Traditional suppliers of finance to the WASH sector in developing countries, mainly for capital expenditure, include development banks, bilateral and multilateral agencies, NGOs and governments through budget allocations. The goal is to maximize the impact of those traditional sources and to crowd in new potential sources, such as commercial banks, pension funds and impact investors.
Integrating two disparate types of investor, broadly categorized in this paper as public and private, has so far proven challenging in many developing countries. Available data from The World Bank Private Participation in Infrastructure (PPI) database suggests that private WASH investments in the least developed countries (LDCs) are limited to a handful of large-scale infrastructure investments. Domestic private finance is not always available in many emerging markets, and where it is available, it is usually limited to microfinance.
As discussed in previous sections, the WASH sector in many developing countries is not yet attractive to private sector investment, and this paper has highlighted areas where the sector can be strengthened at government/sector and service provider levels to make it more attractive. Traditional suppliers of finance to the WASH sector, therefore, need to coordinate to support these initiatives and innovate to help attract new sources of finance into the sector.
3.3.1. Rectifying the Mismatch between Commercial Bank Risk Profiles and WASH Sector Realities
Commercial lenders, as a rule, seek to minimise risk while maximising returns. As noted above, the WASH sector in developing countries is often less attractive because of foundational issues.
The reluctance of a commercial bank to invest in the WASH sector may go beyond a specific bank’s perception of sector risk. In some countries, commercial banks are not allowed (e.g., Ethiopia) or are limited in how much they can provide loans at the sub-national level. This section discusses: acceptable collateral, loan tenor, size and complexity.
As identified in Section 3.2
, domestic commercial banks in developing countries are less familiar with lending to water utilities. It may also be difficult for lenders to take collateral over WASH assets—in some countries this is illegal. Even if they can do this legally, they would be constrained from enforcing the collateral and selling those assets, as many are underground and would be hard to unearth and resell. Moreover, while water’s designation as a “human right” is widely acknowledged, appropriate and critical, it can undermine water as an investment opportunity in the eyes of some lenders, as they subsequently perceive water and sanitation as a “public good.”
It is difficult for private lenders to exercise step-in rights (rights that give lenders, on the occurrence of certain events, the right to take over the borrower’s shares or assets) over assets deemed to be public, and water assets are often categorised in this way. Frequently, the only collateral service providers have is the regular cash-flow coming from consumers paying their tariffs. As discussed elsewhere, if the revenues from tariffs do not provide a surplus, then securing tariffs as collateral will be difficult. For smaller private service providers, this can lead to lenders requiring collateral from the service provider owners’ other assets, such as vehicles, real estate and other fixed transfers from the national government. Finally, in some markets, the lack of clarity between the role of sub-government authorities and service providers also undermines investment opportunities.
WASH sector assets are expected to last a long time, so projects are amortized over a long period (ranging from 10 years up to 40 years). However, most capital markets in emerging markets cannot lend beyond seven to 15 years, meaning that there is a mismatch between the financing and the asset life. In addition to this, most providers, even small ones, need more money than they can realistically borrow. They are building “backbone” infrastructure and strictly financing this through commercial debt is costly, meaning there is an additional mismatch between the demand for money and the supply that can be provided.
At the same time, financing requests from service providers are often either not large enough or too complex to be attractive for development banks who need economies of scale to make the cost of doing business worthwhile. “There are very high transaction costs of pushing forward projects that are interesting but complicated in set-up,” observes Nick Marchese of the European Investment Bank [39
]. “The investment banks face limits in developing blended options for anything smaller than several million Euros.” The issue of how to deal with foreign currencies so that neither investor nor borrower loses too much from exchange rate fluctuations adds additional costs, complexity and time to any transaction.
Complexity is likely to be a reality for the foreseeable future. Fixing the foundational issues is also a process that requires time and patience, and the actors involved would benefit from adapting their expectations to meet contexts that differ from those in the developed commercial markets. Development stakeholders can assist private investors to manage their expectations for these vehicles, build their comfort levels with this complexity and see the long-term payoffs. They may also be able to do more of the facility design work in the front-end to reduce the need for private investors to develop a complex system that works (e.g., make it easier to ‘plug and play’).
