0U   B    L  I  C          P  0   L  I  C  Y          F  0   R        T    H    E           SEPTEMBER  1998
PrivateMector
5   The East Asian Financial Crisis -
Fallout for Private Power Projects
P David Gray anidJohn Schuster
13 Contingent Liabilities for
Infrastructure Projects-
Implementing a Risk Management
Framework for Governments
CbristopbernM.  aleGs aed
Ashoka MIodv
17 Risk Management Systems
to Improve Contract Design
and Monitoring
Cbristopber M. Lewis and
Asboka Modv
21 Financing Water and Sanitation
Projects-The Unique Risks
David HaarmLyer and
Ashoka M4ody
25 Pooling Water Projects to Mlave
beyond Project Finance
David Haarmeyer and
Ashoka-Mody 
29 International Gas Trade-
The Bolivia-Brazil Gas Pipeline
Peter L. Lau, ad Nelson de Franca
33 Promoting Regional Power
Trade-The Southern African
Power Pool
Donal T. 0 Leart', Jeanz-Pierre
Charpentier. and DianefMinogue
37 Why Performance Contracts
far State-Owned Enterprises
Haven't Worked
fary Shirley
41 Private Participation in the
Water and Sewerage Sector-
Recent Trends
Gisele Silva, Nicola Ty1nan, as 1s
Yesim Yilmaz
The WlBnGu                       inraScr FILE  COPY
1                         ~~~~~~~The World Bank Group  *  Finance. Private Sector, and Infrastructure Netvvork



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F       In this issue
*, '                   - . * s  /   ................ The financial crisis that erupted in East Asia in
^ *.s * 1';.  ,,  'jtt~        '    -        -mid-1997 has led to sharp drops in currencies,
1C_- j........* .t;  *  ....... *  . .  stock markets, and other asset prices. One vear
;    .   p   *          e   , <          *     on, the crisis is starting to have a dramatic ef-
fect on the IPP industry in Asia, which has
b *,  ;    ¢   ,,/   *   dominated the global market for private power
' *    ,j,,. 3rX          et        s         projects. In this issue we review the implica-
tions for power sector reform.
b~~~l 
N *  t  '-.   ',           .         We also review the trends in private participa-
tion in water projects in developing countries,
;  '  ' .  *      .  with an update from the World Bank's private
' _                       _                  infrastructure project database. Future issues
will review projects in other sectors: power, tele-
communications. and transport.
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b        sW;\'*X   
$> 1,'**     .o W~~~~



~~~~~~~~~~~~~~~, ,                  -   ,    ,~       ' ~        .~
* Privatesector
Quarterlv No. 14, September 1998
The East Asian Financial Crisis-Fallout for Private Power Projects       5
R. David Gray and John Schuster discuss the impact of the East Asian financial crisis on the power sectors of
fotir of the most severely affected economies-Indonesia, Malaysia, the Philippines, and Thailand. For each
country thic authors examine the impact of the crisis on the cost of private power and the knock-on effects on
retail tariffs. They also assess the sustainability of ctIrrent private power programs, xvhich hinges on the level of
governtnent risk exposure, the method used in awarding contracts, and the changed capacity needs in the wake
of sloxving or negative GDIP grow-th.
Contingent Liabilities for Infrastructure Projects-Implementing a Risk Management Framework
for Governments        13
To manage their exposure arising from gguarantees to infrastructure projects, governments needl to adopt modern risk
management techniques. Christopher Lewis and Ashoka Mody introduce an integrated risk management system
that draws on recent advances in the private sector, Adapted for use in the public sector, the system enables
governments to budget for expected losses and to set aside reserves against unexpected losses, thus avoiding the
Lbudgetary stress associated with redirecting scarce public resources to cover a sudden increase in costs.
Risk Management Systems for Contingent Infrastructure Liabilities-Applications to Improve
Contract Design and Monitoring         17
Government guarantees for private infrastructure projects represent real liabilities, and their costs can average as
much as a third of the amount guaranteed. Christopher Lewis and Ashoka Mody show how governments can
use a risk valtiation process to analyze the distribution of risks, decide which risks they should bear and which
shoukl be borne by the private sector, and reduce the frequency and size of calls on guarantees.
. C   Financing Water and Sanitation Projects-The Unique Risks           21
A project finance structure allows water projects with attractive cash flows and risk profiles to secure long-term
private capital. Buit even in industrial countries the credit strength of off-taking municipal governments and the
sector's traditional monopoly structure expose lenders to potentiallv significant credit, regLilatory, and political
risks. These risks, combined with the sLink, hiighly specific, and non-redeployable nattire of water infrastructure
investments, mean that lenders and investors are vtilnerable to opportunistic contracting problems and expropria-
C<fe : 4 d ;X X<,    tion. Reviewing some recent innovative water and sanitation projects, David Haarmeyer and Ashoka Mody
show that private capital participation on a limited recourse or nonrecourse basis has required support by third
parties-stich as multilaterals and federal government agencies-to absorb noncommercial risks.
Pooling Water Projects to Move beyond Project Finance         25
To date most private sector water projects have been financed on a limited recourse basis, that is, with project cash
flows and assets as the main security for lenders. The move from project to corporate (balance sheet) financing is
occurring in stages. Financing project debt from the sponsor company's balance sheet exposes that company to
significant risk and thus requires a strong and large balance sheet. Designed in part to shield a company's balance



sheet, innovative financing strLuctures and instrLuments are emerging. Ultimately, the goal is for water utilities to
raise debt and equity from capital markets on the basis of their own balance sheets, strengthened by a diversified
and stable rate-paying customer hase. David Haarmeyer and Ashoka Mody review the new trends.
International Gas Trade-The Bolivia-Brazil Gas Pipeline      29
The Bolivia-B3razil natural gas pipeline, which will transport natural gas more than 3.000 kilometers, will cost
US$2. 1 billion to construct. Despite the substantial benefits for b)oth Bolivia and Brazil and the involvement of
reputable private partners. the perceived risks and complexities of this large project made financing it a major
challenge. Peter Law and Nelson de Franco explain the historical factors that shaped the project, how the
financing package came together, and the role the pipeline will plav in liberalizing the Brazilian hydrocarbon sector.
Promoting Regional Power Trade-The Southern African Power Pool           33
The Southern African Power Pool (SAPP), the first formal international pool to be set up outside North America
and Western Europe, was inaugurated in 1995. While the utilities of southern Africa have been importing and
exporting electricity fir four decades, these trades occurred through bilateral contracts that were complex and
often difficult to administer. The objective of shifting to the pool is to create a more efficient regional market.
Although physically the pool is still embryonic and trade volumes average roughly 3 percent of production,
confidence in the market and mutual trust between the members are being strengthened and sector coordination
is dramatically improved. Donal O'Leary, Jean-Pierre Charpentier, and Diane Minogue review the factors that
have eased the way for the pool agreements and the challenges that remain in getting the multilateral trading
operation under xway.
Why Performance Contracts for State-Owned Enterprises Haven't Worked           37rt
When privatization is not feasible or palatable, developing country governments seeking to improve the perfor- l
mance of state enterprises are often negotiating performance contracts with their managers. Many of these con-
tracts have been put in place with WXorld Bank assistance. Research shows that they rarely work. Mary Shirley   
summarizes the rationale for performance contracts and the evidence against them and explores the reasons wh 'X
they haven't worked. She concludes that since a well-designed and carefully enforced performance contract can
be as politically costly as a well-designed privatization, performance contracts are not likely to be successful in
countries that lack the political will to privatize.
Private Participation in the Water and Sewerage Sector-Recent Trends        41                                 C            $7
Analysis of the World Bank's private participation in infrastructure database shows that by the end of 1997,
private companies operating in developing countries had reached financial closure on US$25 billion of   g.                   S
invesmient in water and sewerage projects and had taken on the management, operations, rehabilitation, or
construction risk of ninety-seven projects in thirty-five developing countries. The database shows an over-
whelming dominance of concession contracts compared with divestitires, greenfield projects, and management
contracts, and that there are still only a few international companies sponsoring and operating most contracts.
r-*    p     4s*Wi



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5
The East Asian Financial Crisis-Fallout for Private
Power Projects
R. David Gray and John Schuster
Countries around the world have increasingly   country's single buyer. The single buyer enters
turned to the private sector to finance and build  into long-term power purchase agreements
new power projects. This trend has been es-  (PPAs) in which the buyer agrees to take power
pecially pronounced in Asia, which accounts   at specified rates from private power produc-
for nearly 60 percent of all new private gen-   ers for periods ranging from ten to thirty years.
eration capacity financed in the developing
world. But the East Asian financial crisis that   While the full extent of the crisis and its fallout in
began in mid-1997, triggering dramatic stock   these four countries is not yet known, information
market and currency slides and stalling eco-   available to date shows that the effects vary widely
nomic growth in the region, has already had a   among the countries. To varying degrees their
profound effect on investment in infrastructure.   private power programs have been affected by:
This Note discusses the impact of the crisis in   * Increased cost of power.
the power sectors of four of the most severely   * Threats of contract defaults and renegotiations.
affecled economies-Indonesia, Malaysia, the   * Contraction of the market for private power.
Philippines, and Thailand. All have major pri-
vate investments in power generation, but their   As the following analysis will show, the diver-
power sectors are still dominated by vertically   gences in the management and impact of the
integrated public utilities that act as the   crisis suggest a number of important lessons for
TABLE 1    CRISIS-RELATED FACTORS AFFECTING THE IMPACT OF IPP COSTS ON RETAIL TARIFFS
Dimensions                 I                      Project     11
Country      of crisis        --I Mvintage    tariffs   _1                                11
Indonesia                  Q
Malaysia                  0    0    0  00    0
Philippines                                                    c          C        C/O
Thailand   a@0                                      cCO  /o
C Little impact E  Some impact    Severe impact



6                  The East Asian Financial Crisis-Fallout for Private Power Projects
power reform  and the role of independent   tricity rates will need to increase only slightly
power producers (JPPs) in that process.          in Malaysia and Thailand to cover increased
IPP costs-though rates may have to increase
Increased cost of power                          further for other reasons.
A currency depreciation of the magnitude of   Dimensions of the economic crisis
those in East Asia increases the cost of most
goods and services, including electric power.   All four countries have suffered severe economic
The extent of the rise in power costs attribut-   setbacks since mid-1997, and the International
able to private power has varied among the    Monetary Fund has forecast a significant slow-
countries, depending on such factors as:         down in economic growth in 1998.1 By early
* The dimensions of the economic crisis.        June 1998 Malaysia, the Philippines, and Thai-
* The origin of the fuel supply.                 land had experienced currency depreciations of
* The currency denomination of the wholesale   around 35 percent, and interest rates in Malay-
tariffs.                                       sia and the Philippines had risen 50 percent from
* The extent of domestic financing for projects.   a year earlier. Interest rates in Thailand are nearly
* The amount and timing of private power   twice the previous year's level. The drop in the
purchases.                                     value of currencies was accompanied by de-
* Wholesale and retail tariffs.                  clines in regional stock markets. The Malaysian
market index fell by more than 50 percent in
Each of these factors is examined below, and    local currency terms between early June 1997
table 1 sums the aggregate implications for tar-   and 1998, while the Philippines and Thailand
iffs. This analysis suggests that the crisis will   suffered slides of 30 and 40 percent. Indonesia
have the most severe impact in the Indonesian    has been hit hardest-the rupiah has dropped
power sector, where retail tariffs may need to   80 percent in value in the past year, increasing
rise by up to 70 percent to pay for the increased    the local cost of imports by a factor of five. In-
cost of private power. In contrast, retail elec-   terest rates are more than three times higher
FIGURE 1 PRIVATE POWER CAPACITY, MARCH 1998
Megawatts                                                                          In construction
6,000                                                                           _  In operation
5,000
4,000
3,000
2.000
1,000
Indonesia             Malaysia              Philippines             Thailand
Source: Hagler Bailly IIP Knowledge Base.



The World Bank Group                  7
than before the crisis, the stock market has fallen   Democratic Republic, payments to private power
by more than 40 percent, and growth is pro-   projects are denominated in baht. Nonetheless,
jected to turn sharply negative this year.   the depreciation of the baht made planned
projects unfinanceable under the existing power
Many regional utilities have high levels of for-   purchase agreements. EGAT reopened negotia-
eign debt, and the depreciation has led to heavy   tions with sponsors to ensure the financial vi-
foreign exchange losses in servicing that debt,   ability of projects needed to reduce the country's
eroding their financial positions. The cost of capi-   power shortages. The utility pegged part of the
tal for new projects is likely to rise sharply as   private power tariff to the U.S. dollar and as-
investors assess additional premiums to com-   sumed some currency risk by agreeing to pay
pensate for higher perceived risk. The skyrock-   IPPs at an exchange rate of 27 baht per dollar,
eting domestic interest rates also make financing   close to the precrisis rate of about 25 baht per
new projects costlier.                        dollar. In early June the baht traded at 40 to 42
per dollar.
Origin of fuel supply
Extent of domestic financing for projects
Fuel costs, a pass-through for power off-takers
under most private power contracts in Asia and   Projects attracting high levels of domestic finance
ihroughout the developing world, can repre-   are less susceptible to exchange rate volatility
sent about a third of the life-cycle cost of a   (although they may be vulnerable to interest
coal project and about three-quarters of the   rate hikes). Malaysia and Thailand both have
life-cycle cost of oil and gas projects.2 If fuel is   high levels of local debt financing for IPPs (90
imported, a depreciation of the size of those in   percent and 75 percent), which help to mitigate
East Asia significantly increases the local cur-  the impact of the currency depreciation. Do-
rency costs of both public and private power.   mestic financing is negligible in the other two
In the Philippines and Thailand most private   countries-14 percent in Indonesia and just 3
projects import fuel-at prices about 50 per-   percent in the Philippines-leaving them more
cent higher in 1998 than in 1997.             exposed to the mismatch between project rev-
enues denominated in local currency, and hard
Currency of wholesale tariffs                 currency obligations to project lenders.
The currency denomination of payments for   Amount and timing of private power purchases
private power is one of the most important dif-
ferentiating factors in the impact of the crisis  Indonesia, Malaysia, and the Philippines are
on those payments. In Indonesia and the Phil-   among the developing world's largest markets
ippines, where wholesale electricity tariffs for   for private power with limited recourse financ-
IPPs have been denominated in hard curren-   ing.3 Each has nearly 5 gigawatts (GW) of pri-
cies, the local currency cost of utilities' off-take   vate power capacity in operation or under
obligations has ballooned. In Malaysia, where   construction (figure 1). Private power now ac-
power purchase payments are denominated in   counts for more than half of all generation in
local currency and interest rates have risen com-   Malaysia and the Philippines. It has played a
paratively less, the cost of private power has   smaller role in Thailand. But once all the nearly
risen by less than 10 percent.                2 GW of private generating capacity now under
construction in Thailand becomes commercial-
Thailand's national utility, the Electricity Gener-  ized, private power will account for about 10 to
ating Authority of Thailand (EGAT), has been    15 percent of the country's electricity.
partly insulated from currency exchange risks
because, with the exception of purchases from    The four countries differ in the timing of their
a private power project in the Lao People's   private purchases. Malaysia and the Philippines



8                   The East Asian Financial Crisis-Fallout for Private Power Projects
began their private power programs early and    Wholesale and retail tariffs
now account for about 80 percent of the com-
mercial private power capacity in operation in    A rational system of wholesale IPP tariffs and
the four countries. The financial crisis is likely   retail consumer tariffs is a prerequisite for a
to have a large impact on electricity costs in   successful private power program. Wholesale
the Philippines, which must make dollar pay-   power costs should on average be about two-
ments to several operating IPPs. But in both   thirds of retail rates, which must also cover
Malaysia and the Philippines relatively little new    nongeneration costs (such as transmission,
private power is expected to be commercial   distribution, administration, and customer ser-
by 2001. The fact that relatively little new pri-   vice). Wholesale IPP tariffs in Malaysia and
vate capacity is coming on line, along with the    Thailand range from 3¢ to 4¢ per kilowatt-hour
substantial payments for private power made    (kWh), while retail tariffs are substantially
before the crisis, will help mitigate the short-   greater, suggesting that utilities in these coun-
term impact of the crisis in these two countries.   tries have adequate margins to pay nongener-
The longer-term  impact of the crisis will de-   ation expenses.
pend on the cost and timing of development
after 2001. Currently, the Philippines plans to    The relationship between retail and wholesale
commercialize substantial gas and hydroelectric    power tariffs in Indonesia and the Philippines
capacity starting in about 2002.                 implies a less stable financial situation. Whole-
sale power tariffs in the Philippines are rela-
The crisis will have the largest impact in Indo-   tively high, and retail rates may not be sufficient
nesia, which accounts for nearly half the new    to cover the cost of operations by the national
IPP capacity due to begin operation in these    power utility, Napocor. The increase in inter-
countries in 1998-2001. In all, more than 9,000    est costs on foreign debt and in fuel and other
megawatts (MW) of capacity is under construc-    costs in the wake of the crisis has further eroded
tion or at an advanced stage of development   Napocor's financial position. Rates should rise
in Indonesia (figure 2).                         substantially as a result of automatic tariff ad-
FIGURE 2 CUMULATIVE DEVELOPMENT OF PRIVATE POWER
CAPACITY, 1991-2001
Megawatts
12,000
10,000                                                                          Indonesia
8,000
Philippines/
6,000
4,000                               Malaysia
2,000                                                                        d
1991    1992    1993      1994    1995    1996    1997    1998'    1999'    2000'    2001'
a. Projected.
