The Financing Gap: Re-examining the Role of Private Financing & P3s

aerial view of treatment plant

By Bastien Simeon


The pressure to invest in water infrastructure is steadily increasing due to aging assets, more stringent standards, climate change and urbanization, while the global crisis has left many governments and municipalities over-indebted. They are therefore looking to push more responsibility for financing water assets onto the utilities, making private finance an increasingly attractive option.

Traditional vs. Privately-financed Procurement

Traditionally, governments have addressed the cost of building and maintaining water plants and networks by collecting user fees, raising taxes, and issuing bonds against those revenue streams. The government entities assume most of the financial risks for the project such as construction delays.

However, shortages of funding, rising maintenance costs, scarcity, as well as more stringent environmental standards, have placed many governments in the position of needing to undertake substantial capital replacement, refurbishment, or expansion of their facilities without sufficient available capital.

The fundamental basis of privately financed transactions is that they provide a well-established mechanism for governments to alleviate the need for direct capital expenditure on new facilities while also potentially improving service provision.

The long-term nature of a Public-Private Partnership (PPP or P3) provides a source of dependable cash flow for project sponsors (contractors, operators, and other long-term private sector investors that invest in public infrastructure). Although these transactions bring together groups with traditionally different objectives — public needs vs. private interests — they are bound by a common commitment to deliver long-term benefits to society.

A Global Perspective of the Widening Gap Between Capital Demand & Supply

Yearly capital expenditure needs globally are currently estimated at c. $125 billion in water and c. $150 billion in wastewater, with private finance providing only c. 1 percent, according to Global Water Intelligence (GWI). Investments in water compete with other infrastructure sectors, as financiers are primarily driven by the attractiveness of the risk-return profile. Mobilizing more commercial financing in water therefore needs to be underpinned by policy reforms, cost reduction and improved affordability.

Development institutions have a critical role to play in addressing the ever-growing water infrastructure financing gap but nevertheless should not be thought as playing a substantial role in actually filling it through direct finance. In developing economies, Multi-lateral Development Banks are actively seeking to tap into private capital through mechanisms such as blended finance. This model seeks to reduce risks and guaranteeing investments via instruments such as guarantees or flexible (concessional) debt or equity in order to attract private sector funding.

Despite these ongoing efforts, not enough of the potential investment is finding its way to the water sector, especially in developing countries. This low investment level is predominantly due to perceived risks around political instability, currency fluctuations, the degree to which earnings can be repatriated, rule of law and the affordability of projects, linked to the ability of end users to pay economically viable tariffs.

Furthermore, project structures involving private investment tend to be complex and costly to put in place, requiring a certain scale to become economically viable, whereas many water assets tend to be small, adding to the challenge. Devising creative structures under which small assets can be pooled together, creating a portfolio effect and helping spread individual projects’ risks, would go a long way in addressing the shortage of investment opportunities.

The Role of P3s in the United States

In the United States, the average annual investment needs in water and wastewater are estimated at c. $45 billion. Nevertheless, there has been a downward trend in capital expenditure these past years, in part because utilities have a reduced capacity to spend. Private finance accounts for less than 1 percent of funding sources for new capex, while government grants and loans represent almost 40 percent. Rates would need to double from current levels to provide municipalities with enough debt capacity to support infrastructure investment needs.

Moreover, there is a shift towards cost optimization and operational improvement. Utilities are increasingly recognizing the long-term life cycle savings and risk transfer benefits of P3 structures, and a diverse pipeline of projects has been developing in the country. Meanwhile, the acquisition of municipal systems by the private sector in certain states is allowing cash-strapped municipalities to offload the costs and risks of owning the infrastructure and is contributing to the consolidation of the municipal water sector, a process which might also be driven by cuts to public funding.

Private finance accounts for less than 1 percent of funding sources for new capex, while government grants and loans represent almost 40 percent. Rates would need to double from current levels to provide municipalities with enough debt capacity to support infrastructure investment needs.

Legislation establishing a framework for P3s has been introduced in many states, such as Texas or California, and there have been successful precedents such as the $900 million San Antonio Water System’s Vista Ridge Pipeline project in Texas, which reached financial close in 2016. The Santa Clara Valley Water District in California decided to procure a $650 million expansion of its wastewater treatment and reuse infrastructure as a P3; it is currently under procurement.

No Shortage of Capital in the Market

A sustained period of low interest rates, institutional capital targeting infrastructure, the rise of local currency financing, and the growth of sustainable investment vehicles have led to a wave of new financing options becoming available to projects.

We are now seeing a flow of new capital from pension funds and insurance companies who, now that the risks are better understood, are looking aggressively at brownfield assets and greenfield projects. These institutional investors are logical holders of infrastructure debt, because it matches with their long-term liabilities.

However, as most private investors generally shy away from early-stage projects in developing countries, they tend to target a limited group of well-structured assets perceived to be safer, leading to significant pressure on returns and large amounts of capital remaining undeployed.

Source: Global Water Intelligence, “Financing Water to 2030.”

Shifting Our Private Financing Paradigm

Simply put, in order for more private finance to be channeled into water infrastructure, particularly in emerging markets, there needs to be more well-prepared projects, and more de-risked investments through the use of a range of financing mechanisms.

Especially when projects are in the pre-construction phase, an effective way to attract private capital is to increase the emphasis on mechanisms such as viability gap funding or blended finance, leveraging on multilateral and philanthropic sources of development capital. This helps balance the allocation of risk among the different stakeholders.

Looking across the current global environment for water infrastructure financing, the biggest challenge isn’t the availability of funds but rather lies in mobilizing them more effectively: building a pipeline of feasible projects and broadening the structures and incentives needed to convince private capital to invest.

The following chart shows the projected increase of private finance, to annual inflows of c. $18 billion by 2030, while highlighting it remains a very small fraction of the overall funding mix.

Conclusion

Water is vital to human survival, and it is also expensive to treat, distribute, and recycle. Capital and maintenance funding needs — coupled with particularly acute budget pressures in the wake of the COVID-19 pandemic — necessitate governments to seek creative funding and project delivery options.

Relying on private funding can serve as a proven alternative to traditional infrastructure provision for leveraging scarce public resources and relieving the pressures on government entities. Development financing institutions and impact investors generally have an increasing role to play in attracting private capital to the sector and help address the tantalizing needs estimated to be in excess of $20 trillion by 2050, according to the Organisation for Economic Co-operation and Development (OECD).

Accessing private funding is also a tool for public sector procurement that focuses on public service outcomes, which is particularly relevant to the water sector: privately funded transactions holistically seek value based on the outcome of the facility, focusing on the outcomes of quality projects delivered on time and within budget.


Bastien Simeon

Bastien Simeon is a partner at Amane Advisors, a global advisory firm dedicated to the water industry. His extensive international background in the water industry includes project finance, public-private partnerships and M&A advisory. He also advises clients on the structuring and the economic and financial feasibility of infrastructure projects. He is based in Amane’s Paris office.

Leave a Reply

Your email address will not be published.

*