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Going with the Flow: Financing Water Infrastructure

by Charlie Corbett


This article was first published in Quantum magazine.

Raising money for much-needed water infrastructure projects is becoming a major challenge for the global financial sector. This article examines how project sponsors are seeking new methods of funding.

Project Finance Problems

Demand for water infrastructure projects has remained consistently strong during the last five years and is certain to remain so, but the finance available to fund it has decreased dramatically. The benign economic and regulatory environment that made it relatively easy to fund these projects has all but disappeared, particularly as one source—commercial banking—is becoming far more nervous about lending into the sector.

Industry specialists predict an enhanced role for development banks and multilaterals, as well as for export credit agencies (ECAs). More borrowing is likely in local currencies, providing access to a new investor base, and sponsors see a role for both Islamic and conventional bonds.

Commercial banks are also becoming more innovative. Margins are under severe pressure as borrowing costs continue to increase; impending stringent liquidity requirements—as a result of Basel III—make the provision of long-term debt even less attractive; and the European sovereign debt crisis adds to the nervousness of lenders. Some Western banks, concerned about instability in parts of the Middle East following the Arab Spring, are withdrawing from a part of the world where there is considerable demand for financing of water and power projects.

These factors create a tough environment in which to arrange project finance deals, not least because of the need to attract long-term money—most water-financing projects involve tenors of 20 years or more. This means that project sponsors are being forced to examine other sources of finance (see Figure 1)—and it looks as if institutions like the World Bank’s International Finance Corporation and other development banks and multilaterals will hold the key to releasing billions of dollars of private finance.

Rise of the In-Betweeners

Chris Head, founder of Chris Head & Associates, a consultancy specializing in advice on water projects and author of the World Bank’s 2006 paper on the financing of water infrastructure, argues that it is only with the support of these so-called “in-betweener” institutions that the financing gap will ever be filled. “Multilaterals and ECAs need to step in when projects are not financially viable to make them appeal to the private sector. State-operated banks and credit agencies will go where others fear to tread,” he says.

The European Investment Bank (EIB), for example, uses its AAA credit rating to raise money at reasonable rates on the international bond markets, which it then packages into project finance loans. In the last five years the EIB has lent €16 billion (US$20 billion) directly to water-related projects worldwide. It is the single largest source of finance to the global water sector to date, and the EIB—and similar institutions—will underpin future water infrastructure financing.

According to the law firm Norton Rose, the strongest source of finance for water projects in the Middle East over the last 12 months has been ECAs, and in particular those able to provide direct lending. “Japan Bank for International Cooperation and Export Import Bank of Korea have demonstrated a strong capability to fill the gap in lending since the 2008 financial crisis,” the firm says. “Some of these agencies can provide pricing at a discount to the commercial pricing that is achieved by developers on the same deals. This, together with their ability to provide long tenors, has proved attractive.”

Pros and Cons of Local Finance

State and multilateral institution support may provide one solution to the funding drought, but there are other challenges to be addressed, says Christopher Gasson, publisher of the magazine Global Water Intelligence. Foreign exchange risk remains a fundamental stumbling block, he says. “Most plants will follow the standard project finance model, where the most important element is a creditworthy off-taker. The fundamental problem with this model, however, is that all cash flows will be domestic, and therefore foreign investors will be exposed to currency risk.”

The solution, he says, is to raise money in local currency. This strategy has worked in the Middle East, where there is a deep pool of local liquidity to fund projects—particularly in Saudi Arabia, where independent power and water projects are often part-funded by regional banks.

However, local finance tends to struggle when it comes to the longer-term tenors involved in water projects. Hedging local currency can also prove tricky for sponsors when construction costs are predominately denominated in dollars and euros. However, used in conjunction with international bank loans and ECA funding, local currency funding will in future make up an increasingly important part of water-based project financing.

A growing market in Islamic bonds, or sukuk, is one way to plug the financing gap left by more nervous international banks. In fact, Islamic finance, where future payments need to be backed by a solid asset, is in many ways a perfect fit for water financing. This is because payments to investors will come in the form of tariffs and not interest. However, Islamic finance has not been immune from the effects of the global economic downturn—though its supporters insist that it is in better shape than conventional banking.

Lending from these institutions has been constrained by weak growth in the Middle East—in particular after the Dubai property crash—and also by continuing uncertainty surrounding how creditors are paid in the event of a sukuk default. Moreover, Islamic finance, though growing fast, remains a relatively small part of the global financial sector. This means that, for the foreseeable future, it will only be able to supplement rather than replace commercial lending.

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