NOTE: THIS PAPER WAS PUBLISHED IN 2005 WHEN THE AUTHOR WAS STILL ADMINISTRATOR OF LWUA

Credit Rating System to Enhance Credit Flow
for Water Supply Projects in the Philippines

by Administrator Lorenzo H. Jamora
Local Water Utilities Administration
Quezon City, Philippines

ABSTRACT. Traditionally, Water Districts in the Philippines have acquired concession loans from the Local Water Utilities Administration for their development. However, with the tight capital expenditure of the National Government, there is a need to rationalize the allocation of scarce and concessional funds in the water supply sector and a need to enhance the flow of credit into the sector from nontraditional fund sources.

Executive Order 279, "Instituting Reforms In The Financing Policies For The Water Supply and Sewerage Sector And Water Service Providers And Providing For The Rationalization Of LWUA's Organizational Structure And Operations In Support Thereof' which among other things, seeks to enhance credit to WDs by improving investor confidence in the water supply sector and seeks to rationalize the allocation of scarce financial resources in the sector. One of the instruments of LWUA in realizing these objectives is the establishment of a classification system where WDs are classified either as Creditworthy or Semicreditworty or Precreditworthy or Noncreditworthy. The Classification System together with Project Evaluation and Business Profile sum up to become a WD Credit Rating System to provide investors with critical information to make an informed investment decision based on the investor's risk-return preferences.


Sector Background

In the year 2003, the population of the Philippines was almost 80 million with. 16 percent residing in Metro Manila and the rest (84%) are in the provinces. Thirty-four percent (34%) of this provincial population is classified as urban which is served by house connections and sixty-six percent (66%) are considered as rural which is served by water systems ranging from Level I to Level III type of service 1. Though 87 percent of the urban population is served by a water system, many of them require improvement in water quality, reduction of unaccounted water and maintaining continuous supply. In terms of Water District (WD) coverage, 47% of the 1,500 cities and municipalities are served by WDs. However, 86% of those covered by WDs have population coverage below 50% of their populace.

The Water Crisis Act of 1994 stimulated private sector interest in water supply projects, resulting to the forging of the concession agreements of the private sector with Metropolitan Water and Sewerage System. It took sometime though, before its impact reached the cities and municipalities in the provinces. There is a cynical view of consumers and local leaders that the participation of the private sector in water supply projects has always been traditionally perceived significantly raise water tariff. On the other hand, in the absence of credit information on potential projects, the private creditors have to assess the market and the perceived credit and business risks are usually applied a higher debt premium.

One of the key objectives in The Medium-Term Philippine Development Plan (2004-2010) in the water supply sector is to provide water to 200 waterless municipalities outside of Metro Manila. Waterless municipalities are those with less than 50% water service coverage. Of the 444 operational water districts only 53 have more than 50% service coverage.
The increasing demand for increased quantity and quality of water placed a heavy financial burden on the national government. These circumstances led to the Study on Reforms In Financial Policies In The Water Supply Sector (2003) that presented reforms to rationalize the application of development funds and enhance its flow into the water supply sector of the Philippines.

Availability of Investment Funds

A. Corporate Capital Structure of Local Water Utilities Administration (LWUA). LWUA capital fund has been considered concessionary. It is a blend of the NG's equity or subsidy with local and foreign borrowings from donor countries or multilateral agencies. LWUA's sources of capital funds for its loans to WDs are: (1) Foreign and Local borrowings. The debt cap for LWUA is nearing exhaustion and the balance is about 200M US dollars in foreign denomination or an equivalent of about 11B Phil. Peso. Foreign capital comes from bilateral and multilateral loans and grants. A total of P1B has been borrowed from local banks. (2) National Government's (NG) equity investments of P2.5B. This has been fully subscribed in 1991 but there is a pending congressional bill to increase LWUA's authorized capitalization to, P10B. After exhaustion of the P2.5B, releases to LWUA from the NG were in the form of subsidies totaling to about P2.0B. The General Appropriations Act provides that these subsidies are advances to LWUA's future capitalization. As one of the NG's efforts to cut its deficit spending, LWUA does not expect further subsidy releases unless its capitalization is increased by legislation. (3) Internally Generated Cash (ICG). LWUA generates cash from its earnings in its operation and invests it back to its water supply projects. Its ability to internally generate cash has been impaired through the years mainly by the unprecedented increase in its foreign debt servicing owing to the doubling of exchange rate of the Philippine Peso to the Dollar US.

B. Present Private and Government Financing Institutions. Traditionally, LWUA is the main source of long-term credit for WDs using foreign sources (bilateral and multilateral loans or grants) blended with equity contributions. Multilateral agencies are the JBIC, ADB, IBRD, USAID, AusAid/EFIC, KfW, French Protocol and DANIDA. Donors like the JICA has extended grants to a number of WD projects requiring water quality improvement. In the absence of peso counterpart (from equity or subsidy releases from the NG) for these foreign loans/grants, securing foreign longterm credit is no longer feasible. Further, the doubling of the foreign exchange rate relative to the Philippine Peso has hurt the financial position of LWUA.