Belief in the big idea that the combination of technical services and access to financial capital that enables water service providers (WSP) to improve and expand services led Catholic Relief Services (CRS) and local partners to design a strategy to unlock private sector finance to improve and expand water and sanitation services in El Salvador. The Azure model mobilizes technical support and investment capital tailored to water and sanitation service providers in rural communities and small towns. In El Salvador, WASH services outside the large cities are often provided by independent community associations or municipal operators, which face challenges in accessing commercial finance because they are seen to be high risk borrowers: interest rates are typically very high and loan amounts are relatively small.
To provide WSPs access to loans that are affordable and large enough to meet their needs, CRS and local partners under the Azure model are providing engineering and business development services to WSPs, at affordable rates, brokering loan negotiations between local financial institutions and WSPs and providing capacity building, support and monitoring to help them repay their loans. Since piloting in 2015/2016, local finance institutions (including banks and credit cooperatives) have accrued loans totalling $521,000 to WSPs, and there have been no defaults on these loans to date. More than 70 additional WSPs are currently seeking TA and access to finance to improve and expand water and sanitation services. After the success of these first loans, local financial institutions expressed interest in expanding loans to additional WSPs but needed additional capital to do so. In response, CRS collaborated with the Inter-American Development Bank (BID-Lab) to set up an investment vehicle called Azure Source Capital (ASC) to provide capital to local financial institutions to on-lend to WSPs.
ASC raises capital through impact investors, then disburses these funds through a trust (FideAgua) established in El Salvador. FideAgua is administrated by the Development Bank of El Salvador (BANDESAL), which uses FideAgua to loan capital to local finance institutions at market rates, who then on-lend to WSPs. Azure technical services are funded by grants from CRS, BID-Lab, fees charged to WSPs and by the revenues earned by ASC, as per their regulations, to ensure that WSPs are functioning and capable of operating their services, generating revenue for operations and maintenance and repaying loans. By the time the Azure concept took shape in El Salvador, CRS had already spent a decade building relationships and ensuring a sound enabling environment. These conditions included an open, non-risk averse financial sector, empowerment of decentralised water utilities, people who were willing and able to pay for piped water services and an environment where grant funding did not crowd out commercial financing. TA included developing modalities for impact investment in water and sanitation, and educating various partners at regional, international and local levels. The team observes that replicating the Azure model in places where these environmental context features are not as favourable will inevitably encounter different conditions and require a different set-up [40
There may also be opportunities to standardize approaches in respect to public–private partnership transactions, as demonstrated by the case from India. The Ganga basin supports over 500 million people, more than 200 million of whom are below the poverty line. Pollution from domestic wastewater accounts for 80 percent of the pollution load and only half of the wastewater generated on the Ganga is treated. Thirty percent of the wastewater treatment plants monitored in the basin are non-functional and only 5 percent meet relevant discharge standards. Due to low cost recovery (less than 30 percent) for sewerage services in the basin states, operations and maintenances (O&M) expenses are paid out of budget funds and are typically under-funded.
To address these concerns and to make contractors more accountable, the Government of India (GoI) turned to the hybrid annuity model (HAM) contracting approach, under which the private sector designs, builds and operates the facility. It also finances up to 60 percent of the capex investment. This is repaid, along with financing charges and O&M fees, through periodic annuity payments during the O&M period of the concession, typically 15 years. The GoI, with IFC transaction advisory support, developed standard bidding documents to streamline and standardize private contractor solicitations for concessions. So far, three projects have reached financial close and eight more are in different stages of preparation and bidding. The government portion of the capex for three projects is being funded from a World Bank loan.
The market is becoming comfortable with the risk allocation and it has created a new market for primarily domestic developers. Using this model, projects are now being prepared and bid out relatively quickly. Significant handholding was required to support the GoI in developing this approach, including analytical studies; consultative workshops with private sector and banks; and transaction advisory support.
