Water Supply And Cash Flows

What has prompted state governments to resort to project financing of water supply projects is their tight budgetary constraints. Each of these projects would cost about Rs 200 crore, depending on the nature of the terrain and the distance of water delivery. Depending on budgetary resources would mean projects getting delayed, and accordingly revenue realisations also getting delayed something which is now becoming unacceptable for the states as they find themselves already hamstrung with revenue and fiscal deficits.

Alternative sources of raising funds would be through long term financial institutions (FIs) like Housing and Urban Development Corporation and LIC. Yet such sources of funds have become quite expensive since the FIs own sources are high cost. Consequently, the most sought after alternative is project financing mechanics. Keeping the costs down using such mechanics has become possible in view of the five year tax holiday now available for such projects.

 

But project financing of water projects is not new. Andhra Pradesh, Karnataka, Maharashtra and Gujarat have been experimenting with water projects for some time now Hyderabad Metropolitan Water Supply Project and Vishakhapatnam Urban Water Supply Project (Andhra Pradesh), Krishna Jala Bhagya Nigam Limited (Karnataka), Maharashtra Krishna Valley Development Corporation (MKVDC) and Sardar Sarovar Project (Gujarat).

These projects are expected to begin generating returns only by the turn of the century. Also, these projects are totally state-sponsored in terms of equity; private sector participation is only dedicated to the debt financing portion.

But still, such projects face the difficulty of bankability. In fact, most of the project that were initially offered were unable to achieve financial closure using the special purpose vehicle (SPV) mechanics due to this very problem. Besides, the cash flows faced uncertainties. These uncertainties came about in view of the fact that there was no way that debt financiers could get into any form of take or pay arrangements with the end users.

Such pay or take arrangements can be worked out only if there is form of institutionalised consumption as in the case of the power sector, where independent producers output is absorbed by the electricity boards, who in turn collect the revenues. The revenues are then credited into an escrow account where the suppliers have the first charge.

In the case of water projects, specifically irrigation projects, such a structure is not workable. Even if workable, the current revenues generated in the form of irrigation taxes is barely sufficient to meet the operations and maintenance costs.

Consequently Gujarat, Maharashtra and Karnataka made their respective projects bankable through state intervention. MKVDC, Sardar Sarovar and KBJNL had eliminated these uncertainties over cash flows, with the respective states assuming the entire equity of these entities. The debt financiers were assured of payment by a tripartite arrangement which involved the SPVs receiving prompt payment of interest and principal through the states assigning some of the budgetary transfers to the financiers.

The options in these cases were to choose between a high debt equity ratio or a low debt equity ratio. Choosing a high debt equity ratio route would mean that the interest payments on the debt would have to be refinanced at periodic points of time as and when they fall due. But low debt equity ratios are possible only for projects with long gestation periods. Essentially this would mean that the interest would be refinanced with subordinated debt or in the form of equity from the state governments.

However, there is no pre-fixed formula, though in a high interest situation the preference would be more in favour of equity refinancing route so as to keep the project costs down. But even here there are certain difficulties. High debt equity ratios may be acceptable to financiers only if the operational risks are very low.

But these risks are virtually unknown in water projects. This is because irrigation revenues are tax based. Tax recoveries are made through levies by state governments in the form of state level irrigation taxes. Although these taxes are currently very low and do not work on the basis of capital and variable costs, the states have the flexibility to raise tax rates.

Yet, despite this kind of flexibility, none of the states have ventured to do so in the past. This was because revision of tax rates is an extremely sensitive issue. And till such time a revision in irrigation tariffs/taxes takes place, borrowings are being restricted, and the financing of the irrigation projects is being done on extremely conservative debt-equity ratios. KBJNL is currently working on a debt equity ratio of less than 1, and in the case of the MKVDC the ratio is 1:1. In both the cases, the refinancing of the debt is done through budgetary support, the bulk of which is in the form of equity.

MKVDC has already managed to raise a little over Rs 700 crore through private placement and is expected to make a repeat foray into the market. The committed budgetary support for the project from the Maharashtra government is Rs 3,500 crore and the market borrowings target is also Rs 3,500 crore. The final debt equity ratio in the case of MKVDC may well turn out to be closer to 2:1, given the subordinated debt component. But after capitalisation of the subordinated debt, the debt equity ratio is likely to come down.

KBJNL managed to raise Rs 2,000 crore through bond issues both through private placement and public issue methods. The budgetary support so far has been Rs 1,983 crore, of which the entire component is in the form of equity. But given the high costs of borrowings in the markets, capitalisation of interest is becoming inevitable for KBJNL so as to restrict project cost escalation on account of steep interest rates. The yield offered on the bond issues was over 19 per cent in this case.

One way out would be raising equity directly from the markets at a premium. And the Karnataka government has not ruled out this option that of targeting specific farmers cooperatives for such equity support, or community equity.

In a high interest situation this would be a more preferable option. This way the operational risks involved in the project could be completely eliminated, as in the case of the Krishna Rajasagar project. But that would also require some amendments in the state water/irrigation acts which vest ownership of irrigation projects only with the state governments or local bodies.

But irrespective of the debt component, servicing would still have to take place. Current revenue estimates are based on the tariffs recommended by the Central Water Commission. Accordingly, while the estimated inflow through such tariffs is barely Rs 81 crore in the case of KBJNL by 1999, the bullet repayment could be upwards of Rs 500 crore. The situation is identical in the case of Maharashtra as well, where the interest payments are expected to be Rs 522 crore in 2001 when the project becomes operational, and the revenues are expected to be a mere Rs 150 crore.

Therefore, tariffs would have to take into account the cost of capital. Since the weighted average cost of borrowings has been around 13.5 per cent, (after factoring in the possibility of further bond issues through the Section 10(23G) route), the effective cost of capital would also be around the same region. Hence, tariffs would have to be structured accordingly.

It is then clear that irrigation tariff/tax revision is inevitable. But the question is how soon or how late?