The importance of clean water to human health and industry is so obvious that we take it for granted. Why, then, is there such a large gap between our demands for clean water and the current reality?

A major contributing factor is the lack of appropriate financing. Demand for water infrastructure in Mexico exceeds the nation's capacity for traditional financing by a large margin. While we will focus on Mexico here, identical arguments are just as valid in most other rapidly developing countries and the most developed nations, who also face significant financing hurdles. Accumulated debt burdens, continuing recessions, stricter environmental regulations, all are common problems across the Americas.

In Mexico, the central government has, historically, played a major role in developing infrastructure. There is nothing in Mexico comparable to the U.S. municipal bond market for financing local projects. The current emphasis on involving the private sector in this infrastructure is quite new. Toll roads, energy projects, water infrastructure, all are now being opened up to closer partnerships between the public and private sectors. Let's examine three topics in more detail:

* The Mexican national program for drinkable water and for sewage.

* The role envisaged for the private sector in meeting the goals of this program.

* Mexico City's approach to upgrading its water supply and wastewater treatment facilities.

By the national program, I mean Mexico's Programa Nacional de Agua Potable y Saneamiento. Launched in 1990, this program sets the following goals:

* To increase, by three million people per year, the coverage of drinking water in Mexico.

* To increase at a similar pace the sewage system coverage.

* To increase coverage in drinking water supply to reach at least 70% of cities of more than 50,000 inhabitants. There are 135 such cities, most of which will need increases in their water supply.

* To treat all domestic wastewater in urban centers by the end of the century.

* To attain various other management, organizational, and institutional strengthening goals.

The Mexican government has encouraged the private sector to become involved in financing, building, and operating water infrastructure. In the first years of the national program, the private sector was involved mainly in the design and construction of facilities. However, this has changed in the last two years.

The National Water Bill passed in December 1992 states specifically that the promotion of the participation by the private sector in water projects is in the public interest. Various mechanisms were defined to encourage this participation.

The Build-Operate-Transfer approach stands out as being particularly important in the construction of sewage water treatment plants. We will have more to say about this approach when we look at the whole range of innovative financing approaches. For the moment, we will just note that Build-Operate-Transfer requires close cooperation between the public and private sectors. Already, about $400 million worth of such projects have been agreed upon in Mexico. Project financing is an integral part of all such systems and the Mexican government has made it plain that it approves of this approach.

The Mexican law encourages a variety of other private sector approaches, including contracting out and granting concessions for "in bulk" water supply. Experience in these two approaches is limited to date, but they are being watched with interest.

Let's look at a recent example, the use of the concession approach by Mexico City.

Mexico City's water problems are well known: high physical leakage, low revenues, rapid growth, a network that was unmapped, and so on.

Little was known about the condition of the asset base, but the city government was aware that significant water loss was taking place. In addition, water sources available to the city were limited and rapid population growth has begun to seriously strain the area aquifers, creating dangerous sinkholes. The high costs of developing new water sources has made it imperative to reduce water loss from the system. At the same time, the record of rate payments was low -- it was estimated that only about 18% to 20% of users actually pay their bills. In some cases, bill were not even sent out and metering was nonexistent. Users had little financial incentive to conserve water.

Solutions were expensive, and beyond the capability of the city to afford. So the city entered into an arrangement, actually four arrangements, with the private sector.

It is a public-private partnership that has three phases, beginning with the private sector being simply contractors. Each subsequent phase increases the level of private sector participation, with the potential for the private sector to become financing and operating partners.

The first phase of the arrangement has begun, with the private sector companies contracting to provide drinking water in Mexico City.

General contracts were awarded by la Comision de Agua del Distrito Federale, the city agency in charge of water, for a 10-year period which may be extended. Awards were based on a competitive bidding process. Several firms pre-qualified and six submitted bids to operate the city water supply system. The intention was to award at least two contracts to ensure competition: four contracts were actually awarded.