Source: Hagler Bailly IIP Knowledge Base.



The World Bank Group                   9
justments and will need to rise even more if
Napocor is to cover its costs.
TABLE2   EFFECT OF THE CRISIS ON EXPECTED NEW
In Indonesia Perusahaan Listrik Negara's (PLN)                 GREENFIELD PROJECT DEVELOPMENT, 1998-2001
financial situation appears even more critical.                Gigawafts
Even before the crisis retail tariffs appeared
inadequate relative to costs. While wholesale                                          ,
tariffs for private power ranged from 5.4q to
8.5¢ per kWh, retail tariffs were just over 7¢                       Precrisis
per kWh, implying that margins were inad-            Country        projections
equate to pay for nongeneration expenses.
When the rupiah fell from roughly 2,500 per          Indonesia          7.3            3.8         4.0
U.S. dollar to more than 10,000, PLN's position      Malaysia          IA              0.1         0.5
deteriorated. Even with price hikes in March         Philippines        3.6            2.8         3.3
and May 1998 totaling more than 30 percent,          Thailand           3.8            0.2         2.0
retail tariffs remained below 3¢ per kWh.            Toal              18              0.2         9.0
Total             16.1           6.9          9.8
Some of the region's utilities will need massive
cash infusions from either government trans-         Soce:Hegler8aillyPKnowledgeBase.
fers or privatization to meet their debt obliga-
tions. As a rcsult, their ratings by international
credit agencies have been downgraded, and    an interest in reviewing agreements that may
some are now considered technically bankrupt.   lead to an unsustainable situation. Many factors
affect the sustainability of IPP programs, includ-
Threats of contract defaults and                ing (as outlined below) the appropriateness of
renegotiations                                  government support for private projects, the use
of competitive procurement procedures for
The public utilities' worsening situation has in-   projects, and the need for power. Analysis of
creased pressures to renegotiate contracts. Sev-   such factors in the four countries predicts sus-
eral planned projects with signed PPAs have been   tained government commitment to private
reviewed or postponed. Governments have also    projects in most countries. But it also points to
sought to modify contracts for projects already    a high risk of breach of contract by the govern-
in operation. Indonesia, the most heavily exposed    ment or public utilities in some cases.
country, hias called on project sponsors to lower
power prices and has tried to negotiate lower   Government risk sharing
purchase obligations. In February 1998 PLN issued
letters to three IPPs unilaterally setting an ex-   Governments have assumed some risk for
change rate for its payments to the private projects   private power projects in all four countries.
of 2,450 rupiah per dollar (the rupiah was then    Such support may take the form of govern-
trading below 8,450), in violation of the existing    ment guarantees backstopping the obligations
PPAs. PLN later backed away from this position,   of the power purchasing utilities or financial
promising eventual full payment in dollars. But   participation in the projects. While direct sup-
international rating agencies have assessed an    port to projects can serve as an indicator of
increased risk of default for several projects.  government commitment, excessive liabilities
that are likely to come due when governments
Renegotiating or defaulting on contracts can be    can least afford them (such as during a finan-
costly to governments as well as to sponsors   cial crisis) can undermine the sustainability of
and investors. Countries that have breached con-   private investment programs, leading to default
tracts will deter investors. But all parties have    and renegotiation.



10                The East Asian Financial Crisis-Fallout for Private Power Projects
In Malaysia and Thailand the central govern-   ters of comfort" in which it agreed to support
ments have assumed some risk, but have   the discharge of PLN's responsibilities. These
granted no guarantees or other direct official  letters do not amount to a guarantee, however.
forms of support. They have provided no spe-   Project sponsors assumed some fuel supply and
cial foreign exchange protections for private   other risks.
power projects beyond those granted to all
foreign investors. Government fuel suppliers   Competitive bidding
have provided similar levels of security to
projects as would be provided under commer-   Recent experiences such as Enron's Dabhol
cial fuel supply contracts. In manv projects   project in India have shown that governments
governments have assumed risks mainly by pro-   may face pressure to renegotiate projects that
viding loans through government pension   have not had to undergo the scrutiny of a for-
funds, state banks, or other public sources of   mal competitive bidding process. Both Malay-
funds, thus assuming similar commercial risk   sia and Thailand procured new generation
as other lenders.                            using competitive bidding-one reason for the
lower wholesale tariffs in these two countries-
In contrast, the government of the Philippines   while most IPP projects in Indonesia and many
assumed fairly substantial risks through sover-   of the early projects in the Philippines were
eign guarantees, including all fuel supply, in-   concluded through direct negotiation with
flation, and foreign exchange risks.' Its   project sponsors. The Philippines has since
willingness to assume these risks was impor-   adopted international competitive bidding to
tant to the successful financing of several early  increase transparency and lower costs.
projects. Now that the market is fairly mature,
the Philippines has recently reduced the guar-   Need for power
antees offered to new projects, and some are
being financed with no sovereign guarantees.   The primary motivation in seeking private power
The Indonesian government assumed fewer   was the dire need for more generation capac-
risks for projects, but it granted projects "let-  ity. Widespread power shortages and blackouts
TABLE 3  FACTORS AFFECTING THE SUSTAINABILITY OF CURRENT PRIVATE POWER PROGRAMS
|~~~~~~~~~~ I    .I                 *  i    .1             I1L  *:                .1L  . :l "  
Indonesia          C                  0                      0                  0/c
Malaysia           Q/ C     &
Philippines        *                                                                 I
Thailand           0                  *                      t                  °/#i
Q Low             t\Low to medium  )Medium to high      High



The World Bank Group                11
are a costly drag on private investment and eco-   most equipment and construction costs are in
nomic growth. As long as this need persists, it  hard currency.
creates powerful incentives for governments to
remain committed to private power projects.  Implications for private power policy
There is a long-term need for power in all four   While no one could easily have predicted the
countries. While there is currently excess capa-   dimensions of the crisis or have designed a
city in the Philippines and Thailand, future de-   power policy to protect projects from the eco-
mand growth should eliminate these surpluses   nomic shocks, analysis of the effects offers les-
and create a need for new projects. The future   sons for Asia and the rest of the developing
balance of supply and demand depends on the   world. Countries such as Malaysia and Thailand
pace of new capacity additions. Excess capac-   have adopted power policies that appear to have
ity is expected to materialize in parts of the In-   left them less exposed than other countries (table
donesian power system as large plants now    3). Price reform, domestic financing, competi-
under construction become operational. Exces-  tive bidding, and appropriate government sup-
sive surpluses could lead to pressures to break   port mechanisms mitigate the effects of the crisis
agreements on new projects. Thailand has taken   on the cost of power and the sustainability of
steps to avoid surpluses by delaying power   investment programs. The timing of project de-
projects for two years.                      velopment also appears to be a major factor in
the severity with which the crisis has affected
A shrinking market for private power         regional power programs.
The economic slowdown and the higher prices   The Philippines and Thailand are pushing ahead
for many basic goods have reduced demand   with plans to privatize their national utility com-
for electricity, restricting future private power   panies, despite the more difficult environment
opportunities. It is estimated that total new    for privatization in the wake of the crisis. But
private power development in the region could   unlike many countries in Latin America, no Asian
fall from around 16 GW to less than 7 over the   countries have yet undertaken fundamental
period 1998-2001 (table 2). In Indonesia alone   restructuring and privatization of their power
new private power development could decline   sectors to reduce the burden of public sector
by 3.5 GW, and near-term markets for new    liabilities and put the whole power industry on
projects in Malaysia and Thailand could all but   a more sustainable footing.
disappear. In the Philippines the crisis is ex-
pected to have a modest impact on new project   The market for private power in Asia appears
commercialization through 2001.              both smaller and more fraught with uncertainty
than before the crisis. In this new environment
The financial crisis has stalled many new con-   investors will scrutinize projects more closely,
struction projects, both public and private, as   and governments will need to manage power
the construction costs have soared in local cur-   programs judiciously to continue to attract
rency terms. PLN has canceled sixteen IPP   investment. They need to strike a balance in
projects, many of which had signed contracts.   providing support to the industry, shoring up
Plans for a 1,000-MW private power project in   private projects in the near term while avoid-
Malaysia have reportedly been shelved because   ing burdensome, open-ended commitments
the drop in the exchange rate increased the   that could hamper the longer-term prospects
project's prospective costs by more than 1   for reform.
billion ringgits (about US$260 million). Depre-
ciation poses a greater challenge to countries
stil in th  eal  hsso  p eeomn              This text wvas finalized in late June.
still in the early phases of IPP development,   l InternationalMonetaryFund, WordEconomicOiutlook(Washington,
when construction risks are important, since   D.C., May 1998).



2 Power off-takers accept fuel risks in most projects with power pur-
chase agreements. Banks generally helieve that power off-takers
are hetter ahle to take these risks than other project participants
hecause of their ahility to pass fuel price increases along to
consumers. See Suman Bahhao and John Schuster. "Power Project
Finance: Experience in Developinig Countries' (RMC Discussion
Paper 119, World Bank, Resource Mohilization and Cofinancing
Vice Presidency, Washington, D.C., 1998).
See Suand n Babhar and John Schuster, 'Poer Project Finance: Ex-
perience in Developing Countries" (RMNC Discussion Paper 119.
WVorld Bank. Resource Mohilization and Cofinanci~ng Vice Presi-
dency. Washington, D.C., 1998).
See David Baughman and Manhew Buresch, "Mohilizing Private
Capital for the Power Sector: Experience in Asia and LUtin America"
(U.S. Agency for Initernational Developmenit and World Bank, W8a.sh-
ington, D.C., 1994).
R. David Gray (rgray@worIdbank.orgit consult-
ant, Private Sector Development Department,
and jobn Schutster ()scbuste@baglerbazlly.com),
manager, Hag/er Bailly Consulting



13
Contingent Liabilities for Infrastructure Projects
Implementing a risk management framework for governments
Cbristopher M. Leuis anid Ashoka Mody
To manage their exposure arising from guarantees to infrastructure projects, governments need
to adopt modern risk management techniques. Because guarantees come due only if particular
events occur and involve no immediate cost to the government, they rarely appear in the
government accounts or have funds budgeted to cover them. This Note introduces an integrated
risk management system that draws on recent advances in the private sector. The system,
adapted for use in the public sector, enables governments to budget for expected losses and to
set aside reserves against unexpected losses, thus avoiding the budgetary stress associated with
redirecting scarce public resources to cover a sudden increase in costs.
Over the past several years many large multi-   * Assessing the government's tolerance for
national firms, including Bankers Trust, Chase  bearing risk.
Manhattan, and Microsoft, have implemented   * Using the government's risk tolerance as a
enterprisewide systems for risk management.    basis for establishing policies and procedures
For each risk identified as important, these firms  for structuring reserves against unexpected
determine the best approach for improving their    losses.
management of exposure, whether by insur-   * Implementing risk mitigation and control
ing, transferring, mitigating, or retaining the  mechanisms to prevent unintended losses on
risk. The goal is not just to hedge a fixed set of    those risks and establishing systems to contin-
risk exposures, but to determine the areas and  ually monitor and reassess the government's
lines of business in which a company is will-    risk exposure over time (see page 17).
ing to retain risks in order to generate target
returns.                                    As in the private sector, these steps should be
applied to four general categories of risk:
Adapted to the public sector environment-  financial, operational, business, and event risk.
and customized to reflect the government's
budgetary and regulatory processes, the legis-   Measuring risk
lative and legal environments, and the risks
being evaluated-this approach can be used   A government's exposure to loss can arise from
to manage a government's exposure to risk,   a wide variety of events, and attempting to ac-
particularly contingent liability risk. The model   count for every source of exposure is not fea-
involves six main steps:                   sible. A better approach, and that followed in
* Identifying the government's risk exposures.  the private sector model, is to first examine gen-
* Measuring or quantifying expected and unex-   eral categories of risk and then focus on the
pected exposures.                         areas of highest risk (see figure 1 for a lattice of
* Provisioning for expected costs in the bud-   generic risks). The next step is to value the ex-
getary process.                           pected and unexpected losses (see box 1 for a



14               Contingent Liabilities for Infrastructure Projects
FIGURE 1 RISK IDENTIFICATION LATTICE
C:~~~~~~~~~~~~~~~~~~~~~~k
definition of expected and unexpected losses).  on a present value basis, most government bod-
The valuation techniques used will depend on   ies account for credit and insurance products
the type of risk being analyzed and the data   using a simple cash-based system of budgeting.
available. Actuarial and econometric models can   Cash-based budgeting misrepresents and masks
be used to estimate exposures, but both tech-  the aggregate exposure associated with loan
niques require substantial data on the perfor-   guarantees and government insurance programs
mance of a program (or on a comparable   and creates perverse incentives for selecting one
program). For project finance, where deals are  form of financing assistance over another.' By
unique and data records often missing or of low   failing to align the budgetary impact of direct
quality, more advanced modeling approaches  loans, loan guarantees, insurance, and grant pro-
are required. The most powerful are those com-   grams with their true economic costs at the time
monly used to value options in financial mar-  commitments are made, a simple cash budget
kets; these can be applied to value direct loans,  creates an intertemporal myopia, moral hazard,
loan guarantees, and insurance contracts granted   or both. Only by enforcing budgetary controls
to support infrastructure liabilities.     at the time the financial assistance is committed
can the budgetary incentives be realigned to
Budgeting for expected costs-the           eliminate this effect.
accounting challenge
Many governments face significant legal, regula-
Armed with a measure of risk exposure for  tory, and political hurdles in moving from
expected costs, a government can use the infor-  current budgetary practices to a full account-
mation as a budgetary control mechanism and   ing of the risks of contingent liabilities. Often
work out how to improve the budgetary process   governments prefer incremental changes or in-
to provide stronger incentives for risk man-  terim steps to smooth the transition. Implement-
agement. The government could publish its risk  ing risk-adjusted performance measures allows
exposure in the national budget, use it to estab-   governments to manage their exposures to con-
lish exposure limits or credit limits, or use it to  tingent liabilities even if an immediate change
develop risk-adjusted performance measures.  in national budgetary policy is not feasible.
(Such measures could be applied to reward pro-   Nonbudgetary control mechanisms for contin-
grams that deliver social benefits with the least  gent liabilities (publishing information, estab-
risk to the public budget.)                lishing credit quotas or exposure limits, and
earmarking future funds to cover guarantee
The nmain impediment to implementing these   costs) also could be used during a transition to
options is the cash budget accounting system    a new budgetary system. And they could be
used by most governments. While private insti-  used on a permanent basis for liabilities
tutions compute virtually all investment deci-  grandfathered during a change in budgetary
sions, expenditures, plans, and budget forecasts   policy or as a permanent management solu-



The World Bank Group                    15
BOX 1     DEFINING EXPECTED AND UNEXPECTED LOSSES
Consider a government loan guarantee program        Probability         Exposure
characterized by the following very simple           (percent)    (millions of U.S. dollars)
probability distribution. While the expected            5                  0
costs of the program (the mean of the distribu-         5                  2
tion) are US$10. losses will exceed this               15                  5
expectation 35 percent of the time. That means         15                  8
that if the government sets reserves only to cover  -
expected losses, it will have to request               15                 12
additional funds in 35 percent of all possible          5                 14
outcomes of the guarantee. For a portfolio of           5                  16
thirty similar programs and with five-year              5                  18
guarantees, the central government would               2.5                20
have to go to the legislature tNice a year for         2.5                30
additional funds.
tion if the government fails to enact a change   how often the executive wants to go to the legis-
in the budget law.                                lature for funds. Once the proper valuation tools
are in place, the government can set reserve
Reserving for unexpected costs                    policy based on an assessment of its aversion to
making frequent funding requests. The govern-
In addition to budgeting for the full expected   ment's leverage considerations will also be dif-
present value of costs, governments need to set  ferent from those in the private sector. Holding
aside reserves against unexpected losses. For a   more funds in reserve increases the liquidity of
private firm with multiple lines of business, de-   the guarantees that the reserve supports, increas-
termining the appropriate level of capital or re-  ing their value and allowing the government to
serves is a complex procedure that takes into  leverage more private funding in the guarantee
account both the variability of losses for each   program. But reserving funds in a separate ac-
product line and the correlation between prod-   count reduces the money available for other pub-
uct returns and the opportunity cost of capital.  lic sector projects and services. If the net benefits
of additional public spending exceed the liquid-
A private firn  must also weigh the expecta-   ity benefits of adding to the guarantee reserve,
tions of shareholders and stakeholders, rating   the government may want to direct additional
agencies, and business partners in determining   funds toward public spending.2
the optimal level of capital. The capital or re-
serves held by an enterprise reflect its relative   Setting reserves
risk aversion and its ability to withstand a spe-
cific level of unexpected losses. Thus a firm    Having assessed which risks and what level of
seeking a AAA rating will hold considerably  loss it is willing to bear, the government can set its
more capital against unexpected losses (say,   reserves against unexpected losses ("risk capital")
capital to cover a 99 percentile event over a   in its credit and insurance programs. But first it
one-year period) than a firm seeking an A rat-   needs to determine whether reserves will be set
ing (capital to cover a 90 percentile event).    based on the additive unexpected loss exposure
of each guarantee or on a portfolio value-at-risk
Similar pressures come into play in assessing   approach to account for portfolio diversifica-
government tolerance for risk. But the assess-  tion, what the investment policy of the reserves
ment must also consider the unique question of   will be, and where the reserves should reside.



