Easing the Transition to commercial Finance for Sustainable Water and Sanitation

The Challenge Since the turn of this century, many countries have made significant progress toward meeting their water and sanitation access goals. At a global level, the Millennium Development Goal (MDG) target for water was achieved by 2010, but the target for sanitation was not achieved by 2015. During the MDG period a total of 2.6 billion people gained access to improved water, and 2.1 billion gained access to improved sanitation (WHO/UNICEF 2015). Despite this worldwide effort, 660 million people still lack access to clean water, and 2.4 billion lack access to sanitation. Coupled with the growing challenges of the 21st century—rapid urbanization, climate change, pollution, and higher demand for water resources—the challenge of bringing water supply and sanitation (WSS) to all remains immense. Eager to meet this challenge, the global community has responded by endorsing Sustainable Development Goal 6 (SDG 6)—the so-called “water SDG”—which calls for universal access to WSS services by 2030 that are safe, affordable, and available when needed. In addition, there are targets for increasing efficiency of water use across all sectors, protecting and restoring waterrelated ecosystems, and improving water quality. The cost of meeting the targets of SDG 6.1 and 6.2 is substantially higher than current annual WSS investment levels. Historical levels of funding for extending access to water supply, sanitation, and hygiene (WASH) services during the MDG era were estimated at $16 billion in 140 countries, whereas what’s needed to ensure universal access to safely managed services by 2030 is around $112 billion per year (World Bank/UNICEF 2017). In essence, the sector is currently only financing about 15 percent of the estimated needs. Clearly, the status quo financing model in many low- and middle-income countries relies on public funds that are insufficient, poorly targeted, and often crowd out, rather than crowd in, new sources of financing. This model will not deliver on the SDG targets. A new paradigm is therefore needed that turns this approach on its head and asks governments to work toward “crowding in” commercial finance to supplement existing sources of finance. This approach will help ensure that service providers strive toward more efficient services and that scarce public funds are used in a more targeted manner. The overall objective is for those currently without WSS services, who are predominantly poor, to have the same access that wealthier citizens already receive—and at a price that is affordable to them. The Possibility Increasing the level of commercial finance for the sector would allow service providers to borrow and invest in expanding and improving the quality of WSS services, without having to wait for scarce public resources to be made available. A gradual move to mobilizing more finance requires improving the financial performance of service providers through a mix of improved technical and commercial efficiencies and through governance and regulatory reforms. These improvements will generate the financial surplus needed to access commercial finance, thus complementing limited public funds. Although commercial finance generally comes at a higher up-front cost, it has many significant benefits over concessional finance, including faster access to finance, more flexibility in the use of the funds, and greater responsiveness to changes in circumstances. Taken together, these advantages will translate into faster results and benefits on the ground. Commercial finance is also associated with further improving the governance and accountability of service providers. Moreover, commercial finance can help countries tap into domestic financial resources that are new to the sector, such as pension funds or institutional investors. And when dominated in local currency commercial finance does not carry foreign exchange risk. Borrowers can blend concessional with commercial loans to reap some of these benefits while maintaining affordability, as evidenced by the many countries that have already started the transition: • Indonesia’s ambitious WSS targets are backed by a financial strategy that leverages commercial finance. • The Arab Republic of Egypt is using public funds as an incentive for improving the performance of sanitation service providers. • Kenya is pioneering the use of shadow credit ratings to attract a new cadre of financiers. • In Colombia, donor-funded credit enhancements have already paved the way to a commercially viable sector. • Countries from Bangladesh to Malawi are expanding the use of microfinance in WSS. The Proposal This report calls for countries to place a greater priority on leveraging commercial finance into the sector while at the same time bolstering public funds for the sector. The question is not whether to finance with public or private money. More of both will be needed—and sooner rather than later. This will require a transition to a more balanced mix of public and commercial financing, which must be driven by changing mindsets across all sector stakeholders: central governments, local governments, customers, donors and financiers. The proposed framework (figure ES.1) advocates a transition that uses public funds to leverage commercial finance. This transition is not just about money. It requires attention to better targeting of scarce public funds, improving the efficiency and governance of service providers, using capital more efficiently, and developing new financing relationships in the sector— between service providers (as borrowers) and banks (as lenders). The net effect is to build a sector that uses every dollar of scarce public funds to deliver maximum benefit to society. Countries can prioritize efficiency and leverage their resources through working on the framework’s three components (figure ES.1): • Plan, budget, and allocate public resources more efficiently • Improve service providers’ performance and governance • Leverage public funds to attract commercial finance The three components of the framework can progress in parallel. However, in nearly all cases it will be critical to first work on the main foundational components so as to improve sector efficiency and targeting of existing resources and thus enable the leveraging of commercial finance. Reforms made within each component will be iterative and incremental to allow for policies and capacity to align. There are also significant feedback loops among the components as represented by the overlapping circles. For example, investor scrutiny resulting from actions in component 3 can improve transparency and efficiency in component 