South Africa is a water scarce country and subject to both droughts and periodic floods. Over the last few months there have been a number of news reports advising that various municipalities in South Africa have been without water. Increasing investments into water resource infrastructure is becoming increasingly important for the country.
Coincidentally, on Tuesday, 19 March 2013, to mark the beginning of National Water Week in South Africa, the Water and Environmental Affairs Minister Edna Molewa officially unveiled the Komati Water Augmentation Scheme, a water resource project estimated to cost approximately R1.7 billion to complete.
One of the main difficulties that most infrastructure projects of this nature must overcome is securing financing, particularly from the private sector. This is a challenge for numerous reasons. In this article we will briefly consider one of the major constraints, namely the creditworthiness of the municipalities, which are integral in the provision of water services.
In South Africa, the National Water Act, No 36 of 1998 (Act) provides for all matters relating to water. The Act empowers the government, through the Minister of Water Affairs, to be the custodian of water and the only entity with the right to allocate and distribute water directly to the South African public (end consumer), through local municipalities. Importantly the Constitution recognises local government (municipalities) as an independent sphere of government with its own unique set of rules and level of importance.
Municipalities must raise their own funding
This means that municipalities have to raise their own funding (apart from the national budgetary allocation) and such funding will not be guaranteed by the national fiscus. Instead, when municipalities raise funding for infrastructure investments, they have to raise finance on their own books (or balance sheet) and bear the responsibility for repaying the debt. This presents certain constraints and complexities because municipalities have limited balance sheets and lack liquidity due to the current framework of local revenues, which is discouraging to private financiers.
Further, special purpose vehicles such as the Trans-Caledon Tunnel Authority (TCTA) established in terms of the Act, through which the government seeks funding for infrastructural investment of a project, also depend on the creditworthiness of municipalities when raising funding for the supply of water to urban areas.
TCTA undertakes many projects with the cash flows from each project ring-fenced and only to be used to repay the lenders to that specific project. Accordingly, TCTA’s ability to repay a loan for a specific project of an urban nature is directly dependent on the creditworthiness of the municipality benefitting from the project.
Creditworthiness a crucial issue
Thus, when lenders decide to lend money to TCTA for an urban water project or a municipality for upgrading its own water infrastructure, they will examine the creditworthiness of the municipality.
Creditworthiness is important because when financing projects, lenders are most comfortable when lending money against known or identifiable commercial risks. This is because lenders are able to establish certain formulas for assessing the risk associated with loans to a project. A municipality is ‘creditworthy’ when its borrowing meets the risk standards of a lender. The following are some of the factors which may be considered when assessing creditworthiness and rating a municipality, including:
- Local revenue sharing – municipalities are entitled to receive a portion of some nationally collected revenue source, the amount of which is uncertain. This uncertainty about revenue levels translates into credit risk.
- Development fund institutions’ default rates – the extent to which municipalities default when lent money by development fund institutions.
- Legal issues surrounding municipal default – the extent to which there is a well-defined legal or political process that clarifies what happened in the event of default.
- Economic conditions – economic risk depends upon a municipality’s revenue and expenditure.
- Cross subsidisation – the extent to which revenue recovered from certain ratepayers for services will be used to subsidise non-recovery from other rate payers.
- Generally, lenders have considered the creditworthiness of most municipalities other than the metropolitan municipalities to be lacking because:
- Municipalities may at times experience difficulty in effectively collecting revenue from the public to make timeous repayments of loans. This may be because municipalities have to provide water and sanitation services (as well as other services) to all South Africans, the majority of whom are poor and unable to pay for the municipal services provided to them. This may affect the ability of the municipality to collect revenue from the public.
- Some municipalities have experienced financial distress.
- Private lenders have found it difficult to use municipal budgets and municipal financial reports to gauge underlying financial condition so as to assess the credit risks involved in lending to the municipality.
- The municipalities’ liquidity (most municipalities are not always liquid).
By Biddy Faber, Director, and Bridgett Majola, Senior Associate at the Finance and Banking practice of Cliffe Dekker Hofmeyr, a Cape Town-based law firm.