16                       Contingent Liabilities for Infrastructure Projects
Under an additive reserve standard the govern-                 ing the reserve offshore to circumvent convert-
ment calculates the unexpected loss exposure                   ibility risk issues. This strategy would greatly
of each  of its contingent liabilities indepen-                enhance the market value of the guarantees and
dently (that is, examines the sensitivity of each              provide the government with greater leverage
guarantee valuation to changes in the underly-                 from  the guarantee program. However, decisions
ing factors). Then, for a given confidence level               on the location of the reserves must be made in
and time interval, it determines the amount of                 the context of the government's broader for-
unexpected  loss it wishes to  cover for each                  eign currency risk management program.
guarantee, taking into consideration the op-
portunity cost of capital. It then identifies the              Next step
average cash reserve required to fund these
unexpected losses. Finally, it aggregates the in-              This approach to risk management provides a
dividual cash  reserve balances to  arrive at a                mechanism  for governments to critically assess
total unexpected loss reserve.                                 the distribution of risks within a loan guaran-
tee or insurance program and come up with
The problem  with the additive approach is that                better designed contracts and fewer and smaller
it fails to account for portfolio diversification-             calls on guarantees. And as risks change over
the fact that pooling imperfectly correlated risks             time, the framework provides a basis for easy
will reduce the variance in the expected  loss                 reestimation and quick adjustments to the bud-
of a portfolio. As a result the risk of the overall            getary and reserve system. A companion Note
portfolio will be overstated, and more protec-                 on page 17 shows how.
tion against unexpected losses provided than
originally sought by the government. The al-                   This Note is based on a longer paper by the authors in Timothy Irwin,
ternative is to calculate the aggregate loss dis-              Michael Klein, Guillermo E. Perry. and Mateen Thobani, eds., Dealing
tribution of the government's portfolio of risks,              with Public Risk in Pr-ivate Infrastructure (Latin American and Carih-
using a value-at-risk approach that incorporates               bean Studies. Washington, D.C.: World Bank, 1998).
1 To see how these incentives skew decisionmaking, consider the
cross-correlations between  guarantee  expo-                      different ways in which a government could help finance a US$100
sures, and  then  set reserves to  cover unex-                    loan to a private infrastructure provider If the govemnient pro-
pected  losses based  on  the unexpected  loss                    vides a 10 percent loan subsidv, the cash budget cost would he
US$10 in year one. If it prtovides the loan directly, the cash budget
profile of the entire portfolio.                                  cost in year one would be US$100-the full face value of the loan.
And if it agrees to guarantee a loan by a private bank, the budget-
Investing reserves                                                ary cost would be zero (or negative if a guarantee fee is collected)
in the first year. Thus while the economic and financial values of
the three form.s of financial assistance are equal, a legislative hody
The objective  in  investing  the reserve funds                   would favor the guarantee option.
should be to maximize the value of the assets                  2 When a private company assesses the tradeoff between holding
reserves and investing in oUtier programis, it USoially has a targeted
when the costs to the government increase-                        economic return that helps guide its capital policy. For a govern-
that is, to invest the reserve funids in assets that              ment the comparable concept is social return. Calculating social
return requires a comnplete asset-liability management program that
provide the best hedge against the government's
goes beyondJ the valuation of infra.strucmure liabilities or other forms
cost for a given return. In doing this, the gov-                  of direct loan.s, loan guarantees, and insurance. This Note focuses
ernment may achieve better results by manag-                      on reserving against contingent liabilities without considering a
ing its assets and liabilities at the balance sheet               broader asset-liability management policy.
level rather than on a program  basis.
ChristopherM. Lewis, Ernst &9 Young, and
The government also needs to decide whether   Ashoka Mody (amody@worldbank.org), Project
to hold its reserves offshore, in a foreign cur-               Finance and Guarantees Department
rency, or domestically, in the domestic currency.
If the guarantees are denominated in dollars,
the government should consider investing the
reserve fund in dollar assets and possibly keep-



17
Risk Management Systems for Contingent
Infrastructure Liabilities
Applications to improve contract design and monitoring
Christopher M. Lewis and Asboka Mody
Government guarantees for private infrastructure projects represent real liabilities, and their
costs can average as much as a third of the amount guaranteed. Most governments do not know
the full extent of these liabilities, because they have made no attempt to systematically estimate
them. A companion Note proposes a new framework for identifying government exposures,
valuing expected and unexpected risks, and budgeting for expected risks and reserving for
unexpected ones. This Note shows how governments can use the valuation process to analyze
the distribution of risks, decide which risks they should bear and which should be borne by the
private sector, and reduce the frequency and size of calls on guarantees.
In what may be the first time that a sophisti-  the government assessed a number of risk ex-
cated contingent valuation method was applied   posures: market risk (relating to market volumes
to government infrastructure projects, the World  and prices), construction risk (from cost and
Bank and the Colombian government collabo-   schedule overruns), counterparty risk (opera-
rated to estimate the government's exposure  tions risk and risk of failure of participating
in three infrastructure finance projects:  companies), currency risk (relating to exchange
* The US$20 million El Cortijo-El Vino toll road   rates and liquidity), force majeure, termination
project, where the government guarantees  risk (risk of contract buyout, possibly includ-
construction costs and traffic volumes.  ing penalties), and regulatory risk (the risk of
* A joint venture telecommunications project   adverse regulatory changes).
between Telecom S.A. and Siemens, where
Siemens will supply switching equipment and   The assessment for the El Cortijo-El Vino toll
cables for more than 80,000 new lines and   road project showed that the greatest exposures
the government guarantees annual minimum   for the government are from the market risk
cash returns to Siemens in the period after   associated with traffic volatility and the risk of
construction.                            construction cost overruns. The total expected
• A US$755 million privately sponsored power  loss to the government under these two guar-
project to supply a government-owned dis-  antees was estimated at about US$4.2 million
tribution company, where the government  (table 1). The assessment of the telecommuni-
provides guarantees for the power purchase   cations project identified regulatory and market
agreement (box 1).                      risk and construction risk as the largest risks.
Regulatory and market risk exposure-stemming
The valuation of the government's exposure  from Colombia's deregulation of telecommuni-
in these three projects used a technique called   cations, which ended the monopoly held by
stochastic simulation to identify the net ex-   Telecom S.A.-was estimated at US$10 million.
pected loss. In keeping with the lattice of risks   Construction risk was estimated at US$9.8 mil-
outlined in a companion Note (see page 14),  lion, but whether this risk is borne by Telecom



18                     Risk Management Systems for Contingent Infrastructure Liabilities
Tollroads
or Siemens is not clear from  the contracts. In
The government provided a construction cost overrun guarantee and a traffic  the energy project the government's exposure
volume guarantee once road construction was finished. Underthe terms of   to CORELCA was estimated at US$67 million.
the cost overrun guarantee the government would cover 10) percent of the   Most of the exposure relates to the risk that re-
costof overrun up to 30percent of the original construction bid, 75 percent of  tail energy prices will be insufficient to support
the overrun between 31 and 50 percent of the bid, and none of the overrun  CORELCA's operations, causing the company to
above 50 percent of the bid. The traffic volume guarantee commits the      default.
government to reimbursing the concessionaire if traffic volume falls 10
The loss variances for each project were also
percent below the projections agreed to in the project budgiet. H traffic  analyzed, and scenario analyses were run to
volume exceeds projections by more than 10 percent the additional revenues  see how  different conditions would affect the
areplacedinareservefundtocoverfutureshortfallsintrafficvolumeorfor        risks of each project, Scenario analysis is an
road maintenance.                                                          extremely important tool for governments in
reviewing their exposure to a project finance
Telecommunications                                                        transaction in the context of general fiscal poli-
Thetelecommunicationsproject,a jointventurebetweenTelecomS.A.and           cies. In the toll road project, for example, such
Siemens, hasastructure similartoabuild-operate-lease arrangement under     analysis can show  how  anti-inflationary fiscal
which Siemens wiW install the switching equipmentand cables for more than  policy would affect the government's exposure
MM Dnew lines. Under a risk sharing agreement Telecom beers 20 percent of  under traffic volume guarantees. Scenario analy-
therisk/retumwina10pent band around the expected revenue of the           sis is also  useful in analyzing  alternative
approaches to achieving the government's ob-
projectand 10[percentoftherisk/retumoutsidethis 1perentband.The          jective in an infrastructure project. For example,
contracts do not clearly specifythe allocation of construction risks.     in addition to underwriting the power purchase
agreement, the Colombian government pro-
Power                                                                     vided a subordinated loan to CORELCA. As a
The government has provided several forms of supportto the US$755 million  result, the evaluation of any action designed
expansion of the 240-megawatt Barranqeilla thermal power plant The 75-     to increase the value of the energy guarantee
megawatt plant will be constructed by TEBSA to provide power to            must take into account its impact on the value
CORELCA, an undercapiftalized state-owned power distributor on Colombia's  of the subordinated loan to CORELCA.
Atlantic coast that runs a narrow-margin energy distribution serice. TEBSA  Risk sharing between the public and
is a special-purpose vehicle capitalized bythe old Barranquilia thermal    private sector
plant now jointly owned by CODRELCA and ABB Distral. The government
support consists of a power purchase agreement between CORELCA and         The valuation process allows governments to
TEBSA, three guarantees, and a subordinated loan:                          critically assess the distribution of risks under
* UnderthepowerpurchaseagreementCORELCAagreesto makecapacity               a direct loan, a guarantee, or an insurance
paymentstoTEBSAforthefirsttwentyearsoftfheplantsoperation.As            program  and to design contracts that lead to
long as the plant is eperational, CORELCA must pay a schedule of fees that  fewer and smaller calls on guarantees. For ex-
start high and decline overtime.                                        ample, in soliciting bids for the toll road project,
the Colombian government asked prospective
* The Ministry of Energy guarantees CEAs ability to make these             concessionaires to bid on the basis of a pre-
paymentstoTEBSA,andtheColosmbiangovernmentguaranteesthe                 liminary set of engineering designs. Recogniz-
ministysabilitytohonorthiscommibment                                    ing that these designs provided too little detail,
* To prevent CORELCA from failing, the ministy has taken a subordinated    the government granted cost overrun guaran-
debtpositioninthecompanyto helpeaseanyliquiditycrisis.                  tees that would compensate the concession-
* EcopetroL thesupplierofgastoTEBSAandCORELCA.guaranteesforce              aire for cost variances within a wide band
majeure payments.                                                       around the submitted bid. While the guaran-
tees served the purpose of attracting qualified
bidders, their structure allowed concessionaires



The World Bank Group                      19
TABLE I       EXPECTED GOVERNMENT LOSSES IN COLOMBIAN INFRASTRUCTURE PROJECTS
Millions of U.S. dollars
El Corti jo-El Vino  Telecom S.A.-Siemens           CORELCA
Type of risk          toll road project         joint venture          energy guarantees
Market                      3.1                     2.5                      52.0
Construction                1.1                     9.8'                       0
Counterpartv                03                      0.1                      5s
Currency                      0                    -1.3                       20
Force majeure               02                      0.3                       7.0
Termination                -02                      02                        1.0
Regulatory                    0                    101                         0
Total                       4.5                    213                       67.0
a. t is unclear from the conracts whether thi risk is borne by Tetecom or Siemens.
Source:Timothy Irwin, Michael Klein uillermo E Perry, ansd Mateen Thbani, edse. Dealing with PrWic Risk in Prtvsfe lnfrastnuture
(Ltin American and Caribbean Studies. Washingtn, O.C.: World Sa. 199I).
to extract a near-certain rent from the govern-    effectively monitor and control the risks or
ment of about 35 percent of the original bid.       whether a private servicer should be employed
to service the loans. Where the government
After assessing the risk transfer associated with    delegates servicing, it must have systems for
the toll road project and quantifying the risks in    monitoring the performance of the servicers.
the project, the government changed its toll road
guarantee program. It now commissions more    Even if the government has the best access to
detailed engineering studies before it solicits bids    information on a risk, it might choose to provide
to limit the uncertainty in the bidding process,    assistance through a guarantee targeted at a spe-
and provides a narrow  guarantee. The new           cific layer rather than through direct credit. The
policy is less expensive than the old one but   reason is that a contingent guarantee can be
provides the same benefit to the concession-    more narrowly focused on the market failure,
aires. The change made the Colombian toll road    as in the switch from providing a broad guar-
program more efficient-achieving a higher risk-    antee to funding engineering reports in the
adjusted rate of return by reducing the govern-    Colombian toll road concessions. Because guar-
ment's risk of delivering a fixed benefit.          antees and insurance can be narrowly targeted,
they can be used to get the private sector to
The valuation process enables a government    absorb as much risk as possible.
to assess how efficiently risks have been allo-
cated and derive lessons from its findings. To    Where the private sector is better able to under-
do this the government must first assess which    write and service the underlying risks but some
party (public or private) has the best access to    government assistance is needed, public-private
the information needed to objectively and most   risk sharing is often the best solution. In this
accurately evaluate the underlying risks. It must    case pro rata guarantees and insurance under
then assess which party is in the best position    which the private sector and the government
to monitor, control, and service the risks once    share all losses on a risk equally are often the
they are underwritten. If the government is in    best form of assistance. Risk sharing gives the
the best position to underwrite the risks di-    private entity an incentive to price the cover-
rectly, it should consider providing direct credit,   age appropriately, ensuring that it will not shift
targeting the credit to the area of concern. The    additional risks to the government. Other risk
government should then determine whether it   sharing mechanisms within and between classes
also has the information and skills to most   of risk are also feasible. But they usually require



20                  Risk Management Systems for Contingent Infrastructure Liabilities
more government oversight and more govern-   anteed party, to ensure that their value is unim-
ment underwriting expertise.                     paired during periods in which a loss event is
likely. They can structure their support to pro-
Managing federal-state partnerships              mote pro rata risk sharing, where a private party
shares risk equally with the government for some
Risk management tools and techniques are also    or all types of loss. Since the private party in
helpful in analyzing the structure of government   this transaction would then bear the same risk
programs that share responsibilities between the    per dollar of exposure as the government, the
federal and state levels. Such programs can    government can benefit from the private sector's
combine the national government's ability to    pricing of risks. Finally, governments can levy
redistribute resources across economically   risk-based guarantee fees that both reduce the
diverse regions with the ability of state and lo-   budgetary cost of issuing guarantees and im-
cal governments to identify investment needs   prove the alignment of incentives between the
at the local level. The national government funds    guaranteed party and the central government.
the program, while state and local governments
provide the underwriting and administrative    Conclusion
function. A potentially powerful combination,
this type of federal-state partnership is analo-   Allocating risks efficiently and limiting the abil-
gous to a parent company's providing a guar-   ity of private agents to shift additional losses to
anteed source of financing to a subsidiary   the government reduces the budgetary costs of
established to perform a particular service.     issuing guarantees and improves the allocation
of scarce budgetary resources. But techniques
Such federal-state partnerships are not without   for assessing risk are only as good as the infor-
risks, however. If the federal government does   mation on which the models are based, and over
not retain oversight of the underwriting func-   time institutions change, markets evolve, and
tion, the national budget remains at risk. But if   new information on risk exposures emerges. A
it is overly prescriptive in setting regulations    series of loss events can reveal risks that were
for the program, it reduces the flexibility of   previously unknown or unquantifiable, leading
the state and local governments to identify   to radical changes in risk assessment. Using the
needs in the local community. The goal is to   risk management framework outlined in this and
reach the optimal tradeoff between delegation    a companion Note, governments can quickly
of project selection and federal oversight of   incorporate new information on risk exposures
state underwriting performance.                  into their pricing of new contingent liabilities
and reestimate the expected costs of previously
Minimizing the loss shifting                     issued liabilities.
need to implement strong risk This Note is based on a longer paper by the autbors in Timnotby Irwin,
Governments need to implement strong risk    Miha Klein, uilleo E. Perry, and MateenThiobani, eds., Dealing
management programs to limit their contingent   with Public Risk in Private Infrastructure (Latin American and Carib-
liability exposure to additional loss shifting by    bean Studies, Washington, D.C.: World Banrk, 1998).
the guaranteed party. The valuation process
provides a basis for determining the best strat-   ChristopherM. Lewis, Ernst& Young, and
egy for limiting such exposure. Governments   Ashokla Mody (amody@worldbank.org), Project
can require the guaranteed party to hold a cer-   Finance and Guarantees Department
tain amount of capital or collateral to serve as a
first-loss protection barrier for the project,
thereby aligning the guaranteed party's incen-
tives to remain vested in the project with the
government. They can place restrictions on the
use and investment of reserves held by the guar-



21
Financing Water and Sanitation Projects-
The Unique Risks
David Haarmeyer and Ashoka Mody
A project finance structure allows water projects with attractive cash flows and risk profiles to
secure long-term private capital. This structure provides a direct link between a project's cash
flow and its funding to give project sponsors, investors, and lenders strong incentives to ensure
that projects are structured and operated to generate stable revenue streams. But even in
industrial countries the credit strength of off-taking municipal governments and the sector's
traditional monopoly structure expose lenders to potentially significant credit, regulatory, and
political risks. These risks, combined with the sunk, highly specific, and non-redeployable nature
of water investments, mean that lenders and investors are vulnerable to government
opportunism and expropriation. Reviewing some recent innovative projects, this Note shows
that private participation on a limited recourse or nonrecourse basis has required support from
multilaterals and federal government agencies to absorb noncommercial risks.