The Land Bank of the Philippines has been the source of the Peso counterpart of LWUA's foreign loan when no subsidy was released from the NG. Since the year 2003, a Memorandum of Agreement was signed with the Development Bank of the Philippines where a P2B credit facility was established for direct lending to WDs. (cf IV.A. 5.)

Attempts were made to bring in private investments in the form of debt capital for BOT/BOO investors. But delay in satisfying conditions precedent, e.g., buy-out guaranty, eroded the viability of the project. Another hindrance was the absence of an Agency to regulate the water tariff and its increases.

Hindrances of Capital Flow Into WD Projects

A. Credit Rating System/Agency. Due to the lack of critical information provided to private capital market and due to their lack of experience in water projects, many are reluctant to invest in long-term lending programs for water supply projects. The lack of a standard rating information and the absence of a rating agency oblige the investors to do their own and very often the risk is passed on to the borrower.

B. Concession Loans. Presently, there are institutional and policy issues that are constraining capital flow into the water supply sector. Using equity investments from the national government, LWUA provided concession loans to water districts. Due to NEDA Resolution No.4, LWUA's financial assistance to financially viable projects that can afford to borrow at commercial terms. LWUA confined its financial assistance to mostly the larger and more viable WDs. Under this condition, private or commercial Credit cannot compete with LWUA's concession loans. LWUA interest rate is tiered according to this table (GO TO TABLE 1).

C. Maturity Mismatch. There is a maturity mismatch of the short term lending of some GFls and PFls compared to the WDs' need for long term debt. This is happening with the counterpart peso funded portion of the recent water supply projects funded by LWUA under the ADS Small Towns, KfW and AUSaid funding. The peso borrowed to fund the peso portion of these projects is 7 years that is short of the useful life of the water supply facilities. Though borrowed at 7-year maturity, LWUA tried to cushion the impact of the short-term loan by relending it at 7-10 years depending on the capability of the WD to service its debt. Front-end loading unnecessarily raised the water rates during the first 7 years of the project making it more difficult to secure advocacy on the part of the consumers and local leaders. This is so because LWUA has required that projects funded shall have their water rates fully recover all costs.

D. Issue on Collateral. Banks require collateral pledges for the loans directly extended to WDs. Due to the heavy infrastructures required of water supply projects, it is very likely that the available collateral from' most of these WDs cannot match the Bank's requirement. Furthermore, a substantial portion of the total assets of most of the WDs is still being amortized as a long-term loan with LWUA. Table 2 (GO TO TABLE 2) is indicative of the level of collateral some WDs can raise.

Reforms In Financing Water Supply Projects

A. Establishment Of WDs' Creditworthiness

1. Rating System. The Study on Reforms In Financial Policies The Water Supply sector (2003) presented several reforms to rationalize and enhance the flow of development funds in the water supply sector of the Philippines. One of the recommendations being implemented is the establishment of a Credit Rating System for water districts and the Local Water Utilities Administration as the Rating Agency. Private capital investors considered the lack of suitable credit rating or other creditworthiness information as one of the obstacles in the willingness of the sector to participate in water financing.

The rating system assesses the WD's overall financial and operational health, ability to take on more long-term debt. The rating system or WD classification determines which financing market a WD can obtain loans for its system development and improvement. A WD can be reclassified by LWUA once every three years.

2. Criteria. Part of the provisions enunciated in EO 279 is for LWUA to prepare the criteria for classification in coordination with GFls. It is submitted to the Oversight Committee for approval. The classification criteria cover two major areas, namely, financial and operational each with a weight of 50 percent. Table 5 (GO TO TABLE 5) shows how WDs are classified as Creditworthy, Semi-creditworthy, Pre-Creditworthy and Non-Creditworthy based on the total points earned using the rating system. The parameters and their corresponding weights are shown in Table 3 (GO TO TABLE 3) together with the points to be garnered for each class.

3. Financial and Operating Parameters (GO TO TABLE 4)

4. Rationalization of Financing Policies for Water Districts. With the policy reforms in financing of water supply projects being installed, LWUA concession funds will now be confined to develop SCW and PCW WDs and eventually graduate them into CW WDs. Concession funds will be given to those that need them most. On the other hand, the CW water districts will now source their development funds from the capital market and private/government financing institutions (PFls and GFls). These sampled water districts are anecdotally more financially capable water districts and are more capable of absorbing additional investment to undertake large capital projects. In the case of Tagum and Nasugbu WDs, they went directly to the Development Bank of the Philippines (DBP) to secure a project loan.