Each winning firm has a general contract with the CADF under which it has the right to negotiate specific contracts to conduct the work planned for Phases 1, 2, and 3. The specific contracts are not put out to competitive bidding but are negotiated individually with each of the four contractors. The city will retain ownership of all facilities.

Under Phase 1, which is expected to last about two years, contractors will map out the system, determine the conditions of the facilities, measure the quantity of unaccounted-for water, identify repairs required to prevent water losses, and install meters for all users. In Phase 2, contractors will develop a billing system and bill customers, but the contractors are paid on a fee basis throughout the first two phases. Investments in the first two phases are underwritten by Banobras, the Mexican public works bank; Banobras has opened a line of credit to the Distrito Federale in case the city faces liquidity problems and is unable to pay the contractors.

Phase 2 is a trial period to gauge the response of user groups. If there is significant political resistance to receiving metered bills, then the CADF may delay or cancel Phase 3.

Under Phase 3 it is expected that the contractors will purchase bulk water from the city and distribute it to users. Payment will consist of a portion of rates collected. It has not yet been determined whether contractors will collect rates directly and send a portion of revenues to the CADF, or whether the funds will be deposited directly with CADF, who in turn, will reimburse the contractors.

Both phasing and the creation of internal competition offer many advantages to the Mexico City model.

Phasing allows the private concessionaires to scale up operations and react in a calculated way as they learn more about the physical and financial operating conditions in Mexico City. Phasing also allows the public to ease into more disciplined, market-like conditions, which are necessary to sustain private interest in the project.

Competition encourages future services at least cost. Of course, the existence of competitive conditions only provides the environment for least-cost solutions -- execution will prove critical to realizing these solutions.

So what we see here is that Mexico City is a real center of innovation in searching for ways to meet the ambitious goals of the national water program. Many other Mexican cities (Puebla, Colima, Aguascalientes, and Ciudad Juarez, for example) offer alternative build-operate-own and build-operate-transfer structures. According to one recent estimate, Mexico offers opportunities for private water and wastewater concessions that could amount to $5.4 billion between 1994 and 2010.

Innovative Financing in Mexico

Now let's look more closely at the full range of innovative financing approaches that are getting considered throughout Mexico.

Mexico's "needs" for investment in public works infrastructure are not well documented, but estimates range to the hundreds of billions of dollars. Water and wastewater needs on the U.S.-Mexico border alone are estimated to total $6.5 billion through the year 2003. We don't need precise estimates, however, to conclude with some confidence that no single source of finance will suffice to meet expenditures of this size.

The search for new financing approaches also is being driven by a number of difficulties with existing Mexican capital markets. A recent report prepared by the U.S. Department of Commerce and the Mexican Secretariat of Social Development identified a number of important barriers to the financing of this infrastructure. A major difficulty identified was the shortage of long-term investment capital in Mexico. It is hard to build water supply and wastewater treatment plants on short-term loans. It is highly likely that foreign capital will be required to achieve the goals of the national program, either through public-private partnerships or international lending.

I'm going to focus on seven approaches being considered in Mexico, both traditional and emerging, in response to the challenge. Not all of them offer immediate hope, but my company, Apogee Research International Ltd., will make a recommendation that we think could "jumpstart" the search for useful innovative financing approaches.

First, traditional approaches:

* Multilateral and bilateral project financing.

* Sovereign debt.

And emerging approaches:

* Sub-sovereign credit.

* Public-private partnerships.

* World Bank credit guarantees for private concessions.

* Credit pooling to strengthen the creditworthiness of projects.

* Strengthening the creditworthiness of the projects through multilateral instituions.

The first two are the traditional approaches and have been used extensively. They will probably continue to be important also. Both the World Bank and the Inter-American Development Bank have targeted infrastructure as key areas for investment. The North American Development Bank is the new kid on the block, but has been floating some interesting ideas, some of which we will be covering here. Let's spend more time looking at the emerging approaches because they surely will change the financing landscape.