Private sector participation in water and sani-  tures. As one of the last monopoly utility sec-
tation has most often taken the form of special-  tors, water and sanitation can be especially
purpose build-operate-transfer (BOT) projects  attractive to long-term private investors. But
following the project finance or limited recourse   financing water and sanitation projects has
model. These are self-contained projects that   been a special challenge because of their
address the need for more water and sanita-   unique risks:
tion. Although these bulk suppliers can allevi-    Expensive to transport but cheap to store,
ate immediate shortages, they have virtually  water is essentially a local service and sub-
no effect on systemwide revenue problems (for    ject to control by local government, which
example, leakage and tax collection) or labor  can be more politicized and have weaker
cost problems. These long-term problems are  credit than state or federal government.
sometimes tackled incrementally through leases   * With most of the assets underground, their
and management contracts. An increasing num-  condition is hard to assess. That makes invest-
ber of countries have gone further by award-  ment planning difficult, posing risks for con-
ing operating concessions for entire systems,    tract renegotiations.
which require investment commitments from    - Inadequate provision is associated with
the concessionaire. Beyond such concessions  health and environmental risks, so govern-
lies full privatization of assets, which facilitates  ment has a strong interest in extending ac-
financing by creating collateral.            cess to service, regardless of ability to pay.
* Significant currency risk arises because cus-
The promise of steady-if not growing-long-   tomers pay in domestic currency that does
term future cash flows is the basis of the   not match the currency of international debt
private sector's interest in financing these ven-  and equity financing.



22                Financing Water and Sanitation Projects-The Unique Risks
* There has so far been little scope to intro-   entity in a BOT or BOO project. For the BOT in
duce direct competition in treatment, trans-   Chihuahua, Mexico, for example, Banobras, the
mission, and distribution.                  domestic development bank, provided credit
support to the local government entity. In Izmit
The risk profile of a project is also influenced   the Turkish government stands behind the lo-
by its type and by its stage of development.   cal government's water purchase agreement. In
Greenfield projects with a build-operate-transfer   Sydney the state government guarantees the pay-
or build-own-operate (BOO) structure, because   ment of the city water utility (Sydney Water
they involve a period of construction before rev-   Corp.) to the private project company even
enues are generated, generally expose lenders   though the utility's debt is rated AAA by Stan-
to greater credit, political, and regulatory risks   dard & Poor's. In Buenos Aires the Argentine
than concessions for infrastructure services that   government's guarantee to pay compensation if
are up and running. Similarly, older and more   the concession is terminated early provides the
efficiently run systems with longer operating his-   chief form of security for lenders.
tories tend to have more secure and predictable
cash flows and mature investment profiles, and   Sources of debt
thus expose lenders and investors to fewer risks.
In countries with weak sovereign credit rat-
The water and sanitation sector's exposure to   ings financing has been provided by multilat-
risks that are often difficult and costly to cover   eral and export credit agencies. These agencies
has two important ramifications:              are generally in the best position to shoulder
* Fewer projects have been successfully financed   political and regulatory risk and thus provide
with private capital than in other infrastructure   long-term finance at reasonable rates. The US$9
sectors, such as power and telecornmunications.   million Chase Manhattan Bank loan to the Chi-
* Projects financed with private capital have   huahua BOT project, which received no multi-
tended to involve direct financial or credit  lateral or bilateral funding but did receive grant
support from government or third parties   and credit support from Banobras, is a rare case
such as bilateral, multilateral, and export   of commercial bank participation. In a similar
credit agencies.                            BOT project in Puerto Vallarta, Mexico, the In-
ternational Finance Corporation provided debt
Case studies in finance                       finance backed by a revolving and irrevocable
letter of credit from Banobras.
The experience of six water and sanitation
projects and one set of utilities in accessing   In countries with high sovereign credit ratings
and structuring private finance illustrates the   projects have been financed by domestic com-
level of government or third-party support   mercial bank loans. The BOT project in Johor,
(table 1). All the projects follow the standard   Malaysia, and the BOO project in Sydney, Aus-
project finance structure except for the more   tralia, were financecl by commercial debt. As a
mature English and Welsh water companies,   result of the project structure (existing cash flows)
which rely on corporate finance.              and Malaysia's highly developed capital market
and relatively low interest rates, the Johor project
Only the BOT project in Johor, Malaysia, was   was financed entirely with local debt. The Sydney
financed on a nonrecourse basis with no spon-   project had both local and offshore financing.
sor or third-party support to cover risk of non-
payment. All other projects were financed on a   The limited capital market financing of water
limited recourse basis. The recourse was gener-   and sanitation indicates that individual inves-
ally provided by payment guarantees to the par-  tors are not in a position to accurately evaluate
ties off-taking the service (buying bulk water or   and mitigate the risks. But as the experience of
wastewater services), such as a local government   the English and Welsh water companies shows,



The World Bank Group                      23
TABLE 1   FUNDING FOR SELECTED WATER AND SANITATION PROJECTS
Debt/     =i1TmlIwX
Project site, type, and date     Project cost                          rating    SoLurce and maturity of debt
Malaysia                     US$2A billion               75/25          A+       Government soft loans due to
Concession 11993)            (about US$500 million                               severe tariff collection problems
in first 2 years)
Buenos Aires, Argentina      US$4 billion                60/40          BB-      10-year IFC A-loan,
Concession (1993)            (US$300 million                                     12-year IFC B-loan
in first 2 years)                                  (recourse to Argentine
govemment in event of
early termination)
lkmit Turkey                 US$800 million              85/15           8       13-year export credit agency loans,
BOT (1995)                                                                      7-year MITI" loan,
7-year commercial bank loan
(recourse to Turkish govemnent)
Chihuahua, Mexico            US$17 million              53/15/32h       BB      15-year commercial bank loan
ROT (1994)                                                                       with limited recourse to Banobras
Johor, Malaysia               US$284 million             50/N           A+       10-year project finance loan
BOT (1992)                                                                       from Public Bank Bhd
(nonrecourse)
Sydney, Australia            A$230 million               80/20         AAA       15-year commercial loans
800 (1993)                                                                      (State govemment stands behind
Sydney Water Corp. payment)
England and Wales            US$5.24 billion             25175         AAA       Capital markets, corporate finance,
Full privatization (1989)                                                        European Investment Bank and
other sources
a. Ministry of International Trade and Industry of Japan.
b. Debt/equity/grant
Source: Haarmeyer and Mody 193.
projects can be expected to access capital mar-   issue priced at just fifty-three basis points over
kets as their cash flows to support debt service    U.K. Treasury gilts due November 2006. Stan-
become more stable and certain and indepen-    dard & Poor's based its AA rating of the £150
dent regulatory agencies are established.            million Eurobond on Anglian's "robust financial
profile and stable operating environment," which
The English and Welsh companies have drawn    "should provide the company with a fair degree
on a variety of financing sources, including the    of insulation from the impact of key regulatory
bond markets. Anglian Water, one of the ten    and political risks going forward." The English
privatized water companies, reflects the low risk    and Welsh companies have also taken advantage
profile of more mature water utilities. In 1990    of low-cost loans from the quasi-governmental
the company floated a twenty-four-year bond    European Investment Bank.



24                  Financing Water and Sanitation Projects-The Unique Risks
Equity financing                                     lator, these returns are expected to fall as
the water companies become more estab-
Although debt is generally cheaper than equity,      lished and capital expenditures decline.
a long-term equity stake by the sponsor (which
is sometimes also the operator) ensures that   To compensate for the greater country and po-
management has a long-term  interest in the    litical risks, required returns in most develop-
project and that cash flow growth leads to capi-   ing country projects are likely to be significantly
tal appreciation. Equity also reduces the debt   higher and closer to those in other infrastruc-
service burden on the cash flow, which can be    ture sectors. For a sample of power projects in
especially important in a projects early devel-   Asia and Latin America Baughman and Buresch
opment phase.                                      (1994) estimated the equity return at between
18 and 25 percent. And for privately financed
Equity has been provided largely by sponsors.   toll roads Fishbein and Babbar (1996) found
For large projects especially, equity, like debt,   that investors expect annual returns to range
is often sourced from  multiple consortium         between 15 and 30 percent.
members, both international developers and
local investors. The Buenos Aires concession,    Conclusion
for example, has four international sharehold-
ers and four local shareholders (including the    The challenge for the future is in mitigating the
utility's employees).                              noncommercial risks that characterize the sec-
tor and moving beyond the limited capacity of
Lenders like to see sponsors achieve a reason-    third parties. Part of the solution lies in generat-
able return on their investment, to ensure that   ing better information about these risks so that
sponsors have adequate incentive to maintain   they are more transparent and their costs are
support for the project, at least through the life    more fully recognized by parties that can miti-
of the loans. Equity holders partially shield lend-    gate them. Two tracks to achieve this end are
ers, because the lower priority of their claims    independent regulatory agencies and competi-
on a project's revenues means that they will   tion-for the market and for rights to supply
absorb unexpected shortfalls in revenue. In full   individual customers, as in England and Wales.
concessions and privately owned utility com-
panies internal cash generation can provide an    References
important source of equity for financing
investment.                                        Baughmnan, David, and Matthew Buresch. 1994. "Mobilizing Private
Capital for the Power Sector: Experience in Asia and Latin America."
U.S. Agency for International Development and W'orld Bank, Wash-
Although information on the return on equity        ington, D.C.
for project sponsors is not widely available, the    Fishbein, Gregory. and Sumiiani Babbar. 1996. "Private Financing of Toll
for pjtp oin wdyRoads." RMC Discussion Paper 117. World Bank, Resource Mobili-
return can be expected to vary with project risk     zation and Cofinancing Vice Presidency, Washington, D.C.
and cash flow profiles. In two of the cases dis-    Haarmeyer, David, and Ashoka Mvody. 1998. "Tapping the Private Sec-
cussed here returns to investors are regulated'      tor: Approaches to Managing Risk in W'ater and Sanitation." RNIC
Discussion Paper 122. World Bank, Resource Mobilization and
* The Malaysian government has guaranteed re-        Cofinancing Vice Presidency, Washington, D.C.
turns of 14 to 18 percent on investment in the
national sewerage project; actual returns are cur-   David Haarmeyer (david.baarmeyer@
rently at 12 percent because the concessionaire    stoneweb.com), Stone & Webster Consultants,
failed to achieve a 90 percent tariff collection rate.   Boston, and Ashoka Mody (amody@worldbank.
* For the English and Welsh water companies    org), Project Finance and Guarantees
the returns on regulatory capital (the assets    Department
of the core business) were 11.5 percent in
1995-96 and 12 percent in 1994-95. Accord-
ing to Ofwat, the U.K. water company regu-



25
Pooling Water Projects to Move beyond
Project Finance
David Haarmeyer an d Asboka Mody
Many commercial banks have had little interest in water and sanitation projects not only because
of noncommercial political and regulatory risks, but also the small size, weak local government
credit, and high transactions costs (the legal, consulting, and financial costs of structuring). Most
projects have been financed on a limited recourse basis, that is, with project cash flows and
assets as the main security for lenders. The move from project to corporate (balance sheet)
financing is occurring in stages. Financing project debt frorn the sponsor company's balance
sheet exposes that company to significant risk and thus requires a strong and large balance
sheet. Designed in part to shield a company's balance sheet, innovative structures and financial
instruments are emerging. Ultimately, the goal is for water utilities to raise debt and equity from
capital markets on the basis of their own balance sheets, strengthened by a diversified and
stable rate-paying customer base. This Note reviews the new trends.
In the transition from government to private fi-   * Integration of water and sanitation utilities
nancing, projects in the water and sanitation sec-  with other utilities (such as natural gas dis-
tor require a heavy focus on risk allocation and  tribution or power generation and distribu-
mitigation, which has often implied drawn-out    tion entities) to form holding companies with
negotiations before and sometimes after finan-  stronger balance sheets.
cial closure. To address noncommercial risk,
many projects have required some form of on-   Corporate finance and capital markets
going government or third-party support (see
page 21). To transform themselves into economi-   Corporate finance can simplify the transition
cally viable enterprises, projects must mitigate  to capital market financing because the risk of
commercial risks and gain credit strength (sig-   a project's debt is absorbed in part by other
nificant cash for investments and the ability to   corporate activities. As in other sectors, projects
raise funds from capital markets). Risk pooling   in water and sanitation have been financed with
structures and asset aggregating instruments may   some ("limited") recourse to a sponsor's bal-
be one way to achieve the funding objectives:   ance sheet. For example, the Buenos Aires
* Financing of project debt on the basis of the   project protects the balance sheets of its cor-
sponsor's balance sheet, or corporate finance   porate sponsors (see page 23).
(pooling risks with the corporation's other
activities).                              Increasing balance sheet financing may require
* Equity funds to leverage sponsors' equity and   significant industry restructuring, such as con-
attract a larger group of investors.      solidating the ownership and operation of water
* Bundling of water and sanitation projects to   utilities in a region or encouraging the integra-
form economically viable entities that can be   tion of different utility sectors (box 1). Such
attractive to lenders.                    restructuring is already happening. Malaysia has



26                  Pooling Water Projects to Move beyond Project Finance
bundled its entire sewerage system under one    The use of bond financing by privately financed
concession, a case of project pooling. While    water projects and utilities is relatively new.
this project has forgone the benefits of com-    Leading the way, the English and Welsh utili-
parative competition achieved when systems    ties have used bond financing based on their
operate side by side, it creates the potential   balance sheets. In most developing countries,
for securing revenue streams to finance a large    however, the development both of bond mar-
number of small investments that would not   kets and of economically viable water utilities
be commercially viable on their own.              is at an incipient stage. The United States has
the most mature bond market for municipal
In the long term, however, achieving financial and    infrastructure; its development has been aided
operational sustainability will require a utility to    by tax exemptions and credit enhancements
finance investments from internal cash and long-   (see the discussion below on state revolving
term bond issues. As the English and Welsh water   funds). Although the funds are used primarily
companies demonstrate, water projects have the    by utilities owned by local governments, this
potential to do this. Once established, they can    "municipal" bond market taps private financing.
produce stable revenues that not only permit in-
ternal financing but also allow access to a much    Equity funds
broader class of investors through bond issues.
Among developing country projects, only Aguas    Over the past few years infrastructure equity
Argentinas has moved significantly in this direc-   funds have provided a means by which devel-
tion: internal cash generation accounted for 9 per-   opers can raise financing for infrastructure
cent of financing in the first three years and was    projects and investors can participate in this
expected to rise to 30 percent in the next three.  emerging market. Such funds can be particu-
larly attractive to infrastructure developers
because they allow them to leverage their con-
tributions with those of other investors and thus
to spread their capital. For investors, equity funds
mitigate project and country risk by creating a
New investments in the water and wastewater sector tend to be    portfolio of projects under one company.
much smaller than those in other infrastructure sectors because of
the market's fragmentation. Municipalities are in charge of water and  The French water and sanitation company
sanitation,soinvestmentsinfacilitiesreflectdemandonlywithin      Lyonnaise des Eaux, for example, introduced
their jurisdictions. The Mexican wastewater program, for example,  an infrastructure equity fund in Asia in 1995, a
US$300 million w ater fund. Besides Lyonnaise,
will build many small wastewater plants, with an average cost of  cont ior tote fund incldes L            nsur
contributors to the fund include Allstate Insur-
about US$25 million to US$30 million. Even where large investments  ance Company, the Employees Provident Fund
are expected, they are spread overtime, keeping pace with growth in  Board of Malaysia, and the Lend Lease Corpo-
demand. The massive Buenos Aires concession is expected to make  ration of Australia. Investors are expected to
investments worth a few billion dollars over its lifetime, but the initial  benefit from  the water company's significant
financing was for less than US$200 million. Similarly, the Manila  market position and deal flow in the region.
