How can municipalities finance their water projects? The short answer: taxes, tariffs, transfers, bonds, loans, and grants. The long answer was divulged yesterday by a panel of finance experts who discussed strategic financial planning for water at the World Water Forum in Marseille, France.
The crux of the issue was best outlined through a post-panel interview with Richard Torkelson – Managing Director, ButcherMark Financial Advisors LLC and Board Member for UNSGAB. I asked him “How can you effectively adapt a strategic financial plan in countries where the governments are working on cumbersome, if not outdated, laws and policies?” He responded that “the awareness of the need to change has almost gone off the curve. . . . More places want to do something, and they know they need to finance, but then they struggle with how to do that.” That’s when these municipalities turn to finance experts who advise them on financing opportunities and ways to adjust their laws and policies.
The panel “Where Does the Money Come From? Moving Forward on Strategic Financial Planning for Water” included some of these water finance experts: Anthony Cox – Head, Environment and Economy Integration, Division Environment Directorate of the OECD; Richard Torkelson – Managing Director, ButcherMark Financial Advisors LLC and Board Member for the United Nations Secretary General’s Advisory Board on Water and Sanitation (UNSGAB); Ian Banda – Chief Executive Officer of Kabufu Water & Sewerage CO LTD; and Michael Jacobsen – Senior Water Resources Specialist, Water Anchor of the World Bank.
Strategic financial planning for water begins, according to World Bank’s Mr. Jacobsen, with understanding “the link between water and growth, between livelihood and people.” The global discussion on sustainability in environmental practices has extended into the financial realm. Indeed, sustainable finance was the topic of discussion for the panelists. Sustainable financing in the water sector is necessary because human beings’ water needs have changed. Countries are facing water scarcity, competition between urban and rural areas, and between irrigation, power and other uses. Expanding middle classes are becoming more demanding on global resources. Independent, self-sufficient systems are no longer the rule. People are demanding services from the public sector. The public sector of any country has the ability to create a long-term cohesive plan for tackling water issues. If planned and executed properly from the beginning, it will diminish the effort expended for unifying the investments of private groups.
Mr. Torkelson emphasized the need to tap the “local currency capital market.” This eliminates the foreign exchange risk when borrowing from foreign countries. There is no exchange risk with local capital markets. “If people bring money into a high-inflation environment, then they have to hedge somehow and that cost is always passed through to the borrower,” he said. So choose a local currency debt market to keep the inflation risk out of the equation. This philosophy directly mirrors Mr. Angel Gurria’s emphasis that “Water is Local, Local, Local.”
Ministers of finance are renowned skeptics on financing water projects and so many municipalities lack sufficient funding for water and sanitation. This is, according to Mr. Jacobsen, because ministers “want to allocate their funds to where they get the most bang for the buck.” As a result, municipalities have to look to alternative areas of financing to fund their water projects. Some municipalities receive grants, loans or bonds from investors. Grants, however, “have been inadequate and unpredictable” according to Mr. Torkelson. Loans tend to be unreliable: accessing them is time consuming and they reduce the availability of the market rate. Bonds are similarly limited because “conservative lenders demand that their risk be mitigated, there are high transaction costs and the capital needs must be significant to generate investor interest.”
I had the opportunity to receive a comprehensive lesson on public finances when I interviewed Mr. Torkelson after the panel. “Pooled financing combines the needs of individual utilities and diversifies the risk to lenders,” he said. He used a personal example of advising the state of Tamil Nadu in India regarding its options for funding water projects in its municipalities. The individual towns did not have enough credit to access the local currency capital markets and receive loans on their own. However, when Tamil Nadu pooled these municipalities together, the credit rating of the pool increased to AA. This rating allowed the State-created Fund to make loans to Urban Local Bodies for their water projects. A schematic is depicted below. The “Special Purpose Vehicle” represents the Fund that was created to pool or aggregate loans for the individual municipalities. This pool can then raise money from grants, bonds or loans from investors. Bonds are a limited source of financing for small individual municipalities because, according to Mr. Torkelson, they “demand a mitigation of credit risk, have high transaction costs, and require significant size to generate investor interest.” As a result of these limitations, less traditional sources are also emerging to support sustainable financial planning. These are: pooled financing, revolving funds and microfinance.
The primary sustainable model, according to Mr. Torkelson, is a revolving fund. This is generally financed by a capitalization grant to “support creating a perpetual funding source.” The revolving funds can “directly loan the capitalization grant money and then get repaid and then reuse those repayments to make new direct loans. If more funding is needed, it can then go to the capital market where it can pool various borrowers and raise additional moneys in the local currency capital market (leverage). When that money is raised they loan it out to the new pool borrowers. Repayment of all loans made by the Fund (direct loans from the capitalization grant and the market financed loans) first goes to pay back the market loans and the remainder (excess) flows back to the revolving fund to make new direct loans.” Therefore, there are two streams working in parallel.