Sub-Sovereign Capital Markets

European countries are beginning to experiment with what is called "sub- sovereign" debt -- bonds issued by regional or municipal governments. Some countries have a history of this financing approach, the United States and Candad in particular. Where the new issues have been brought to market -- in Germany, Sweden, France, and Spain, for example -- issues have been backed by direct and indirect guarantees or tax revenues of the parent sovereign.

Within the last six months or so, we have seen a few new sub-sovereign entities look to finance strong infrastructure projects with stand-alone credits. According to the experts, these debt issues will continue to be limited recourse obligations backed strictly by fees and charges generated by project operations.

These instruments, although new, might be useful to finance some types of water and wastewater projects in Mexico. Water and wastewater services can be franchised and are seen as essential to economic and social well-being -- two good indicators of the potential for development of credit markets.

What prerequisites may be needed to develop sub-sovereign markets for limited recourse revenue bonds, especially for water infrastructure projects?

There are many, but two stand out from our experience.

The first requirement is that there must be reasonable assurance that the fees for the water services will be paid. Typically, this means that the service must be metered to individual users; bills must be accurate, timely, and enforceable; and individuals must be convinced that services are worth their cost.

Long-term investors must be convinced that over time and in response to unforeseen events, a reliable system exists to secure adjustments in rates and charges to assure the required revenues. To put it more bluntly: there has to be demonstrable evidence that the users of the system are willing to pay the required rates. This can turn out to be one of the major stumbling blocks.

The second prerequisite is that investors and issuers alike must be able to gain a clear understanding of credit quality.

Under traditional lending practices of the multilateral institutions, investors look to the major lender to actively manage risks -- to step in and restructure loans when necessary. Broader capital markets, like the U.S. municipal bond market, rely on credit quality to tell them that they will get their payments regardless of unexpected events. They have no interest in managing the facility nor its loans. New forms of documentation and rating of credit strength may be needed. New forms of credit support also might help, a topic we will return to later.

Essential information for these issuances consists of reliable projections and dedication of project revenues, and third-party credit evaluation (by Moody's, Fitch, Standard & Poor's, for example) of risks.

Some problems remain, however, especially in cross-border markets. Two of the most important are exchange rate risks and currency convertibility risks.

Debt issues face both exchange rate and currency convertibility risks when investors lend and expect to be repaid in a currency that is different from the one in which revenues are generated. Markets probably cannot be sustained if such risks are borne by investors. If the country has a history of currency volatility and government imposition of controls on exchange, the required interest rates may be too high to finance projects practically.

If this risk is borne by issuers, exchange rate hedges may offer one solution. Currency convertibility risks can be managed perhaps by unbundling credits into domestic and cross-border components. Still, issuers can expect to pay higher rates for international investment if exchange rates and convertibility are in question.

How useful would the sub-sovereign credit approach be to help Mexico meet the needs of its national water program? Long term, the approach might be useful. In the short term, unfortunately, it is unlikely to be of much use, except perhaps when combined with privatization and limited recourse debt obligations.

In other nations, privatization appears to be drawing dozens of sub-sovereign issuers inot the credit markets on their own behalf. Yet in Mexico, conditions for sub-sovereign credits are significantly less favorable. At present, I understand that it is not possible for a Mexican city to issue bonds for a water project on the international market. Political stability remains a significant source of risk to many potential buyers of Mexican sub-sovereign debt.

Another difficulty is that, typically, sub-sovereign governments such as a municipality or region get a credit rating that is no higher than that of the country. Mexico's current rating for dollar-denominated instruments is less than investment grade. It is possible that, in the future, municipal or project bonds might get two ratings: one being the country rtng wth the second reflecting the rating of the project itself, independent of the country rating. But again it will take time for that kind of approach to develop and be tested.

World Bank Guarantee

One strategy that might help the development of public-private partnerships is a little-known and infrequently used guarantee mechanism available under the original charter of the World Bank. Apparently, while the World Bank has had this authority since the Bretton Woods convention in the mid-1940s, it has been offered only five or six times and only in Asia and Eastern Europe.