. .  .            ~~~~The fund refinances the equity of the original
concessions are expected to invest about US$5 billion over thirty     Th      us itac es    soo equity       for
sponsors. Thus it conserves sponsor equity for
years, butthe initial round of financing pobablywill notexceed   the riskier development phase; sponsors ap-
US$350 million. This pattern of small, incremental investments   ply their expertise in the early phase to get
contrasts with that of power and transportation projects, which  projects started and can then move on to other
typically require large investments over a short period and gain the  projects. Investors in the fund expect to re-
attention, and often the support, of national governments.       ceive steady. utility-like returns and potentially
stand to gain significantly if the fund or a por-
tion of it is publicly listed.



The World Bank Group                27
Houston-based Enron Corporation used a similar   State revolving funds
strategy, though the fund took the form of a pub-
licly listed company. In 1994 Enron packaged its  In the United States the federal government
emerging market power plants and natural gas   has supported state and local governments in
pipelines in a new company that it floated on   financing the construction of wastewater treat-
the New York Stock Exchange. Capitalized at   ment plants since the 1950s. In 1987, in an ef-
about US$165 million, Global Power and Pipe-   fort to delegate more responsibility to state and
lines (GPP) included the assets of two power   local governments, the U.S. Congress replaced
plants in the Philippines, a power plant in Gua-   the existing grant funding with a program to
temala, and a natural gas pipeline system in Ar-   capitalize state revolving funds (SRFs). States
gentina. Enron retained a 50 percent share of the   are required to contribute an amount equal to
company and sold the rest to investors. GPP has   at least 20 percent of the federal capitalization
the right to buy into projects developed by Enron   funding. The program is aimed at leveraging
at favorable prices, providing Enron an ensured   federal resources and creating a renewable and
exit mechanism to free up capital for high-risk,   perpetual source of financial assistance for
high-return development opportunities.       wastewater infrastructure. Unlike with grant
funding, the need to repay SRF loans intro-
EBRD's private multiproject financing        duces an important element of accountability,
facility                                     as well as a basis for new loans.
To mobilize private investment in Eastern Eu-   The structure of each state's revolving fund pro-
rope, the European Bank for Reconstruction   gram depends primarily on the state's needs and
and Development (EBRD) has developed a   circumstances (such as its borrowing limit and
multiproject financing facility (MPF) that pro-   ability to repay loans). Some states use program
vides a framework for financing a series of   funds to provide direct loans to local govern-
projects that may be too small to be consid-   ments of up to 100 percent of a project's cost at
ered individually. The MPF is made available   below-market rates. Others provide excess re-
to a private company, which uses the facility   serves or excess debt payment coverage that
to make equity investments in and loans to pri-   helps secure bonds backed by the revenues of
vate water and sanitation projects. Under this   a wastewater facility. Program funds may be used
arrangement the company largely takes on the   as collateral to borrow new resources; because
task of due diligence, which helps to reduce   several jurisdictions borrow on the basis of the
the transactions costs for each project financed.   same collateral, spreading the risks, the overall
costs of borrowing are lowered.
EBRD signed its first MPF in July 1995-a US$90
million equity and loan facility with Lyonnaise   The large, diversified pools of municipal bor-
des Eaux. The company was recently awarded   rowers created under SRF programs are attrac-
a project that could be the first to access the   tive to lenders because they spread the risks
facility, a US$41 million, twenty-five-year BOT   of debt payment interruption or default. Pool-
(build-operate-transfer) wastewater treatment   ing projects for financing on a statewide basis
project in Maribor, Slovenia (population    also makes it more economical for credit rat-
150,000). In 1996 the second MPF was signed,   ing agencies to evaluate credit risks. While a
with three Austrian companies. The agreement   single project might not be large enough to
involves a S 700 million (approximately US$140   justify a credit assessment, a large group of
million) equity and loan facility to support an   projects will be attractive. Credit rating agen-
investment program of S 2 billion. The Austrian   cies provide important information to prospec-
companies will also receive financial support in  tive lenders about the creditworthiness of SRF
the form of a guarantee from the East-West Fund   programs by, for example, assessing and moni-
of the Austrian Finanzierungsgarantie GmbH.    toring reserve fund and debt coverage levels and



28                  Pooling Water Projects to Move beyond Project Finance
evaluating the size and composition of the bor-   awarded in Casablanca and Gabon and is be-
rower pool. Size and diversity matter. Rating agen-   ing considered for water and power projects
cies have found that smaller pools (20-100    in the Republic of Congo. However, the impli-
borrowers) generally face more stringent credit   cations for the concentration of monopoly
requirements from lenders than larger pools be-   power are a concern. Chile recently passed a
cause the behavior of individual borrowers has   law prohibiting owners of water utilities from
an amplified effect. For pools with fewer than    simultaneously owning power distribution or
twenty borrowers the weakest borrower tends to   telephone service in the same area.
determine the credit rating.
Conclusion
The revolving nature of the funds has had a
significant effect on purchasing power. Accord-   As a utility matures and its revenues become
ing to the U.S. Environmental Protection Agency,   increasingly predictable and secure, its financ-
funds invested in the SRFs provide about four   ing structure can be expected to shift to corpo-
times the purchasing power over twenty years   rate finance or greater balance sheet support.
than funds used to make grants. Even so, the    Internally generated revenues are an important
funds represent only a fraction of the invest-   source of funding for water projects that have
ment needed to upgrade municipal plants. In    achieved a stable and diversified customer base.
1997 states were expected to make SRF loans of   And strong balance sheets permit utilities to
US$3 billion, compared with US$11 billion in    obtain external financing by issuing long-term
total capital investment in wastewater infrastruc-   debt to a broader class of investors. As a result
ture from all sources (federal, state, and local).   of high political risk and shallow or nonexistent
capital markets, in developing countries the
Multiutilities                                   work of building stronger balance sheets and
tapping capital markets generally takes time,
Deregulation and increasing competition in in-   however.
dustrial countries are creating pressures for dif-
ferent utility sectors to combine. By combining,   New financing techniques in other sectors and
utilities hope to achieve not only economies   their early applications in water and sanitation
of scope but also larger balance sheets and    suggest that pooling projects may be a way to
increased credit strength (through diversity) to    move beyond project finance, particularly for
attract long-term private financing. The trend    the many small projects that need financing.
has been most pronounced in the United    Multiutilities, entities that deliver multiple infra-
Kingdom  but is growing elsewhere. United    structure services such as water and electricity,
Utilities and ScottishPower, two of the three    offer another approach to attracting private capi-
U.K. multiutilities, provide utility services that   tal. These multiutilities can gain credit strength
run the gamut-principally electricity genera-   through a diversified revenue base that enhances
tion and distribution and water and sanitation,   the prospects for corporate finance.
but also gas distribution and telecommunica-
tions services.
The Note is based on a longer paper by the authors, "Tapping the
Private Sector: Approaches to Managing Risk in Water and Sanitation"
Multiutilities in developing countries may soon    (RMC Discussion Paper 122, World Bank, Resource Mobilization and
play a growing role. Argentina and Slovenia   Cofinancing Vice Presidency, Washington, D.C., 1998).
have combined gas and water utilities. In Cote
d'lvoire the project company developing the    David Haarmeyer (david.haarmeyer@
water supply concession went on to develop    stoneweb.com), Stone & Webster Consultants,
the electricity distribution system and a power   Boston, and Asboka Mody (amody@worldbank.
generation project. This multiutility approach    org), Project Finance and Guarantees
is being adopted in the concessions recently    Department



29
International Gas Trade-The Bolivia-Brazil
Gas Pipeline
Peter L. Law and Nelson de Franco
The Bolivia-Brazil natural gas pipeline, which will transport natural gas more than 3,000
kilometers, will cost US$2.1 billion to construct. Despite the substantial benefits for both Bolivia
and Brazil and the involvement of reputable private partners, the perceived risks and
complexities of this large project made financing it a major challenge. The pipeline will link
supply in one country to a potential market in another. Neither of these countries has a tradition
of independent regulation or economic pricing of fuels. And the pipeline will be the first major
gas infrastructure project involving the private sector in Brazil, where the natural gas market is
underdeveloped and the gas distribution infrastructure still very limited. This Note explains the
historical factors that shaped the project, how the financing package came together, and the role
the pipeline will play in liberalizing the Brazilian hydrocarbon sector.
When the pipeline project started to get off
the ground in the early 1990s, the Brazilian
hydrocarbon sector was dominated by govern-      FIGURE 1 THE BOLIVIA-BRAZIL NATURAL GAS PIPELINE
ment-owned entities and prices were heavily
regulated. At the federal level the oil and gas      -     Xw pipeline
company Petrobras, the main player in the                                            A Exitinre pripelone
project, still had a monopoly on exploration,
exploitation, refining, and maritime and pipe-
line transportation. Natural gas distribution was
reserved for state-owned distribution compa-
nies, although petroleum distribution was open
to foreign investors. Prices were equalized
across regions, and the prices of liquefied pe-                                Janeiro
troleum gas (LPG) and fuel oil were subsidized.
For Petrobras, exploiting Brazil's modest natu-
ral gas reserves had been secondary to pro-
ducing oil, and the share of natural gas in the        .                                 4    l
/)_        ~~Sup* l"vcr   lrPFB{8ivald,
energy market in the early 1990s was a mere 2                                        Pa tIC PbM ll)
percent. Petrobras had introduced natural gas
only in 1988, supplying small quantities to the                             "l"Siet B _N, Uow.41buI .
existing Sao Paulo distribution network as as-                             s      8          b   b
sociated gas from local oil fields.' But with                          _is_ c_sp.rdsv.
Brazil forecasting strong growth in energy



30                International Gas Trade-The Bolivia-Brazil Gas Pipeline
demand, natural gas gained appeal as a means   tion of the pipeline. YPFB was being prepared
to offset increasing dependence on more   for capitalization and sale by international tender.
expensive fuels. Meanwhile, Bolivia needed to   A hydrocarbon law passed in 1996 committed
find a new market for gas exports. The country   Bolivian reserves to the export project and de-
had been exporting gas by pipeline to Argen-   fined a diminished (but still critical) role for YPFB
tina since the 1970s, with these export sales rep-   as the aggregator and shipper of future gas ex-
resenting some 80 percent of Bolivia's total gas   ports to Brazil. The capitalization of YPFB fol-
production, but new discoveries in Argentina   lowed shortly after, and two private exploration
gave notice that this was no longer tenable. The   and production companies and one oil and gas
idea of natural gas trade between Bolivia and   transportation company eventually won the in-
Brazil had been around since the 1930s, and in  ternational competitive tender. The Bolivian
1990 the two governments decided to give a   transportation company, Gas Transboliviano S.A.
gas export pipeline another serious look. After   (GTB), was formed for the gas export project as
a preliminary feasibility study the two state mo-   a private joint venture among Enron, Shell, and
nopolies, Petrobras in Brazil and Yacimientos   Bolivian pension funds.
Petroliferos Fiscales Bolivianos (YPFB) in Bo-
livia, signed a gas sales contract in 1993.  The project structure allowed a degree of cross-
border ownership by each sponsor group, and
Private investors emerge                     special committees were formed with repre-
sentation from all sponsors to resolve techni-
Neither government was in a position to fund   cal and financial issues and ensure cross-border
the pipeline project. As a first step to raise pri-   harmonization of the project. These commit-
vate finance, Petrobras embarked on a series   tecs provcd effcctive in helping to speed up
of road shows in 1994 to choose private equity   project development.
partners for a new pipeline company on the
Brazilian side. Petrobras ultimately selected the   A financing plan takes shape
BTB consortium, comprising British Gas,
Tenneco (now El Paso Energy), and Broken   In 1997 the project still lacked a firm financing
Hill Proprietary, to form the Brazilian trans-   plan. The project required a large, bulky, up-
port company (Transportadora Brasileira   front investment with a gradual buildup of tar-
Gasoduto Bolivia-Brasil, S.A. [TBG]). This com-   iff revenues, and a final gas price that would
pany, with an initial 51 percent ownership by   provide incentives for a speedy uptake of gas
Petrobras, would own the Brazilian part of the   by potential customers-industrial users and
pipeline. However, the private partners began   power plants. Market soundings had indicated
to signal to the government that fair access to   a lack of capacity for long-term commercial
downstream markets and market-based pric-   funding. Commercial debt would be high cost
ing policies would be important for the real-   with short maturities (eight to ten years) be-
ization of the project-policies in line with   cause of perceived Brazilian country risk, regu-
those recommended earlier by the World Bank   latory risk, and supply risks, resulting in debt
to the Brazilian government as key for the de-   service difficulties and a final gas price that
velopment of the hydrocarbon sector. In late   could severely limit market penetration during
1995 an amendment to the Brazilian constitu-   the critical initial years. (Commercial lenders
tion removed the Petrobras monopoly, subject   perceived some supply risks because known
to an implementation law that was approved   Bolivian reserves were only sufficient to meet
by Brazil's Congress in August 1997.         80 percent of the gas sales contract. But in the
World Bank's view the risks were likely to be
On the Bolivian side an agreement of associa-   small because the capitalization of YPFB had
tion was reached between Enron and YPFB that   attracted some US$1 billion of private capital
included the development of the Bolivian sec-   for further exploration and development.)



The World Bank Group                  31
FIGURE 2 THE BOLIVIA-BRAZIL PIPELINE-TAKE (AND SHIP) OR PAY FRAMEWORK
Gas is transferred from YPFB to
Petrobras at the border.
BOLIVIAN       YPFB                GTB                TOG                           BRAZILIAN GAS
DISTRIBUTION
PRODUCERS               -w         tasot  I          TGtasot                           OPNE
YPFB collects gas   GTB transports     TB6 transports     Petrobras sells    COMPANIES
-~ -  -- -from producers and   gas to the border   gas to states for  gas to distribution   -
delivers it to the   for YPFB.          Petrobras.        companies.
pipeline.
In 1997 the World Bank and its multilateral coun-   government, realizing that this threatened to de-
terparts, convinced that both countries were se-   lay the project until a new government was
rious about opening their hydrocarbon sectors   elected, urged Petrobras to quickly seek a solu-
to competition and private participation, decided   tion. Petrobras responded through two mecha-
to appraise the project on the understanding    nisms. First, it agreed to finance a fixed price
that transmission tariffs (and private investor   turnkey construction contract for the Bolivian
rates of return) would be regulated to ensure   section of the pipeline, with repayment to be
that any benefits of extended maturities result-   made through the waiver of future transportation
ing from their loans and guarantees would be   fees. Second, it agreed to prepurchase part of
passed on to final consumers. A World Bank   the uncommitted upside capacity of the pipe-
analysis showed the project to be economically   line on both sides of the border, an arrange-
viable and the best of several alternatives, in-   ment that became known as the transport
cluding using different pipeline routes from    capacity option.
Bolivia, constructing a pipeline from Argentina
to Brazil, and constructing large gas-fired power   Who takes the risks?
plants in Bolivia and transporting the power to
Brazil using high-voltage transmission lines. (The    Petrobras bears most of the project risk on both
final pipeline route was selected to minimize   sides of the border. YPFB will collect gas from
environmental impact, and the project includes   the producers, and the gas will be transported
full measures to protect the interests of indig-   to the border under a ship-or-pay contract with
enous people living near the pipeline.) On the    GTB (figure 2). Here, Petrobras will take own-
Brazilian side multilateral lending and partial   ership of the gas for delivery to the five Brazil-
credit guarantees offered the prospect of longer   ian state gas distribution companies under
loan maturities and a gas price just right to pen-   similar transportation arrangements with TBG.
etrate the market. Thus the World Bank agreed
in December 1997 to provide a direct loan of   The supply risk on the Bolivian side falls on
US$130 million and to continue preparing a   YPFB. But this risk is small because of addi-
partial credit guarantee of US$180 million to   tional supply likely to become available from
TBG. Other multilaterals, including the Inter-   new discoveries in southern Bolivia and possi-
American Development Bank, provided financ-   bly northern Argentina. The biggest risk lies in
ing totaling US$380 million. The multilateral   the market in Brazil. Four of the five distribu-
financing covered 40 percent of the financing   tion companies are paper companies with as
requirements as senior debt, Petrobras provided    yet no pipes in the ground, and gas will have to
another 40 percent sourced from bilateral agen-   penetrate a market dominated by high-sulfur fuel
cies, and the equity sponsors provided the rest.   oil. (Petrobras has an equity stake of about one-
third in several of the distribution companies.)2
On the Bolivian side only 20 percent of financ-   Although the ultimate market risk lies with the
ing was available from shareholder equity. With   distribution companies, it is Petrobras that is
the Bolivian government unprepared to provide    contractually obligated to pay YPFB for the gas
sovereign guarantees, little progress was being    and the transportation companies for their
made to close the financing gap. The Brazilian   transportation services.



