems, they are in fact being overcharged for for donor and IFI programs and may not necessarily the services being provided. accept customer deposits. IRR vs. NPV. The Net Present Value (NPV) is the value of Favorable Financial Leverage. Financial leverage is the the sum of a project’s projected cash flows discounted ability of the WSP to use borrowed financing to at the cost of capital. Any value over zero indicates ade- increase the overall returns of the enterprise. quate return, but the higher positive value indicates a Favorable financial leverage occurs if the cost of bor- higher return. The NPV calculation does not give an rowed funds is less that the overall return on assets of exact rate of return in percentage terms. It just indi- the entity, creating the incentive to increase the debt cates that you are either above or below your threshold to equity ratio of the enterprise, particularly in times level. A project’s Internal Rate of Return (IRR) is the where the cost of borrowed funds is low. However, as rate of return that it yields, expressed as a percentage with any enterprise a highly leveraged capital struc- for the same projected cash flows. The formula for NPV ture can increase risk considerably and may be con- and IRR are the same for the economic analysis as they sidered negatively by a commercial lender. are for the financial analysis. In such cases, they are usually referred to as the ENPV or the EIRR instead Guarantees. Guarantees are a specialized form of insur- of  the  FNPV and the FIRR. The difference between ance related to financial transactions in which the risk the two is how you define the costs and benefits. The of noncompliance by one of the two sides in a transac- financial analysis only includes cost and benefits that tion is taken on by a third party external to the original accrued to the project, not externalities that accrue transaction. They are essentially a transfer of risk outside the project to the wider economy. It is important related to a portion of a specific financial transaction. to underscore that these indicators should be applied Guarantees can work in several ways to transform to project analysis and are particularly important for opportunities into effective investments. First, they the economic justification of the project. The financial can mitigate risks that lie outside the inherent project assessment must consider the consolidate financial fundamentals (that is, political, regulatory, and policy projection of the WSP to ascertain positive cash- and sovereign risks). Second, they can enhance the flows throughout the projected period and the abil- creditworthiness of the borrower to extend maturities ity to meet all financial obligations during the and lower the effective cost of debt. period. Implicit Subsidies. A subsidy is a form of financial aid Municipal Water Departments. These include water ser- provided by government where the recipient does not vice providers that are part of the municipal organiza- have to bear the full economic cost of a given product tional structure and as such are not regarded as or service, but something typically lower. Implicit sub- separate legal entities. Municipal water departments sidies arise through financial support for performance are in direct contrast to water utilities which have been related issues and are a form of operational subsidies. chartered as separate legal entity in various forms Operational subsidies can also be explicit when a spe- either as public corporations or special law companies. cific policy decision is made to shore-up revenue to The key difference from a financing point of view is subsidize the tariff of a certain class of consumer. If the that the municipal government would be the legal bor- government covers the operational deficit due to addi- rower for municipal water departments. Nonetheless tional cost of performance related issues, they would for lenders it is important that water providers that are Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 61 part of the municipal or provincial organization retain not only measures the technical efficiency of the oper- complete operational and financial information for ation, but also the commercial efficiency of theft con- credit analysis. Notwithstanding lenders would evalu- trol and of the billing and collection process. ate the creditworthiness of the municipal government Non-Revenue Water has several components: (i) for approving credit. unbilled authorized consumption—reflecting prob- lems with the billing system that is not capturing National Transfer Intercept. A form of third party loan authorized consumption; (ii) commercial losses— security available to WSPs that are owned by munici- reflecting losses related to unauthorized consumption pal or provincial governments. Under a decentralized either through theft, faulty meters or the inability of framework local government units receive an annual the utility to measure actual usage and (iii) physical transfer from the national government for redistribut- losses—reflects problems with the actual system ing tax revenues. The transfer payment is pledged as through leaks that are not detected. additional security through an automatic intercept mechanism in the event the WSP delays or defaults on Operating Cash Flow. Its importance is often overlooked its debt service payments. but it is just as important as net income from