Saturday, March 1, 2008

Debt financing urban water and sewerage projects

Safe drinking water and basic sanitation – the bare essentials of any civilized life. But even this does not come cheap! The World Bank estimates that the 5161 Indian cities, housing 30% of its population, would require investments of around Rs 1,50,000 Cr over the next decade, just to provide safe drinking water and basic sanitation services.

Hitherto these projects were financed mainly through internal revenues, dominated by property taxes and assigned revenues, apart from state grants. These revenues while adequate for financing smaller works are but a trifle when it comes to financing capital-intensive major infrastructure projects, even for the larger Urban Local Bodies (ULBs). Further, internal cash flow streams are uncertain and irregular, thereby resulting in spillovers and cost over-runs. The adhoc and limited nature of such financing fosters a piece-meal approach and acts as a road block to long-term planned project conception and execution. It is therefore inevitable that such projects be fully or partially funded through long term debt – bonds, project finance or pooled finance.

However, there are serious demand side impediments to accessing the debt markets. Most ULBs suffer from inefficient property tax collection and relatively small tax base due to large numbers of un-assessed and under-assessed properties. This, coupled with the over dependence on government grants and assigned revenues, and the uncertainty associated with it given the fiscal imbalances affecting State and Central governments, have lowered their credit worthiness. The deficiencies in accounting and financial reporting conceal the deep rooted financial rot and mars the potential for improvements.

Further, infrastructure projects, especially in the urban sector, often suffer from the vagaries of inadequate and uncertain revenues streams, therefore making them highly risky for private investors. There are very few successful examples in the country of large private investments or project finance in urban infrastructure.

Water and sewerage projects have certain inherent characteristics that make them ideal for project finance or other debt funding. They are capital intensive, have long operational lives and generate assured and periodic cash flows. Further, typical integrated projects in these sectors have stand alone characteristics, with the assets being distinct entities, making them eminently suitable for off balance sheet funding. The basic components of both water and sewerage are essentially the same - treatment facilities, pumping mains, storage reservoirs (or sump cum pump houses) and distribution (or collection) network. Each of these entities or an appropriate bundle of them are amenable to being financed by non-recourse project debt.

Both have two revenue streams - a one time connection charge and monthly tariff. The connection charges are a significant up front cash inflow, and if appropriately priced, can pay back atleast a third of the project cost immediately. The monthly tariffs are either metered or a flat rate for water, and flat rate or a proportion of the water charges, for each water closet connected to the sewerage system. The connection charges and tariff cash flows can be escrowed to pay off project debt.

There are three major credit risks associated with project financing for such projects – cash flow (tariff), collection and coverage risks. It has been observed globally that 76% of all PPP contracts in water and sanitation have had to be re-negotiated - on average within 1.6 years of signing the contracts - due to credit risks materializing. Contracts with price caps on user fees or tariffs are especially vulnerable, as they adversely affect both the regular Operation & Maintenance (O&M) and system expansion investments. A high collection efficiency, high coverage ratio, and assured and known cash flow figures, can considerably mitigate these risks.

Some small steps can go a long way towards ensuring that the aforementioned objectives are achieved with minimum risk. Water and sewerage tariff collection can be bundled together with robust and regular revenue stream like the Property Tax so as to improve collection efficiency. Since expenditure on fixed assets is independent of the number of connections, economically efficient utilization of the assets demands maximizing the coverage. Lowering connection charges and permitting payments in installments coupled with rationalization of procedures, will help more people access these services. Removing public taps, except in exceptional cases, and disconnecting ground water sources, will also incentivize household water connections.

Aggressive public awareness campaigns on the benefits of taking a sewerage connection, by highlighting the possibility of eliminating clogged, unhygienic and mosquito breeding open drains, can be very effective in ensuring universal coverage of sewerage. Once the sewerage line is laid, households could be penalized for letting out their waste water into the storm water drains. Other steps like re-laying roads only after everyone takes connections, and selectively invoking penal public health provisions can also incentivize universal coverage. The success of these measures requires the active participation of all local stakeholders like Residents Welfare Associations and people’s representatives.

Providing continuous water supply and installing water meters can substantially reduce the Non Revenue Water and lower the O&M costs, and thereby improve the project finances.

Appropriate measures to insulate tarrifs and other revenue streams from political interference or decisions based on such considerations will certainly assist in reassuring investors. Construction risks, arising from delays in obtaining clearances, taking possession of site, finalizing tenders, removing encroachments and other unforeseen contingencies results in time spill overs and cost over-runs. This can be avoided by handing over in advance the possession of work site, appointing professional Project Management Consultants, achieving financial closure before starting work, and expediting Government level clearances. Another alternative is for the Government or its agencies to assume the entire construction risk.

Fortunately, thanks to external and internal compulsions, all the aforementioned desirables are already under implementation in many ULBs, albeit at varying pace. With the JNNURM providing 50-70% of the project cost for the over-Rs 25,000 Cr worth water and sewerage projects sanctioned, there is a great opportunity for cities to leverage private capital to finance all their water and sewerage investments.

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