32                  International Gas Trade-The Bolivia-Brazil Gas Pipeline
Moreover, through its turnkey construction con-   fore submit a plan for eventual reduction of
tract, Petrobras takes the construction risk on    Petrobras's shareholding in a way that will en-
the Bolivian side. And if the pipeline in Brazil   sure the best chances for commercial success.
is not built on time, it is Petrobras that will
incur financial penalties payable to YPFB and    As part of the agreements reached with the
the distribution companies.                      World Bank, the Brazilian government has de-
veloped a plan to phase out fuel price subsi-
Toward sector liberalization                     dies and deregulate petroleum product prices
within a three-year transition period (from
The size and scope of the pipeline give it the    August 1997). The concept of distance-based
leverage to play a key role in opening the Bra-   transport tariffs, a departure from the traditional
zilian hydrocarbon sector to competition and    pricing mechanisms, will encourage use of the
private participation. The project and accom-   best fuel supply option in each area of Brazil.
panying policy reforms will establish the prin-   Open access to transmission systems, combined
ciples of unbundling and transparent pricing    with increased private participation in upstream
in transactions between gas supply, transpor-   development, will be a major force in control-
tation, and distribution. The pipeline will help   ling extraction costs and increasing supplies
promote interfuel competition in Brazil by al-   of domestic gas in Brazil. It will ultimately lead
lowing a large increase in gas supply, and in-   to wider choices for consumers, allowing large
crease the number of players in the market by    consumers to negotiate directly with produc-
making the upside capacity of the pipeline    ers and importers for the best commercial terms.
available to shippers other than Petrobras.
Conclusion
During the project preparation stage it was still
unclear to what extent Brazil's hydrocarbon sec-   Many prospective international gas pipeline
tor would be opened to competition, as the hy-   projects are under consideration-projects in
drocarbon law was not passed until later. The    Central and South Asia and projects proposing
World Bank therefore sought to include good    pipelines from Russia to China and from Tur-
practice policy principles relating to open ac-   key to Eastern Europe. Given the large invest-
cess, ownership, and pricing in the authoriza-   ments required, the main challenge is to design
tion agreement between the government of   financing schemes that work. There are few
Brazil and TBG that sets out the parameters    blueprints to draw on. The World Bank can
under which the pipeline will eventually oper-   play a key transitional role in such projects.
ate. These policies include nondiscriminatory    But there needs to be demonstrable commit-
third-party access, the adoption of distance-   ment to opening the natural gas industry to
related transmission tariffs for the uncommitted    competition and private investment and estab-
upside capacity of the pipeline, and the require-   lishing sound regulatory and pricing policies.
ment that TBG would act only as a gas trans-
porter and not engage in gas trading or upstream    lThe Sao Paulo distribution network was originally constructed to
or downstream  cross-ownership. Although           distribute ranufactured gas.
Petrobras will be the dominant shareholder of   2To counter Petrobras's bargaining power, the distribution compa-
nlies used collective negotiations to achieve acceptable price and
the Brazilian transportation company for a tran-   take-or-pay conditions, an approach that proved highly effective.
sition period, the Brazilian government has
agreed with the World Bank to eventually maxi-   Peter L. Law (plaw@worldbank. org),
mize private participation in the project. To ini-   Energy Specialist, Oil and Gas Division, and
tiate this too quickly would risk unraveling the    Nelson de Franco (ndefranco@worldbank.org),
many complex project agreements already    Principal Power Engineer, Latin America and
reached and fail to maximize the value of the    the Caribbean Regional Office
Petrobras shares. The government will there-



33
Promoting Regional Power Trade-
The Southern African Power Pool
Donal T O'Leary, Jean-Pierre Cbarpentier, and Diane Minogue
The Southern African Power Pool (SAPP), the first formal international pool to be set up outside
North America and Western Europe, was inaugurated in 1995. While the utilities of southern
Africa have been importing and exporting electricity for four decades, these trades occurred
through bilateral contracts that were complex and often difficult to administer. The objective of
shifting to the pool is to create a more efficient regional market. Although physically the pool is
still embryonic and trade volumes average roughly 3 percent of production, confidence in the
market and mutual trust between the members are being strengthened and sector coordination
is dramatically improved. This Note reviews the factors that have eased the way for the pool
agreements and the challenges that remain in getting the multilateral trading operation under way.
Power exchange first arose because of the dis-
tribution of power sources in the region: a large  FIGURE 1 SOUTHERN AFRICAN POWER POOL
reserve of low-cost hydroelectricity in the north-
ern part (especially the Inga Reservoir in the
Democratic Republic of Congo and the Cahora
Bassa Reservoir in Mozambique), large reserves
of cheap coal in South Africa, and the Kariba
Dam (on the border between Zambia and Zim-                        1  r
babwe), which. being in the middle of the re-O
gional system, can play the "buffer" role (figure
1). As the network has been reinforced and ex-
tended, many arrangements have arisen for the                                              MIW
sale and wheeling of electrical power between
countries in the region.                                                             0AIE
The new pool agreements cover about 9 million
square kilometers and 200 million people. The
number of customers of the interconnected                                              ora  ssa
national systems has been estimated at more than
4.1 million, though this figure understates the total
number of retail customers because some of the
customers are distribution companies.                                            SWUND
The SAPP members agreed to develop their           Existing
pooling operations as a `loose pool" along the     orplwaned
lines of NORDEL/NordPool (Scandinavia),
UCPTE (Western Europe), and such U.S. pools



34                  Promoting Regional Power Trade-The Southern African Power Pool
SAPP members and    as the Midcontinent Area Power Pool before the    a majority of the SADC members. The memo-
their utilities     1996 restructuring of the U.S. electricity market.   randum  of understanding and its subsidiary
Angola              Loose pools emphasize the constant exchange    agreements-the Inter-Utility Memorandum of
Empresa             of information in order to maximize both the    Understanding, the Agreement between Oper-
National de         economic and reliability benefits from trading    ating Members, and the Operating Guidelines
Electricidade (ENE)  and system autonomy. These pools do not use   -have now been signed by all the SADC mem-
central dispatch of power plants, often relying    bers and their national power utilities.
Botswana            instead on long-term bilateral contracts for elec-
Botswana Power
Corporation (BPC)   tricity supply between generators and custom-   The SAPP agreements state that the purpose of
ers. These contracts are supplemented with   the pool is to allow its members to coordinate
Democratic          short-term contracts and other deals under the   the planning and operation of their systems
Republic of Congo   overall agreement. Loose pools may provide cen-   while maintaining reliability, autonomy, and
Socictr Nationale  tral selvices, however, including producing con-   self-sufficiency, and to share in the benefits of
dElectricit6 (SNEL)  tinuous, real-time data to match generation and    operating the pool. The agreements incorpo-
Lesotho             demand, developing indicative expansion plans,   rate the SADC treaty, the SADC Dispute Reso-
Lesotho Electricity  and implementing emergency procedures. Loose   lution Tribunal, the SADC energy ministers, and
Commission (LEC)    pools also establish detailed common design and    the Technical and Administrative Unit. The
Malawi              operational standards to ensure system security   Inter-Governmental Memorandum  of Under-
Malawi Electricity  and reliability and to facilitate trades.        standing establishes that the SAPP agreements
Supply Commission                                                    must be interpreted in a manner consistent with
(ESCOM)             In the SAPP full membcrship is limitcd to the   the SADC treaty and that the final and binding
national utilities. Most are still vertically integrated,   dispute resolution forum is the SADC Dispute
Electricidade de    with a primary mandate of ensuring the autonomy    Resolution Tribunal. The energy ministers are
Mozambique (EDM)    and self-sufficiency of the domestic system. The    responsible for resolving major policy issues
benefits of the pool include reductions or post-   in the SAPP and for admitting new members to
Namibia             ponements in new requirements for generating    the pool. The Technical and Administrative Unit
Namibia Power       capacity and reserves, reductions in fuel costs,   provides secretariat and other services to the
(NAMPOWEB)          and more efficient use of hydroelectricity. To es-   SAPP executive committee, acts as liaison to
South Africa        timate the potential gains, a Southern African De-   the SADC, and seeks funding according to the
Electricity Supply  velopment Community (SADC) electric power   recommendations of the executive committee.
Commission (ESKOM)    study conducted in 1990-92 compared the costs
of integrated regional development with those    The SAPP is organized under the executive
Swaziland           of independent development, in which each    committee, which acts as the board of direc-
Swaziland Electricity    country follows a strategy of self-sufficiency. The   tors of the pool, and a management commit-
study showed savings of US$785 million (1992   tee, which oversees the administration of the
Tanzania            prices), or 20 percent, over 1995-2010. Because    pool. Three subcommittees serve under the
Tanzania Electricity  the Democratic Republic of Congo and South Af-   direction of the management committee: the
Supply Company      rica were not members of the SADC at the time    planning subcommittee (which focuses on re-
(TANESCO)           of the study, the comparison did not include their   viewing wheeling rates annually and develop-
Zambia              system expansion plans, though it did account   ing an indicative SAPP expansion plan every
Zambian Electricity  for energy trade opportunities. Including these   two years), the operating subcommittee and
Supply Corporation  two countries boosts the benefits significantly.  its associated coordination center, and the en-
(ZESCO)                                                              vironmental subcommittee. The coordination
Zimbabwe            The agreements                                   center, which is still being set up, will be re-
Zimbabwe Electricity                                                 sponsible for such tasks as undertaking most
Supply Authority    The Southern African Power Pool is based on    pool monitoring activities, carrying out oper-
(ZESA)              agreements rather than on law. The pool was    ating and planning studies, determining trans-
inaugurated after the Inter-Governmental   fer limits on tie-lines, administering a regional
Memorandum of Understanding was signed by    database, disseminating maintenance sched-



The World Bank Group                 35
ules, providing technical advice, and seeking   The experience of the SAPP shows that in mov-
funding for its needs.                       ing from pool agreements to implementation, it
is possible for some participants to move in
Each member must meet its Accredited Capac-   smaller, incremental steps toward the overall goals
ity Obligation, a requirement that each utility   set by the agreements. While all participants must
have sufficient capacity to cover the forecast  take consistent steps, they do not need to move
monthly peak. Each member is also obligated   at the same pace. And while all participants have
to supply emergency energy for up to six hours,   agreed to an international pool, it is reasonable
to provide automatic generation control and   to expect that self-sufficiency and autonomy will
other facilities in its control area, to allow    remain the priority for some members, at least
wheeling through its system where technically   through the first phase of operations. The pool
and economically feasible, to submit mainte-   agreements include provisions that recognize
nance schedules, to disclose information and   these concerns while also encouraging greater
costs related to thermal generating facilities,  integration, for example, by permitting members
and to contribute toward the center's costs.  to meet their Accredited Capacity Obligation
through a contract with another member. Not all
A key element in the operation of the pool is   countries prefer such a gradualist approach, how-
the SAPP pricing arrangement, set out in thir-   ever: Botswana, Mozambique, and Namibia have
teen detailed schedules in the operating agree-   opted to rely more on importing power than on
ment. These schedules cover four broad types   building new capacity. Regardless of the preferred
of transaction: firm power contracts of varying   path, it is essential to set pool governance rules
duration; nonfirm power contracts of varying   so that all members, large and small, perceive
duration; mutual support contracts such as op-   that they have a voice.
erating reserve, emergency energy, and con-
trol area services; and scheduled outage energy,   As national regulatory agencies develop and be-
energy banking, and wheeling.                 gin to assert their authority, there is a risk that
they might not be sufficiently attuned to the needs
Implementation                                of the regional market. Experience in other coun-
tries shows that although a pool can operate
Three major factors played a key part in the   where regulatory regimes differ, as they do among
development of the regional pool agreements:   SAPP countries, possibilities for gaming or unfair
the availability of complementary power sources,   advantage created by differences in regulatory
an active regional organization for economic co-   systems can undermine members' willingness to
operation, and the political will to support in-   participate. Thus national-level regulatory stat-
creased regional energy trade. The Southern   utes should be carefully drafted so that the agency
African Development Community and its pre-   jurisdictions are properly defined, directed, and
decessor, the Southern African Development Co-   restrained in order to avoid regulatory obstacles
ordination Conference, served as a focal point   to trade. There should also be periodic reviews
for the promotion of regional integration, facili-   of regulatory compatibility as the SAPP devel-
tating investment in projects (such as intercon-   ops. In addition, the need for a consistent ap-
nection projects) that allowed increased regional   proach to transmission access is becoming
power trade. The momentum for regional inte-   apparent as more independent power producers
gration, including increased power trade, was   (IPPs) and independent transmission projects
further strengthened by the emergence of more   (ITPs) express interest in investing in the region.
democratic governments in several countries and   So far only Zambia has required its regulator to
the cessation of hostilities in others. Also help-   take into account SAPP interests.
ful has been having at least one country or part-
ner (South Africa) act as a driver, encouraging   A review of the SAPP's first year of operation
more passive parties.                         shows that several important practical issues need



36                Promoting Regional Power Trade-The Southern African Power Pool
to be addressed to support the development of   utilities should unbundle their domestic trans-
the pool. First, the power utilities in each coun-   mission pricing and ensure that members adopt
try need to be put on a more viable financial  identical rules to set transmission costs. In ad-
footing to ensure that they are creditworthy and   dition, a study is needed to assess the effects
able to respond to commercial incentives for trad-   on pool development of transmission pricing
ing power, including the ability to generate foreign   under the SAPP and current national pricing
exchange. Toward this end, commercialization   policies.
programs are under way or undcr consideration
at half the utilities (EDM, ENE, ESCOM, ESKOM,   Fifth, SAPP members need to estimate and meet
ZESA, and ZESCO). Most advanced in power   financing requirements for operations and new
system reform are South Africa and Zambia.    generation and transmission projects. In identi-
fying potential new projects, they should use
Second, the SAPP members need to reach agree-   compatible generation and transmission plan-
ment on the design and staffing of the coordi-   ning software that explicitly allows for risk analy-
nation center, a politically challenging task, so   sis and for dealing with hydrological uncertainty.
that the center can become operational. The key
steps are deciding on a neutral location; select-   Sixth, SAPP members need to harmonize
ing a neutral manager with sufficient autonomy;   ESKOM's internal competitive generators pool
establishing a legal status; defining clear gover-   with the SAPP cooperative pool. The internal
nance rules; setting guidelines for the interface   pool, set up in 1996, is based on the England
between the center, SAPP members, and the   and Wales model and currently does not pro-
SADC; identifying equipment needs, especially   vide for access to third-party operators. SAPP
ccmputer hardware and software; training op-   members also need to address the risk that the
erators; twinning with a mature pool to develop    different triggers for capacity addition (price
skills; and developing a realistic budget. By the   signals for the internal pool and a planned ap-
end of the first year SAPP members had made   proach for the other SAPP members) could lead
progress on only a few of these issues. They   to suboptimal investment.
had agreed to establish the center in Harare,
Zimbabwe, separate from ZESA, and had ad-   Finally, because the SAPP establishes a largely
vertised for a manager. The operating subcom-   self-governing regime at the operating level,
mittee had drafted a constitution that was being   and as experience in Argentina, Europe, and
finalized. And training programs for operators   North America shows, members will need to
had been offered, with more under preparation.   quickly set up an effective dispute resolution
process. Clear resolution procedures combined
Third, the pool would benefit from broadening   with realistic enforcement could also help in
its membership to include existing institutions   attracting new generation and minimizing na-
that control or influence significant generation   tional self-sufficiency concerns.
or transmission, such as Hidroelectrica de Cahora
Bassa, the Copperbelt Energy Consortium, the   This Note draws heavily from a longer work by the authors. Support-
new private owner of the Power Division of the   ing the Implementation ofthe Southern African Power Pool, forthcom-
Zambia Consolidated Copper Mining Company,   ing as a World Bank Technical Paper (Washington, D.C.).
and the Zambezi River Authority. But this will
mean developing procedures (voting rules) to   Donal T O'Leary (currently working with
give voice to and account for the interests of   Siemens AG under the World Bank Staff
these players as well as other new entrants, such   Exchange Program), Jean-Pierre Charpentier,
as IPPs and ITPs.                             and Diane Ainogue, Energy, Mining, and
Telecommunications Deparlment
Fourth, to allow efficient operation of the pool
and encourage an IPP presence, all the SAPP



37
Why Performance Contracts for State-Owned
Enterprises Haven't Worked
Mary Shirley
When privatization is not feasible or palatable, some developing country governments seek to
improve the performance of state enterprises by negotiating performance contracts with their
managers. Many of these contracts have been put in place with World Bank assistance. Research
shows that they rarely work. This Note summarizes the rationale for performance contracts and
explores the reasons why they haven't worked. It concludes that since a well-designed and -enforced
performance contract can be as politically costly as a well-designed privatization, performance
contracts are not likely to be successful in countries that lack the political will to privatize.