opera- tions because it reflects the internal cash generation Negative Pledge. A negative pledge is a clause in the produced by the utility to pay down its debt service loan agreement stating that the borrower will not obligations and what remains for leveraging additional pledge any of its assets to another lender if doing so financing. Every analyst must look at the financial gives the lenders less security. The borrower is limited results of the utility from two very important perspec- to financial transactions in which the original lender tives; (i) profits from operations, and (ii) cash flow maintained priority if assets are seized as part of a since both are needed for different reasons and often a default. It also limits the likelihood an asset is pledged WSP can achieve one but not the other. Operating cash more than once, creating an issue of which institution flow is calculated by adding back to net income, inter- has rights to the asset in the event of borrower default. est charges and depreciation expense, and including The negative pledge clause can be utilized in the loan net changes in working capital (a net increase of work- agreement of the senior lender to ensure that other ing capital would reduce operating cash flow). This lenders are subordinated to it in the event of default. amount is then compared against the total debt service Net Profit Ratio. The net profit ratio is a common profit- requirement to determine the DSCR. Any residual is ability ratio that assesses the net return from revenues. then “free cash flow” available for new investment As such, it is calculated as net income after taxes to expenditures or to pay down debt. total revenues. A more precise calculation should focus OPEX Subsidies. Provide financial support for the on operational revenue to obtain a better understand- explicit purpose of reducing the cost to consumers for ing of operational effectiveness. Like many other finan- the water service if there is a deliberate policy to keep cial indicators, the net profit ratio can vary widely tariffs below cost recovery levels. Government also between on WSP and another depending on technical bear the burden of operational losses of WSP which and financial factors. But generally, an acceptable ratio also need to be funded. For the most part, operational ranges between 10% to 30%. For infant WSPs with siz- subsidies are handled as cash infusions to the cash able investment requirements, this ratio should be on flow statement to compensate for operational losses of the higher side. the WSP. Rarely they are included as an added revenue Non-Revenue Water (NRW). Non-revenue water item on the income statement of the WSP as this would if  probably the most important indicator since it be improper from and accounting perspective. At 62 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations times, operational subsidies are made on an “off-bal- payments; agreed subsidy payments; minimum revenue ance sheet” basis such as the payment of civil servants guarantees), etc. by a government ministry instead of the WSP. However, Project vs. Entity Analysis. The assessment of the proj- this is administratively more difficult to achieve. ect versus the entity is largely a consequence of the Operating Cost Coverage Ratio (OCCR). The OCCR mea- perspective of the stakeholder. While it is always sures operational efficiency of a water entity and is cal- important to analyze the specific project as part of any culated by operating costs divided by operating feasibility analysis, from a financial point of view it is revenues. It does not include other non-operating most critical to analyze the financial capacity of the charges to the income statement such as, depreciation entity to fulfill all its financial obligations, not just or interest expense. Generally, an OCCR of 1.5 has been those of the project being considered. As such, the regarded as adequate for developing countries. financial information of the project must be consoli- However, this value should always be reviewed against dated with all other financial parameters of the entity the need for additional financing and particularly, the into a projected cash flow to ascertain financial capac- current size of the fixed asset based in relation to its ity throughout the projected period. The project analy- new investment requirements. sis is most critical for the economic valuation to ensure that the project is economically justified and surpasses Partial Credit Guarantees (PCG). Credit risk instruments the opportunity cost of capital of the government. are more important for domestic lenders and bond- holders and are designed to cover the portion of the Return on Investment (ROI). Measures the overall prof- debt service that falls dues beyond the normal tenor of itability of the utility and whether the utility is gener- commercial loans available from commercial lenders. ating an adequate rate of return on capital invested. As such, they are typically used to extend maturities WSS providers that have received substantial external beyond what is available through commercial lenders ODA grants may be financially healthy with ROIs ratios or bondholders in a partial domestic market. PRGs well below what may be generally accepted. However, cover non-payment of the guaranteed portion of the the cost of grant contributions from national or local debt obligations. In that sense, they are