Messages for Financiers

The United Nations World Water Development

Report 3

Messages Series

The water sector is severely under-funded in many developing countriesThis is something of a paradox, given that the economic, social, environmental and public-health benefits of investing in water and sanitation are well established.

The financial track record of the sector is still patchy, but well-run utilities in regulated markets have provided solid investment opportunities that fit well in diversified portfolios. Looking at long-term trends, the sector has a non-cyclical demand with positive trends and relatively stable cash flows. It is comparatively resilient to technological change and entry barriers for new players tend to be comparatively high.

The role of the target readership and links with the UN World Water Development ReportThis Message is aimed broadly at the financial community, including the following:• commercial banks• institutional investors such as insurance companies and

pension funds• private equity, infrastructure, and water investment funds• insurance companies and credit guarantee agencies;• private companies investing in water services and

infrastructure (Including corporations with a majority public ownership but a commercial orientation, and joint ventures between public and private equity holders)

• companies and agencies involved in providing or facilitating commercial finance and private equity

• it is also relevant to international development banks and development agencies with market-oriented operations

‘Investment’ here refers to forms of financing that involve risk, notably various kinds of equity or bonds. And a ‘loan’ is regarded as a form of commercial finance, not as an investment (though a delinquent loan may subsequently be converted into equity). It is also important to remember that equity is not necessarily private – it can be issued, as well as held, by either private or public parties. And the same is true of loans and bonds.In a number of countries, governments have recently taken major equity holdings in hitherto private banks and insurance companies, while sovereign wealth funds in emerging economies have become major international investors. Simultaneously, private companies with profit-oriented business models are becoming involved in philanthropic and ‘blended value’1 operations with strong developmental motives; and private water operators are increasingly emerging from developing countries and becoming regional investors themselves. But what is important is the motivation and modus operandi of a company or agent, rather than its formal legal status or domicile.The financial community has been severely affected by the global financial crisis, the full impacts of which are still being assessed. Against this sobering background, the 2009 UN World Water Development Report argues that water’s various sub-sectors are going to need increasing amounts of finance from all sources. Global water infrastructure provides a market for goods and services valued at over US$ 350 billion annually2 Although compared to other types of infrastructure, water has traditionally yielded lower returns and presents specific risks. Risk-mitigation measures and hybrid instruments are now available to meet risks in this sector. While returns are comparatively lower than those of other sectors, water investments have been providing stable and predictable returns.

1 These are funds that are earmarked for projects with a social or developmental, as well as a commercial, objective, with the usual financial rate of return modified accordingly2 Goldman Sachs - 2005: Water: Pure, Refreshing Defensive Growth

Messages for Financiers | The United Nations World Water Development Report 3

In order to move forward, the debate needs to be framed properly. Loans and equity sources are financial instruments that allow the cost of investment to be spread and repaid over a period of time.Ultimately, there are only three sources of funds for financing water investments: tariffs, which are paid by customers, taxes, which are paid by the broader population, and transfers from international aid – known collectively as the Three Ts. In practice, there is a wide discrepancy in the relative proportion of funds derived from tariffs, taxes and transfers, even in countries that have successfully implemented a sustainable financing strategy for their water sector. Investment flows need to be well established for the sector to attract commercial financing. Therefore, investment programmes need to be framed within the constraints of the Three Ts by setting affordable service standards, making operations more efficient (through good housekeeping), and improving services to bolster users’ willingness-to-pay – both for supply and for waste-water services. Greater use of tariff revenues calls for more attention to be paid to affordability, especially in poorer areas.

While the water sector as a whole is under-funded, the investment picture varies from sub-sector to sub-sector – infrastructure is better funded than are recurrent costs, rehabilitation, and the ‘soft’ services and functions, which need to develop new financing instruments. Multipurpose schemes, including hydropower, can normally attract commercial finance more easily than can stand-alone irrigation projects. Commercial financiers should use the full range of risk-mitigation instruments and facilities to manage the specific risks of this sector. Securities issued by solvent and well-managed water concerns appeal to savers and institutional investors with long time horizons.

