By Kevin Bender, Consultant, Development Finance Specialist
In the efforts to increase integrity in the water and sanitation services sector throughout the developing world, the role creditworthiness can play in creating systemic change is often overlooked. Commercial lenders must hold utility borrowers to a high standard of operational, managerial and financial performance and require reliable, and often public, reporting of this standard. This reporting, whether mandated by a commercial lender or by a regulator, directly increases accountability and can lead to increased transparency. Moreover, if the required reporting is available to the public, stakeholders’ involvement in the oversight of the management of the utility should benefit as well.
Private sector lenders, whether commercial banks or institutional lenders via capital markets, are highly skilled in assessing creditworthiness — the ability and willingness of a borrower to repay debt in a timely manner. The majority of this risk assessment depends on quantitative factors found via financial statement analysis. Simply requiring utilities to produce audited financial statements is often a great step in operational management and greatly increases accountability. Deeper creditworthiness analysis incorporates qualitative factors, such as corporate governance, often including community participation in the decision-making process.
Although we have found no direct studies on the correlation of creditworthiness and integrity in the water sector in the developing world, there are reasons to believe that increasing, or even simply measuring creditworthiness will lead to increased accountability of water utilities. Regulatory mandates can and should lead to increased transparency and provide an opportunity for increased stakeholder involvement in decision-making and oversight.
To illustrate this, we can turn to the example of Kenya, where the government has pursued a steady process of increasing transparency and accountability of the water sector. The Water Services Regulatory Board (WASREB), the regulator, created a sector-wide system to collect and report operational ratios and corporate governance indicators. These indicators are published in its annual Impact report . Recently, to facilitate commercial lending to the sector and further increase integrity, WASREB included a Creditworthiness Index covering over 40 utilities in Kenya. While it is early days for the index, it is clear the index has increased utility accountability and transparency.
There are many potential benefits, as well as plenty of challenges, associated with water utilities in the developing world being able to access commercial borrowing to finance water infrastructure. The obvious benefit is that commercial financing provides additional sources of funding to often cash-strapped public budgets. In addition, long-term repayable finance, regardless of being sourced from commercial or public sources, matches the financing of an asset to the life of the asset — allowing current and future users to pay their share of the cost of the infrastructure via the tariff.
However, arguably the greatest potential benefit of commercial financing is the required improvement in institutional management skills and efficiency in the sector. Commercial financing forces utilities to incorporate private sector best practices as commercial lenders will only lend to entities with acceptable credit risk. The measurement of creditworthiness is a quantification of these best practices.
Water, being a public good, is often run via public water utilities. However, public entities can be less transparent than private ones, particularly private companies subject to commercial financing via the capital markets such as a listed equity or commercial debt. Companies listed on stock exchanges are regulatorily bound to a high level of transparency; however, not many water utilities in the developing world are listed on stock exchanges. If commercial finance is not compelling utilities to be more accountable and transparent, regulators can put in place similar reporting requirements on utilities.
CREDITWORTHINESS, CREDIT ANALYSIS, AND CREDIT RATINGS
Creditworthiness assessment, whether done internally at a bank or by an independent rating agency, provides lenders an objective evaluation of a utility’s credit risk and an accurate predictor of default risk. The assessment identifies operational, financial and governance issues that the utility must target to strengthen or uphold its creditworthiness. A regulator with this information gains an increased ability to identify individual utility and overall systemic weaknesses, particularly if the entire sector is reporting on creditworthiness.
To assess the creditworthiness of borrowers, lenders review both quantitative and qualitative factors. Quantitative factors rely on financial statement analysis and look mainly at financial ratios. Financial ratio analysis is broken down into categories: technical indicators (e.g. Non-Revenue Water, collection rates, billing rates); revenue indicators (e.g. revenue diversification, tariff differential); cost indicators (e.g. staff costs/Operational Expenditure, Operations and Maintenance coverage, EBITDA/revenue); and liquidity/insolvency indicators (e.g. cash/current liabilities, debtor days, debt service coverage ratio, grant dependency). Qualitative factors include corporate governance, management and staff capacity, legal and regulatory framework, economic issues and stakeholder support.
In most developing economies, commercial lenders have little knowledge of the water sector and utilities often have no experience with or history of commercial borrowing. Without a standard approach to rating water utilities, lenders have limited inputs and ability to assess the relative risk of water supply projects. To introduce credit assessment of water utilities for lending, technical assistance is often required for both utilities and lenders .
