Financing investments in water and sewerage

It is estimated that the 5161 Indian cities, housing 30% of its population, would require investments of over $200 bn in urban infrastructure over the next decade. The World Bank estimates that atleast $37 bn is needed over the same period, just to provide safe drinking water and sanitation to our city residents.

Property taxes and assigned revenues (stamp duty, entertainment tax, motor vehicle tax), apart from state grants, form the overwhelmingly major share of municipal finances. These revenues while adequate for financing smaller works, are nowhere large enough to finance capital intensive major infrastructure projects, that will qualitatively improve our cities. The infrastructure investment requirements are so massive that even the larger ULBs will be able to meet their financial needs from internal resources only for a couple of years. Further, such cash flow streams financing them were uncertain and irregular, and often inadequate, thereby resulting in spillovers and cost over-runs. The adhoc nature of such financing also meant that these Projects were not conceived and executed in an integrated manner. It is therefore imperative that our Urban Local Bodies (ULBs) look at raising resources externally to fund its huge requirements.

But there exists serious obstacles to accessing the debt markets and raising private capital. Most ULBs suffer from poor property tax collection efficiency and relatively small property tax base, due to large numbers of un-assessed and under-assessed properties. 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 absence of proper accounting and financial reporting systems, exacerbates the financial problems by concealing the deep rooted economic and financial inefficiencies and also the potential for improvements.

Infrastructure projects, especially in the urban sector, generally suffer from uncertainty associated with cash flow projections and collection mechanism. Therefore urban infrastructure projects face difficulties in attracting investment from private capital. In fact, there are very few successful examples of private investments or project finance in urban infrastructure.

However, water and sewerage projects have certain inherent characteristics, that make them ideally suited for project finance funding. Both involve massive capital investments, have long operational lives and generate assured and periodic cash flows. Further, typical integrated projects in these sectors have stand alone characteristics, with the project assets being distinct entities, making them eminently suitable for off balance sheet funding.

There are three major credit risks associated with project financing in urban infrastructure projects – cash flow (tariff), collection and coverage risks. It has been observed that 76% of all PPP contracts in water and sanitation sectors have had to be re-negotiated, on average within 1.6 years of signing the contracts. Contracts with price caps on user fees or tariffs are especially vulnerable, as they adversely affect both the regular O&M and system expansion investments. The first risk can be mitigated by direct transfers of the differential between cost recovery and user charges, to the service provider. Collection risk can be substantially mitigated by bundling the collection with some existing revenue stream with robust collection efficiency. Coverage risks can be reduced by lowering access charges and making it mandatory for all citizens to utilize the services.

In both water and sewerage projects, there are two revenue streams - a one time connection charge and monthly tariff. The connection charges are a significant amount, and if appropriately priced, can pay back atleast 30% of the project cost immediately. The monthly tariffs are either metered or a flat rate for water supply and is a flat rate (or a portion of the metered water charge) for each water closet connected to the sewerage system. Except in case of metered water supply connections, flat rate tariffs for both can be bundled together with the Property Tax and collected.

A high collection efficiency (and collection bundled with property tax), high coverage ratio (universal coverage of sewerage), and known revenue streams, help considerably mitigate the credit risk associated with such projects. Further, both the monthly tariffs and more particularly, the connection charges, for both water and sewerage are considerably high enough in many cities, if the coverage is maximized (and this can be achieved), to more than recover the project costs over a period of time. The connection charges and tariff cash flows can be easily escrowed to pay off the debt leveraged. In fact, a very convincing case can be made that these two revenue streams are large enough in most ULBs to pay off the entire project cost over a 15-20 year period.

Some small steps can go a long way towards mitigating the risks associated with financing UGD and water assets. Given the same expenditure on fixed assets, irrespective of the number of connections, economically efficient utilization of the assets requires 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 help mobilize household water connections. Public awareness campaigns supplemented by judiciously invoking the penal public health provisions, can be effective in ensuring that every household in a street accesses the sewerage service and do not let out their waste water into the storm water drains. Apart from regulatory interventions, all these measures can become successful only with the involvement of local stakeholders like Residents Welfare Associations (RWAs) and people’s representatives.

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 advance possession of work site, appointing professional Project Management Consultants, achieving financial closure before starting work, expediting Government level clearances. These risks need to be appropriately allocated between Government and the contractor.

There have also been examples where the Government or its agencies have assumed the entire construction risk. and transferred only the credit risks to the lender. Another alternative is to complete the project with short term bank loans, which can be raised at lower cost. After the construction is completed and revenues streams established, this loan can be swapped with long term debt. This will ensure that the loan term lender will not have to assume many risks, besides also bringing in some discipline to the ULB's project management systems.