These guarantees are applicable only where a private concession company builds, finances, owns, and operates a facility and sells services to a national enterprise. The national enterprise remains in day-to-day contact with its customers and is responsible for all aspects of service delivery. A concession contract codifies the terms and conditions under which services will be supplied to the national enterprise and how the private concessionaire will be compensated. The government continues to regulate prices that municipal and industrial customers pay. Clearly, this model is applicable to water and wastewater financing in Mexico.

The World Bank offers contractual compliance guarantees to private lenders who finance such concession partnerships. While the bank's guarantee would not shelter the lender from traditional commercial project risks (cost and time overruns during construction, adverse movements in interest and exchange rates, or inefficient operations, for example), it would repay lenders in the event that the government partner failed to meet its contractual obligations spelled out in the concession contract, which could be as far ranging as could be negotiated between the private concessionaire, the sovereign government, and the government-sponsored enterprise.

Under the terms of the bank's mandatory counter-guarantee agreement with the sovereign government, the bank has the right to demand immediate repayment from the government for any bank payments made to satisfy its contractual compliance guarantee. This type of guarantee mechanism has several advantages:

* Risk unbundling. Private investors can handle commercial risks, which they understand and can deal with, while the bank assumes many of the political risks of doing business with the government, which the private sector risks as well.

* Market introduction. With the help of the bank's guarantee, the private concession process will ease access to international capital markets. If the initial projects go smoothly, the entire process will earn a reputation for creditworthiness that should translate into progressively less guarantee support over time. Eventually, bank-guaranteed concession financing would be unnecessary and commercially attractive enterprises will earn access to capital markets on their own.

* Enterprise benefits. By buying instead of building, the government-sponsored enterprise can avoid construction and completion risks. In addition, the enterprise has no cash-flow requirements until the project is operating and generating revenues.

* Complementarity of capital. The bank guarantee will act as a catalyst to help commercially viable projects attract non-guaranteed sources of capital that might not otherwise be available, such as export credit agencies or other bilateral or multilateral lenders. The demand for government guaranteed loans would decline.

* Low costs to the sovereign government. Under most circumstances, the bank guarantee will impose low or no costs on sovereign governments since guarantee fees would be paid by the private project sponsor. The sovereign is completely insulated from commercial risks. The costs of the sovereign's counter-guarantee would be expected to be limited to debt service payments for a short time while it gets back into compliance with the concession contract (the sovereign would be unlikely to remain out of compliance with contractual obligations for the entire life of the loan). Where other non-guaranteed lending is pooled, the sovereign's exposure even under non-compliance might amount to only a small fraction of total costs.

* Risk mitigation would be a mutual obligation -- all participants to the guaranteed financing would have some obligation to perform, which imposes discipline on all partners mutually.

To maximize private interest in bidding for bank-guaranteed concessions, certain conditions should be adhered to. These conditions are quite similar to the conditions necessary for other forms of P3's, and we will return to them.

Establishing all the relevant legal authorities well in advance of a concession helps convince potential private bidders that the competition and award will take place within an orderly, businesslike environment. Many government units find it helpful to retain specialized financial and legal advisers. A financial adviser, for example, can prepare estimates of proposed private rates of return, which can help government negotiators strike a deal that is fair to all parties.

Pre-qualification can limit the exposure of a great number of potential bidders if only three to five are selected to prepare a full-blown proposal. Clear articulation of the dimensions and timing of the proposed project as well as the government's proposed financial and risk participation, if any, provides private bidders with assurances that the public partner is serious about going forward and that a concession will indeed be awarded.

Bolstering Creditworthiness

The last two ideas are slightly different ways to improve the credit-worthiness of water infrastructure projects: credit pooling of projects and the involvement of a multilateral or bilateral institution in the credit issuance supporting the project.

Credit pooling has been considered for financing the required water projects along the Mexican-U.S. border. The underlying idea here is that local government units with limited access to capital, or that lack the required size, financial expertise, or credit history, pool their resources to make themselves more attractive to investors. The goal is to achieve economies of scale, easier access to capital, and, ultimately, lower borrowing costs. Two of the many ideas that have been considered for Mexican projects are bond banks and revolving loan funds.