Regulators can develop a system of creditworthiness standards and reporting on their own or facilitate partnerships with credit rating organizations. For example, the Government of the Philippines created the Water District Credit Rating System, classifying districts on a scale of creditworthiness. Water districts assessed as creditworthy are deemed ready for private investment. Less creditworthy are targeted for technical assistance aim at addressing their weaknesses. Under this system, water utilities identify operational and financial weaknesses to improve their creditworthiness and bankability. Such sector-wide creditworthiness reporting systems allows utilities, lenders and regulator to benchmark the utilities with one another as well as with other corporate entities.
SCALE OF COMMERCIAL FINANCE AND INTEGRITY
There is reason to assume that the more developed the sector financing system is, the more sophisticated credit analysis will be, which in turn implies stronger systemic integrity.
In a system where the sector solely relies on public funding, it is often only the Ministry, or possibly a national auditor, that has the responsibility to review the operating capacity of the utility. With no responsibility to payback the financing, there is little incentive for the Ministry to assess the creditworthiness of the utilities.
The next step toward commercial financing and creditworthiness assessment is often a structure where the utility receives pass-through concessional financing from a donor, replicating the process of commercial finance. In this type of lending the utility assumes the responsibility of repaying the loan; however, the repayment risk still lies with the government. The donor may offer some level of technical assistance to perform an increased level of creditworthiness assessment, but the accountability has only increased slightly, and the transparency only increases by one player, the donor.
Commercial bank financing, often partially guaranteed in the initial stages, greatly expands the oversight and reporting assessment to include a private bank, and likely an independent auditor. While the results of this assessment is rarely made public, the information that a commercial bank is willing to assume some if not all of the credit risk of the utility provides some increase in the level of public information available. In addition, regulators should have public guidelines stating minimum levels of operational capacity required for a utility to include the cost of borrowing in the cost recovery to set the tariff.
Capital market borrowing, via local bond issues, is likely to achieve the highest level of transparency. Bond issuances often require a credit rating performed by a licensed credit rating agency. Rating agencies require that the rating, and any updates/reviews from the rating agency, are made public. One challenge to note is that not many developing economies have local bond markets sufficiently advanced to allow water utilities to issue bonds.
KENYA: INTEGRITY EVOLUTION TO A CREDITWORTHINESS INDEX
As mentioned above, regulators can play a key role in increasing integrity by guiding the sector toward creditworthiness and commercial finance. The Kenya water sector, driven by WASREB, has witnessed significant increases in accountability and transparency of the utilities as well as the Water Services Boards under the Ministry of Water and Irrigation.
The Water Act of 2002, transformed the Kenya water sector to a more private sector-like structure by separating water utilities into agents for the asset holding Water Services Boards and licensing the utilities under the Kenya Companies Act. The Act also created WASREB as an independent regulator.
In 2008, WASREB released its first annual Impact report , reporting on the operational and technical efficiencies of 25 of the largest utilities as well as the 7 public sector Water Services Boards. In the same year, through technical assistance funding, Nairobi Water and Sewerage Company and the public entity Athi Water Services Board received local currency credit ratings from Global Credit Rating Company and published the reports . In 2010, Kenya adopted a new constitution recognizing access to safe and sufficient water and sanitation as a basic human right.
In 2011, WASREB continued its efforts to deepen the integrity of the sector by publishing a one-off utility shadow rating report  assessing the credit rating of 43 utilities in Kenya, further increasing the transparency and accountability of the largest water utilities.
In 2014, WASREB developed an indicator on corporate governance based on their corporate governance guidelines and began tracking the correlation between the corporate governance score and the technical/operational score of utilities in the Impact report. WASREB believed that utilities with governance standards “are better placed to attain financial sustainability and deliver better services to their consumers.” The governance indicator is calculated on six indicators: utility supervision, information and control systems, financial management, service standards, human resources, and the community participation in the decision-making.
As full shadow credit ratings are too costly to perform annually, WASREB created the Creditworthiness Index  in 2015. The index provides a simple snap-shot of the financial and operational performance of the utilities. The Creditworthiness Index is automated and calculated from data collected by WASREB.
Currently, the creditworthiness index and the corporate governance indicator are incorporated with the operational and technical reporting in the annual Impact Report . These three components of the Impact Report provide the foundation for full credit analysis. Local lenders, utility managers, WASREB, local governments (who own the utilities), and civil society are free to use this public information to facilitate the Constitutional right of access to safe and sufficient water and sanitation for all.
About the Author:
Kevin Bender is a Development Finance Specialist, currently working as an independent consultant. He was formerly a Senior Financial Specialist at the World Bank, working on the Kenya Urban Commercial Financing for Water and Sanitation Technical Assistance program. In this capacity he worked directly with utilities, county governments, local banks, multiple Government of Kenya entities and the donor community to establish the legal, regulatory and knowledge environment for commercial lending to water utilities