Written contracts between governments and state   put in place most governments were trying to
enterprises have been widely used in World  run their state enterprises without any form of
Bank projects since the first Bank operation sup-   performance evaluation. As one architect of
porting performance contracts, a 1975 opera-   performancc contracts noted, this was like play-
tion in Senegal. A Bank survey of developing   ing football without rules, scoreboards, or ref-
countries found 565 such contracts in thirty-two   erees. Performance contracts seemed a logical
countries, and another 103,000 in China as of   solution to this problem, since similar contracts
June 1994 (World Bank 1995). Although these   had been successful in the private sector.
performance contracts go by different names-
contrat-plan. memorandum of understanding,   No one, including the proponents of perfor-
signaling system-they share common features.   mance contracts, minimized the problems
All are negotiated, written agreements between   governments would face in designing such
governments and the managers of state enter-  contracts, however. Much has been written about
prises that specify targets that management  the problems that principals (in this case, gov-
pledges to achieve in a given time frame and   ernments) face because they cannot accurately
define how performance will be measured at   measure the effort expended by their agents
the end of a specified period.             (managers) or sort it out from other factors af-
fecting performance. These agency problems are
The case for performance contracts         compounded in the public sector, where politi-
cians have many points of view and bureau-
Despite a global wave of privatizations, state   crats have many different agendas. Under such
enterprises still account for about 10 percent   circumstances it is hard to judge performance
of gross domestic product (GDP) in develop-   and to motivate managers and hold them ac-
ing countries. These enterprises are often the   countable for results. Moreover, unlike private
largest and most valuable or problematic firms,   owners, politicians may not benefit from better
with monopolies in mining, petroleum, infra-   performance, and so may try to make managers
structure, and heavy industry. For these firms   serve objectives that conflict with efficiency, such
performance contracts have often seemed to   as rewarding political supporters with jobs or
nmake good sense. Before the contracts were   subsidies.



38                  Why Performance Contracts for State-Owned Enterprises Haven't Worked
Proponents of performance contracts argue that   tween performance contracts and productivity
they can be written in ways that clarify mul-   in hundreds of state enterprises in China-found
tiple objectives and make it easier to judge per-   no evidence that performance contracts had im-
formance. For example, a contract could apply    proved efficiency. The first study analyzed the
weights to the multiple objectives, spell out   effects of contracts in monopoly enterprises (in
the obligations for which managers will be held    water, electricity, telecommunications, and oil
accountable, and specify rewards (such as    and gas) in Ghana, India, the Republic of Ko-
bonuses) and penalties (such as demotion or   rea, Mexico, the Philippines, and Senegal. It
firing). Even where a government seeks to   found no pattern of improvement associated
maximize social or political objectives, a per-   with the performance contracts in productivity
formance contract can improve efficiency by    or profitability trends (figure 1).
setting appropriate targets. For example, a state
enterprise required to retain redundant work-   The second study used a much larger sample in
ers could still achieve contractual targets aimed    manufacturing but in only one country, China.
at improving quality. And an overstaffed firm    The results showed that the increasing use of
could still improve labor productivity by mak-   performance contracts in China could not stem
ing better use of plant and equipment. The fact   the fall in productivity among state enterprises
that managers operate under such constraints   (figure 2). More important, the study found no
could be taken into account by judging perfor-   robust, positive association between perfor-
mance against past trends.                       mance contracts and productivity. And a com-
parison of a sample of state enterprises that had
The contrary evidence                            signed performance contracts with a sample of
firms that had not found no significant differ-
The logic of performance contracts is persua-   ence between the two groups.
sive, but the reality has been disappointing. Two
empirical studies-one analyzing the effect of   Is it possible that performance contracts failed
such contracts on profitability and productivity   to improve productivity because managers were
in twelve companies in six countries and the    told to maximize social benefits, such as increas-
other examining statistically the correlation be-   ing employment or developing backward re-
gions? Although the studies did not measure
social benefits, the weights that contracts as-
FIGURE 1  PERFORMANCE CHANGES IN STATE ENTERPRISES                   signed to productivity targets (two-thirds on
AFTER SIGNING PERFORMANCE CONTRACTS                        average) and the stated goals of the parties to
the contracts suggest that improving operating
Enterprises                                                          efficiency was the prime objective. Moreover,
12                                                                   most social and political goals imposed constant
I1proved               .::Ljn ...costs on state enterprises during the period and
Improved     V       so should not have affected the trends being
8                                                                    measured.
Why not simply judge performance contracts on
4        ,   9.                                   I                  whether the firms met the targets specified in the
2                                                                contract? All the firms in the first study did achieve
at least satisfactory ratings where some sort of
o                                 _ Labor   _   Toa                  score was assigned, and all the contracts assign a
Return on assets    Labor productivity    Total factor productivity  high weight to economic goals. The problem is
that many of the targets are soft or flawed mea-
Note: The data cover twelve state enterprises in Ghana, India, the Republic of Korea, Mexico, the
Philippines, and Senegal.                                            sures of economic performance. For example,
Source: Company data and World Bank estimates.                       30 percent of the score for one of the electricity



The World Bank Group                  39
FIGURE 2 CHINESE STATE ENTERPRISES UNDER PERFORMANCE
CONTRACTS AND THEIR PRODUCTIVITY, 1980-89
Productivity
Firms under performance contracts                  Index (1980 = 1.0)
700                                                         2.75
companies (India's National Thermal Power Cor-
poration) depended on the volume of electricity   600                                                       2.50
it generated. The company achieved its target   500               Productivity                              2.25
and received a score of excellent, yet its total                  Puv
factor productivity actually fell below precontract   400                                                   2.00
levels. Output went up, but inputs rose three times    /                                                     17
faster. The target was flawed because it could be    3e/                                                     1.75
met by increasing inputs, even if efficiency de-   200                                                      1.50
clined. The contracts have many such flaws, for
reasons explored below.                         100Firm                                                     1.25
What is the problem?                             1980  1981  1982  1983  1984  1985  1986  1987  1988  1989
The theory of contracting suggests that to im-   Note:The data for productivity refer to the state enterprises with performance contracts each year.
prove performance, performance contracts must:
3 Reduce the information advantage that man-
agers enjoy over owners.                      a bonus or punished underachievement. And
* Motivate managers through rewards or pen-   the second study, in China, found that the in-
alties to achieve the contract's targets.     centive (wage increases linked to profits) was
- Convince managers that the government   set too low to motivate improvements in most
promises in the contract (such as to pay bo-   of the firms and was aimed only at workers.
nuses or impose penalties) are credible.
Finally, governments' commitment to enforc-
The performance contracts in the two studies   ing the contracts and keeping their promises
failed on all three counts. First, managers were    was not credible. All the contracts lacked neu-
able to use their information advantage to nego-   tral, third-party enforcement mechanisms (the
tiate targets that were either hard for outsiders   state enterprises could not take the government
to evaluate or easy for the firm to achieve. Per-   to court, for example), and governments often
formance is hard to evaluate, for example, when   reneged on their promises. In Ghana, India,
there are many targets (the contract for Korea's   and Senegal, for example, the government did
telecommunications company had forty) or   not force public entities to pay their bills to
when targets change frequently (a third of the   the electricity companies.
targets for Ghana's water company changed
every year). Targets can also simply be soft; in   There is evidence that a performance contract
India, for example, negotiations dragged on so   that overcomes the three contracting problems
long that targets were set equal to ex post per-   can improve efficiency. The study of China simu-
formance. The managers' information advantage   lated what would have happened with a "good"
was compounded by governments' failure to   performance contract-one that addressed the
give the bureaucrats responsible for negotiat-   information, incentive, and commitment prob-
ing the contracts and evaluating results the    lems-and found that it would have had a sta-
power, resources, and status they needed to face   tistically significant and large positive effect,
enterprise managers on a level playing field.   boosting productivity growth rates by 10 per-
Managers were thus able to negotiate targets   cent. But only 2.2 percent of the firms in the
that they could achieve without making addi-   sample had "good" performance contracts. All
tional efforts to improve productivity.         the other performance contracts had either in-
significant or negative effects on productivity.
Second, the incentives provided under the con-
tracts failed to motivate managers. The first study    Why did so few performance contracts con-
found that only two of the twelve contracts paid   tain the provisions necessary for success?



40                  Why Performance Contracts for State-Owned Enterprises Haven't Worked
Performance contracting assumes that govern-    nated all subsidies, transfers, and government
ment objectives can be maximized and perfor-    guarantees for debts of state enterprises and
mance improved by setting targets that take    instructed banks to lend to them under the same
into account the constraints placed on manag-    criteria as for private enterprises. State enter-
ers. For this to occur, politicians and bureau-    prises were required to pay a 10 percent re-
crats must state thieir objectives explicitly and    turn on assets as a dividend, and moniey losers
agree to weights that reflect their priorities,   were required to sell assets to pay their divi-
empower a supervisory body to translate these    dend. The govcrnment privatized almost all
objectives into monitorable targets negotiated    commercial and financial firms and most utili-
with managers, punish and reward managers   ties, allowing it to concentrate its supervision
on the basis of their performance, and keep    on relatively few firms (such as the water and
any promises made in the contract. Few of these    sewerage companies).
actions occurred for the contracts studied.
Do these findings mean that World Bank opera-
Why would governments sign performance    tions should not support or encourage perfor-
contracts and then not try to make them work?    mance contracts? Although the studies found few
Some governments may have been motivated    successful contracts, they did show that in those
to pledge actions that were politically unreal-   rare cases where a performance contract is prop-
istic because it enabled them to meet condi-   erly written, it can improve efficiency. But they
tions of a World Bank loan. Some governments   also found that performance contracts can do
may have underestimated the political costs of   harm. If targets are set too low, managers might
adhering to a performance contract, such as   reduce their efforts to improve performance. And
firing politically loyal but underperforming    flawed targets can have perverse effects, as in
managers, paying incentives that might raise a    the case of India's electricity company. Since a
manager's salary well above a minister's, shift-   well-designed and carefully enforced perfor-
ing funds from other purposes to pay electric-    mance contract can be as politically costly as a
ity bills, or allowing overstaffed state enterprises    well-designed privatization, performance con-
to lay off workers. All governments seem  to   tracts are not likely to be successful in countries
have underestimated the extent of their infor-   that lack the political will to privatize, where
mation disadvantage relative to managers.         they may be viewed as a soft alternative to
privatization. The findings suggest that perfor-
Improving enterprise performance                  mance contracts should be used only where gov-
ernments are politically prepared to make tough
Chile's successful experience in reforming its   decisions and the contract is part of a broader
state enterprises points to actions that are key    package of state enterprise reforms.
to improving efficiency: Chile increased com-
petition by ending any legally mandated state
monopolies and barriers to entry, reducing    References
import tariffs to 10 percent across the board,
breaking up monopolies in such sectors as elec-   Shirley, Mary, and Lixin Cohn Xo 1997a Eprl Effeseror-
maunce Contracts: Evidence from China.' WVorld Bank, Develop-
tricity, and pushing state enterprises to con-      ment Research Group, Washington, D.C.
tract out competitive activities under strict rules  c  1997b. "Information, Incentives, and Commitment: An Empiri-
of competitive bidding. It placed state enter-         Analysis of Contracts between Government and State Enter-
poses.' Policy Research Working Paper 1769. World Bank, Devel-
prises under private commercial law, and mem-       opment Researclh Group, Washington, D.C.
bers of the boards of directors became liable   WXorld Bank. 1995. BureaucratsinBusiness, The Economics and Poli-
for their decisions. Private parties were named     tics ofGouernment Oumberhip. Newv York: Oxford University Press.
to boards, and boards were kept small (five
people) to reduce the political value of keep-   Mary Shirley, Research bfanager Development
ing companies public. The government elimi-   Research Group



41
Private Participation in the Water and Sewerage
Sector-Recent Trends
Gisele Silva, Nicola Tynan, and Yesim Yilmaz
In developing countries private sector partici-   in recent years decentralized responsibility for    The PPI Project
pation in water and sewerage is a relatively    water and sewerage services to municipal or    Database covers
private participation
recent phenomenon. Before 1990 almost all de-    provincial governments, which often had little   in infrastructure in
veloping countries relied on government pro-    experience with private sector contracting and    developing countries.
vision of water supply and sewerage services;    regulation and were thus relatively unlikely to    The database records
details of all projects
private participation in the sector was rare. The    initiate private transactions.                         owned or managed by
potential for gains from private sector involve-                                                            private companies in
ment, through greater efficiency and improved    Between 1984 and 1990 developing countries    1984-97 in the water,
energy, transport, and
access to finance for new investments, was as    awarded contracts for only eight water and sew-    telecommunications
great in water and sewerage as in other infra-    erage projects to private companies. The pri-   sectors. This Note
structure sectors. But governments' willingness    vate capital investment in these projects was    focuses on private water
and sewerage projects
to take the steps to secure private participa-    US$297 million.' Since 1990 private participa-    that reached financial
tion was relatively limited. In many countries    tion in the water sector in developing countries    closure between 1990
water continued to be treated as a social rather    has accelerated (figures 1 and 2). The number    and 1997 and surveys
than an economic commodity. There was con-    of private water projects reaching financial clo-    regional trends rtype
of private participation,
siderable political resistance to raising tariffs    sure increased more than tenfold between 1990    project size, and top
to cost recovery levels, increasing the risk of    and 1997, though private involvement is still   sponsors and operators.
See box I for an
long-term  investment in water and sewerage    small relative to public provision in the water    explanation of the PPI
assets. In addition, many national governments    sector and to private participation in other    project criteria and
database terminology.
FIGURE 1  CUMULATIVE WATER AND                        FIGURE 2  CUMULATIVE NEW CAPITAL
SEWERAGE PROJECTS WITH                                EXPENDITURE IN PRIVATE WATER
PRIVATE PARTICIPATION IN                              AND SEWERAGE PROJECTS IN
DEVELOPING COUNTRIES, 1990-97                         DEVELOPING COUNTRIES, 1990-97
100                                                   1997 US$ millions
25.000
80
20,000
60                                                   15,000
40                                                   10,000
20                                                    5.000
0                                                       0
1990  1991  1992  1993  1994  1995  1996  1997           1990 1991 1992 1993 1994 1995 1996 1997
Source: PPI Project Database.                         Source: PPI Project Database.



42                   Private Participation in the Water and Sewerage Sector-Recent Trends
TABLE 1   PRIVATE WATER AND SEWERAGE PROJECTS IN
DEVELOPING COUNTRIES, BY REGION, 1990-97
infrastructure sectors (particularly energy; see
the next issue for data on private participation
in the energy sector).
By the end of 1997 private companies operat-
East Asia and the Pacific       30            11,913                 ing in developing countries had reached finan-
Europe and Central Asia         15             1,499                 cial closure on US$25 billion of investment in
Latin America and the Caribbean  40            8,225                 water and sewerage projects. In total, ninety-
MiddleEastandNorthAfrica         4             3,275                 seven projects had been  implemented in
Sub-Saharan Africa               8                37                 thirty-five developing countries, ranging from
management contracts to leases, concessions,
Total                           97            24,950                 divestitures, and greenfield build-operate-own
(BOO) or build-operate-transfer (BOT) arrange-
Note:Datamaynetsumrtotetalbecauseofrounding.                         ments. This Note provides an overview of pat-
Source: PPI Project Database.                                        terns and trends in these projects.
Sector trends
FIGURE 3 PRIVATE PARTICIPATION IN WATER AND SEWERAGE
IN DEVELOPING COUNTRIES, BY REGION, 1990-97                    The PPI Project Database reveals the follow-
ing trends in private participation in water and
Projects                                  sewerage:
Europe and                  *A regional and national concentration of private
CentralsAsia                   water projects, reflecting varied government
efforts to create conditions for sustainable pri-
East Asia and                                Sub-Saharan Africa      vate involvement through pricing, regulatory,
the Pacific                                                         and institutional reforms, but also a ripple ef-
Middle East and       fect from growing governmnent familiarity with
. _ l _    North Africa  private involvement in the sector.
* A dominance of concession contracts com-
pared with divestitures, BOT contracts, leases,
andc managemlent contracts.
Latin America                                                   * A few  international companies sponsoring
and the Caribbean          42%                                      and operating most major projects. But the
number of companies involved in private
Total investment                                contracts is growing, and it remains too early
Middle East and                to tell whether other new  entrants will in-
13%    North Africa                  crease their international presence.
. g       Mlddle ~Europ and
East Asia and                             Central Afia            Latin America and East Asia dominate
the Pacific                                   -   ran Africa
A regional breakdown of private sector involve-
rnent in the water and sewerage sector shows
-                           ~~~~~~~~a concentration of projects in Latin America
-             Latin America         ~~~~and the Caribbeani and East Asia and the Pacific
an mte Cribban       (table 1 and figure 3). This regional concentra-
Caribbeantion is similar to that in energy and transport.