2. Component 1: Plan, Budget, and Allocate Public Resources More Efficiently Governments need to establish the policy, planning, and governance frameworks that will improve sector efficiency and creditworthiness to attract the commercial finance required to meet WSS goals. In most countries, major sector reforms will be needed. Sector policies need to be realistic, fully funded, and integrated with investment plans that, at the local level, include well-defined and well-targeted subsidies. Incentives need to be created to improve performance. Policies need to encourage mobilization and efficient use of additional funding (particularly domestic financing) from tariffs, charges, and government taxes. Given the range of possible government financing sources in the sector, this will require close coordination and policy enforcement across a range of line ministries— including finance and water and sanitation—as well as local governments. Component 2: Improve Service Providers’ Performance and Governance Efficiency gains are a source of untapped finance, and inefficiencies represent an opportunity cost to the government or service provider. Improving both operational and capital efficiency allows service providers to deliver better services more cheaply, thereby freeing up resources to invest in improving or extending services. Moreover, improved efficiency and service quality can help justify increased tariffs and transfers from government sources because stakeholders are more willing to pay or allocate funding when services improve. Governments should expect more from service providers and incentivize improved efficiency, in terms of both operational performance and the use of capital. Under the right corporate governance and incentive structures, service providers will recover more costs, use less capital, and become more self-sufficient—building the foundations that will enable them to attract commercial finance on their own. Component 3: Leverage Public Funds to Attract Commercial Finance Public funding should be used to leverage commercial finance to the extent possible at any time. This will require governments, through their line ministries and local governments, to take leadership in the design and implementation of an integrated and consistent approach to sector financing built around policies that encourage efficiency and mobilization of new sources of capital. Such leadership is based on an acceptance that change is needed, and that financing costs may increase, but that the benefits flowing from faster access to improved WSS services will outweigh the cost of failing to act now to mobilize these new sources of financing. Building the foundations for commercial finance in the sector will take time. Creating new markets between lenders and borrowers will also require ongoing support from the public sector. Commercial borrowing terms will normally be less attractive at face value than those of concessional finance, but using domestic commercial finance has the potential to save money in the long run, especially in countries with high currency risk. Affordability is often given as a reason for not accessing commercial finance. However, such concerns can be addressed, in a practical and transitional way, by blending concessional or public funds with commercial finance—for example, with grants and tenor extensions. These approaches will mitigate the potentially higher borrowing costs of private finance relative to concessional funds, which currently dominate the sector. It is important to recognize the “supply side” of this new paradigm. Even if service providers are efficient and well governed, that doesn’t mean lenders will immediately respond to new lending opportunities when they are presented. Certain financing tools can be catalyzed to de-risk the sector and make it more attractive to lenders—including, for example, guarantees, benchmarking, creditworthiness assessments, and project preparation funds. Political leadership is needed to pioneer the use of de-risking tools in nearly all countries, and especially in less-developed countries where financial markets are still evolving. The Paradigm Shift Crowding in will take the place of crowding out, or simply ignoring, commercial finance. This is a new mindset for a sector that has traditionally relied on public or concessional funds for the bulk of its investments, particularly in emerging markets. It will require new thinking and new policies that are not yet readily available. It will also require all stakeholders to buy into, and support, this new paradigm and for each to take responsibility for those parts they can influence. The goal is to deliver universal access to sustainable WSS services. It is important to note that accessing commercial or private finance does not equate to privatizing the sector. In fact, in many high-income countries, publicly owned water service providers have leveraged substantial commercial finance without relinquishing control over management of the service or selling shares. For example, the majority of people living in the United States are served by publicly owned water utilities. Many of these utilities have relied for the past 40 years on State Revolving Funds created by the Clean Water Act to tap into domestic bond investors. This is because the source of finance is separate and different from the implementation model (that is, who owns or manages the assets). As with any paradigm shift, the transition will require strong political will and government leadership. Recognizing that the current funding model will not deliver WSS goals by 2030, governments need to take a holistic and long-term policy view of the sector. Initial investments will have high rewards in the medium and long term, but will require the strategic use and targeting of limited public and donor resources to facilitate the new model. Consistent application of a national sector policy to encourage new sources of finance will be important. Regression to a politically expedient public-finance-only model will undermine progress toward the new, balanced financing model proposed here. Political leadership is therefore critical if the sector is to reach the ambitious goals of universal access. The Water Global Practice (WGP) of the World Bank supports this paradigm shift, which is in line with the Financing for Development agenda outlined at the Addis Ababa conference in July 2015. Access to finance requires technical and financial efficiency of sector institutions, as well as a strong enabling environments and governance that guide institutions via the right incentives. This paper refers to other recent publications prepared by the WGP on these broader topics.