The debate about how to increase investment flows and realize the social and financial benefits of investments in water has been going for some time

Messages

Ensuring an adequate, reliable and predictable cash flow from the Three Ts allows interim financing to be put in place to spread the cost of investment over a period of time.Tariff revenue is at the heart of sustainable financing, though full cost recovery through tariffs is rare in practice, and most countries take a pragmatic approach, captured in the term ‘sustainable cost recovery’.

However, relying more on tariffs requires careful thinking about how to deal with affordability. Many poorer people are not connected to networked water and sanitation systems (WSS) and have to make their own arrangements – usually at a multiple of the cost. For such people, connection is more important than the tariff rate (though the connection charge may be a hurdle, for which special provisions must be made). For connected customers, affordability benchmarks (e.g. 3% or 5% of household income), are frequently used as a guide for tariff setting - these are of greatest value when applied to the poorest segments of the population. Affordability can be tackled either through the tariff structure (e.g. free or cheap basic quotas, followed by full tariffs for subsequent increments) or through social security payments targeting deserving groups.

Managing the demand for finance is just as important as increasing its supply. Although the future financial needs of water are large, water can be kept affordable by choosing more realistic investment programmes and service standards, introducing demand-management approaches, maximizing the efficiency of operations, and improving services in order to nurture users’ willingness-to-pay.

Currently, there is a particular need for improved housekeeping in the form of greater technical and commercial efficiency. The financial climate has created great uncertainty for commercial funding and private equity. National budgets in many countries are also coming under strain and borrowing is more difficult. It’s hard to predict how these forces will resolve themselves, or what the final impact will be on water-sector financing. Agencies and service providers will need to take all possible measures to reinforce basic revenues, improve financial viability and minimize the need for external funding.

Finance will be needed for the full range of water services and functions

Certain parts of the sector are seriously under-funded and there is a mismatch between the type of financing available and what’s really needed.• There is an imbalance between funding for

capital investment – which is more attractive to external financiers – and funding for operation and maintenance (O&M), which tends to be deficient. To fund O&M, tariff revenues need to be enhanced and budgetary transfers provided on a more solid and predictable basis.

• Little provision is made for the high cost of rehabilitating and modernizing ageing systems. This is a problem for municipal distributions systems, irrigation networks and other types of hydraulic infrastructure. A forward-looking financial strategy is essential.

• It is much easier to get finance for water-sector hardware than for ‘software’ such as watershed management, research, policy-making, monitoring, environmental and pollution control, training, and public awareness. While some of these might not seem as essential as infrastructure and frontline services, neglecting them will adversely affect all water users. Ingenuity is required to develop proper funding for these functions, using schemes such as Payments for Environmental Services (PES) or earmarking the proceeds of pollution charges for waste-water treatment or environmental remediation.

Messages for Financiers | The United Nations World Water Development Report 3

Calls on private sector resources are likely to increase and will require different kinds of Private-Sector Participation (PSP)In the coming decades, the adjustment of water economies to the stresses portrayed in UN World Water Development Report WWDR3: Water in a Changing World will call on all the resources of private agents. This is particularly true for municipal water services, but there will continue to be potential for PSPs. The prevalent PSP model, continues to be one where ownership and control are public, with long-term financing burdens resting on public sector balance sheets, with private parties involved only in the lower-risk elements of the value chain. This applies to PSP solutions in municipal WSS,3 and also to major infrastructure projects such as storage, hydropower and bulk conveyance. However, much of the recent growth of PSPs in water services in Latin America, South East Asia, East Asia, Russia, and the Middle East has been driven by new national and regional operators with distinctive origins and business models, and access to finance from their own cash flow or from local banks and investors.Financiers should make use of the big range of risk-mitigation instruments in order to manage the specific risks of the water sector. The main risk categories to be addressed are political, regulatory/contractual, credit, foreign exchange and sub-sovereign. Among the mechanisms available are guarantees, political-risk insurance, subsidies that balance the demands on cash flow from operations, output-based aid, convertible loans, debt-equity swaps, blended value models, challenge funds, securitization, or project-preparation facilities. The aims of these devices are to eliminate specific risks, multiply the volume of finance, make more attractive financing packages, improve transparency, strengthen balance sheets, elicit better financial performance, reduce transactions costs, attract non-traditional sources, and projectize potential earnings streams. However, risk-mitigation instruments do not compensate for the absence of strong fundamentals.

