By James Scarrow

The water industry is the final major utility sector to be opened to the rigors of private competition, following in the footsteps of the telecommunications, power, and gas industries.  Estimates put the value of the international water market at $300 billion a year, with infra-structure investment needs approaching $60 billion a year over the next decade in developing countries alone.  Although the water market is still considered relatively immature, the World Bank reports that the number of financial closings in this sector increased by tenfold between 1990 and 1997, with approximately one hundred closings reported during this eight-year period.

Water projects offer obvious attractions to project finance veterans interested in new frontiers.  However, it is important to appreciate the economic, financial and technical characteristics that distinguish the water and power sectors.

Monopolistic Characteristics

Monopolies abound in water.  While the unbundling of generation, transmission and distribution assets revolutionized the power industry, the same thing is unlikely to occur in water.

There are several reasons for this.  First, water systems typically are local in nature and are not usually interconnected to regional or national grids.  Thus, it is hard to imagine a realistic scenario in which residential or commercial customers could be given the option of choosing among multiple wastewater treatment providers.  Second, the localized nature of water monopolies means that there may be limited economic gains to be achieved by unbundling water services, particularly since such “localized unbundling” can result in high transaction costs and losses of economies of scale. (Even though there are numerous examples of wastewater treatment plants being unbundled — that is, owned or operated by entities other than the owners of the water distribution and wastewater collection networks — it should be recognized that the great majority of investments in water systems are associated with collection and distribution networks, not treatment plants.  Therefore, the limited unbundling that has occurred to date does not go to the heart of the water sector.) Finally, even where a water system might be large enough to allow some form of unbundling, each component of the system would continue to be a natural monopoly and not be subject to marketplace competition.

Because the water sector probably will retain its monopolistic nature, companies entering this sector can expect to reap steady, long-term investment returns free from marketplace risks.  However, these companies can also expect that a relatively high degree of government regulation will continue, even as the water sector matures over the next twenty years.  As a consequence, a reasonable expectation for internal rates of return in the water sector may be in the range of 10-15%, with perhaps higher returns going to industry pioneers.  On a risk-adjusted basis, however, such returns may exceed the nominally higher returns that have been available in the power sector

Subsidies

In almost every country, water companies continue to receive significant government subsidies.  These subsidies have prevented or retarded the development of commercial pricing for water services.  Therefore, the success of a water sector privatization program frequently depends upon the private sector’s ability to improve operational efficiencies to such an extent that reasonable investment returns can be achieved even after the subsidies are eliminated.

In many cases, such improvements are achievable.  For example, during the first three years following privatization of water and wastewater services in greater Buenos Aires, labor productivity nearly tripled, and network rehabilitation significantly reduced water losses, allowing water distribution coverage to increase by 10 percent without any corresponding increase in water production.

In the event that efficiency gains cannot eliminate the need for subsidies, then either tariffs must be raised or some form of subsidy must continue even after privatization.  There are risks associated with either course.  A dramatic rise in tariffs can result in public backlash and reduction in bill collection rates.  Meanwhile, reliance on continued government subsidies — as occurs, for example, where the government enters a contract for wastewater treatment services but does not collect adequate fees from end-users to cover contract fees — would raise both political and credit concerns.  These risks can be reduced by encouraging governments to implement tariff reform prior to private participation in the sector, and by taking steps to ensure that whatever subsidies remain are phased out as quickly as reasonably possible.

Credit Concerns

Water sector privatization programs frequently require the private water service provider to accept payment from the local government (or its publicly-owned water company), rather than directly from residential or commercial end-users.  Such structures can raise serious credit risks.  For example, a Brazilian state-owned water company proposed issuing a sub-concession in which the private sub-concessionaire would be responsible for major capital investments and all operations within the service area.  The sub-concessionaire was to have the right to a large portion of tariffs generated within the sub-concession area.  However, tariffs were to be paid in the first instance to the water company by end-users, with the water company paying the sub-concessionaire from its own account.  Because the sub-concessionaire would be relying on payment from a water company with a poor credit rating, and not directly from end-users, potential investors had serious concerns with the project even though there was a general consensus that the project would generate sufficient tariff revenues to provide an attractive return on investment.

In some instances, credit support for local governments (including municipal or state-owned water companies) may be available from state governments or through domestic or multi-lateral development banks.  In other cases, the local government may agree that tariff receipts will not be co-mingled with other funds and instead will be deposited in a dedicated account in which the service provider has priority rights.

Evaluation of Assets

Participants in water sector privatization programs often face the difficult task of evaluating the condition of buried water distribution and wastewater collection networks for which there are no as-built drawings or maps.  These networks can be decades old and, in the case of water distribution networks, may be losing through leakage 10, 20 or even 50% of the flow passing through them.  While there is no simple way to address the challenge of buying or leasing assets “site unseen,” there may be innovate approaches to mitigating the associated risks.  For example, because detailed metering information is frequently not available, it is often difficult to determine what percentages of a system’s water losses are respectively caused by leakage (technical losses) and unmetered or illegal connections (commercial losses).

In situations where bulk water supplies are government owned and sold to the water utility at a subsidized, non-commercial price, a private investor may not be able to capture the full economic gain of system renovations that reduce leakage and other technical losses.  Therefore, a potential investor that mistakenly believes that most of the system’s losses are commercial losses may be at risk of overestimating the potential for increasing revenues through improved metering.

There may be creative ways to reduce this type of risk.  For example, the owner of the bulk water supply may be willing to agree to share a portion of the economic benefits derived from any reductions in technical losses achieved by the investor in the distribution system. (Such agreements would be loosely analogous to electric utilities profiting from “demand side” management programs.) The appropriate time for discussing this and other types of innovative arrangements is during the formal or informal communications that occur with government authorities prior to formal initiation of the privatization program.

The value of wastewater collection networks not only depends on the physical condition of the infrastructure, but also on the quantity and quality of wastewater generated within the service territory.  To evaluate these flows, a wide variety of demographic and hydrologic factors must be considered.  Also of central importance is the scope and effectiveness of the local government’s industrial “pre-treatment” program, requiring local industries to remove hazardous substances from their wastewater prior to its discharge into the wastewater collection system.  If these programs do not remain effective following privatization, there could be a significant risk of disruptions to the wastewater treatment plant, in addition to damage to the wastewater collection pipes and other assets.  Therefore, unlike the power sector, where the government may have little or no responsibility for ensuring the quality of fuel or other inputs to a power plant, in the water sector, the government must continue to be an active partner with the service provider

By Neil Golden and James Scarrow, in Washington