As discussed in my previous post, there are a number of ways to finance water projects. However the topic of what options cash-strapped municipalities with low or non-existent credit ratings have for financing their water projects requires a more intensive look. This is a big concern for municipalities around the world because they need to somehow finance expensive water and sanitation projects, such as putting in new pipes to expand water and sanitation coverage and maintaining and updating aging infrastructure.
Following the session on “Where Does the Money Come From? Moving Forward on Strategic Financial Planning for Water” at the 6th World Water Forum, I sought to find the answer to this question. I interviewed both Anthony Cox – Head of the Environment and Economy Integration Division Environment Directorate of the OECD – and Richard Torkelson – Managing Director, ButcherMark Financial Advisors LLC and a Board Member of UNSGAB.
“It’s a very difficult time for countries to be funding big infrastructure projects” like the ones proposed at the World Water Forum, stated Mr. Cox. “The financial crisis means that funds are scarce, risk profiles are increasing, governments are no longer stable sources of funding for these infrastructure projects. . . . Billions and billions of dollars are needed [just] to maintain existing infrastructure,” never-mind fund new projects. Adding insult to injury, many countries have not put aside money to upgrade or re-build aging infrastructure. One reason is that it is not politically popular to delegate money to maintenance – politicians are much more apt to want to fund new projects that attract attention.
Mr. Torkelson said that governments do not have the flexibility to fund as many water projects as are needed. His main message, however, was that there are many finance and credit options available to help communities, both in the public and in the private sector. “There is a lot of experience on how to help poor, not so poor, and wealthy companies,” he said.
One way to finance water projects is through loans. A little background: When an investor extends a loan to a borrower, it must assess the risk that the borrower will not repay the debt, i.e. default on the loan. It bases this analysis on the credit rating of the borrower and other due diligence. A triple-A rating is deemed the best rating and an essential guarantee that the borrower will repay the debt. The interest rate charged for the loan tends to be inversely related to the credit rating. Typically, the riskier the investment, i.e. the lower the credit rating, the higher the interest rate.
In terms of funding water projects, insolvency remains an issue during the entire loan period. According to Mr. Torkelson, when governments “look at the array of municipalities, they need to understand their ability to repay, their willingness to repay, and whether they are under any stress because of the economic situation.”
There are means by which investors can have their loans guaranteed. This means that “sub-prime” borrowers, i.e. those with very low or non-existent credit ratings can receive a loan from a creditor because someone else will pay the loan (or a percentage of the loan) if the borrower defaults. These guarantees are provided based upon the guarantor’s assessment of credit worthiness of the borrower. The U.S. State Department’s USAID, for example, has a program that partially guarantees loans. According to Mr. Torkelson, “guarantees give comfort to investors that someone other than the borrower will stand behind the debt, if a repayment issue arises.” The World Bank also guarantees loans but at a higher level than the USAID. Here’s an example of how this works: B (borrower) wants to loan money from L (lender). L agrees that B’s project is necessary and that B will need funding from it. However, B is very risky and L wants a guarantee so that if B defaults, it can still recover the money. So, the World Bank comes in and guarantees the loan. In other words, if B defaults, then World Bank will pay L for up to 100% of the loan.
Additionally, some laws enable public investors to adjust direct loan terms and even reduce the interest rate to a negative interest rate for borrowers who have some inability to repay their loans. One such law exists in the United States Clean Water Act, title 6, section 1045, which allows creditors to reduce the cost of debt to poor communities to a negative interest rate. If, for example, a borrower who normally would get a loan at a 4% interest rate but can demonstrate an inability to fully repay that loan at 4%, the public lender can reduce the interest rate to 0% or lower the amount of principal that has to be repaid (“negative interest rate”). This gives the borrower the ability to repay the loan without defaulting on its debt.
In other words, there are many creative options available for municipalities and communities to fund water projects. As summarized by Mr. Torkelson, “I think the message is, there is a lot of hope and many ways to structure financial help.”