A major advantage of this pooling is that the risk of default is spread among the jurisdictions. Another way to improve the attractiveness of the pooled bonds to investors is if the bond banks enjoy some form of credit support, either through an obligation of a senior level of government or a debt reserve fund.

A difficulty with this option is that it tends to be most useful to less-established communities that can't get investment-grade ratings on their own bonds. This option on its own might not be all that useful for Mexico, at least not without some form of credit enhancement. We will return to the point of credit enhancement.

Revolving loan funds consist of an initial injection of capital -- debt, equity, or both -- that is lent on projects, with the proceeds being recycled to finance successive generations of similar projects. These funds have existed in the United States for many years now. Investors who purchase the bonds of this type of fund emphasize the ability of the fund management to ensure that the inflows and outflows are matched, with sufficient reserves to cater to defaults or delays. As in the case of credit pooling, it may be difficult to implement this kind of arrangement in Mexico until there are longer credit histories of the groups that would get involved.

Again as in the pooling situation, some type of international credit support to the revolving fund could make a difference.


By now, I hope we have convinced you that two problems are plain: weaknesses in Mexican capital markets, in particular a shortage of longterm investment capital, and the unwillingness of international investors to back stand-alone environmental projects until there has been a history of successes.

This is where the multilateral lending institutions, in particular, the World Bank and the Inter-American Development Bank, could go beyond their traditional project lending roles. They could instead create a powerful new mechanism to speed the implementation of much needed water and sewer projects throughout Mexico by channeling resources into a new financing bank dedicated to water and sewer projects. Let's call it the Mexican Water Project Financing Facility, or the MWPFF for short. Now it has an acronym, so it exists.

The MWPFF would be capable of leveraging its initial capitalization if held as a debt reserve against its own bonds, which could be reissued domestically or internationally. The fund could make direct loans to sub-sovereign governments across Mexico, purchase sub-sovereign debt obligations, pool and securitize local debt. The proposed fund could even purchase commercial bond insurance on behalf of Mexican municipal or state governments who might issue their own debt obligations into the domestic or international capital markets. These are all things the World Bank and its International Finance Corp. have done before.

If successful, such a financing facility would greatly increase the funding velocity of water and sewer projects in Mexico, increase the attractiveness of Mexican projects to international investors, help pave the way for strengthened sub-sovereign capital markets, and lead to innovation in stand-alone, revenue-based project financing in the future.

Over time, as international investors realized their returns and confidence increased, the fund could become a major financier of water projects. The fund could pool credits for individual water projects, securitize project financing, and re-issue debt into Mexican and international financial markets. As repayments on the MWPFF's loan portfolio began to revolve, additional project loans or other forms of financial assistance would be self-sustaining, even as the World Bank's original capitalization was repaid. The World Bank's original investment would be leveraged many times over.

What Lies Ahead

What does this experimentation with innovative finance mean? Where is it going? And where should it go?

Most observers agree that innovative financing of water infrastructure is going to continue throughout the world. Traditional sources of financing are just not up to the task. BOT schemes in particular, and variations on them, will grow in number and expand in complexity. Firms that hope to participate in meeting the burgeoning need for water and wastewater treatment facilities in Mexico and the Americas will participate more meaningfully in project finance.

Yet not all financing problems can be solved strictly through privatization arrangements. In the short run, a key role will remain for new types of financing facilities that access the capital of the multilateral lending institutions and the international capital markets. The World Bank in particular seems poised to help capitalize a flexible revolving Mexican loan facility dedicated to water and wastewater finance -- one that can offer project finance, pool and securitize local debt, and purchase credit enhancement on behalf of local borrowers.

Development of such an institution -- and evolution of the market discipline it will help foster -- will take time. In the longer run, fully self-sustaining sub-sovereign capital markets are not out of the question. Key issues deserve attention, however, before risks are appropriately managed, borrowers demonstrate both ability and willingness to repay debt, long-term financing becomes available, and revenue stability is assured.

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