5. LWUA-DBP Experience. In a MOA between LWUA and DBP, the latter provides a credit facility (initially P2B) directly extended to WDs that are CW with a category of at least Big WD. LWUA, on the other hand, shall review the projects to be funded under this facility. This working agreement forged between LWUA and DBP is an example of building confidence of water project financiers to invest in water projects. This arrangement couples LWUA's WD credit rating system with its expertise in evaluating water supply projects proposed for funding. LWUA charges a review fee that may be taken up in the loan of the WD. If there is a need to increase the water tariff: LWUA (as temporarily deputized by the NWRB) conducts public hearing for the proposed increase in tariff and those found to be viable are officially endorsed to DBP for funding. If the applicant WD has an existing loan with LWUA, the endorsement takes also the form of a waiver for that WD to borrow additional loan from DBP. One of the salient provisions of the MOA is for L WUA to takeover WDs in default and together with DBP may sit in the Board of the taken over WD.

WDs being considered by DBP are: (a) Nasugbu - endorsed to DBP for P65M (b) Tagum - endorsed to DBP for P382M (c) Valencia - project proposal under review (P65M) (d) Zamboanga - project proposal preparation (P150M) (e) Pagadian - project proposal preparation

B. Tapping the PFls and GFls.

6. Issues To Address. There are still some policies and institutional reforms that need to be in place to further stimulate financing of water supply projects by the private and government financing institutions and from the capital market. Some issues to be tackled are:

a. Maturity Mismatch. Presently, the PFls and some GFls are not prepared to mobilize funds for WD projects because of the severe mismatch of the short-term credit (7 years maximum) against the useful life (25-50 years) of the physical assets of the WD.

Possible capital markets to tap for investment in water supply projects are the pension funds like those of the GSIS and S.S.S. Public pension funds can extend credit beyond ten years without introducing a mismatch of the term of the credit they extended with their assets and liabilities. Pension funds are actively planning to shift their portfolio to long-term infrastructure investments. Private pension funds, on the other hand, are not restricted in their investment and there is encouragement from the" Insurance Commissioner to be involved in long-term investments.

b. Need for Government Guarantees. The hard reality is that it is very difficult to encourage the private sector to invest in the infrastructure sector when there is uncertainty in the market due to regulation, subsidies and political interference which could present real constraints to efficient operation and improved profitability. In such situations, the private sector sought government guarantees to cover a wide variety of perceived risks. However, the National Government has been growingly concerned with its increasing contingent liabilities associated with the guarantees and performance undertakings it issued. Some of them have become real and are now taking a painful hit on the resources of the National Government.

7. Non-traditional Financing. The following directions need to be explored and pursued by LWUA to further enhance the flow of funds into the water sector:

a. Bond issue by LWUA/GFI. LWUA can operate as intermediary between WD projects and the capital market. LWUA can issue bonds for a pool of projects of which the bonds shall be backed by government guarantee. LWUA's authority to take over a WD in case of default serves also as an indirect guaranty for such bonds. In addition, securitization of repayment stream of the pool of WDs can be explored to further lower the investment risk. When LWUA's request for increase in capitalization is approved, issuance of bond is made more attractive by using the future equity releases to LWUA from the national government as reserves for bond cover.

Bond issue avoids the need for NG to release equity or subsidy for WD projects. Long-term bonds are usually less expensive than private participation contracts. Possible capital market to tap for this undertaking will be the pension funds like those of the GSIS and SSS 12. Private pension funds are not restricted in their investment and there is encouragement from the Insurance Commissioner to be involved in long-term investments.

Aside from LWUA, government financial institutions can also venture into the selling of bonds for a pool of WD projects. The balance sheet of these or the guarantee programs of these agencies can be used as cover for the bonds issued.

b. Another option is to further strengthen the mobilization of donor and ILA long-term financing through GFls. The risk due to foreign exchange fluctuations can be easier absorbed by GFls having a larger portfolio of diversified investments where the risk is very much spread compared to a single or limited number of projects. These investments can then take the form of long-term peso loans to WDs or purchase WD long-term bonds issued by LWUA for a pool of projects or for debt capital for BOT/BOO projects. Thus, fluctuation in currency exchange does not have to be passed on to the WDs and eventually to the consumers. Cost of technical services rendered by LWUA during the takeover shall be charged to the WD and it becomes part of the income of LWUA as envisioned in EO 279.

The Future of the Water Districts

Although the MTPDP outlines an ambitious goal, it is not unattainable. The demand for capital in the water supply sector is large and critical. The traditional source of equity and subsidies from the national and local government continues to diminish and cannot meet the demand for capital. Non-traditional sources and even the more expensive capital markets will have to be tapped. The question to ask is, "will the investors develop increasing confidence to come up with publicprivate partnership in water supply projects?."

There is a huge challenge ahead and the National Government, LWUA and the financial institutions and the private sector need to come up with innovative ways of stimulating additional financing for the country's water supply program. LWUA's credit rating system, rationalization of lending policies and LWUA's technical expertise in project studies/review may be just an infant's small steps but they will start the greater strides towards fully developing the water supply sector in these years to come.