considered a government should be benchmarked at the opportu- comprehensive guarantee for both principal and inter- nity cost of capital of those entities. est for maturities beyond what can be obtained by Security Instruments. Loans can be secured and unse- commercial lenders without enhancements. Credit cured. Secured loans carry less risk because they are risk can be offered on only a portion of the debt obliga- backed up by a real asset such as property and equip- tion (i.e., typically the periods where maturities have ment that can be held as collateral for the loan. been extended) or a portion of the loan throughout the Unsecured loans are riskier to lenders because they are life of the loan. Credit risk guarantees have also been based solely on the borrower’s creditworthiness (i.e., known to lower the cost of financing overall. its ability to cover all the debt service obligations). Partial Risk Guarantees (PRG). Cover commercial lenders Typically, WSPs have few assets that can be collateral- against the risk of a government (or government-owned ized for loans given that most of their fixed assets are entity) failing to perform its contractual  obligations. in the form or civil works of pipes underground. PRGs can cover several risks, including changes of laws However, there are some techniques that can be uti- and regulations; non-allowance for agreed tariff adjust- lized to collateralize loans by (i) pledging the WSP’s ment formula; government (or government entity) con- revenues through a collection account; (ii) creating an tractual payment obligations (i.e., periodic or termination intercept mechanism from National transfers to the Crowding-In Commercial Finance in World Bank Water and Sanitation Operations 63 local municipality where the utility operates or; by the performance related issues of the WSP. The tariff ade- local government itself pledging its tax revenues. Third quacy analysis recasts operating results under more party guarantees can also minimize the risk of unse- acceptable performance standards, as well as adding cured loans by commercial banks. back foregone maintenance that should have taken place. The analysis is important because it determines Self-Financing Ratio (SFR). The SFR measures the abil- what are justifiable tariff levels versus other items that ity of the WSP to fund new investments from internally should be corrected through capital infusions, debt generated funds. Lenders review this indicator closely restructuring or for performance improvements. to determine, not only the available free cash flow of the utility but its capacity to contribute to the financ- Underutilized System. Refers to an entire network or ing plan for a proposed investment program. This is a just part of the network running at less than desired prospective ratio that would allow the analyst to deter- capacity. During the investment planning process, it is mine whether the entity has the capacity to contribute important to size new investments in the network to a portion of their planned CAPEX program from inter- ensure that the related debt service can be handled nally generated financing, typically at least 20% to effectively. If the system is significantly underutilized 30% of the total investment costs. or the investment has been oversized, the revenue to cost ratio will be low and hence the utility may have Senior vs. Subordinated Debt. Senior debt has first difficulty in servicing the related debt that was taken claims on repayment in the event of default and as up to finance the CAPEX program. From an economic such it is less risky that subordinated debt. Senior perspective, an underutilized system would also be debt is usually collateralized but can also be secured considered inefficient. against the earnings of the WSP. Subordinated debt ranks below senior debt with regard to claims on a Viable vs. Bankable. Financial viability addresses the WSP’s  assets  or  earnings and is more risky than ability of the WSP to fully meet its financial obligations senior debt. or in other words, it can pay its debts and earn an acceptable rate of return on its assets. Bankability on Subsidiary Loan Agreement. This is generally separate the other hand deals with the WSP being able to source and additional to the main loan agreement between a commercial loan or another form of commercial IFIs or donors and Governments, and specifies differ- finance. The two are not the same as it is very possible ent terms and conditions to be offered to the benefi- that a viable utility contemplating a capital investment ciary. The mix of loans and grants, tenors, grace may not be able to qualify for a loan either because (i) periods and interest rates offered to the beneficiary the payback period is greater than the maximum tenor could be changed considerably to suite the objectives of the loan that can be offered; (ii) that the utility can- of a given project or financing structure. not meet the lending requirements for collateral or; Tariff Adequacy Analysis. The analysis of whether the (iii) that the commercial lender is not familiar with tariff is truly cost reflective needs to determine lending to the sector and considers involvement as too whether consumers are substantially overcharged for risky. 64 Crowding-In Commercial Finance in World Bank Water and Sanitation Operations Bibliography Advani, R. 2016. 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