ROCKBlue recently had the privilege to interview specialist Aldo Baietti and get his expert insight on a few finance topics. Mr. Baietti has over 37 years of experience in international development, with a primary focus on financing, reform and private sector participation of infrastructure sectors, particularly emphasizing clean energy, water infrastructure, irrigation, and road transport sectors. We are sharing these in a series of two blogs starting with Accessing External Finance.
Part 1: Accessing External Finance
Is there a connection between benchmarking tools such as AguaRating, performance improvement plans (PIPs), credit rating, and access to finance?
A credit rating doesn’t always accurately portray the creditworthiness of a utility. I also have issues with benchmark systems, generally. I prefer a benchmark system that tracks the utility’s own performance over time, not those that compare one utility against others. This is unless, there are a lot of similarities among the utilities. For example, large utilities tend to be more comparable – I have experience benchmarking Bangkok Water with Singapore Water and Manila Water – and still there can be technical and commercial differences that must be isolated. But with smaller utilities, the differences can be more significant. For example water utilities that source water from polluted rivers will have very high production costs. This is due to increased chemical costs. Their cost of production can be much higher over those systems that rely on pure ground water. Benchmarking those utilities with others, having different configurations, might result in inaccurate conclusions. Again, I prefer the benchmarking of the utility against its own performance over time.
For performance improvement plans (PIPs), milestones or targets should also be individualized. Some donor agencies like to treat them all the same insofar as performance progress. This is not ideal. Each utility should have its own set of milestones that are achievable given their special circumstances. It is important that utility management agree on the PIP milestones, given the available resources. A PIP typically requires commitments and actions of three-parties to be successful. Those are:
a) the utility management
b) the oversight ministry with access to funding as well as authority to change policy (e.g., tariffs)
c) a donor agency that provides technical assistance or funding, as well as oversight – as honest broker
Again, the PIP should be customized to the utility and its capacity since all utilities are different. Targets to reduce non-revenue water or dramatically reduce the cost of service should also be customized to the utility. Unfortunately, for some utilities, customers must pay higher tariffs. This is because their cost of service is much higher than other utilities.
As the PIP is often linked to benchmark information, so too is creditworthiness. The stronger the creditworthiness, the easier it becomes to access finance.
Can you provide more detail on the subject of credit and borrowing?
First, it’s fruitless to do a credit assessment of utilities that have no borrowing capacity. Standard & Poor’s (S&P) provides credit scores for many public companies. The problem with utilities, however, is that most have never borrowed before. The first important element is how much they need to borrow. The next is whether they can show an acceptable (projected) debt service coverage ratio. That is, one high enough for a lender to feel comfortable with its financial exposure. Creditworthiness has more to with a forward-looking plan. And less to do with a static credit score or credit assessment based on historical data.
Also, a credit assessment based on historical data doesn’t tell much. Except maybe that the utility is doing well and earning a sufficient rate of return. But you don’t know how much they need to borrow. And, whether that borrowing is significant or insignificant relative to the existing operations. That question is answered by creating a consolidated financial projection – of the entire operation. This is inclusive of the proposed project where you can assess the projected debt service capacity or the related financing. One could have a good credit rating but still not be able to access any financing. This is because the projected cash flows are not enough to cover the debt service obligation in future years.
Also, there’s a difference between being bankable and being viable. Being bankable depends on whether you can service a loan. And whether the lending institution can give terms required by the proposed project(s). Sometimes a utility is not bankable because it requires say 15-year financing and the lender can only give 5 years. In such cases, the dilemma has nothing to do with the creditworthiness of the utility. It has more to do with the mismatch between the capacity of the lender and the financing requirements of the utility. That is, the capacity to put together a large project (e.g., a water treatment plant where you typically require closer to a 15 year involvement). Financing on a 5-year basis for such a project would be challenging and unlikely to be sustainable. So, from the financing point of view, that’s where blended financing becomes critical. That is, commercial/market finance blended with philanthropic/aid funds and government grants. This blending reduces the effective cost of borrowing and lengthen maturities. The ultimate intent is to maintain an affordable tariff for customers.
Currently, we have two main problems regarding commercial financing of water utilities. One, the financial markets are under-developed, and two, the utilities have insufficient financial and institutional capacity. So, we need to support both fronts. And this is where donors can have a significant role to play. They can assist with blended rates but also manage expectations on the extent of borrowing that is realistic from commercial banks. We must not provide false hopes, but we must progress in this area.
Let me provide an interesting case in Kenya, illustrating the financing challenge. Most of Kenya’s water utilities are service providers, not full utilities. Another agency has been responsible for development, financing, and ownership of productive assets. If I recall correctly, it is a central Water Board. So, all the investments and the related financing from donors went through this one agency. By contrast Kenya’s water service providers have not purchased major productive assets or have borrowed in the past; and because they are just service providers with no major system assets, they don’t have significant depreciation expenses which can be included in their revenue requirement formula for tariff setting.
To be credit worthy, their tariff formula would need to recover all costs, including depreciation and interest charges. If they’re allowed to recover only their operating costs and no depreciation or interest expense, then the amount of allowable profit that they generate will not be enough to become financially independent and to secure finance large new investments. They will have difficulty going forward now that the devolution to the provinces has taken place. Unless that the agency starts reallocating the assets back to the utilities, and the revenue requirement is readjusted in the tariff setting formula, they will continue to recover only O&M costs and not be bankable for significant new investments.
This underscores the problem with a credit rating of these service providers. They could have a good credit rating but have no real capacity to borrow.
Let’s say I’ve got a service provider that needs $100 million of external financing. What are the top recommendations you would suggest to them?
A utility that has never accessed commercial finance or other private finance could not go to market for a $100 million project unless they decided on a public-private partnership (PPP). And, even in this case, they would have to secure the commitments with a well-structured project so that the risks are minimized for the lenders. Normally a public utility that doesn’t have access to corporate finance would not have the capacity to go for a $100 million project. What they need to do from the beginning is to start developing a relationship with lenders in their area. They should go after the low hanging fruit (e.g., a smaller loan) and develop that relationship. Perhaps for service improvements. In other words, you must be able to crawl before you can walk and walk before you can run. Again, this starts with establishing a relationship with lenders.
A big problem with commercial lenders in some African countries is the high interest rates. Not enough is being done to reduce the cost of borrowing. So, as I said before, donors can help by blending financing. It works well. A good example is the situation where you have excess water capacity and need to expand connections to better utilize that capacity. You can blend financing from banks, as they’ve done in Kenya, with subsidized financing that donors provide. This reduces the net cost of financing, which would ordinarily be prohibitive if they tried to finance 100% from commercial banks. It’s not ideal for a utility to just go to a commercial bank and borrow at 18 percent when they could instead ask the World Bank, African Development Bank or USAID for much cheaper financing say, at 1- 2 percent, maybe even cheaper. But it’s also not good to keep on borrowing from donor agencies. If correctly used development financing serves a purpose in the reform process but ultimately utilities need to access the commercial fiancé market.
There’s a need to break the overreliance on public donor financing, so blending is a good way to transition. But, in one of my publications, the How-to Guide for Crowding-in Commercial Finance, I write that any support from commercial banks represents success. This implies even small amounts because what you’re doing is establishing/building this relationship and then bridging the information gap that currently prevails between the two sectors (commercial finance and water services). Initially the utility should focus on low hanging fruit projects (e.g., performance improvement projects). And then, ultimately, once there is enough credibility, the utility can go for larger projects and financing. For example, Manila Water, a private company/concession, doesn’t have any problems with accessing commercial finance exclusively. They’re also traded on the Philippine stock exchange.