The growth of the sector in these two regions
coincides with the opening of markets and,
Source. PPI Project Database,                                              particularly in Latin Amnerica, progress toward



The World Bank Group                   43
BOX 1     PPI PROJECT DATABASE: PROJECT CRITERIA AND DATABASE TERMINOLOGY
Database coverage                            significant investment risk. This category
* To be included, a project must have reached  includes build-transfer-operate, build-lease-
financial closure and directly or indirectly  transfer, and build-rehabilitate-operate-transfer
serve the general public.                  contracts as applied to existing facilities.
* Sectors covered are energy, water, transport,  Greenfield projects-A private entity or a
and telecommunications.                    public-private joint venture builds and
• The water sector includes the following     operates a new facility. This category includes
subsectors and segments: potable water     build-operate-transfer and build-operate-own
treatment and distribution and sewage       contracts.
collection and treatment.                  Divestitures-The state sells an equity stake
* Moveable assets, incinerators and stand-   to private entities; this may or may not involve
alone solid waste projects, and small projects  private management. This category includes
such as windmills are excluded.            full and partial divestitures.
* The period covered is 1984-97.
• The countries covered are developing      Definition of financial closure. For greenfield
countries, as defined and classified by the  projects and for operations and maintenance
World Bank, in East Asia and the Pacific,  contracts with major capital expenditure
Europe and Central Asia, Latin America and  financial closure is defined as the existence of a
the Caribbean, the Middle East and North  legally binding commitment of equity holders or
Africa, South Asia, and Sub-Saharan Africa.  debt financiers to provide or mobilize funding for
the project. The funding must account for a
Definition of private participation. The private  significant part of the project cost, securing the
company must assume operating risk during the  construction of the facility. For operations and
operating period or assume development and  management projects a lease agreement or a
operating risk during the contract period. In  contract authorizing the commencement of
addition, the operator must consist of one or  management service must exist. For divestitures
more corporate entities, with signfficant private    the equity holders must have a legally binding
equity participation, that are separate from any  commitment to acquire the assets of the facility.
government agency.
Sources
Project types                              * The World Wide Web.
* Operations and management contracts-The   * Commercial databases.
private entity takes over the management of a  * Developers and sponsors.
publicly owned enterprise for a given period.  * Regulatory agencies.
This category includes management contracts
and leases.                               Contact. The database is maintained by the
* Operations and management contracts with  Private Participation in Infrastructure Group of
major capital expenditure-These are      the World Bank. For more information contact
concession contracts for existing facilities  Mina Salehi at 202 473 7157 or msalehi@
under which the private entity also assumes  worldbank.org.



44                 Private Participation in the Water and Sewerage Sector-Recent Trends
TABLE 2   TOP FIVE DEVELOPING COUNTRIES BY TOTAL
INVESTMENT IN PRIVATE WATER AND
SEWERAGE PROJECTS, 1990-97
regions, following a similar project imple-
mented in Casablanca in 1997. Sub-Saharan
'.'JIIIEII 3hr.iusIflhiIIM u in       Africa has almost no private investment, but
_   *   _       has eight management and lease contracts.
Despite an early start in the region, private
Argentina             6,183                    7              participation in Africa is progressing slowly. In
Philippines           5,20                     3             the absence of strong commitments on tariffs
Malaysia              5,030                    6             and credible regulatory provisions, private com-
panies have been unwilling to take investment
Turkey                1,230                    2              risk in the region. In some cases they have
Mexico                 597                    12             taken on a degree of commercial risk under
Source: PPI Project Database.                                lease contracts. In other cases private partici-
pation has been limited to short-term manage-
ment contracts. No country in South Asia has
TABLE 3   TOP FIVE DEVELOPING COUNTRIES BY NUMBER            yet awarded a water or sewerage contract to
OF PRIVATE WATER AND SEWERAGE PROJECTS,            the private sector, but a number of proposals
are being considered (for example, in Tiripur,
1990-97                                            India, and Karachi, Pakistan).
--I -  1_                      A few countries lead the way
Similar to the trend in power and transport, in
China                  503                    13             each region a few countries have awarded the
majority of the water and sewerage contracts
M'v1exico              597                    12             (tables 2 and 3). In East Asia, for example, China
Brazil                 583                     8             has awarded thirteen contracts and Malaysia six,
Argentina             6,183                    7              together representing 63 percent of the East
Malaysia              5,030                    6'            Asian total of thirty projects. A similar picture
emerges in Latin America, with Mexico award-
a. ihe Czech Republicalsoimpementedsixprojetsbetween WO and1997.WIfttot5l  ing twelve contracts, Brazil eight, and Argen-
Source: PPI Project Database.                                tina seven. This pattern is largely explained by
the relative ease of implementing further projects
once an initial project is in place, given the de-
velopment of local private participation models
the establishment of credible legal and regula-   and a degree of local experience with private
tory institutions. Latin American countries have   transaction processes. In Argentina, for example,
awarded forty private contracts, which have   the availability of model contracts and regula-
brought investment commitments of US$8,225   tory documents is assisting smaller cities and
million. East Asian countries have awarded    provinces in working with the private sector.
thirty contracts, with investment commitments
of US$11,913 million.2                         The relationship between total investment and
the number of projects awarded is not strong.
Europe and Central Asia and the Middle East   The total investment in any country depends
and North Africa have small but growing private   on how and where the projects have been
involvement in the water sector, and recent   implemented. The top three countries in terms
projects arc likcly to encourage imitation. For   of number of projects-China, Mexico, and
example, the Moroccan government awarded    Brazil-have awarded small contracts, and they
a thirty-year concession contract for a power-   account for only 7 percent of investment in
water-sewerage operation in the Rabat and Sale   developing countries in the water and sewer-



The World Bank Group                   45
TABLE 4   PRIVATE WATER AND SEWERAGE PROJECTS IN
DEVELOPING COUNTRIES, BY TYPE, 1990-97
age sector. The top three countries as ranked                                                          l
by investment in private projects have awarded
fewer contracts but of larger scale. Argentina,                                               ,,
the Philippines, and Malaysia have awarded 16
percent of private projects, but they account
for 69 percent of all private investment in water      Concession                 48             19,909
and sewerage.                                          Greenfield                 30              4,037
Operations and management   13              n.a.
Projects differ vastly in size                         Divestiture                 6               997
Project sizes also differ within countries. In Ar-     Total                      97             24,950
gentina, for example, one project, Aguas               n.a.Notapplicable.
Argentinas, accounts for US$4,464 million (54          Note: Data may not sum to tal because of ounding.
percent) of the planned private investment in          Source:PPI Project Database.
Latin America, while the country as a whole
accounts for US$6,183 million. Similarly, in East
Asia three Philippine projects account for half   FIGURE 4  PRIVATE PARTICIPATION IN WATER AND SEWERAGE IN
the total investment commitments.                           DEVELOPING COUNTRIES, BY TYPE OF CONTRACT, 1990-97
Concessions are the most popular                                               Projects
Operations and management
One striking feature of the water and sewerage
sector is the dominance of concessions com-                Greenfield i                          Divstiur
pared with other forms of private participation.3                       *ivestiture
Concessions are attractive to governments be-
cause they place full operational and investment
responsibilities, and associated commercial and
investment risk, with the private sector, maxi-
mizing potential benefits from efficiency gains
and access to private sector financing. But they
also require significant government commitment,                                                Concessions
and efforts to create a credible regulatory envi-
ronment for private investment. Of ninety-seven
contracts with the private sector, forty-eight are
concession contracts, accounting for 49 percent                            Total investment
of all water and sewerage projects and 80 per-                                             Greenfield
cent of all private capital investment (table 4
and figure 4). By contrast, in the energy sector
most private projects are greenfield projects or                                                  Divestiture
divestitures,
Differences in government objectives help
explain differences in the contracts preferred in
each sector. In the energy sector private involve-       Concessions
ment has been driven largely by an increasingCoesin
demand for new capacity, requiring significant
private sector investment. In the water sector
most developing countries not only need to
expand capacity and distribution networks, but   Source: PPI Project Database.



46                 Private Participation in the Water and Sewerage Sector-Recent Trends
TABLE 5   PRIVATE WATER AND SEWERAGE PROJECTS IN
DEVELOPING COUNTRIES. BY SUBSECTOR.
1990-97
Some BOT contracts also give the private spon-
_*m  7 _     sor responsibility for management of the distri-
- . 1  5 ¢l   | bution network, making them  more like
* i I     l lI aconcession contracts. There are only five projects
in which the private company retains owner-
ship of the facilities. All these build-operate-own
Water treatment                25           4,249              schemes are in Latin America and the Caribbean.
Full water and sewerage service  19        11,935
Full water and sewerage seivice  19  11,935   Most of the greenfield projects in the sector
Water treatmnent and distribution  16       1,177              (twenty-five of thirty, with one project covering
Sewage treatment               12            673               both water and sewerage) are for the construc-
Water and sewerage netwotks     7            496               tion and operation of water treatment plants in
Waterdistribution               5            218               countries with an increasing demand for piped
Sewage collection and treatment  5          2,754              water. In these cases companies typically have
Other                          8            3,536              a take-or-pay agreement with the municipal gov-
ernment for bulk water sales. All six greenfield
Total                          97          24.950              projects in China, for example, are for water
treatment plants. In the relatively high-income
Sote:PPI PDatamnt utbasec                                      countries of Latin America governments have
awarded greenfield contracts to meet thle grow-
ing demand for sewage treatment plants.
also face high levels of unaccounted-for water   Divestitures are rare
and inefficient services. The creation of new
capacity detached from  the management of   Divestiture of public water and sewerage assets
distribution networks can exacerbate system    is comparatively rare; six projects, all partial di-
inefficiencies. The construction of new water   vestitures, account for 6 percent of all water
treatment plants, for example, increases the pres-   projects and only 4 percent of private investments.
sure of water going into the distribution nct-   This small sharc highlights the sectoral differ-
work, increasing leaks. If. in addition, collections   ence between water and energy in asset own-
performance is poor, raising funds to meet take-   ership: most water and sewerage assets remain
or-pay commitments will be difficult. Greenfield   in the public sector, and governments are resis-
contracts often do not give the private contrac-   tant to giving them up. The availability of con-
tor an incentive to take these problems into ac-   cession contracts as an alternative to divestiture
count. By contrast, concessions can encourage    has allowed governments to maintain owner-
improved management and maintenance of the    ship of sector assets while delegating substan-
whole network.                                   tial responsibility and risk to the private sector.
Greenfield projects typically involve bulk       Management and lease contracts are less risky
water sales
Management contracts and leases are intended
The thirty greenfield contracts account for 31   to improve the performance of loss-making pub-
percent of all projects and US$4,037 million of   lic utilities while leaving the public sector pri-
private investment. Almost all greenfield projects   marily responsible for new investments. Funding
take the form of BOT contracts, with owner-   for this investment often comes from develop-
ship reverting to the government after the ini-   ment bank loans, and all investment risk is borne
tial contract period. In public-private joint   by the government. These types of contracts
ventures ownership of the assets often remains   have therefore proved attractive in countries
with the public partner during the contract term.   where the private sector perceives investment



The World Bank Group                    47
TABLE 6   TOP FIVE PRIVATE SPONSORS BY NUMBER OF PROJECTS, 1990-97
Total investment in projects with private participation
Sponsor                          Projects                           (1997 USS millions)
Suez Lyonnaise des Eaux             28                                   16,153
Vivendi Iformerly CGE)              13                                    5,275
Aguas de Barcelona                  6                                     9,072
Thames Water                        6                                     1,375
SAUR International                  5                                       38
Source: PPI Poject Database.
TABLE 7   TOP FIVE PRIVATE SPONSORS, BY REGION, 1990-97
Number of projects
East Asia     Europe and   j Latin America   Middle East   Sub-Saharan
Sponsor                  and Pacific    Central Asia   and Caribbean   and North Africa    Africa   , Total
Suez Lyonnaise des Eaux      11             7               6               2            2          28
Vivendi (formerly COE)       4              3               3               0            3          13
Aguas de Barcelona           0              0               6               0            0           6
Thames Water                 4              1               1               0            0           6
SAUR International           1              1               0               0            3           5
Source: PPI Project Database.
risk to be high. Management contracts attempt   age collection, sewage treatment) highlights the
to improve efficiency through incentive pay-    greater prevalence of private sector involve-
ments based on measured performance and in-    ment in water relative to sewerage (table 5).
volve minimal transfer of risk to the private    Government priorities have generally given
sector. Leases do transfer commercial risk to the    greater emphasis to supplying water than to
private partner, thereby creating direct incen-    removing wastewater after use. Consumers are
tives to improve revenues and reduce costs.    more willing to pay for water delivery service
Together, management contracts and leases con-   that yields immediate and direct benefits than
stitute 13 percent of all projects. Seven of the    for services such as sewage treatment, the ben-
ten projects in Africa are management contracts   efits of which are more dispersed. In Asia con-
or leases. Management and lease contracts ac-   tracts commonly focus solely on the water
count for all single-sector water projects in Af-   sector (the national concession for sewerage
rica; all three concessions for water services in   services in Malaysia is an exception, as are the
Africa also involve electricity generation, trans-   Manila water and sewerage concessions in the
mission, and distribution.                        Philippines). By contrast, concessions cover-
ing water treatment, water distribution, and
Private participation is easier in water than     sewerage services, as well as BOTs for sewage
in sewerage                                       treatment, are relatively common in Latin
American countries. In this region a well-
A breakdown of private involvement by sub-    developed water infrastructure is more often
sector (water treatment, water distribution, sew-    already in place, and increasing wealth allows



48                     Private Participation in the Water and Sewerage Sector-Recent Trends
municipal governments to extend concessions              Private participation in the water sector is very
to sewerage.                                             new. The small number of projects and the
dominance of a few major international play-
Few major players so far                                 ers are characteristics of an industry in transi-
tion. Developing countries are opening their
A few major companies dominate private par-    water and sewerage sectors to greater private
ticipation in the water and sewerage sector in           participation and giving more private opera-
developing countries (see table 6 for the top            tors the opportunity to gain experience in the
five sponsors by number of projects in which             sector. As opportunities in developing coun-
they are involved).' The top five sponsors are    tries increase, water sector projects are likely
involved primarily in concessions and lease or    to attract companies with domestic experience,
management contracts, more rarely in divesti-    as well as new  companies. (We have recently
tures and greenfield projects.                           witnessed Enron's acquisition of a water com-
pany in England with the aim of expanding
The small number of major players reveals the            into the water sector overseas.) Companies al-
novelty of private contracts in the water sector    ready operating in developing countries are
compared with other sectors. Many contracts are    taking on additional projects as they acquire
awarded to consortia made up of local compa-    experience in the sector, but may face a con-
nies, often operating in other industries, and one       straint from  managerial economies of scale.
or two experienced international companies. A            Expansion may therefore depend on new  en-
breakdown of the major players by region high-    trants to the sector.
lights even more clearly how few major inter-
national players operate in developing countries    I All dollar amounts are in 1997 U.S. dollars.
(table 7). Only one of the top five sponsors op-    2 Any impact of the East Asian financial crisis is likely to show in the
crates in all five developing regions. There are           next update of the water project database.
signs, however, that the growth of the sector              For details con cession consh ay to Privaie Gnfrastmcture Sector Mo-
will bring an increase in the number of interna-           nopolies" (Public Policy for the Private Sector, September 1995),
tional players. Water and sewerage contracts in-           Claude Crampes and Antonio Estache, "Regulating Water Conces-
creasingly are attracting bids from  consortia of          sions" (Public Policy for the Private Sector, September 1996),
Penelope J. Brook coweti, 'The Private Sector in Water and Saniria-
multisector utility and construction companies.            ton-How to Get Started" (Public Policyjbr the Private Sector, Sep-
tember 1997), and Helen Nankani, "Testing the Waters-A Phased
Conclusion                                                 Approach to a Water Concession in Trinidad and robago' (Public
Policyforthe Private Sector December 1996).
Sponsor companies that have a small stake in a few large projects
The water sector has a long history of tariffs             have an inflated market share if market share is calculated accord-
below  costs and political resistance to raising           ing to the total investment in projects. At the other extreme, major
resistance           ~~~~sponsors that focus on management and lease contracts but under-
them. Considerable government commitment is                take little or no capital investment are exduded from a calculation
required to raise tariffs to cover costs, and to           based on investment. Utsing the number of projects avoids this bias
build regulator  arrangements tat give private and highilights the major players in the sector better than the size of
build regulatory arrangements that give private            projects in which each company has a stake. The number of projects
companies confidence that they can make a fair             still is not a perfect measure, however, because it ignores the cross-
rate of return on their investments. Even rela-            ownership between some sponsor companies and therefore double
tively low-rskcotracs,suhasmanagmcounts when two affiliated companies have a stake in the same
tively low-risk contracts, such as management              ptoject.
contracts and leases, still require governments
to establish their credibility as good partners for    Gse Silva, Nicola Tynan, and Yesim Yilmaz,
the private sector. While many governments are           George Mason University and Private Participa-
currently contemplating reforms that will make           tion in Infrastructure Group
private participation in water and sewerage
possible, only thirty-five countries in the devel-
oping world have so far succeeded in imple-
menting private transactions in the sector.