When considering capacity building in the WASH sector, the focus tends to be on the demand side of finance: on assisting service providers to build their operations and business cases to be more attractive to commercial lenders. Helping the domestic finance suppliers—the investors—see the opportunities for financing WASH and how small adjustments to making transactions can improve the risk profile for these loans is an equally critical aspect of the enabling environment.
Grants can be used to build the skills of commercial banks, and pension regulators and securities commissions, so that they better understand how investments in the water sector can match their long-term liabilities. In Kenya, a set of tools has been developed to help banks evaluate investments in the WASH sector, and that has been rolled out successfully, to the extent that banks are now extending finance to service providers [41
3.3.2. Avoiding Mechanisms That Can Result in Market Distortions
Some governments and development actors have explored incentives to “open” up local financial markets to the WASH sector. However, some of these initiatives can give rise to market distortions and impede progress towards sustainability.
One approach to opening WASH markets has been to allow or encourage actors to target new WASH loan products to low-income clients. While permitting this new market to flourish, governments and other stakeholders sometimes strive to protect low-income borrowers from being exploited by predatory lenders. One protection mechanism has been to set limits upon the interest rate margin charged on microlending. (The interest rate margin is the spread between the interest rate an on-lender obtains their bulk loan and the interest rate they charge a borrower; fundamentally serving as a transactions fee.) While this margin cap may be well-intentioned, there is still not enough evidence for the long-term impact of this action on the larger objectives of making local finance more readily available or opening WASH markets.
A 2016 regulatory change in Kenya capped the maximum lending rate at no more than four percent above the Central Bank base rate. The current base rate is nine percent, meaning that the maximum lending rate is 13 percent, a rate which does not allow the lender to recover their costs on higher-risk loans. This has led to a steep decline in issue of microloans in Kenya, so that poorer borrowers are denied formal banking opportunities and may have to seek (or return to) informal solutions, like loan sharks or mafia-like water distribution systems that can dictate the price. Reuters reported [42
] in August 2018 that, “As a result [of the interest rate margin cap], lending to the private sector fell from 9.3 percent in 2016 to 2.4 percent last year,” and that, “Many thousands of Kenyans, now unable to access bank lending, have turned to more expensive borrowing.”
In 2015, the Government of the Netherlands funded a five-year project in Ghana aiming to boost WASH services for households and small/medium enterprise (SME) WASH institutions in-country. The project budget was six million Euros, of which four million were allocated to a revolving fund for lending and two million for TA to financial institutions, SMEs and households to accelerate private sector involvement in WASH [43
]. The main financial instrument used was the revolving fund, which lent funds to micro-finance institutions (MFIs) willing to on-lend for WASH at an interest rate of 10 percent, as opposed to the 30 percent that was locally available. (MFIs specialise in microlending to low-income borrowers.)
The maximum on-lending rate that a borrowing institution can charge to a client is limited to 17 percent for a 12-month loan. However, the seven percent difference is too low for the MFIs in Ghana to recuperate their costs. In a World Bank assessment of WASH financing options in Ghana, Steel and Darteh [44
] observed that on-lending institutions in Ghana need to charge at least 24 percent over a 12-month period to cover basic operating costs, and above that amount to be sustainable and competitive against other uses of capital (Steel, W.F. and Darteh, B. 2018). This inability to recover costs makes the revolving fund unattractive to larger lending institutions. Steel and Darteh confirm: “As of March 2018, about €2 million has been lent to 24 MFIs for on-lending—mostly small NGOs in the northern part of the country. Larger MFIs […] generally have not taken up these funds because of the limited spread between the wholesale rate of 10 percent and the 17 percent ceiling placed on the retail rate that they can charge.”
There are many opportunities for providing TA and capacity-building to the supply side of finance, but a more comprehensive understanding of the long-term implications of policies is required. As long as market distortions exist, regardless of how well-intentioned, private finance will not be able to compete.