Although the financial problems of water investment have

been well publicized, the shares and bonds of well-managed water institutions can be attractive elements of an investment portfolio. WSS has the potential for stable cash flows over the long term – meeting the requirements of investors who need to monitor performance into the future, such as pension funds, insurance companies and specialized water and infrastructure funds. A number of emerging and developing countries are issuing municipal bonds to fund water development. Many of the securities issued by municipalities and utilities are backed by credit enhancements that bring them to the investment-grade status often required by institutional investors.

Finally, the UN World Water Development Report contains ample evidence of the large expenditure urgently needed in all parts of the water sector. Water resources management needs to adapt to climate change through investments in storage, flood control, and more efficient irrigation systems. WSS need to be provided to the billions of people lacking these basic services. In more developed countries, ageing infrastructure needs to be upgraded to meet current expectations and systems need to be optimized to make them more efficient. Many existing water infrastructure projects began as anti-recessionary schemes, and there are influential calls to use fiscal stimuli to promote ‘green’ development. It is important to take a longer view of the current global financial uncertainty and see the opportunities it offers, as well as the obvious difficulties it raises for water finance.

Just as private financiers are leaning more heavily on governments to provide leadership out of the current financial crisis, international financial institutions (IFIs) are reporting a surge of interest in their lending and risk-sharing products. It is important that any short-term measures aimed at immediate macroeconomic and social pressures do not harm longer-term growth and development prospects. Across-the-board spending cuts that affect both investment and maintenance outlays can be costly in the longer term. It is the responsibility of financiers to be flexible in the face of these new challenges.

3 The World Bank’s Public-Private Infrastructure Advisory Facility (PPIAF). 2008. Public-private partnerships for urban water utilities: a review of experiences in developing countries. Washington D. C., World Bank

The United Nations World Water Development Report 3: Water in a Changing World

The report is presented together with a case study volume: Facing the Challenge. Adopting the premise that local actions and on-the-ground insights are the starting point of a global strategy to improve management of the world’s freshwater resources, these 20 case studies from around the world examine water challenges and the differing management approaches taken in response in Bangladesh, Cameroon, China, the Cholistan desert (Pakistan), Estonia, the Han River basin (Republic of Korea), Istanbul (Turkey), the Lake Merín basin (Brazil and Uruguay), La Plata River basin (Argentina, Bolivia, Brazil, Paraguay and Uruguay), the Netherlands, Pacific island states, the Po River basin (Italy), the Autonomous Community of the Basque Country (Spain), Sri Lanka, Sudan, Swaziland, Tunisia, Uzbekistan, the Vuoksi River basin (Finland and the Russian Federation) and Zambia.

SC-2009/WS/14

Water is vital to all aspects of human life. Using water wisely and managing our water resources is an essential component of growth, socioeconomic development and reducing poverty. Yet around the world we see water scarcity problems rising. And if we don’t take action, they risk becoming even more severe.Coordinated by the World Water Assessment Programme, the United Nations World Water Development Report 3: Water in a Changing World is a joint effort of the 26 United Nations agencies and entities that make up UN-Water. The report

brings together some of the world’s leading experts to analyse the state of the world’s freshwater resources: it monitors changes in our water supplies and in how we manage them, and tracks our progress towards achieving international development targets. Water in a Changing World also provides decision makers with the tools to implement sustainable use of our water – offering best practices to help stimulate ideas and actions for better stewardship of this most essential resource.

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